W ILEY

CAIA® Exam Review

STUDY GUIDE 2020-2021: Level I
 CAIA® Exam Review
STUDY GUIDE 2020-2021: Level I
Kathryn Wilkens, Stuart A. McCrary, and Urbi Garay

Wil ey
Copyright © 2020 by John Wiley & Sons, Inc. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any
form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise,
except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without
either the prior written permission of the Publisher, or authorization through payment of the
appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers,
MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests
to the Publisher for permission should be addressed to the Permissions Department, John Wiley &
Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online
at http://www.wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best
efforts in preparing this book, they make no representations or warranties with respect to the
accuracy or completeness of the contents of this book and specifically disclaim any implied
warranties of merchantability or fitness for a particular purpose. No warranty may be created or
extended by sales representatives or written sales materials. The advice and strategies contained
herein may not be suitable for your situation. You should consult with a professional where
appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other
commercial damages, including but not limited to special, incidental, consequential, or other
damages.
For general information on our other products and services or for technical support, please contact
our Customer Care Department within the United States at (800) 762-2974, outside the United
States at (317) 572-3993 or fax (317) 572-4002.
Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some
material included with standard print versions of this book may not be included in e-books or in
print-on-demand. If this book refers to media such as a CD or DVD that is not included in the
version you purchased, you may download this material at http://booksupport.wiley.com. For
more information about Wiley products, visit www.wiley.com.
ISBN 978-1-119-69744-2; 978-1-119-70756-1; 978-1-119-70758-5
Printed in the United States of America.
10 9 8 7 6 5 4 3 2 1
Contents
About the Professors vii

Welcome to CAIA® Level I viii

Professional Standards and Ethics

Introduction to Professional Standards and Ethics 3

Standard I: Professionalism 5

Standard II: Integrity of Capital Markets 31

Standard III: Duties to Clients 43

Standard IV: Duties to Employers 67

Standard V: Investment Analysis, Recommendations, and Actions 83

Standard VI: Conflicts of Interest 97

Introduction to Alternative Investm ents

What Is an Alternative Investment? 111

The Environment of Alternative Investments: Funds and Participants 119

The Environment of Alternative Investments: Markets 127

Quantitative Foundations: Calculating Returns 135

Quantitative Foundations: NPV, IRR, and the Cash Flow Waterfall 141

Statistical Foundations: Basic Statistics 151

Statistical Foundations: Dependency, Normality, and Volatility Forecasting 163

Foundations of Financial Economics: Time Value of Money 173

Foundations of Financial Economics: Models 183

© 2020 Wiley
CONTENTS

Derivatives and Risk-Neutral Valuation: Forwards and Futures 191

Derivatives and Risk-Neutral Valuation: Options 201

Measures of Risk and Performance 207

Alpha, Beta, and Hypothesis Testing: Regression 219

Alpha, Beta, and Hypothesis Testing: ReturnAttribution 227

Real Assets

Natural Resources and Land 241

Commodities 253

Other Real Assets 265

Real Estate Assets and Debt 279

Real Estate Equity Investments 293

H edge Funds

Structure of the Hedge Fund Industry 307

Macro and Managed Futures Funds 321

Event-Driven Hedge Funds 339

Relative Value Hedge Funds: Relative Value Strategies and Convertible Bond Arbitrage 351

Relative Value Hedge Funds: Volatility Arbitrage, Fixed-Income Arbitrage, and Relative
Value Multistrategy Hedge Funds 357

Equity Hedge Funds 367

Funds of Hedge Funds 379

Private Equity

Private Equity Assets 389

Private Equity Funds: VC Funds, Relationships,and Life Cycles 401

Private Equity Funds: LBO Funds and Private Investments in Public Equity 411

Private Credit and Distressed Debt 419

© 2020 Wiley
CONTENTS

Structured Products

Introduction to Structuring 433

Credit Risk and Credit Derivatives 445

CDO Structuring of Credit Risk 465

Equity-Linked Structured Products 475

© 2020 Wiley 5)
ABOUT THE PROFESSORS

Kathryn Wilkens, PhD, CAIA has been involved directly and indirectly with CAIA since
its inception in 2002. As its first Director of Curriculum, she oversaw the development of
the curriculum committees, study guide updates, and the production of the first set of CAIA
textbooks. In 2011, she founded Pearl Quest, an independent consulting company primarily
focused on producing various formats of educational offerings in alternative investments.
Pearl Quest is currently working with the CAIA Foundation to produce courses, and with
Quantitative Investment Technologies (QIT) on innovative replication products.

Ms. Wilkens teaches online courses on investments, international finance, financial

modeling and personal finance, and serves on the editorial board of the Journal of
Alternative Investments.

Stuart A. McCrary is a trader and portfolio manager at BRG who specializes in traditional
and alternative investments, quantitative valuation, risk management, and financial
software. Before joining BRG, he spent 18 years consulting on a wide range of capital
markets issues including litigation consulting, valuation, modeling, and risk management.
Previously, he was president of Frontier Asset Management, a market-neutral hedge fund.
He held positions with Fenchurch Capital Management as senior options trader and CS
First Boston as vice president and market maker, where he traded OTC options and
mortgagebacked securities. Prior to that, he was a vice president with the Securities Groups
and a portfolio manager with Comerica Bank.

Mr. McCrary is the author of several books, including How to Create and Manage a
Hedge Fund: A Professional’s Guide (John Wiley & Sons, 2002).

Urbi Garay has a PhD in finance from the University of Massachusetts, Amherst, and
holds an MA in International and development economics from Yale University and a BA
in economics from Universidad Catolica Andres Bello. He is a full professor of finance at
IESA Business School and a chaired member of the Venezuelan Academy of Economic
Sciences. He has been a visiting professor at several business schools in the United States,
Latin America, and Europe; and has been involved with CAIA since 2008. His research
focus is on alternative investments (mainly real estate, hedge funds, and art) and emerging
markets.

Mr. Garay is the author of the real estate and structured products chapters of CAIA’s
Alternative Investments Level II book, as well as the Workbook, Level II. He has published
seven books and more than 30 articles in peer reviewed finance and business journals,
including the Journal o f Alternative Investments, Emerging Markets Review, Corporate
Governance: An International Review, and the Journal o f Business Research.

© 2020 Wiley 5)
WELCOME TO CAIA® LEVEL I

Congratulations on choosing Wiley as your study partner. This study guide is closely
organized around the CAIA Level I Study Guide: It includes all learning objectives and
definitions for the key terms contained in the CAIA Level I Study Guide. While the CAIA
Level I Workbook includes a list of glossary terms, they are listed alphabetically for each
chapter. In contrast, we present the key terms and equations in the order that they appear in
the textbook published by Wiley, Alternative Investments: CAIA Level /, which is the
primary background reading material for the Level I exam. We believe that this approach
provides both a comprehensive and concise presentation conducive to grasping important
related concepts in an efficient manner. We take a similar approach when covering the
background reading prepared by the CFA Institute: The Standards o f Practice Handbook.

TOPIC WEIGHTINGS AND EXAM POLICIES

We follow the CAIA Level I Study Guide topic presentation, which starts with coverage of
the entire Standards o f Practice Handbook by the CFA Institute. If you are relatively new to
the area, you may want to start with the first two chapters covered in Topic 2 before tackling
Topic 1. These two chapters are titled “What is an Alternative Investment?” and “The
Environment of Alternative Investments,” and they may provide some additional
perspective prior to your studies of the CFA Standards.

CAIA Exam Topic Weightings

Approximate
Topic # Level I Topic Exam Weight Base Curriculum
1 Professional Standards and 15%-20% CFA Standards and
Ethics Practice Handbook
2 Introduction to Alternative 20%-25% CAIA Level I Text, Part 1:
Investments Chapters 1-8
3 Real Assets 10%-20% CAIA Level I Text, Part 2:
Chapters 9-13
4 Hedge Funds 10%-20% CAIA Level I Text, Part 3:
Chapters 14-19
5 Private Equity 5%-10% CAIA Level I Text, Part 4:
Chapters 20-22
6 Structured Products 10%-15% CAIA Level I Text, Part 5:
Chapters 23-26

The Level I exam is a four-hour computerized test with one break in the middle. Candidates
must use one of the two calculators approved by the CAIA Association for use while taking
the exam:

1. Texas Instruments BA II Plus (including the TI BA II Plus Professional); or

2. Hewlett Packard 12C (including the HP 12C Platinum).

© 2020 Wiley
 WELCOME TO CAIA® LEVEL I

There are 200 multiple-choice questions on the Level I exam. Less than 30% of the
questions require calculations. The CAIA Study Guide provides an equations exception list
indicating that you are not expected to memorize those equations. We point those out as we
cover the learning objectives.

The only items you may bring into the examination room are your identification card (ID),
calculator, and locker key. All personal belongings must be put in a locker.

Exam specific policies are found at www.caia.org/policy.

© 2020 Wiley
 Pr o f e s s io n a l
St a n d a r d s a n d E t h ic s

© 2020 Wiley 2
 In t r o d u c t io n t o P r o f e s s io n a l St a n d a r d s a n d E t h ic s

With permission from CFA Institute, the CAIA Association (CAIAA) has included the CFA
standards as an important component of its curriculum. CFA Institute is well recognized in
the area of traditional investments and has put a considerable amount of time and effort into
developing its Standards of Practice.

The first topic, Professional Standards and Ethics, is based on the Standards o f Practice
Handbook, 11th edition, CFA Institute, 2014. This material is weighted between 15% to
20% on the exam, so candidates should expect 30 to 40 multiple choice questions on the
standards. The six learning objectives for this topic indicate that candidates should be able
to state, interpret, and recognize procedures for compliance for each of the following six
standards.

Standard I: Professionalism

Standard H: Integrity of Capital Markets

Standard III: Duties to Clients

Standard IV: Duties to Employers

Standard V: Investment Analysis, Recommendations, and Actions

Standard VI: Conflicts of Interest

WHAT IS NOT IN THE CAIA CURRICULUM

CFA Institute’s seventh standard, Responsibilities as a CFA Institute Member or CFA
Candidate, is not in the CAIA curriculum. In addition, CFA Institute’s code of ethics (page
7 in the Standards o f Practice Handbook) is not covered in the CAIA curriculum. Here, it is
appropriate to clarify that CAIAA approves of CFA Institute’s Standards of Practice and
encourages their adoption. However, these are not CAIAA’s standards and we do not refer
to them as such. They belong to CFA Institute and are used in the CAIA curriculum with
permission from CFA Institute. CAIAA has its own code of ethics.

CAIA ASSOCIATION CODE OF ETHICS AND INTELLECTUAL PROPERTY

POLICIES
CAIAA’s Candidate and Member Agreement asks candidates to represent and warrant that
they have read and will abide by several policies, including the examination policies
(identification, calculator, and personal belongings), Code of Ethics, and Intellectual
Property (IP) Policy, among others.

CAIAA’s Intellectual Property Policy largely addresses issues that CFA Institute addresses
in its Standard VII: Responsibilities as a CFA Institute Member or CFA Candidate
(particularly Part B, Reference to CFA Institute, the CFA Designation, and the CFA
Program). For example, in CAIAA’s Intellectual Property Policy, the CAIAA specifies what
marks the CAIAA owns or has rights to. The service marks are for use by the Association,
while the Certification and Collective marks are for use by CAIA Members.

The following is an excerpt from CAIAA’s Intellectual Property (IP) Policy. It is provided
only to emphasize that CAIAA has its own Code of Ethics and set of policies for Members
and why we refer to the standards as CFA standards rather than CAIA standards. The IP
Policy is not in the curriculum, nor is it tested.

© 2020 Wiley !
PROFESSIONAL STANDARDS AND ETHICS

CAIA policies are found at www.caia.org/policy.

L CERTIFICATION MARKS
• CAIA®
• Chartered Alternative Investment Analyst

Purpose
CAIAA’s certification marks have a very specific and limited purpose: they indicate that
the Member using them has passed all of CAIAA’s required examinations and has been
granted membership by CAIAA. These certification marks are a critical means of
assuring the public that it can always expect a high level of training and expertise when
the CAIA® and Chartered Alternative Investment Analyst designations are used.

Proper Use
The certification marks are typically used after the Member’s name. For example:

• Adam Roberts, CAIA® or Adam Roberts, CAIA

• Jane Smith, Chartered Alternative Investment Analyst

II. COLLECTIVE MEMBERSHIP MARKS

• CAIA Association®
• Chartered Alternative Investment Analyst Association®

Purpose
The purpose of the collective membership marks is very similar to that of the
certification marks: to assure the public that the person using the collective membership
marks is a Member in good standing of CAIAA.

Proper Use
The collective membership marks must be preceded by the words “Full Member” or
“Retired Member” and come after the Member’s name. The ® symbol should be placed
in close proximity to the collective membership marks wherever they appear (e.g., on
business cards and website advertisements). For example:

• Jane Smith, Full Member, CAIA Association®

• Adam Roberts, Retired Member, Chartered Alternative Investment Analyst
Association®

III. SERVICE MARKS

• CAIASM
• CAIA AssociationSM
• Chartered Alternative Investment Analyst AssociationSM
• The CAIA Association logo

© 2020 Wiley
 St a n d a r d I: P r o f e s s io n a l is m

LESSON MAP
• Knowledge of the Law
• Independence and Objectivity
• Misrepresentation
• Misconduct

Learning Objective: Dem onstrate knowledge o f Standard I: Professionalism .

Standard 1(A): Knowledge of the Law

The Standard
Members and candidates must understand and comply with all applicable laws, rules, and
regulations (including the CFA Institute Code of Ethics and Standards of Professional
Conduct) of any government, regulatory organization, licensing agency, or professional
association governing their professional activities. In the event of conflict, members and
candidates must comply with the more strict law, rule, or regulation. Members and
candidates must not knowingly participate or assist in, and must dissociate from, any
violation of such laws, rules, or regulations.

Guidance
• Members and candidates must understand the applicable laws and regulations of the
countries and jurisdictions where they engage in professional activities.
• On the basis of their reasonable and good faith understanding, members and
candidates must comply with the laws and regulations that directly govern their
professional activities and resulting outcomes and that protect the interests of the
clients.
• When questions arise, members and candidates should know their firm’s policies and
procedures for accessing compliance guidance.
• During times of changing regulations, members and candidates must remain vigilant
in maintaining their knowledge of the requirements for their professional activities.

Relationship between the Code and Standards and Applicable Law

• When applicable law and the Code and Standards require different conduct, members
and candidates must follow the stricter of the applicable law or the Code and
Standards.
o “Applicable law” is the law that governs the member’s or candidate’s
conduct. Which law applies will depend on the particular facts and
circumstances of each case.
o The “more strict” law or regulation is the law or regulation that imposes
greater restrictions on the action of the member or candidate, or calls for the
member or candidate to exert a greater degree of action that protects the
interests of investors.

Global Application of the Code and Standards

Members and candidates who practice in multiple jurisdictions may be subject to varied
securities laws and regulations. The following chart provides illustrations involving a
member who may be subject to the securities laws and regulations of three different types of
countries:

© 2020 Wiley !
PROFESSIONAL STANDARDS AND ETHICS

NS: country with no Applicable Law Duties Explanation

securities laws or
regulations Member resides in NS country, Member must Because applicable law is less
does business in LS country; adhere to the strict than the Code and
LS: country with less
strict securities laws LS law applies. Code and Standards, the member must
and regulations than
the Code and Standards. adhere to the Code and
Standards Standards.
MS: country with Member resides in NS country, Member must Because applicable law is
more strict securities does business in MS country; adhere to the law stricter than the Code and
laws and regulations
than the Code and MS law applies. of MS country. Standards, member must adhere
Standards
to the more strict applicable law.
Member resides in LS country, Member must Because applicable law is less
does business in NS country; adhere to the strict than the Code and
LS law applies. Code and Standards, member must adhere
Standards. to the Code and Standards.
Member resides in LS country, Member must Because applicable law is
does business in MS country; adhere to the law stricter than the Code and
MS law applies. of MS country. Standards, member must adhere
to the more strict applicable law.
Member resides in LS country, Member must Because applicable law states
does business in NS country; adhere to the that the law of the locality where
LS law applies, but it states that Code and the business is conducted
law of locality where business is Standards. governs and there is no local
conducted governs. law, the member must adhere to
the Code and Standards.
Member resides in LS country, Member must Because applicable law of the
does business in MS country; adhere to the law locality where the business is
LS law applies, but it states that of MS country. conducted governs and local law
law of locality where business is is stricter than the Code and
conducted governs. Standards, member must adhere
to the more strict applicable law.
Member resides in MS country, Member must Because applicable law is
does business in LS country; adhere to the law stricter than the Code and
MS law applies. of MS country. Standards, member must adhere
to the more strict applicable law.
Member resides in MS country, Member must Because applicable law states
does business in LS country; adhere to the that the law of the locality where
MS law applies, but it states that Code and the business is conducted
law of locality where business is Standards. governs and local law is less
conducted governs. strict than the Code and
Standards, member must adhere
to the Code and Standards.
Member resides in MS country, Member must Because applicable law states
does business in LS country adhere to the that the law of the client’s home
with a client who is a citizen of Code and country governs (which is less
LS country; MS law applies, but Standards. strict than the Code and
it states that the law of the Standards), member must adhere
client’s home country governs. to the Code and Standards.

* © 2020 Wiley
 STANDARD I: PROFESSIONALISM

Applicable Law Duties Explanation

Member resides in MS country, Member must Because applicable law states
does business in LS country adhere to the law that the law of the client’s home
with a client who is a citizen of of MS country. country governs and the law of
MS country; MS law applies, the client’s home country is
but it states that the law of the stricter than the Code and
client’s home country governs. Standards, the member must
adhere to the more strict
applicable law.

Participation in or Association with Violations by Others

• Members and candidates are responsible for violations in which they knowingly
participate or assist. Standard 1(A) applies when members and candidates know or
should know that their conduct may contribute to a violation of applicable laws,
rules, or regulations or the Code and Standards.
• If a member or candidate has reasonable grounds to believe that imminent or ongoing
client or employer activities are illegal or unethical, the member or candidate must
dissociate, or separate, from the activity.
• In extreme cases, dissociation may require a member or candidate to leave his or her
employment.
• Members and candidates may take the following intermediate steps to dissociate
from ethical violations of others when direct discussions with the person or persons
committing the violation are unsuccessful.
o Attempt to stop the behavior by bringing it to the attention of the employer
through a supervisor or the firm’s compliance department,
o If this attempt is unsuccessful, then members and candidates have a
responsibility to step away and dissociate from the activity. Inaction
combined with continuing association with those involved in illegal or
unethical conduct may be construed as participation or assistance in the
illegal or unethical conduct.
• CFA Institute strongly encourages members and candidates to report potential
violations of the Code and Standards committed by fellow members and candidates,
although a failure to report is less likely to be construed as a violation than a failure to
dissociate from unethical conduct.

Investment Products and Applicable Laws

• Members and candidates involved in creating or maintaining investment services or
investment products or packages of securities and/or derivatives should be mindful of
where these products or packages will be sold as well as their places of origination.
• They should understand the applicable laws and regulations of the countries or
regions of origination and expected sale, and should make reasonable efforts to
review whether associated firms that are distributing products or services developed
by their employing firms also abide by the laws and regulations of the countries and
regions of distribution.
• Finally, they should undertake the necessary due diligence when transacting cross-
border business to understand the multiple applicable laws and regulations in order to
protect the reputation of their firms and themselves.

© 2020 Wiley i
PROFESSIONAL STANDARDS AND ETHICS

Recommended Procedures for Compliance

Members and Candidates

Suggested methods by which members and candidates can acquire and maintain
understanding of applicable laws, rules, and regulations include the following:

• Stay informed: Members and candidates should establish or encourage their

employers to establish a procedure by which employees are regularly informed about
changes in applicable laws, rules, regulations, and case law.
• Review procedures: Members and candidates should review, or encourage their
employers to review, the firm’s written compliance procedures on a regular basis to
ensure that the procedures reflect current law and provide adequate guidance to
employees about what is permissible conduct under the law and/or the Code and
Standards.
• Maintain current files: Members and candidates should maintain or encourage their
employers to maintain readily accessible current reference copies of applicable
statutes, rules, regulations, and important cases.

Distribution Area Laws

• Members and candidates should make reasonable efforts to understand the applicable
laws—both country and regional—for the countries and regions where their
investment products are developed and are most likely to be distributed to clients.

Legal Counsel
• When in doubt about the appropriate action to undertake, it is recommended that a
member or candidate seek the advice of compliance personnel or legal counsel
concerning legal requirements.
• If a potential violation is being committed by a fellow employee, it may also be
prudent for the member or candidate to seek the advice of the firm’s compliance
department or legal counsel.

Dissociation
• When dissociating from an activity that violates the Code and Standards, members
and candidates should document the violation and urge their firms to attempt to
persuade the perpetrator(s) to cease such conduct. Note that in order to dissociate
from the conduct, a member or candidate may have to resign his or her employment.

Firms
Members and candidates should encourage their firms to consider the following policies and
procedures to support the principles of Standard 1(A):

• Develop and/or adopt a code of ethics.

• Provide information on applicable laws.
• Establish procedures for reporting violations.

Application of the Standard

Example 1 (Notification of Known Violations)

Michael Allen works for a brokerage firm and is responsible for an underwriting of
securities. A company official gives Allen information indicating that the financial
statements Allen filed with the regulator overstate the issuer’s earnings. Allen seeks the

© 2020 Wiley
 STANDARD I: PROFESSIONALISM

advice of the brokerage firm’s general counsel, who states that it would be difficult for
the regulator to prove that Allen has been involved in any wrongdoing.

Comment: Although it is recommended that members and candidates seek the advice of
legal counsel, the reliance on such advice does not absolve a member or candidate from
the requirement to comply with the law or regulation. Allen should report this situation
to his supervisor, seek an independent legal opinion, and determine whether the regulator
should be notified of the error.
______________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________________

Example 2 (Dissociating from a Violation)

Lawrence Brown’s employer, an investment banking firm, is the principal underwriter

for an issue of convertible debentures by the Courtney Company. Brown discovers that
the Courtney Company has concealed severe third-quarter losses in its foreign
operations. The preliminary prospectus has already been distributed.

Comment: Knowing that the preliminary prospectus is misleading, Brown should report
his findings to the appropriate supervisory persons in his firm. If the matter is not
remedied and Brown’s employer does not dissociate from the underwriting, Brown
should sever all his connections with the underwriting. Brown should also seek legal
advice to determine whether additional reporting or other action should be taken.

Example 3 (Following the Highest Requirements)

Laura Jameson works for a multinational investment adviser based in the United States.
Jameson lives and works as a registered investment adviser in the tiny, but wealthy,
island nation of Karramba. Karramba’s securities laws state that no investment adviser
registered and working in that country can participate in initial public offerings (IPOs)
for the adviser’s personal account. Jameson, believing that, as a U.S. citizen working for
a U.S.-based company, she should comply only with U.S. law, has ignored this
Karrambian law. In addition, Jameson believes that as a charterholder, as long as she
adheres to the Code and Standards requirement that she disclose her participation in any
IPO to her employer and clients when such ownership creates a conflict of interest, she is
meeting the highest ethical requirements.

Comment: Jameson is in violation of Standard 1(A). As a registered investment adviser

in Karramba, Jameson is prevented by Karrambian securities law from participating in
IPOs regardless of the law of her home country. In addition, because the law of the
country where she is working is stricter than the Code and Standards, she must follow
the stricter requirements of the local law rather than the requirements of the Code and
Standards.

Example 4 (Reporting Potential Unethical Actions)

Krista Blume is a junior portfolio manager for high-net-worth portfolios at a large global
investment manager. She observes a number of new portfolios and relationships coming
from a country in Europe where the firm did not have previous business and is told that a

9
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

broker in that country is responsible for this new business. At a meeting on allocation of
research resources to third-party research firms, Blume notes that this broker has been
added to the list and is allocated payments for research. However, she knows the
portfolios do not invest in securities in the broker’s country, and she has not seen any
research come from this broker. Blume asks her supervisor about the name being on the
list and is told that someone in marketing is receiving the research and that the name
being on the list is OK. She believes that what may be going on is that the broker is
being paid for new business through the inappropriate research payments, and she
wishes to dissociate from the misconduct.

Comment: Blume should follow the firm’s policies and procedures for reporting
potential unethical activity, which may include discussions with her supervisor or
someone in a designated compliance department. She should communicate her concerns
appropriately while advocating for disclosure between the new broker relationship and
the research payments.

Example 5 (Failure to M aintain Knowledge of the Law)

Colleen White is excited to use new technology to communicate with clients and
potential clients. She recently began posting investment information, including
performance reports and investment opinions and recommendations, to her Facebook
page. In addition, she sends out brief announcements, opinions, and thoughts via her
Twitter account (for example, “Prospects for future growth of XYZ company look good!
#makingmoney4U”). Prior to White’s use of these social media platforms, the local
regulator had issued new requirements and guidance governing online electronic
communication. White’s communications appear to conflict with the recent regulatory
announcements.

Comment: White is in violation of Standard 1(A) because her communications do not

comply with the existing guidance and regulation governing use of social media. White
must be aware of the evolving legal requirements pertaining to new and dynamic areas
of the financial services industry that are applicable to her. She should seek guidance
from appropriate, knowledgeable, and reliable sources, such as her firm’s compliance
department, external service providers, or outside counsel, unless she diligently follows
legal and regulatory trends affecting her professional responsibilities.

Standard 1(B) Independence and Objectivity

The Standard
Members and candidates must use reasonable care and judgment to achieve and maintain
independence and objectivity in their professional activities. Members and candidates must
not offer, solicit, or accept any gift, benefit, compensation, or consideration that reasonably
could be expected to compromise their own or another’s independence and objectivity.

Guidance
• Members and candidates should endeavor to avoid situations that could cause or be
perceived to cause a loss of independence or objectivity in recommending
investments or taking investment action.

" © 2020 Wiley

 STANDARD I: PROFESSIONALISM

• Modest gifts and entertainment are acceptable, but special care must be taken by
members and candidates to resist subtle and not-so-subtle pressures to act in conflict
with the interests of their clients. Best practice dictates that members and candidates
reject any offer of gift or entertainment that could be expected to threaten their
independence and objectivity.
• Receiving a gift, benefit, or consideration from a client can be distinguished from
gifts given by entities seeking to influence a member or candidate to the detriment of
other clients.
• When possible, prior to accepting “bonuses” or gifts from clients, members and
candidates should disclose to their employers such benefits offered by clients. If
notification is not possible prior to acceptance, members and candidates must
disclose to their employer benefits previously accepted from clients.
• Members and candidates are personally responsible for maintaining independence
and objectivity when preparing research reports, making investment
recommendations, and taking investment action on behalf of clients.
Recommendations must convey the member’s or candidate’s true opinions, free of
bias from internal or external pressures, and be stated in clear and unambiguous
language.
• When seeking corporate financial support for conventions, seminars, or even weekly
society luncheons, the members or candidates responsible for the activities should
evaluate both the actual effect of such solicitations on their independence and
whether their objectivity might be perceived to be compromised in the eyes of their
clients.

Investment Banking Relationships

• Some sell-side firms may exert pressure on their analysts to issue favorable research
reports on current or prospective investment banking clients. Members and
candidates must not succumb to such pressures.
• Allowing analysts to work with investment bankers is appropriate only when the
conflicts are adequately and effectively managed and disclosed. Firm managers have
a responsibility to provide an environment in which analysts are neither coerced nor
enticed into issuing research that does not reflect their true opinions. Firms should
require public disclosure of actual conflicts of interest to investors.
• Any “firewalls” between the investment banking and research functions must be
managed to minimize conflicts of interest. Key elements of enhanced firewalls
include:
o Separate reporting structures for personnel on the research side and
personnel on the investment banking side,
o Compensation arrangements that minimize pressures on research analysts
and reward objectivity and accuracy.

Public Companies
• Analysts may be pressured to issue favorable reports and recommendations by the
companies they follow. In making an investment recommendation, the analyst is
responsible for anticipating, interpreting, and assessing a company’s prospects and
stock price performance in a factual manner.
• Due diligence in financial research and analysis involves gathering information from
a wide variety of sources, including public disclosure documents (such as proxy
statements, annual reports, and other regulatory filings) and also company
management and investor-relations personnel, suppliers, customers, competitors, and
other relevant sources. Research analysts may justifiably fear that companies will
limit their ability to conduct thorough research by denying analysts who have

© 2020 Wiley n
PROFESSIONAL STANDARDS AND ETHICS

“negative” views direct access to company managers and/or barring them from
conference calls and other communication venues. This concern may make it
difficult for them to conduct the comprehensive research needed to make objective
recommendations.

Buy-Side Clients
• Portfolio managers may have significant positions in the security of a company under
review. A rating downgrade may adversely affect the portfolio’s performance,
particularly in the short term, because the sensitivity of stock prices to ratings
changes has increased in recent years. A downgrade may also affect the manager’s
compensation, which is usually tied to portfolio performance. Moreover, portfolio
performance is subject to media and public scrutiny, which may affect the manager’s
professional reputation. Consequently, some portfolio managers implicitly or
explicitly support sell-side ratings inflation.
• Portfolio managers have a responsibility to respect and foster the intellectual honesty
of sell-side research. Therefore, it is improper for portfolio managers to threaten or
engage in retaliatory practices, such as reporting sell-side analysts to the covered
company in order to instigate negative corporate reactions.

Fund Manager and Custodial Relationships

• Research analysts are not the only people who must be concerned with maintaining
their independence. Members and candidates who are responsible for hiring and
retaining outside managers and third-party custodians should not accepts gifts,
entertainment, or travel funding that may be perceived as impairing their decisions.

Credit Rating Agency Opinions

• Members and candidates employed at rating agencies should ensure that procedures
and processes at the agencies prevent undue influences from a sponsoring company
during the analysis. Members and candidates should abide by their agencies’ and the
industry’s standards of conduct regarding the analytical process and the distribution
of their reports.
• When using information provided by credit rating agencies, members and candidates
should be mindful of the potential conflicts of interest. And because of the potential
conflicts, members and candidates may need to independently validate the rating
granted.

Issuer-Paid Research
• Some companies hire analysts to produce research reports in case of lack of coverage
from sell-side research, or to increase the company’s visibility in financial markets.
• Analysts must engage in thorough, independent, and unbiased analysis and must
fully disclose potential conflicts, including the nature of their compensation. It
should also be clearly mentioned in the report that the research has been paid for by
the subject company. At a minimum, research should include a thorough analysis of
the company’s financial statements based on publicly disclosed information,
benchmarking within a peer group, and industry analysis.
• Analysts must try to limit the type of compensation they accept for conducting
research. This compensation can be direct, such as payment based on the conclusions
of the report, or more indirect, such as stock warrants or other equity instruments that
could increase in value based on positive coverage in the report. In those instances,
analysts would have an incentive to avoid negative information or conclusions that
would diminish their potential compensation.

, 2
© 2020 Wiley
 STANDARD I: PROFESSIONALISM

• Best practice is for analysts to accept only a flat fee for their work prior to writing the
report, without regard to their conclusions or the report’s recommendations.

Travel Funding
• The benefits related to accepting paid travel extend beyond the cost savings to the
member or candidate and his firm, such as the chance to talk exclusively with the
executives of a company or learning more about the investment options provided by
an investment organization. Acceptance also comes with potential concerns; for
example, members and candidates may be influenced by these discussions when
flying on a corporate or chartered jet, or attending sponsored conferences where
many expenses, including airfare and lodging, are covered.
• To avoid the appearance of compromising their independence and objectivity, best
practice dictates that analysts always use commercial transportation at their expense
or at the expense of their firm rather than accept paid travel arrangements from an
outside company.
• In case of unavailability of commercial travel, they may accept modestly arranged
travel to participate in appropriate information gathering events, such as a property
tour.

Performance Measurement and Attribution

• Members and candidates working within a firm’s investment performance
measurement department may also be presented with situations that challenge their
independence and objectivity. As performance analysts, their analyses may reveal
instances where managers may appear to have strayed from their mandate.
Additionally, the performance analyst may receive requests to alter the construction
of composite indices owing to negative results for a selected account or fund.
Members or candidates must not allow internal or external influences to affect their
independence and objectivity as they faithfully complete their performance
calculation and analysis-related responsibilities.

Influence during the Manager Selection/Procurement Process

• When serving in a hiring capacity, members and candidates should not solicit gifts,
contributions, or other compensation that may affect their independence and
objectivity. Solicitations do not have to benefit members and candidates personally
to conflict with Standard 1(B). Requesting contributions to a favorite charity or
political organization may also be perceived as an attempt to influence the decision-
making process. Additionally, members and candidates serving in a hiring capacity
should refuse gifts, donations, and other offered compensation that may be perceived
to influence their decision-making process.
• When working to earn a new investment allocation, members and candidates should
not offer gifts, contributions, or other compensation to influence the decision of the
hiring representative. The offering of these items with the intent to impair the
independence and objectivity of another person would not comply with Standard
1(B). Such prohibited actions may include offering donations to a charitable
organization or political candidate referred by the hiring representative.

Recommended Procedures for Compliance

Members and candidates should adhere to the following practices and should encourage
their firms to establish procedures to avoid violations of Standard 1(B):

© 2020 Wiley , s
PROFESSIONAL STANDARDS AND ETHICS

• Protect the integrity of opinions: Members, candidates, and their firms should
establish policies stating that every research report concerning the securities of a
corporate client should reflect the unbiased opinion of the analyst.
• Create a restricted list: If the firm is unwilling to permit dissemination of adverse
opinions about a corporate client, members and candidates should encourage the firm
to remove the controversial company from the research universe and put it on a
restricted list so that the firm disseminates only factual information about the
company.
• Restrict special cost arrangements: When attending meetings at an issuer’s
headquarters, members and candidates should pay for commercial transportation and
hotel charges. No corporate issuer should reimburse members or candidates for air
transportation. Members and candidates should encourage issuers to limit the use of
corporate aircraft to situations in which commercial transportation is not available or
in which efficient movement could not otherwise be arranged.
• Limit gifts: Members and candidates must limit the acceptance of gratuities and/or
gifts to token items. Standard 1(B) does not preclude customary, ordinary business-
related entertainment as long as its purpose is not to influence or reward members or
candidates. Firms should consider a strict value limit for acceptable gifts that is based
on the local or regional customs and should address whether the limit is per gift or an
aggregate annual value.
• Restrict investments: Members and candidates should encourage their investment
firms to develop formal polices related to employee purchases of equity or equity-
related IPOs. Firms should require prior approval for employee participation in IPOs,
with prompt disclosure of investment actions taken following the offering. Strict
limits should be imposed on investment personnel acquiring securities in private
placements.
• Review procedures: Members and candidates should encourage their firms to
implement effective supervisory and review procedures to ensure that analysts and
portfolio managers comply with policies relating to their personal investment
activities.
• Independence policy: Members, candidates, and their firms should establish a
formal written policy on the independence and objectivity of research and implement
reporting structures and review procedures to ensure that research analysts do not
report to and are not supervised or controlled by any department of the firm that
could compromise the independence of the analyst.
• Appointed officer: Firms should appoint a senior officer with oversight
responsibilities for compliance with the firm’s code of ethics and all regulations
concerning its business.

Application of the Standard

Example 1 (Research Independence and Intrafirm Pressure)

Walter Fritz is an equity analyst with Hilton Brokerage who covers the mining industry.
He has concluded that the stock of Metals & Mining is overpriced at its current level, but
he is concerned that a negative research report will hurt the good relationship between
Metals & Mining and the investment banking division of his firm. In fact, a senior
manager of Hilton Brokerage has just sent him a copy of a proposal his firm has made to
Metals & Mining to underwrite a debt offering. Fritz needs to produce a report right
away and is concerned about issuing a less-than-favorable rating.

© 2020 Wiley
 STANDARD I: PROFESSIONALISM

Comment: Fritz’s analysis of Metals & Mining must be objective and based solely on
consideration of company fundamentals. Any pressure from other divisions of his firm is
inappropriate. This conflict could have been eliminated if, in anticipation of the offering,
Hilton Brokerage had placed Metals & Mining on a restricted list for its sales force.

Example 2 (Research Independence and Issuer Relationship Pressure)

As in Example 1, Walter Fritz has concluded that Metals & Mining stock is overvalued
at its current level, but he is concerned that a negative research report might jeopardize a
close rapport that he has nurtured over the years with Metals & Mining’s CEO, chief
finance officer, and investment relations officer. Fritz is concerned that a negative report
might result also in management retaliation—for instance, cutting him off from
participating in conference calls when a quarterly earnings release is made, denying him
the ability to ask questions on such calls, and/or denying him access to top management
for arranging group meetings between Hilton Brokerage clients and top Metals &
Mining managers.

Comment: As in Example 1, Fritz’s analysis must be objective and based solely on

consideration of company fundamentals. Any pressure from Metals & Mining is
inappropriate. Fritz should reinforce the integrity of his conclusions by stressing that his
investment recommendation is based on relative valuation, which may include
qualitative issues with respect to Metals & Mining’s management.

Example 3 (Gifts and Entertainment from Related Party)

Edward Grant directs a large amount of his commission business to a New York-based
brokerage house. In appreciation for all the business, the brokerage house gives Grant
two tickets to the World Cup in South Africa, two nights at a nearby resort, several
meals, and transportation via limousine to the game. Grant fails to disclose receiving this
package to his supervisor.

Comment: Grant has violated Standard 1(B) because accepting these substantial gifts
may impede his independence and objectivity. Every member and candidate should
endeavor to avoid situations that might cause or be perceived to cause a loss of
independence or objectivity in recommending investments or taking investment action.
By accepting the trip, Grant has opened himself up to the accusation that he may give the
broker favored treatment in return.

Example 4 (Gifts and Entertainment from Client)

Theresa Green manages the portfolio of Ian Knowlden, a client of Tisbury Investments.
Green achieves an annual return for Knowlden that is consistently better than that of the
benchmark she and the client previously agreed to. As a reward, Knowlden offers Green
two tickets to Wimbledon and the use of Knowlden’s flat in London for a week. Green
discloses this gift to her supervisor at Tisbury.

15
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Comment: Green is in compliance with Standard 1(B) because she disclosed the gift
from one of her clients in accordance with the firm’s policies. Members and candidates
may accept bonuses or gifts from clients as long as they disclose them to their employer
because gifts in a client relationship are deemed less likely to affect a member’s or
candidate’s objectivity and independence than gifts in other situations. Disclosure is
required, however, so that supervisors can monitor such situations to guard against
employees favoring a gift-giving client to the detriment of other fee-paying clients (such
as by allocating a greater proportion of IPO stock to the gift-giving client’s portfolio).

Best practices for monitoring include comparing the transaction costs of the Knowlden
account with the costs of other accounts managed by Green and other similar accounts
within Tisbury. The supervisor could also compare the performance returns with the
returns of other clients with the same mandate. This comparison will assist in
determining whether a pattern of favoritism by Green is disadvantaging other Tisbury
clients or the possibility that this favoritism could affect her future behavior.

Example 5 (Research Independence and Compensation Arrangements)

Javier Herrero recently left his job as a research analyst for a large investment adviser.
While looking for a new position, he was hired by an investor-relations firm to write a
research report on one of its clients, a small educational software company. The investor-
relations firm hopes to generate investor interest in the technology company. The firm
will pay Herrero a flat fee plus a bonus if any new investors buy stock in the company as
a result of Herrero’s report.

Comment: If Herrero accepts this payment arrangement, he will be in violation of

Standard 1(B) because the compensation arrangement can reasonably be expected to
compromise his independence and objectivity. Herrero will receive a bonus for attracting
investors, which provides an incentive to draft a positive report regardless of the facts
and to ignore or play down any negative information about the company. Herrero should
accept only a flat fee that is not tied to the conclusions or recommendations of the report.
Issuer-paid research that is objective and unbiased can be done under the right
circumstances as long as the analyst takes steps to maintain his or her objectivity and
includes in the report proper disclosures regarding potential conflicts of interest.

Example 6 (Influencing Manager Selection Decisions)

Adrian Mandel, CFA, is a senior portfolio manager for ZZYY Capital Management who
oversees a team of investment professionals who manage labor union pension funds. A
few years ago, ZZYY sought to win a competitive asset manager search to manage a
significant allocation of the pension fund of the United Doughnut and Pretzel Bakers
Union (UDPBU). UDPBU’s investment board is chaired by a recognized key decision
maker and long-time leader of the union, Ernesto Gomez. To improve ZZYY’s chances
of winning the competition, Mandel made significant monetary contributions to Gomez’s
union reelection campaign fund. Even after ZZYY was hired as a primary manager of
the pension, Mandel believed that his firm’s position was not secure. Mandel continued
to contribute to Gomez’s reelection campaign chest as well as to entertain lavishly the
union leader and his family at top restaurants on a regular basis. All of Mandel’s outlays
were routinely handled as marketing expenses reimbursed by ZZYY’s expense accounts

16
© 2020 Wiley
 STANDARD I: PROFESSIONALISM

and were disclosed to his senior management as being instrumental in maintaining a

strong close relationship with an important client.

Comment: Mandel not only offered but actually gave monetary gifts, benefits, and other
considerations that reasonably could be expected to compromise Gomez’s objectivity.
Therefore, Mandel was in violation of Standard 1(B).

Example 7 (Influencing Manager Selection Decisions)

Adrian Mandel, CFA, had heard about the manager search competition for the UDPBU
Pension Fund through a broker/dealer contact. The contact told him that a well-known
retired professional golfer, Bobby “The Bear” Finlay, who had become a licensed
broker/dealer serving as a pension consultant, was orchestrating the UDPBU manager
search. Finlay had gained celebrity status with several labor union pension fund boards
by entertaining their respective board members and regaling them with colorful stories of
fellow pro golfers’ antics in clubhouses around the world. Mandel decided to improve
ZZYY’s chances of being invited to participate in the search competition by befriending
Finlay to curry his favor. Knowing Finlay’s love of entertainment, Mandel wined and
dined Finlay at high-profile bistros where Finlay could glow in the fan recognition
lavished on him by all the other patrons. Mandel’s endeavors paid off handsomely when
Finlay recommended to the UDPBU board that ZZYY be entered as one of three finalist
asset management firms in its search.

Comment: Mandel lavished gifts, benefits, and other considerations in the form of
expensive entertainment that could reasonably be expected to influence the consultant to
recommend the hiring of his firm. Therefore, Mandel was in violation of Standard 1(B).

Example 8 (Fund Manager Relationships)

Amie Scott is a performance analyst within her firm with responsibilities for analyzing
the performance of external managers. While completing her quarterly analysis, Scott
notices a change in one manager’s reported composite construction. The change
concealed the bad performance of a particularly large account by placing that account
into a new residual composite. This change allowed the manager to remain at the top of
the list of manager performance. Scott knows her firm has a large allocation to this
manager, and the fund’s manager is a close personal friend of the CEO. She needs to
deliver her final report but is concerned with pointing out the composite change.

Comment: Scott would be in violation of Standard 1(B) if she did not disclose the
change in her final report. The analysis of managers’ performance should not be
influenced by personal relationships or the size of the allocation to the outside managers.
By not including the change, Scott would not be providing an independent analysis of
the performance metrics for her firm.

17
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Example 9 (Intrafirm Pressure)

Jill Stein is head of performance measurement for her firm. During the last quarter, many
members of the organization’s research department were removed because of the poor
quality of their recommendations. The subpar research caused one larger account holder
to experience significant underperformance, which resulted in the client withdrawing his
money after the end of the quarter. The head of sales requests that Stein remove this
account from the firm’s performance composite because the performance decline can be
attributed to the departed research team and not the client’s adviser.

Comment: Pressure from other internal departments can create situations that cause a
member or candidate to violate the Code and Standards. Stein must maintain her
independence and objectivity and refuse to exclude specific accounts from the firm’s
performance composites to which they belong. As long as the client invested under a
strategy similar to that of the defined composite, it cannot be excluded because of the
poor stock selections that led to the underperformance and asset withdrawal.

Example 10 (Travel Expenses)

Steven Taylor, a mining analyst with Bronson Brokers, is invited by Precision Metals to
join a group of his peers in a tour of mining facilities in several western U.S. states. The
company arranges for chartered group flights from site to site and for accommodations in
Spartan Motels, the only chain with accommodations near the mines, for three nights.
Taylor allows Precision Metals to pick up his tab, as do the other analysts, with one
exception—John Adams, an employee of a large trust company, who insists on
following his company’s policy and paying for his hotel room himself.

Comment: The policy of the company where Adams works complies closely with
Standard 1(B) by avoiding even the appearance of a conflict of interest, but Taylor and
the other analysts were not necessarily violating Standard 1(B). In general, when
allowing companies to pay for travel and/or accommodations in these circumstances,
members and candidates must use their judgment. They must be on guard that such
arrangements not impinge on a member’s or candidate’s independence and objectivity.
In this example, the trip was strictly for business and Taylor was not accepting irrelevant
or lavish hospitality. The itinerary required chartered flights, for which analysts were not
expected to pay. The accommodations were modest. These arrangements are not unusual
and did not violate Standard 1(B) as long as Taylor’s independence and objectivity were
not compromised. In the final analysis, members and candidates should consider both
whether they can remain objective and whether their integrity might be perceived by
their clients to have been compromised.

Example 11 (Travel Expenses from External Manager)

Tom Wayne is the investment manager of the Franklin City Employees Pension Plan. He
recently completed a successful search for a firm to manage the foreign equity allocation
of the plan’s diversified portfolio. He followed the plan’s standard procedure of seeking
presentations from a number of qualified firms and recommended that his board select
Penguin Advisors because of its experience, well-defined investment strategy, and
performance record. The firm claims compliance with the Global Investment

18
© 2020 Wiley
 STANDARD I: PROFESSIONALISM

Performance Standards (GIPS) and has been verified. Following the selection of
Penguin, a reporter from the Franklin City Record calls to ask if there was any
connection between this action and the fact that Penguin was one of the sponsors of an
“investment fact-finding trip to Asia” that Wayne made earlier in the year. The trip was
one of several conducted by the Pension Investment Academy, which had arranged the
itinerary of meetings with economic, government, and corporate officials in major cities
in several Asian countries. The Pension Investment Academy obtains support for the cost
of these trips from a number of investment managers, including Penguin Advisors; the
Academy then pays the travel expenses of the various pension plan managers on the trip
and provides all meals and accommodations. The president of Penguin Advisors was
also one of the travelers on the trip.

Comment: Although Wayne can probably put to good use the knowledge he gained
from the trip in selecting portfolio managers and in other areas of managing the pension
plan, his recommendation of Penguin Advisors may be tainted by the possible conflict
incurred when he participated in a trip partly paid for by Penguin Advisors and when he
was in the daily company of the president of Penguin Advisors. To avoid violating
Standard 1(B), Wayne’s basic expenses for travel and accommodations should have been
paid by his employer or the pension plan; contact with the president of Penguin Advisors
should have been limited to informational or educational events only; and the trip, the
organizer, and the sponsor should have been made a matter of public record. Even if his
actions were not in violation of Standard 1(B), Wayne should have been sensitive to the
public perception of the trip when reported in the newspaper and the extent to which
the subjective elements of his decision might have been affected by the familiarity that
the daily contact of such a trip would encourage. This advantage would probably not be
shared by firms competing with Penguin Advisors.

Example 12 (Recommendation Objectivity)

Bob Thompson has been doing research for the portfolio manager of the fixed-income
department. His assignment is to do sensitivity analysis on securitized subprime
mortgages. He has discussed with the manager possible scenarios to use to calculate
expected returns. A key assumption in such calculations is housing price appreciation
(HPA) because it drives “prepays” (prepayments of mortgages) and losses. Thompson is
concerned with the significant appreciation experienced over the previous five years as a
result of the increased availability of funds from subprime mortgages. Thompson insists
that the analysis should include a scenario run with -10% for Year 1, -5% for Year 2,
and then (to project a worst-case scenario) 0% for Years 3 through 5. The manager
replies that these assumptions are too dire because there has never been a time in their
available database when HPA was negative.

Thompson conducts his research to better understand the risks inherent in these securities
and evaluates these securities in the worst-case scenario, an unlikely but possible
environment. Based on the results of the enhanced scenarios, Thompson does not
recommend the purchase of the securitization. Against the general market trends, the
manager follows Thompson’s recommendation and does not invest. The following year,
the housing market collapses. In avoiding the subprime investments, the manager’s
portfolio outperforms its peer group that year.

19
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Comment: Thompson’s actions in running the worst-case scenario against the protests
of the portfolio manager are in alignment with the principles of Standard 1(B). Thompson
did not allow his research to be pressured by the general trends of the market or the
manager’s desire to limit the research to historical norms.

Example 13 (Research Independence and Prior Coverage)

Jill Jorund is a securities analyst following airline stocks and a rising star at her firm. Her
boss has been carrying a “buy” recommendation on International Airlines and asks
Jorund to take over coverage of that airline. He tells Jorund that under no circumstances
should the prevailing buy recommendation be changed.

Comment: Jorund must be independent and objective in her analysis of International

Airlines. If she believes that her boss’s instructions have compromised her, she has two
options: She can tell her boss that she cannot cover the company under these constraints,
or she can take over coverage of the company, reach her own independent conclusions,
and if they conflict with her boss’s opinion, share the conclusions with her boss or other
supervisors in the firm so that they can make appropriate recommendations. Jorund must
issue only recommendations that reflect her independent and objective opinion.

Standard 1(C) Misrepresentation

The Standard
Members and candidates must not knowingly make any misrepresentations relating to
investment analysis, recommendations, actions, or other professional activities.

Guidance
• A misrepresentation is any untrue statement or omission of a fact or any statement
that is otherwise false or misleading.
• A member or candidate must not knowingly omit or misrepresent information or give
a false impression of a firm, organization, or security in the member’s or candidate’s
oral representations, advertising (whether in the press or through brochures),
electronic communications, or written materials (whether publicly disseminated
or not).
o In this context, “knowingly” means that the member or candidate either
knows or should have known that the misrepresentation was being made or
that omitted information could alter the investment decision-making
process.
• Members and candidates who use webpages should regularly monitor materials
posted on these sites to ensure that they contain current information. Members and
candidates should also ensure that all reasonable precautions have been taken to
protect the site’s integrity and security and that the site does not misrepresent any
information and does provide full disclosure.
• Members and candidates should not guarantee clients any specific return on volatile
investments. Most investments contain some element of risk that makes their return
inherently unpredictable. For such investments, guaranteeing either a particular rate
of return or a guaranteed preservation of investment capital (e.g., “I can guarantee
that you will earn 8% on equities this year” or “I can guarantee that you will not lose
money on this investment”) is misleading to investors.

© 2020 Wiley
 STANDARD I: PROFESSIONALISM

• Note that Standard 1(C) does not prohibit members and candidates from providing
clients with information on investment products that have guarantees built into the
structure of the products themselves or for which an institution has agreed to cover
any losses.

Impact on Investment Practice

• Members and candidates must not misrepresent any aspect of their practice,
including (but not limited to) their qualifications or credentials, the qualifications or
services provided by their firm, their performance record and the record of their firm,
and the characteristics of an investment.
• Members and candidates should exercise care and diligence when incorporating
third-party information. Misrepresentations resulting from the use of the credit
ratings, research, testimonials, or marketing materials of outside parties become the
responsibility of the investment professional when it affects that professional’s
business practices.
• Members and candidates must disclose their intended use of external managers and
must not represent those managers’ investment practices as their own.

Performance Reporting
• Members and candidates should not misrepresent the success of their performance
record by presenting benchmarks that are not comparable to their strategies. The
benchmark’s results should be reported on a basis comparable to that of the fund’s or
client’s results.
• Note that Standard 1(C) does not require that a benchmark always be provided in
order to comply. Some investment strategies may not lend themselves to displaying
an appropriate benchmark because of the complexity or diversity of the investments
included.
• Members and candidates should discuss with clients on a continuous basis the
appropriate benchmark to be used for performance evaluations and related fee
calculations.
• Members and candidates should take reasonable steps to provide accurate and
reliable security pricing information to clients on a consistent basis. Changing pricing
providers should not be based solely on the justification that the new provider reports
a higher current value of a security.

Social Media
• When communicating through social media channels, members and candidates
should provide only the same information they are allowed to distribute to clients and
potential clients through other traditional forms of communication.
• Along with understanding and following existing and newly developing rules and
regulations regarding the allowed use of social media, members and candidates
should also ensure that all communications in this format adhere to the requirements
of the Code and Standards.
• The perceived anonymity granted through these platforms may entice individuals to
misrepresent their qualifications or abilities or those of their employer. Actions
undertaken through social media that knowingly misrepresent investment
recommendations or professional activities are considered a violation of Standard
1(C).

Omissions
• Members and candidates should not knowingly omit inputs used in any models and
processes they use to scan for new investment opportunities, to develop investment

© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

vehicles, and to produce investment recommendations and ratings as resulting

outcomes may provide misleading information. Further, members and candidates
should not present outcomes from their models as facts because they only represent
expected results.
• Members and candidates should encourage their firms to develop strict policies for
composite development to prevent cherry picking—situations in which selected
accounts are presented as representative of the firm’s abilities. The omission of any
accounts appropriate for the defined composite may misrepresent to clients the
success of the manager’s implementation of its strategy.

Plagiarism
• Plagiarism refers to the practice of copying, or using in substantially the same form,
materials prepared by others without acknowledging the source of the material or
identifying the author and publisher of the material. Plagiarism includes:
o Taking a research report or study performed by another firm or person,
changing the names, and releasing the material as one’s own original
analysis.
o Using excerpts from articles or reports prepared by others either verbatim or
with only slight changes in wording without acknowledgment,
o Citing specific quotations supposedly attributable to “leading analysts” and
“investment experts” without specific reference,
o Presenting statistical estimates of forecasts prepared by others with the
source identified but without qualifying statements or caveats that may have
been used.
o Using charts and graphs without stating their sources,
o Copying proprietary computerized spreadsheets or algorithms without
seeking the cooperation or authorization of their creators.
• In the case of distributing third-party, outsourced research, members and candidates
can use and distribute these reports as long as they do not represent themselves as the
author of the report. They may add value to clients by sifting through research and
repackaging it for them, but should disclose that the research being presented to
clients comes from an outside source.
• The standard also applies to plagiarism in oral communications, such as through
group meetings; visits with associates, clients, and customers; use of audio/video
media (which is rapidly increasing); and telecommunications, such as through
electronic data transfer and the outright copying of electronic media. One of the most
egregious practices in violation of this standard is the preparation of research reports
based on multiple sources of information without acknowledging the sources. Such
information would include, for example, ideas, statistical compilations, and forecasts
combined to give the appearance of original work.

Work Completed for Employer

• Members and candidates may use research conducted by other analysts within their
firm. Any research reports prepared by the analysts are the property of the firm and
may be issued by it even if the original analysts are no longer with the firm.
• Therefore, members and candidates are allowed to use the research conducted by
analysts who were previously employed at their firms. However, they cannot reissue
a previously released report solely under their own name.

Recommended Procedures for Compliance

Factual presentations: Firms should provide guidance for employees who make written or
oral presentations to clients or potential clients by providing a written list of the firm’s

2 © 2020 Wiley
 STANDARD I: PROFESSIONALISM

available services and a description of the firm’s qualifications. Firms can also help prevent
misrepresentation by specifically designating which employees are authorized to speak on
behalf of the firm.

Qualification summary: In order to ensure accurate presentations to clients, the member or

candidate should prepare a summary of her own qualifications and experience, as well as a
list of the services she is capable of performing.

Verify outside information: When providing information to clients from third parties,
members and candidates should ensure the accuracy of the marketing and distribution
materials that pertain to the third party’s capabilities, services, and products. This is because
inaccurate information can damage their individual and their firm’s reputations as well as
the integrity of the capital markets.

Maintain webpages: If they publish a webpage, members and candidates should regularly
monitor materials posted to the site to ensure the site maintains current information.

Plagiarism policy: To avoid plagiarism in preparing research reports or conclusions of

analysis, members and candidates should take the following steps:

• Maintain copies: Keep copies of all research reports, articles containing research
ideas, material with new statistical methodology, and other materials that were relied
on in preparing the research report.
• Attribute quotations". Attribute to their sources any direct quotations, including
projections, tables, statistics, model/product ideas, and new methodologies prepared
by persons other than recognized financial and statistical reporting services or similar
sources.
• Attribute summaries: Attribute to their sources paraphrases or summaries of material
prepared by others.

Application of the Standard

Example 1 (Disclosure of Issuer-Paid Research)

Anthony McGuire is an issuer-paid analyst hired by publicly traded companies to

electronically promote their stocks. McGuire creates a website that promotes his research
efforts as a seemingly independent analyst. McGuire posts a profile and a strong buy
recommendation for each company on the website indicating that the stock is expected to
increase in value. He does not disclose the contractual relationships with the companies
he covers on his website, in the research reports he issues, or in the statements he makes
about the companies in Internet chat rooms.

Comment: McGuire has violated Standard 1(C) because the website is misleading to
potential investors. Even if the recommendations are valid and supported with thorough
research, his omissions regarding the true relationship between himself and the
companies he covers constitute a misrepresentation. McGuire has also violated Standard
VI(A)—Disclosure of Conflicts by not disclosing the existence of an arrangement with
the companies through which he receives compensation in exchange for his services.

© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Example 2 (Correction of Unintentional Errors)

Hijan Yao is responsible for the creation and distribution of the marketing materials for
his firm, which claims compliance with the GIPS standards. Yao creates and distributes a
presentation of performance by the firm’s Asian equity composite that states the
composite has ¥350 billion in assets. In fact, the composite has only ¥35 billion in assets,
and the higher figure on the presentation is a result of a typographical error.
Nevertheless, the erroneous material is distributed to a number of clients before Yao
catches the mistake.

Comment: Once the error is discovered, Yao must take steps to cease distribution of the
incorrect material and correct the error by informing those who have received the
erroneous information. Because Yao did not knowingly make the misrepresentation,
however, he did not violate Standard 1(C). Because his firm claims compliance with the
GIPS standards, it must also comply with the GIPS Guidance Statement on Error
Correction in relation to the error.

Example 3 (Noncorrection of Known Errors)

Syed Muhammad is the president of an investment management firm. The promotional

material for the firm, created by the firm’s marketing department, incorrectly claims that
Muhammad has an advanced degree in finance from a prestigious business school in
addition to the CFA designation. Although Muhammad attended the school for a short
period of time, he did not receive a degree. Over the years, Muhammad and others in the
firm have distributed this material to numerous prospective clients and consultants.

Comment: Even though Muhammad may not have been directly responsible for the
misrepresentation of his credentials in the firm’s promotional material, he used this
material numerous times over an extended period and should have known of the
misrepresentation. Thus, Muhammad has violated Standard 1(C).

Example 4 (Misrepresentation of Information)

When Ricki Marks sells mortgage-backed derivatives called “interest-only strips” (IOs)
to public pension plan clients, she describes them as “guaranteed by the U.S.
government.” Purchasers of the IOs are entitled only to the interest stream generated by
the mortgages, however, not the notional principal itself. One particular municipality’s
investment policies and local law require that securities purchased by its public pension
plans be guaranteed by the U.S. government. Although the underlying mortgages are
guaranteed, neither the investor’s investment nor the interest stream on the IOs is
guaranteed. When interest rates decline, causing an increase in prepayment of mortgages,
interest payments to the IOs’ investors decline, and these investors lose a portion of their
investment.

Comment: Marks violated Standard 1(C) by misrepresenting the terms and character of
the investment.

24
© 2020 Wiley
 STANDARD I: PROFESSIONALISM

Example 5 (Potential Information Misrepresentation)

Khalouck Abdrabbo manages the investments of several high-net-worth individuals in

the United States who are approaching retirement. Abdrabbo advises these individuals
that a portion of their investments should be moved from equity to bank-sponsored
certificates of deposit and money market accounts so that the principal will be
“guaranteed” up to a certain amount. The interest is not guaranteed.

Comment: Although there is risk that the institution offering the certificates of deposit
and money market accounts could go bankrupt, in the United States, these accounts are
insured by the U.S. government through the Federal Deposit Insurance Corporation.
Therefore, using the term “guaranteed” in this context is not inappropriate as long as the
amount is within the government-insured limit. Abdrabbo should explain these facts to
the clients.

Example 6 (Plagiarism)

Steve Swanson is a senior analyst in the investment research department of Ballard and
Company. Apex Corporation has asked Ballard to assist in acquiring the majority
ownership of stock in the Campbell Company, a financial consulting firm, and to prepare
a report recommending that stockholders of Campbell agree to the acquisition. Another
investment firm, Davis and Company, had already prepared a report for Apex analyzing
both Apex and Campbell and recommending an exchange ratio. Apex has given the
Davis report to Ballard officers, who have passed it on to Swanson. Swanson reviews the
Davis report and other available material on Apex and Campbell. From his analysis, he
concludes that the common stocks of Campbell and Apex represent good value at their
current prices; he believes, however, that the Davis report does not consider all the
factors a Campbell stockholder would need to know to make a decision. Swanson
reports his conclusions to the partner in charge, who tells him to “use the Davis report,
change a few words, sign your name, and get it out.”

Comment: If Swanson does as requested, he will violate Standard 1(C). He could refer
to those portions of the Davis report that he agrees with if he identifies Davis as the
source; he could then add his own analysis and conclusions to the report before signing
and distributing it.

Example 7 (Plagiarism)

Claude Browning, a quantitative analyst for Double Alpha, Inc., returns from a seminar
in great excitement. At that seminar, Jack Jorrely, a well-known quantitative analyst at a
national brokerage firm, discussed one of his new models in great detail, and Browning
is intrigued by the new concepts. He proceeds to test the model, making some minor
mechanical changes but retaining the concepts, until he produces some very positive
results. Browning quickly announces to his supervisors at Double Alpha that he has
discovered a new model and that clients and prospective clients should be informed of
this positive finding as ongoing proof of Double Alpha’s continuing innovation and
ability to add value.

25
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Comment: Although Browning tested Jorrely’s model on his own and even slightly
modified it, he must still acknowledge the original source of the idea. Browning can
certainly take credit for the final, practical results; he can also support his conclusions
with his own test. The credit for the innovative thinking, however, must be awarded to
Jorrely.

Example 8 (Plagiarism)

Fernando Zubia would like to include in his firm’s marketing materials some “plain-
language” descriptions of various concepts, such as the price-to-eamings (P/E) multiple
and why standard deviation is used as a measure of risk. The descriptions come from
other sources, but Zubia wishes to use them without reference to the original authors.
Would this use of material be a violation of Standard 1(C)?

Comment: Copying verbatim any material without acknowledgment, including plain-

language descriptions of the P/E multiple and standard deviation, violates Standard 1(C).
Even though these concepts are general, best practice would be for Zubia to describe
them in his own words or cite the sources from which the descriptions are quoted.
Members and candidates would be violating Standard 1(C) if they either were responsible
for creating marketing materials without attribution or knowingly use plagiarized
materials.

Example 9 (Plagiarism)

Through a mainstream media outlet, Erika Schneider learns about a study that she would
like to cite in her research. Should she cite both the mainstream intermediary source as
well as the author of the study itself when using that information?

Comment: In all instances, a member or candidate must cite the actual source of the
information. Best practice for Schneider would be to obtain the information directly from
the author and review it before citing it in a report. In that case, Schneider would not
need to report how she found out about the information. For example, suppose Schneider
read in the Financial Times about a study issued by CFA Institute; best practice for
Schneider would be to obtain a copy of the study from CFA Institute, review it, and then
cite it in her report. If she does not use any interpretation of the report from the Financial
Times and the newspaper does not add value to the report itself, the newspaper is merely
a conduit of the original information and does not need to be cited. If she does not obtain
the report and review the information, Schneider runs the risk of relying on secondhand
information that may misstate facts. If, for example, the Financial Times erroneously
reported some information from the original CFA Institute study and Schneider copied
that erroneous information without acknowledging CFA Institute, she could be the object
of complaints. Best practice would be either to obtain the complete study from its
original author and cite only that author or to use the information provided by the
intermediary and cite both sources.

26
© 2020 Wiley
 STANDARD I: PROFESSIONALISM

Example 10 (Misrepresentation of Information)

Tom Stafford is part of a team within Appleton Investment Management responsible for
managing a pool of assets for Open Air Bank, which distributes structured securities to
offshore clients. He becomes aware that Open Air is promoting the structured securities
as a much less risky investment than the investment management policy followed by him
and the team to manage the original pool of assets. Also, Open Air has procured an
independent rating for the pool that significantly overstates the quality of the
investments. Stafford communicates his concerns to his supervisor, who responds that
Open Air owns the product and is responsible for all marketing and distribution.
Stafford’s supervisor goes on to say that the product is outside of the U.S. regulatory
regime that Appleton follows and that all risks of the product are disclosed at the bottom
of page 184 of the prospectus.

Comment: As a member of the investment team, Stafford is qualified to recognize the

degree of accuracy of the materials that characterize the portfolio, and he is correct to be
worried about Appleton’s responsibility for a misrepresentation of the risks. Thus, he
should continue to pursue the issue of Open Air’s inaccurate promotion of the portfolio
according to the firm’s policies and procedures.

The Code and Standards stress protecting the reputation of the firm and the sustainability
and integrity of the capital markets. Misrepresenting the quality and risks associated with
the investment pool may lead to negative consequences for others well beyond the direct
investors.

Example 11 (Misrepresenting Composite Construction)

Robert Palmer is head of performance for a fund manager. When asked to provide
performance numbers to fund rating agencies, he avoids mentioning that the fund
manager is quite liberal in composite construction. The reason accounts are included/
excluded is not fully explained. The performance values reported to the rating agencies
for the composites, although accurate for the accounts shown each period, may not
present a true representation of the fund manager’s ability.

Comment: “Cherry picking” accounts to include in either published reports or

information provided to rating agencies conflicts with Standard 1(C). Moving accounts
into or out of a composite to influence the overall performance results materially
misrepresents the reported values over time. Palmer should work with his firm to
strengthen its reporting practices concerning composite construction to avoid
misrepresenting the firm’s track record or the quality of the information being provided.

Example 12 (Overemphasis of Firm Results)

Bob Anderson is chief compliance officer for Optima Asset Management Company, a
firm currently offering eight funds to clients. Seven of the eight had 10-year returns
below the median for their respective sectors. Anderson approves a recent advertisement,
which includes this statement: “Optima Asset Management is achieving excellent returns
for its investors. The Optima Emerging Markets Equity fund, for example, has 10-year
returns that exceed the sector median by more than 10%.”

27
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Comment: From the information provided it is difficult to determine whether a violation

has occurred as long as the sector outperformance is correct. Anderson may be
attempting to mislead potential clients by citing the performance of the sole fund that
achieved such results. Past performance is often used to demonstrate a firm’s skill and
abilities in comparison to funds in the same sectors.

However, if all the funds outperformed their respective benchmarks, then Anderson’s
assertion that the company “is achieving excellent returns” may be factual. Funds may
exhibit positive returns for investors, exceed benchmarks, and yet have returns below the
median in their sectors.

Members and candidates need to ensure that their marketing efforts do not include
statements that misrepresent their skills and abilities to remain compliant with Standard
1(C). Unless the returns of a single fund reflect the performance of a firm as a whole, the
use of a singular fund for performance comparisons should be avoided.

Standard 1(D) Misconduct

The Standard
Members and candidates must not engage in any professional conduct involving dishonesty,
fraud, or deceit, or commit any act that reflects adversely on their professional reputation,
integrity, or competence.

Guidance
• While Standard 1(A) addresses the obligation of members and candidates to comply
with applicable law that governs their professional activities, Standard 1(D) addresses
all conduct that reflects poorly on the professional integrity, good reputation, or
competence of members and candidates. Any act that involves lying, cheating,
stealing, or other dishonest conduct is a violation of this standard if the offense
reflects adversely on a member’s or candidate’s professional activities.
• Conduct that damages trustworthiness or competence may include behavior that,
although not illegal, nevertheless negatively affects a member’s or candidate’s ability
to perform his or her responsibilities. For example:
o Abusing alcohol during business hours might constitute a violation of this
standard because it could have a detrimental effect on the member’s or
candidate’s ability to fulfill his or her professional responsibilities,
o Personal bankruptcy may not reflect on the integrity or trustworthiness of the
person declaring bankruptcy, but if the circumstances of the bankruptcy
involve fraudulent or deceitful business conduct, the bankruptcy may be a
violation of this standard.
• In some cases, the absence of appropriate conduct or the lack of sufficient effort may
be a violation of Standard 1(D). The integrity of the investment profession is built on
trust. A member or candidate—whether an investment banker, rating or research
analyst, or portfolio manager—is expected to conduct the necessary due diligence to
properly understand the nature and risks of an investment before making an
investment recommendation. By not taking these steps and, instead, relying on
someone else in the process to perform them, members or candidates may violate the
trust their clients have placed in them. This loss of trust may have a significant impact
on the reputation of the member or candidate and the operations of the financial
market as a whole.

? © 2020 Wiley
 STANDARD I: PROFESSIONALISM

• Note that Standard 1(D) or any other standard should not be used to settle personal,
political, or other disputes unrelated to professional ethics.

Recommended Procedures for Compliance

Members and candidates should encourage their firms to adopt the following policies and
procedures to support the principles of Standard 1(D):

• Code of ethics: Develop and/or adopt a code of ethics to which every employee must
subscribe, and make clear that any personal behavior that reflects poorly on the
individual involved, the institution as a whole, or the investment industry will not be
tolerated.
• List of violations: Disseminate to all employees a list of potential violations and
associated disciplinary sanctions, up to and including dismissal from the firm.
• Employee references: Check references of potential employees to ensure that they
are of good character and not ineligible to work in the investment industry because of
past infractions of the law.

Application of the Standard

Example 13 (Professionalism and Competence)

Simon Sasserman is a trust investment officer at a bank in a small affluent town. He

enjoys lunching every day with friends at the country club, where his clients have
observed him having numerous drinks. Back at work after lunch, he clearly is
intoxicated while making investment decisions. His colleagues make a point of handling
any business with Sasserman in the morning because they distrust his judgment after
lunch.

Comment: Sasserman’s excessive drinking at lunch and subsequent intoxication at work

constitute a violation of Standard 1(D) because this conduct has raised questions about
his professionalism and competence. His behavior reflects poorly on him, his employer,
and the investment industry.

Example 14 (Fraud and Deceit)

Howard Hoffman, a security analyst at ATZ Brothers, Inc., a large brokerage house,
submits reimbursement forms over a two-year period to ATZ’s self-funded health
insurance program for more than two dozen bills, most of which have been altered to
increase the amount due. An investigation by the firm’s director of employee benefits
uncovers the inappropriate conduct. ATZ subsequently terminates Hoffman’s
employment and notifies CFA Institute.

Comment: Hoffman violated Standard 1(D) because he engaged in intentional conduct

involving fraud and deceit in the workplace that adversely reflected on his integrity.

Example 15 (Personal Actions and Integrity)

Carmen Garcia manages a mutual fund dedicated to socially responsible investing. She is
also an environmental activist. As the result of her participation in nonviolent protests,

© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Garcia has been arrested on numerous occasions for trespassing on the property of a
large petrochemical plant that is accused of damaging the environment.

Comment: Generally, Standard 1(D) is not meant to cover legal transgressions resulting
from acts of civil disobedience in support of personal beliefs because such conduct does
not reflect poorly on the member’s or candidate’s professional reputation, integrity, or
competence.

Example 16 (Professional Misconduct)

Meredith Rasmussen works on a buy-side trading desk of an investment management

firm and concentrates on in-house trades for a hedge fund subsidiary managed by a team
at the investment management firm. The hedge fund has been very successful and is
marketed globally by the firm. From her experience as the trader for much of the activity
of the fund, Rasmussen has become quite knowledgeable about the hedge fund’s
strategy, tactics, and performance. When a distinct break in the market occurs and many
of the securities involved in the hedge fund’s strategy decline markedly in value,
Rasmussen observes that the reported performance of the hedge fund does not reflect this
decline. In her experience, the lack of effect is a very unlikely occurrence. She
approaches the head of trading about her concern and is told that she should not ask any
questions and that the fund is big and successful and is not her concern. She is fairly sure
something is not right, so she contacts the compliance officer, who also tells her to stay
away from the issue of the hedge fund’s reporting.

Comment: Rasmussen has clearly come across an error in policies, procedures, and
compliance practices within the firm’s operations. According to the firm’s procedures for
reporting potentially unethical activity, she should pursue the issue by gathering some
proof of her reason for doubt. Should all internal communications within the firm not
satisfy her concerns, Rasmussen should consider reporting the potential unethical
activity to the appropriate regulator.

See also Standard IV(A) for guidance on whistleblowing and Standard IV(C) for the
duties of a supervisor.

30
© 2020 Wiley
 St a n d a r d II: In t e g r it y o f C a p it a l M a r k et s

LESSON MAP
• Material Nonpublic Information
• Market Manipulation

Learning Objective: Demonstrate knowledge of Standard II: Integrity of

Capital Markets.

STANDARD 11(A) MATERIAL NONPUBLIC INFORMATION

The Standard
Members and candidates who possess material nonpublic information that could affect the
value of an investment must not act or cause others to act on the information.

Guidance
• Standard 11(A) is related to information that is material and is nonpublic. Such
information must not be used for direct buying and selling of individual securities or
bonds, nor to influence investment actions related to derivatives, mutual funds, or
other alternative investments.

Material Information
Information is “material” if its disclosure would likely have an impact on the price of a
security, or if reasonable investors would want to know the information before making an
investment decision. Material information may include, but is not limited to, information
relating to the following:

• Earnings.
• Mergers, acquisitions, tender offers, or joint ventures.
• Changes in assets.
• Innovative products, processes, or discoveries.
• New licenses, patents, registered trademarks, or regulatory approval/rejection of a
product.
• Developments regarding customers or suppliers (e.g., the acquisition or loss of a
contract).
• Changes in management.
• Change in auditor notification or the fact that the issuer may no longer rely on an
auditor’s report or qualified opinion.
• Events regarding the issuer’s securities (e.g., defaults on senior securities, calls of
securities for redemption, repurchase plans, stock splits, changes in dividends,
changes to the rights of security holders, public or private sales of additional
securities, and changes in credit ratings).
• Bankruptcies.
• Significant legal disputes.
• Government reports of economic trends (employment, housing starts, currency
information, etc.).
• Orders for large trades before they are executed.
• New or changing equity or debt ratings issued by a third party (e.g., sell-side
recommendations and credit ratings).
• To determine if information is material, members and candidates should consider the
source of information and the information’s likely effect on the relevant stock price.

© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

o The less reliable a source, the less likely the information provided would be
considered material.
o The more ambiguous the effect on price, the less material the information
becomes.
o If it is unclear whether the information will affect the price of a security and
to what extent, information may not be considered material.

Nonpublic Information
• Information is “nonpublic” until it has been disseminated or is available to the
marketplace in general (as opposed to a select group of investors). “Disseminated”
can be defined as “made known.”
o For example, a company report of profits that is posted on the Internet and
distributed widely through a press release or accompanied by a filing has
been effectively disseminated to the marketplace.
• Members and candidates must be particularly aware of information that is selectively
disclosed by corporations to a small group of investors, analysts, or other market
participants. Information that is made available to analysts remains nonpublic until it
is made available to investors in general.
• Analysts should also be alert to the possibility that they are selectively receiving
material nonpublic information when a company provides them with guidance or
interpretation of such publicly available information as financial statements or
regulatory filings.
• A member or candidate may use insider information provided legitimately by the
source company for the specific purpose of conducting due diligence according to the
business agreement between the parties for such activities as mergers, loan
underwriting, credit ratings, and offering engagements. However, the use of insider
information provided by the source company for other purposes, especially to trade
or entice others to trade the securities of the firm, conflicts with this standard.

Mosaic Theory
• A financial analyst may use significant conclusions derived from the analysis of
public information and nonmaterial nonpublic information as the basis for
investment recommendations and decisions. Under the “mosaic theory,” financial
analysts are free to act on this collection, or mosaic, of information without risking
violation, even when the conclusion they reach would have been material inside
information had the company communicated the same.
• Investment professionals should note, however, that although analysts are free to use
mosaic information in their research reports, they should save and document all their
research [see Standard V(C)].

Social Media
• Members and candidates participating in online discussion forums/groups with
membership limitations should verify that material information obtained from these
sources can also be accessed from a source that would be considered available to the
public (e.g., company filings, webpages, and press releases).
• Members and candidates may use social media platforms to communicate with
clients or investors without conflicting with this standard.
• Members and candidates, as required by Standard 1(A), should also complete all
appropriate regulatory filings related to information distributed through social media
platforms.

© 2020 Wiley
 STANDARD II: INTEGRITY OF CAPITAL MARKETS

Using Industry Experts

• The increased demand for insights for understanding the complexities of some
industries has led to an expansion of engagement with outside experts. Members and
candidates may provide compensation to individuals for their insights without
violating this standard.
• However, members and candidates are ultimately responsible for ensuring that they
are not requesting or acting on confidential information received from external
experts, which is in violation of security regulations and laws or duties to others.

Investment Research Reports

• It might often be the case that reports prepared by well-known analysts may have an
effect on the market and thus may be considered material information. Theoretically,
such a report might have to be made public before it was distributed to clients.
However, since the analyst is not a company insider, and presumably prepared the
report based on publicly available information, the report does not need to be made
public just because its conclusions are material. Investors who want to use that report
must become clients of the analyst.

Recommended Procedures for Compliance

Achieve public dissemination: If a member or candidate determines that some nonpublic
information is material, she should encourage the issuer to make the information public. If
public dissemination is not possible, she must communicate the information only to the
designated supervisory and compliance personnel in her firm and must not take investment
action on the basis of the information.

Adopt compliance procedures: Members and candidates should encourage their firms to
adopt compliance procedures to prevent the misuse of material nonpublic information.
Particularly important is improving compliance in areas such as review of employee and
proprietary trading, documentation of firm procedures, and the supervision of
interdepartmental communications in multiservice firms.

Adopt disclosure procedures: Members and candidates should encourage their firms to
develop and follow disclosure policies designed to ensure that information is disseminated
in the marketplace in an equitable manner. An issuing company should not discriminate
among analysts in the provision of information or blackball particular analysts who have
given negative reports on the company in the past.

Issue press releases: Companies should consider issuing press releases prior to analyst
meetings and conference calls and scripting those meetings and calls to decrease the chance
that further information will be disclosed.

Firewall elements: An information barrier commonly referred to as a “firewall” is the most

widely used approach to prevent communication of material nonpublic information within
firms. The minimum elements of such a system include, but are not limited to, the
following:

• Substantial control of relevant interdepartmental communications, preferably

through a clearance area within the firm in either the compliance or legal department.
• Review of employee trading through the maintenance of “watch,” “restricted,” and
“rumor” lists.
• Documentation of the procedures designed to limit the flow of information between
departments and of the enforcement actions taken pursuant to those procedures.

© 2020 Wiley 5
PROFESSIONAL STANDARDS AND ETHICS

Heightened review or restriction of proprietary trading while a firm is in possession

of material nonpublic information.

Appropriate interdepartmental communications: Based on the size of the firm,

procedures concerning interdepartmental communication, the review of trading activity, and
the investigation of possible violations should be compiled and formalized.

Physical separation of departments: As a practical matter, to the extent possible, firms

should consider the physical separation of departments and files to prevent the
communication of sensitive information.

Prevention of personnel overlap: There should be no overlap of personnel between the

investment banking and corporate finance areas of a brokerage firm and the sales and
research departments or between a bank’s commercial lending department and its trust and
research departments. For a firewall to be effective in a multiservice firm, an employee can
be allowed to be on only one side of the wall at any given time.

A reporting system: The least a firm should do to protect itself from liability is have an
information barrier in place. It should authorize people to review and approve
communications between departments. A single supervisor or compliance officer should
have the specific authority and responsibility of deciding whether or not information is
material and whether it is sufficiently public to be used as the basis for investment
decisions.

Personal trading limitations: Firms should also consider restrictions or prohibitions on

personal trading by employees and should carefully monitor both proprietary trading and
personal trading by employees. Further, they should require employees to make periodic
reports (to the extent that such reporting is not already required by securities laws) of their
own transactions and transactions made for the benefit of family members.

Securities should be placed on a restricted list when a firm has or may have material
nonpublic information. Further, the watch list should be shown to only the few people
responsible for compliance to monitor transactions in specified securities. The use of a
watch list in combination with a restricted list has become a common means of ensuring an
effective procedure.

Record maintenance: Multiservice firms should maintain written records of

communications among various departments. Firms should place a high priority on training
and should consider instituting comprehensive training programs, to enable employees to
make informed decisions.

Proprietary trading procedures: Procedures concerning the restriction or review of a

firm’s proprietary trading while it possesses material nonpublic information will necessarily
depend on the types of proprietary trading in which a firm may engage. For example, when
a firm acts as a market maker, a prohibition on proprietary trading may be
counterproductive to the goals of maintaining the confidentiality of information and market
liquidity. However, in the case of risk-arbitrage trading, a firm should suspend arbitrage
activity when a security is placed on the watch list.

Communication to all employees: Written compliance policies and guidelines should be

circulated to all employees of a firm. Further, they must be given sufficient training to either
be able to make an informed decision or to realize that they need to consult a compliance
officer before engaging in questionable transactions.

=4
© 2020 Wiley
 STANDARD II: INTEGRITY OF CAPITAL MARKETS

Application of the Standard

Example 1 (Acting on Nonpublic Information)

Frank Barnes, the president and controlling shareholder of the SmartTown clothing
chain, decides to accept a tender offer and sell the family business at a price almost
double the market price of its shares. He describes this decision to his sister
(SmartTown’s treasurer), who conveys it to her daughter (who owns no stock in the
family company at present), who tells her husband, Staple. Staple, however, tells his
stockbroker, Alex Halsey, who immediately buys SmartTown stock for himself.

Comment: The information regarding the pending sale is both material and nonpublic.
Staple has violated Standard 11(A) by communicating the inside information to his
broker. Halsey also has violated the standard by buying the shares on the basis of
material nonpublic information.

Example 2 (Controlling Nonpublic Information)

Samuel Peter, an analyst with Scotland and Pierce Incorporated, is assisting his firm with
a secondary offering for Bright Ideas Lamp Company. Peter participates, via telephone
conference call, in a meeting with Scotland and Pierce investment banking employees
and Bright Ideas’ CEO. Peter is advised that the company’s earnings projections for the
next year have significantly dropped. Throughout the telephone conference call, several
Scotland and Pierce salespeople and portfolio managers walk in and out of Peter’s office,
where the telephone call is taking place. As a result, they are aware of the drop in
projected earnings for Bright Ideas. Before the conference call is concluded, the
salespeople trade the stock of the company on behalf of the firm’s clients and other firm
personnel trade the stock in a firm proprietary account and in employees’ personal
accounts.

Comment: Peter has violated Standard 11(A) because he failed to prevent the transfer
and misuse of material nonpublic information to others in his firm. Peter’s firm should
have adopted information barriers to prevent the communication of nonpublic
information among departments of the firm. The salespeople and portfolio managers
who traded on the information have also violated Standard 11(A) by trading on inside
information.

Example 3 (Selective Disclosure of Material Information)

Elizabeth Levenson is based in Taipei and covers the Taiwanese market for her firm,
which is based in Singapore. She is invited, together with the other 10 largest
shareholders of a manufacturing company, to meet the finance director of that company.
During the meeting, the finance director states that the company expects its workforce to
strike next Friday, which will cripple productivity and distribution. Can Levenson use
this information as a basis to change her rating on the company from “buy” to “sell”?

Comment: Levenson must first determine whether the material information is public.
According to Standard 11(A), if the company has not made this information public (a

© 2020 Wiley 5
PROFESSIONAL STANDARDS AND ETHICS

small group forum does not qualify as a method of public dissemination), she cannot use
the information.

Example 4 (Determining Materiality)

Leah Fechtman is trying to decide whether to hold or sell shares of an oil-and-gas

exploration company that she owns in several of the funds she manages. Although the
company has underperformed the index for some time already, the trends in the industry
sector signal that companies of this type might become takeover targets. While she is
considering her decision, her doctor, who casually follows the markets, mentions that she
thinks that the company in question will soon be bought out by a large multinational
conglomerate and that it would be a good idea to buy the stock right now. After talking
to various investment professionals and checking their opinions on the company as well
as checking industry trends, Fechtman decides the next day to accumulate more stock in
the oil-and-gas exploration company.

Comment: Although information on an expected takeover bid may be of the type that is
generally material and nonpublic, in this case, the source of information is unreliable, so
the information cannot be considered material. Therefore, Fechtman is not prohibited
from trading the stock on the basis of this information.

Example 5 (Applying the Mosaic Theory)

Jagdish Teja is a buy-side analyst covering the furniture industry. Looking for an
attractive company to recommend as a buy, he analyzes several furniture makers by
studying their financial reports and visiting their operations. He also talks to some
designers and retailers to find out which furniture styles are trendy and popular.
Although none of the companies that he analyzes are a clear buy, he discovers that one
of them, Swan Furniture Company (SFC), may be in financial trouble. SFC’s
extravagant new designs have been introduced at substantial cost. Even though these
designs initially attracted attention, the public is now buying more conservative furniture
from other makers. Based on this information and on a profit-and-loss analysis, Teja
believes that SFC’s next quarter earnings will drop substantially. He issues a sell
recommendation for SFC. Immediately after receiving that recommendation, investment
managers start reducing the SFC stock in their portfolios.

Comment: Information on quarterly earnings data is material and nonpublic. Teja

arrived at his conclusion about the earnings drop on the basis of public information and
on pieces of nonmaterial nonpublic information (such as opinions of designers and
retailers). Therefore, trading based on Teja’s correct conclusion is not prohibited by
Standard 11(A).

Example 6 (Mosaic Theory)

John Doll is a research analyst for a hedge fund that also sells its research to a select
group of paying client investment firms. Doll’s focus is medical technology companies
and products, and he has been in the business long enough and has been successful

36
© 2020 Wiley
 STANDARD II: INTEGRITY OF CAPITAL MARKETS

enough to build up a very credible network of friends and experts in the business. Doll
has been working on a major research report recommending Boyce Health, a medical
device manufacturer. He recently ran into an old acquaintance at a wedding who is a
senior executive at Boyce, and Doll asked about the business. Doll was drawn to a
statement that the executive, who has responsibilities in the new products area, made
about a product: “I would not get too excited about the medium-term prospects; we have
a lot of work to do first.” Doll incorporated this and other information about the new
Boyce product in his long-term recommendation of Boyce.

Comment: Doll’s conversation with the senior executive is part of the mosaic of
information used in recommending Boyce. When holding discussions with a firm
executive, Doll would need to guard against soliciting or obtaining material nonpublic
information. Before issuing the report, the executive’s statement about the continuing
development of the product would need to be weighed against the other known public
facts to determine whether it would be considered material.

Example 7 (Materiality Determination)

Larry Nadler, a trader for a mutual fund, gets a text message from another firm’s trader,
whom he has known for years. The message indicates a software company is going to
report strong earnings when the firm publicly announces in two days. Nadler has a buy
order from a portfolio manager within his firm to purchase several hundred thousand
shares of the stock. Nadler is aggressive in placing the portfolio manager’s order and
completes the purchases by the following morning, a day ahead of the firm’s planned
earnings announcement.

Comment: There are often rumors and whisper numbers before a release of any kind.
The text message from the other trader would most likely be considered market noise.
Unless Nadler knew that the trader had an ongoing business relationship with the public
firm, he had no reason to suspect he was receiving material nonpublic information that
would prevent him from completing the trading request of the portfolio manager.

Example 8 (Using an Expert Network)

Tom Watson is a research analyst working for a hedge fund. To stay informed, Watson
relies on outside experts for information on such industries as technology and
pharmaceuticals, where new advancements occur frequently. The meetings with the
industry experts often are arranged through networks or placement agents that have
specific policies and procedures in place to deter the exchange of material nonpublic
information.

Watson arranges a call to discuss future prospects for one of the fund’s existing
technology company holdings, a company that was testing a new semiconductor
product. The scientist leading the tests indicates his disappointment with the performance
of the new semiconductor. Following the call, Watson relays the insights he received to
others at the fund. The fund sells its current position in the company and writes many put
options because the market is anticipating the success of the new semiconductor and the
share price reflects the market’s optimism.

37
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Comment: Watson has violated Standard 11(A) by passing along material nonpublic
information concerning the ongoing product tests, which the fund used to trade in the
securities and options of the related company. Watson cannot simply rely on the
agreements signed by individuals who participate in expert networks that state that he
has not received information that would prohibit his trading activity. He must make his
own determination whether information he received through these arrangements reaches
a materiality threshold that would affect his trading abilities.

STANDARD 11(B) MARKET MANIPULATION

THE STANDARD
Members and candidates must not engage in practices that distort prices or artificially inflate
trading volume with the intent to mislead market participants.

Guidance
• Members and candidates must uphold market integrity by prohibiting market
manipulation. Market manipulation includes practices that distort security prices or
trading volume with the intent to deceive people or entities that rely on information in
the market.
• Market manipulation includes (1) the dissemination of false or misleading
information and (2) transactions that deceive or would be likely to mislead market
participants by distorting the price-setting mechanism of financial instruments.

Information-Based Manipulation
• Information-based manipulation includes, but is not limited to, spreading false
rumors to induce trading by others.
o For example, members and candidates must refrain from “pumping up” the
price of an investment by issuing misleading positive information or overly
optimistic projections of a security’s worth only to later “dump” the
investment (i.e., sell it) once the price, fueled by the misleading
information’s effect on other market participants, reaches an artificially high
level.

Transaction-Based Manipulation
• Transaction-based manipulation involves instances where a member or candidate
knew or should have known that his or her actions could affect the pricing of a
security. This type of manipulation includes, but is not limited to, the following:
o Transactions that artificially affect prices or volume to give the impression
of activity or price movement in a financial instrument, which represent a
diversion from the expectations of a fair and efficient market.
o Securing a controlling, dominant position in a financial instrument to exploit
and manipulate the price of a related derivative and/or the underlying asset.

Note that Standard 11(B) is not intended to preclude transactions undertaken on legitimate
trading strategies based on perceived market inefficiencies. The intent of the action is
critical to determining whether it is a violation of this standard.

© 2020 Wiley
 STANDARD II: INTEGRITY OF CAPITAL MARKETS

Application of the Standard

Example 1 (Independent Analysis and Company Promotion)

The principal owner of Financial Information Services (FIS) entered into an agreement
with two microcap companies to promote the companies’ stock in exchange for stock
and cash compensation. The principal owner caused FIS to disseminate e-mails, design
and maintain several websites, and distribute an online investment newsletter—all of
which recommended investment in the two companies. The systematic publication of
purportedly independent analyses and recommendations containing inaccurate and
highly promotional and speculative statements increased public investment in the
companies and led to dramatically higher stock prices.

Comment: The principal owner of FIS violated Standard 11(B) by using inaccurate
reporting and misleading information under the guise of independent analysis to
artificially increase the stock price of the companies. Furthermore, the principal owner
violated Standard V(A)—Diligence and Reasonable Basis by not having a reasonable
and adequate basis for recommending the two companies and violated Standard VI(A)—
Disclosure of Conflicts by not disclosing to investors the compensation agreements
(which constituted a conflict of interest).

Example 2 (Personal Trading Practices and Price)

John Gray is a private investor in Belgium who bought a large position several years ago
in Fame Pharmaceuticals, a German small-cap security with limited average trading
volume. He has now decided to significantly reduce his holdings owing to the poor price
performance. Gray is worried that the low trading volume for the stock may cause the
price to decline further as he attempts to sell his large position.

Gray devises a plan to divide his holdings into multiple accounts in different brokerage
firms and private banks in the names of family members, friends, and even a private
religious institution. He then creates a rumor campaign on various blogs and social
media outlets promoting the company.

Gray begins to buy and sell the stock using the accounts in hopes of raising the trading
volume and the price. He conducts the trades through multiple brokers, selling slightly
larger positions than he bought on a tactical schedule, and over time, he is able to reduce
his holding as desired without negatively affecting the sale price.

Comment: Gray violated Standard 11(B) by fraudulently creating the appearance that
there was a greater investor interest in the stock through the online rumors. Additionally,
through his trading strategy, he created the appearance that there was greater liquidity in
the stock than actually existed. He was able to manipulate the price through both
misinformation and trading practices.

© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Example 3 (Personal Trading and Volume)

Rajesh Sekar manages two funds—an equity fund and a balanced fund—whose equity
components are supposed to be managed in accordance with the same model. According
to that model, the funds’ holdings in stock of Digital Design Inc. (DD) are excessive.
Reduction of the DD holdings would not be easy, however, because the stock has low
liquidity in the stock market. Sekar decides to start trading larger portions of DD stock
back and forth between his two funds to slowly increase the price; he believes market
participants will see growing volume and increasing price and become interested in the
stock. If other investors are willing to buy the DD stock because of such interest, then
Sekar will be able to get rid of at least some of his overweight position without inducing
price decreases. In this way, the whole transaction will be for the benefit of fund
participants, even if additional brokers’ commissions are incurred.

Comment: Sekar’s plan would be beneficial for his funds’ participants but is based on
artificial distortion of both trading volume and the price of the DD stock and thus
constitutes a violation of Standard 11(B).

Example 4 (“Pump-Priming” Strategy)

Sergei Gonchar is chairman of the ACME Futures Exchange, which is launching a new
bond futures contract. To convince investors, traders, arbitrageurs, hedgers, and so on, to
use its contract, the exchange attempts to demonstrate that it has the best liquidity. To do
so, it enters into agreements with members in which they commit to a substantial
minimum trading volume on the new contract over a specific period in exchange for
substantial reductions of their regular commissions.

Comment: The formal liquidity of a market is determined by the obligations set on

market makers, but the actual liquidity of a market is better estimated by the actual
trading volume and bid-ask spreads. Attempts to mislead participants about the actual
liquidity of the market constitute a violation of Standard 11(B). In this example, investors
have been intentionally misled to believe they chose the most liquid instrument for some
specific purpose, but they could eventually see the actual liquidity of the contract
significantly reduced after the term of the agreement expires. If the ACME Futures
Exchange fully discloses its agreement with members to boost transactions over some
initial launch period, it will not violate Standard 11(B). ACME’s intent is not to harm
investors but, on the contrary, to give them a better service. For that purpose, it may
engage in a liquidity-pumping strategy, but the strategy must be disclosed.

Example 5 (Pump and Dump Strategy)

In an effort to pump up the price of his holdings in Moosehead & Belfast Railroad
Company, Steve Weinberg logs on to several investor chat rooms on the Internet to start
rumors that the company is about to expand its rail network in anticipation of receiving a
large contract for shipping lumber.

Comment: Weinberg has violated Standard 11(B) by disseminating false information

about Moosehead & Belfast with the intent to mislead market participants.

40
© 2020 Wiley
 STANDARD II: INTEGRITY OF CAPITAL MARKETS

Example 6 (Information Manipulation)

Allen King is a performance analyst for Torrey Investment Funds. King believes that the
portfolio manager for the firm’s small- and microcap equity fund dislikes him because
the manager never offers him tickets to the local baseball team’s games but does offer
tickets to other employees. To incite a potential regulatory review of the manager, King
creates user profiles on several online forums under the portfolio manager’s name and
starts rumors about potential mergers for several of the smaller companies in the
portfolio. As the prices of these companies’ stocks increase, the portfolio manager sells
the position, which leads to an investigation by the regulator as King desired.

Comment: King has violated Standard 11(B) even though he did not personally profit
from the market’s reaction to the rumor. In posting the false information, King misleads
others into believing the companies were likely to be acquired. Although his intent was
to create trouble for the portfolio manager, his actions clearly manipulated the factual
information that was available to the market.

41
© 2020 Wiley
 St a n d a r d III: D u t ie s t o C l ie n t s

LESSON MAP
• Loyalty, Prudence, and Care
• Fair Dealing
• Suitability
• Performance Presentation
• Preservation of Confidentiality

Standard III(A) Loyalty, Prudence, and Care

Learning Objective: Demonstrate knowledge of Standard III: Duties to Clients.

The Standard
Members and candidates have a duty of loyalty to their clients and must act with reasonable
care and exercise prudent judgment. Members and candidates must act for the benefit of
their clients, and place their clients’ interests before their employer’s or their own interests.

Guidance
• Standard III(A) clarifies that client interests are paramount. A member’s or
candidate’s responsibility to a client includes a duty of loyalty and a duty to exercise
reasonable care. Investment actions must be carried out for the sole benefit of the
client and in a manner the member or candidate believes, given the known facts and
circumstances, to be in the best interest of the client. Members and candidates must
exercise the same level of prudence, judgment, and care that they would apply in the
management and disposition of their own interests in similar circumstances.
• Prudence requires caution and discretion. The exercise of prudence by investment
professionals requires that they act with the care, skill, and diligence that a reasonable
person acting in a like capacity and familiar with such matters would use. In the
context of managing a client’s portfolio, prudence requires following the investment
parameters set forth by the client and balancing risk and return. Acting with care
requires members and candidates to act in a prudent and judicious manner in
avoiding harm to clients.
• Standard III(A), however, is not a substitute for a member’s or candidate’s legal or
regulatory obligations. As stated in Standard 1(A), members and candidates must
abide by the most strict requirements imposed on them by regulators or the Code and
Standards, including any legally imposed fiduciary duty.
• Members and candidates must also be aware of whether they have “custody” or
effective control of client assets. If so, a heightened level of responsibility arises.
Members and candidates are considered to have custody if they have any direct or
indirect access to client funds. Members and candidates must manage any pool of
assets in their control in accordance with the terms of the governing documents (such
as trust documents and investment management agreements), which are the primary
determinant of the manager’s powers and duties.

Understanding the Application of Loyalty, Prudence, and Care

• Standard III(A) establishes a minimum benchmark for the duties of loyalty,
prudence, and care that are required of all members and candidates regardless of
whether a legal fiduciary duty applies. Although fiduciary duty often encompasses
the principles of loyalty, prudence, and care, Standard III(A) does not render all
members and candidates fiduciaries. The responsibilities of members and candidates

«
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

for fulfilling their obligations under this standard depend greatly on the nature of
their professional responsibilities and the relationships they have with clients.
• There is a large variety of professional relationships that members and candidates
have with their clients. Standard III(A) requires them to fulfill the obligations
outlined explicitly or implicitly in the client agreements to the best of their abilities
and with loyalty, prudence, and care. Whether a member or candidate is structuring a
new securitization transaction, completing a credit rating analysis, or leading a public
company, he or she must work with prudence and care in delivering the agreed-on
services.

Identifying the Actual Investment Client

• The first step for members and candidates in fulfilling their duty of loyalty to clients
is to determine the identity of the “client” to whom the duty of loyalty is owed. In the
context of an investment manager managing the personal assets of an individual, the
client is easily identified. When the manager is responsible for the portfolios of
pension plans or trusts, however, the client is not the person or entity who hires the
manager but, rather, the beneficiaries of the plan or trust. The duty of loyalty is owed
to the ultimate beneficiaries.
• Members and candidates managing a fund to an index or an expected mandate owe
the duty of loyalty, prudence, and care to invest in a manner consistent with the stated
mandate. The decisions of a fund’s manager, although benefiting all fund investors,
do not have to be based on an individual investor’s requirements and risk profile.
Client loyalty and care for those investing in the fund are the responsibility of
members and candidates who have an advisory relationship with those individuals.

Developing the Client’s Portfolio

• Professional investment managers should ensure that the client’s objectives and
expectations for the performance of the account are realistic and suitable to the
client’s circumstances and that the risks involved are appropriate. In most
circumstances, recommended investment strategies should relate to the long-term
objectives and circumstances of the client.
• When members and candidates cannot avoid potential conflicts between their firm
and clients’ interests, they must provide clear and factual disclosures of the
circumstances to the clients.
• Members and candidates must follow any guidelines set by their clients for the
management of their assets.
• Investment decisions must be judged in the context of the total portfolio rather than
by individual investment within the portfolio. The member’s or candidate’s duty is
satisfied with respect to a particular investment if the individual has thoroughly
considered the investment’s place in the overall portfolio, the risk of loss and
opportunity for gains, tax implications, and the diversification, liquidity, cash flow,
and overall return requirements of the assets or the portion of the assets for which the
manager is responsible.

Soft Commission Policies

• An investment manager often has discretion over the selection of brokers executing
transactions. Conflicts may arise when an investment manager uses client brokerage
to purchase research services, a practice commonly called “soft dollars” or “soft
commissions.” A member or candidate who pays a higher brokerage commission
than he or she would normally pay to allow for the purchase of goods or services,
without corresponding benefit to the client, violates the duty of loyalty to the client.

«
© 2020 Wiley
 STANDARD III: DUTIES TO CLIENTS

• From time to time, a client will direct a manager to use the client’s brokerage to
purchase goods or services for the client, a practice that is commonly called “directed
brokerage.” Because brokerage commission is an asset of the client and is used to
benefit that client, not the manager, such a practice does not violate any duty of
loyalty. However, a member or candidate is obligated to seek “best price” and “best
execution” and be assured by the client that the goods or services purchased from the
brokerage will benefit the account beneficiaries. In addition, the member or candidate
should disclose to the client that the client may not be getting best execution from the
directed brokerage.
o “Best execution” refers to a trading process that seeks to maximize the value
of the client’s portfolio within the client’s stated investment objectives and
constraints.

Proxy Voting Policies

• Part of a member’s or candidate’s duty of loyalty includes voting proxies in an
informed and responsible manner. Proxies have economic value to a client, and
members and candidates must ensure that they properly safeguard and maximize this
value.
• An investment manager who fails to vote, casts a vote without considering the impact
of the question, or votes blindly with management on nonroutine governance issues
(e.g., a change in company capitalization) may violate this standard. Voting of
proxies is an integral part of the management of investments.
• A cost-benefit analysis may show that voting all proxies may not benefit the client,
so voting proxies may not be necessary in all instances.
• Members and candidates should disclose to clients their proxy voting policies.

Recommended Procedures for Compliance

Regular Account Information

Members and candidates with control of client assets should:

• Submit to each client, at least quarterly, an itemized statement showing the funds and
securities in the custody or possession of the member or candidate plus all debits,
credits, and transactions that occurred during the period.
• Disclose to the client where the assets are to be maintained, as well as where or when
they are moved.
• Separate the client’s assets from any other party’s assets, including the member’s or
candidate’s own assets.

Client Approval
• If a member or candidate is uncertain about the appropriate course of action with
respect to a client, the member or candidate should consider what he or she would
expect or demand if the member or candidate were the client.
• If in doubt, a member or candidate should disclose the questionable matter in writing
to the client and obtain client approval.

Firm Policies
Members and candidates should address and encourage their firms to address the following
topics when drafting the statements or manuals containing their policies and procedures
regarding responsibilities to clients:

• Follow all applicable rules and laws: Members and candidates must follow all legal
requirements and applicable provisions of the Code and Standards.

4S
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

• Establish the investment objectives o f the client: Make a reasonable inquiry into a
client’s investment experience, risk and return objectives, and financial constraints
prior to making investment recommendations or taking investment actions.
• Consider all the information when taking actions: When taking investment actions,
members and candidates must consider the appropriateness and suitability of the
investment relative to (1) the client’s needs and circumstances, (2) the investment’s
basic characteristics, and (3) the basic characteristics of the total portfolio.
• Diversify: Members and candidates should diversify investments to reduce the risk of
loss, unless diversification is not consistent with plan guidelines or is contrary to the
account objectives.
• Carry out regular reviews: Members and candidates should establish regular review
schedules to ensure that the investments held in the account adhere to the terms of the
governing documents.
• Deal fairly with all clients with respect to investment actions: Members and
candidates must not favor some clients over others and should establish policies for
allocating trades and disseminating investment recommendations.
• Disclose conflicts o f interest. Members and candidates must disclose all actual and
potential conflicts of interest so that clients can evaluate those conflicts.
• Disclose compensation arrangements'. Members and candidates should make their
clients aware of all forms of manager compensation.
• Vote proxies'. In most cases, members and candidates should determine who is
authorized to vote shares and vote proxies in the best interests of the clients and
ultimate beneficiaries.
• Maintain confidentiality: Members and candidates must preserve the confidentiality
of client information.
• Seek best execution: Unless directed by the client as ultimate beneficiary, members
and candidates must seek best execution for their clients. (Best execution is defined
in the preceding text.)
• Place client interests first: Members and candidates must serve the best interests of
clients.

Application of the Standard

Example 1 (Identifying the Client—Plan Participants)

First Country Bank serves as trustee for the Miller Company’s pension plan. Miller is the
target of a hostile takeover attempt by Newton, Inc. In attempting to ward off Newton,
Miller’s managers persuade Julian Wiley, an investment manager at First Country Bank,
to purchase Miller common stock in the open market for the employee pension plan.
Miller’s officials indicate that such action would be favorably received and would
probably result in other accounts being placed with the bank. Although Wiley believes
the stock is overvalued and would not ordinarily buy it, he purchases the stock to support
Miller’s managers, to maintain Miller’s good favor toward the bank, and to realize
additional new business. The heavy stock purchases cause Miller’s market price to rise to
such a level that Newton retracts its takeover bid.

Comment: Standard III(A) requires that a member or candidate, in evaluating a takeover

bid, act prudently and solely in the interests of plan participants and beneficiaries. To
meet this requirement, a member or candidate must carefully evaluate the long-term
prospects of the company against the short-term prospects presented by the takeover
offer and by the ability to invest elsewhere. In this instance, Wiley, acting on behalf of
his employer, which was the trustee for a pension plan, clearly violated Standard III(A).

© 2020 Wiley
 STANDARD III: DUTIES TO CLIENTS

He used the pension plan to perpetuate existing management, perhaps to the detriment of
plan participants and the company’s shareholders, and to benefit himself. Wiley’s
responsibilities to the plan participants and beneficiaries should have taken precedence
over any ties of his bank to corporate managers and over his self-interest. Wiley had a
duty to examine the takeover offer on its own merits and to make an independent
decision. The guiding principle is the appropriateness of the investment decision to the
pension plan, not whether the decision benefited Wiley or the company that hired him.

Example 2 (Client Commission Practices)

JNI, a successful investment counseling firm, serves as investment manager for the
pension plans of several large regionally based companies. Its trading activities generate
a significant amount of commission-related business. JNI uses the brokerage and
research services of many firms, but most of its trading activity is handled through a
large brokerage company, Thompson, Inc., because the executives of the two firms have
a close friendship. Thompson’s commission structure is high in comparison with charges
for similar brokerage services from other firms. JNI considers Thompson’s research
services and execution capabilities average. In exchange for JNI directing its brokerage
to Thompson, Thompson absorbs a number of JNI overhead expenses, including those
for rent.

Comment: JNI executives are breaching their responsibilities by using client brokerage
for services that do not benefit JNI clients and by not obtaining best price and best
execution for their clients. Because JNI executives are not upholding their duty of
loyalty, they are violating Standard III(A).

Example 3 (Brokerage Arrangements)

Charlotte Everett, a struggling independent investment adviser, serves as investment

manager for the pension plans of several companies. One of her brokers, Scott Company,
is close to consummating management agreements with prospective new clients whereby
Everett would manage the new client accounts and trade the accounts exclusively
through Scott. One of Everett’s existing clients, Crayton Corporation, has directed
Everett to place securities transactions for Crayton’s account exclusively through Scott.
But to induce Scott to exert efforts to send more new accounts to her, Everett also directs
transactions to Scott from other clients without their knowledge.

Comment: Everett has an obligation at all times to seek best price and best execution on
all trades. Everett may direct new client trades exclusively through Scott Company as
long as Everett receives best price and execution on the trades or receives a written
statement from new clients that she is not to seek best price and execution and that they
are aware of the consequence for their accounts. Everett may trade other accounts
through Scott as a reward for directing clients to Everett only if the accounts receive best
price and execution and the practice is disclosed to the accounts. Because Everett does
not disclose the directed trading, Everett has violated Standard III(A).

47
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Example 4 (Brokerage Arrangements)

Emilie Rome is a trust officer for Paget Trust Company. Rome’s supervisor is
responsible for reviewing Rome’s trust account transactions and her monthly reports of
personal stock transactions. Rome has been using Nathan Gray, a broker, almost
exclusively for trust account brokerage transactions. When Gray makes a market in
stocks, he has been giving Rome a lower price for personal purchases and a higher price
for sales than he gives to Rome’s trust accounts and other investors.

Comment: Rome is violating her duty of loyalty to the bank’s trust accounts by using
Gray for brokerage transactions simply because Gray trades Rome’s personal account on
favorable terms. Rome is placing her own interests before those of her clients.

Example 5 (Managing Family Accounts)

Adam Dill recently joined New Investments Asset Managers. To assist Dill in building a
book of clients, both his father and brother opened new fee-paying accounts. Dill
followed all the firm’s procedures in noting his relationships with these clients and in
developing their investment policy statements.

After several years, the number of Dill’s clients has grown, but he still manages the
original accounts of his family members. An IPO is coming to market that is a suitable
investment for many of his clients, including his brother. Dill does not receive the
amount of stock he requested, so to avoid any appearance of a conflict of interest, he
does not allocate any shares to his brother’s account.

Comment: Dill has violated Standard III(A) because he is not acting for the benefit of
his brother’s account as well as his other accounts. The brother’s account is a regular fee-
paying account comparable to the accounts of his other clients. By not allocating the
shares proportionately across all accounts for which he thought the IPO was suitable,
Dill is disadvantaging specific clients.

Dill would have been correct in not allocating shares to his brother’s account if that
account was being managed outside the normal fee structure of the firm.

Example 6 (Identifying the Client)

Donna Hensley has been hired by a law firm to testify as an expert witness. Although the
testimony is intended to represent impartial advice, she is concerned that her work may
have negative consequences for the law firm. If the law firm is Hensley’s client, how
does she ensure that her testimony will not violate the required duty of loyalty, prudence,
and care to one’s client?

Comment: In this situation, the law firm represents Hensley’s employer and the aspect
of “Who is the client?” is not well defined. When acting as an expert witness, Hensley is
bound by the standard of independence and objectivity in the same manner as an
independent research analyst would be bound. Hensley must not let the law firm
influence the testimony she provides in the legal proceedings.

48
© 2020 Wiley
 STANDARD III: DUTIES TO CLIENTS

Example 7 (Client Loyalty)

After providing client account investment performance to the external-facing

departments but prior to it being finalized for release to clients, Teresa Nguyen, an
investment performance analyst, notices the reporting system missed a trade. Correcting
the omission resulted in a large loss for a client that had previously placed the firm on
“watch” for potential termination owing to underperformance in prior periods. Nguyen
knows this news is unpleasant but informs the appropriate individuals that the report
needs to be updated before releasing it to the client.

Comment: Nguyen’s actions align with the requirements of Standard III(A). Even
though the correction may to lead to the firm’s termination by the client, withholding
information on errors would not be in the best interest of the client.

Example 8 (Execution-Only Responsibilities)

Baftija Sulejman recently became a candidate in the CFA Program. Sulejman does not
provide any investment advice and only executes the trading decisions made by clients.
He is concerned that the Code and Standards impose a fiduciary duty on him in his
dealing with clients.

Comment: In this instance, Sulejman serves in an execution-only capacity and his duty
of loyalty, prudence, and care is centered on the skill and diligence used when executing
trades—namely, by seeking best execution and making trades within the parameters set
by the clients (instructions on quantity, price, timing, etc.). Acting in the best interests of
the client dictates that trades are executed on the most favorable terms that can be
achieved for the client. Given this job function, the requirements of the Code and
Standards for loyalty, prudence, and care clearly do not impose a fiduciary duty.

Standard III(B) Fair Dealing

The Standard
Members and candidates must deal fairly and objectively with all clients when providing
investment analysis, making investment recommendations, taking investment action, or
engaging in other professional activities.

Guidance
• Standard 111(B) requires members and candidates to treat all clients fairly when
disseminating investment recommendations or making material changes to prior
investment recommendations, or when taking investment action with regard to
general purchases, new issues, or secondary offerings.
• The term “fairly” implies that the member or candidate must take care not to
discriminate against any clients when disseminating investment recommendations or
taking investment action. Standard III(B) does not state “equally” because members
and candidates could not possibly reach all clients at exactly the same time. Further,
each client has unique needs, investment criteria, and investment objectives, so not
all investment opportunities are suitable for all clients.
• Members and candidates may provide more personal, specialized, or in-depth service
to clients who are willing to pay for premium services through higher management

49
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

fees or higher levels of brokerage. Members and candidates may differentiate their
services to clients, but different levels of service must not disadvantage or negatively
affect clients. In addition, the different service levels should be disclosed to clients
and prospective clients and should be available to everyone (i.e., different service
levels should not be offered selectively).

Investment Recommendations
• An investment recommendation is any opinion expressed by a member or candidate
in regard to purchasing, selling, or holding a given security or other investment. The
opinion may be disseminated to customers or clients through an initial detailed
research report, through a brief update report, by addition to or deletion from a list of
recommended securities, or simply by oral communication. A recommendation that
is distributed to anyone outside the organization is considered a communication for
general distribution under Standard III(B).
• Each member or candidate is obligated to ensure that information is disseminated in
such a manner that all clients have a fair opportunity to act on every recommendation.
Members and candidates should encourage their firms to design an equitable system
to prevent selective or discriminatory disclosure and should inform clients about
what kind of communications they will receive.
• The duty to clients imposed by Standard III(B) may be more critical when members
or candidates change their recommendations than when they make initial
recommendations. Material changes in a member’s or candidate’s prior investment
recommendations because of subsequent research should be communicated to all
current clients; particular care should be taken that the information reaches those
clients who the member or candidate knows have acted on or been affected by the
earlier advice.
• Clients who do not know that the member or candidate has changed a
recommendation and who, therefore, place orders contrary to a current
recommendation should be advised of the changed recommendation before the order
is accepted.

Investment Action
• Members or candidates must treat all clients fairly in light of their investment
objectives and circumstances. For example, when making investments in new
offerings or in secondary financings, members and candidates should distribute the
issues to all customers for whom the investments are appropriate in a manner
consistent with the policies of the firm for allocating blocks of stock. If the issue is
oversubscribed, then the issue should be prorated to all subscribers. If the issue is
oversubscribed, members and candidates should forgo any sales to themselves or
their immediate families in order to free up additional shares for clients.
o If the investment professional’s family-member accounts are managed
similarly to the accounts of other clients of the firm, however, the family-
member accounts should not be excluded from buying such shares.
• Members and candidates must make every effort to treat all individual and
institutional clients in a fair and impartial manner.
• Members and candidates should disclose to clients and prospective clients the
documented allocation procedures they or their firms have in place and how the
procedures would affect the client or prospect. The disclosure should be clear and
complete so that the client can make an informed investment decision. Even when
complete disclosure is made, however, members and candidates must put client
interests ahead of their own. A member’s or candidate’s duty of fairness and loyalty

» © 2020 Wiley
 STANDARD III: DUTIES TO CLIENTS

to clients can never be overridden by client consent to patently unfair allocation

procedures.
• Treating clients fairly also means that members and candidates should not take
advantage of their position in the industry to the detriment of clients. For instance, in
the context of IPOs, members and candidates must make bona fide public
distributions of “hot issue” securities (defined as securities of a public offering that
are trading at a premium in the secondary market whenever such trading commences
because of the great demand for the securities). Members and candidates are
prohibited from withholding such securities for their own benefit and must not use
such securities as a reward or incentive to gain benefit.

Recommended Procedures for Compliance

Develop Firm Policies

• A member or candidate should recommend appropriate procedures to management if
none are in place.
• A member or candidate should make management aware of possible violations of
fair-dealing practices within the firm when they come to the attention of the member
or candidate.
• Although a member or candidate need not communicate a recommendation to all
customers, the selection process by which customers receive information should be
based on suitability and known interest, not on any preferred or favored status.

A common practice to assure fair dealing is to communicate recommendations

simultaneously within the firm and to customers. Members and candidates should consider
the following points when establishing fair-dealing compliance procedures:

• Limit the number of people involved.

• Shorten the time frame between decision and dissemination.
• Publish guidelines for pre-dissemination behavior.
• Simultaneous dissemination.
• Maintain a list of clients and their holdings.
• Develop and document trade allocation procedures that ensure:
o Fairness to advisory clients, both in priority of execution of orders and in the
allocation of the price obtained in execution of block orders or trades,
o Timeliness and efficiency in the execution of orders,
o Accuracy of the member’s or candidate’s records as to trade orders and
client account positions.

With these principles in mind, members and candidates should develop or encourage their
firm to develop written allocation procedures, with particular attention to procedures for
block trades and new issues. Procedures to consider are as follows:

• Requiring orders and modifications or cancellations of orders to be documented and

time stamped.
• Processing and executing orders on a first-in, first-out basis with consideration of
bundling orders for efficiency as appropriate for the asset class or the security.
• Developing a policy to address such issues as calculating execution prices and
“partial fills” when trades are grouped, or in a block, for efficiency.
• Giving all client accounts participating in a block trade the same execution price and
charging the same commission.

© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

• When the full amount of the block order is not executed, allocating partially executed
orders among the participating client accounts pro rata on the basis of order size
while not going below an established minimum lot size for some securities (e.g.,
bonds).
• When allocating trades for new issues, obtaining advance indications of interest,
allocating securities by client (rather than portfolio manager), and providing a
method for calculating allocations.

Disclose Trade Allocation Procedures

• Members and candidates should disclose to clients and prospective clients how they
select accounts to participate in an order and how they determine the amount of
securities each account will buy or sell. Trade allocation procedures must be fair and
equitable, and disclosure of inequitable allocation methods does not relieve the
member or candidate of this obligation.

Establish Systematic Account Review

• Member and candidate supervisors should review each account on a regular basis to
ensure that no client or customer is being given preferential treatment and that the
investment actions taken for each account are suitable for each account’s objectives.
• Because investments should be based on individual needs and circumstances, an
investment manager may have good reasons for placing a given security or other
investment in one account while selling it from another account and should fully
document the reasons behind both sides of the transaction.
• Members and candidates should encourage firms to establish review procedures,
however, to detect whether trading in one account is being used to benefit a favored
client.

Disclose Levels of Service

• Members and candidates should disclose to all clients whether the organization offers
different levels of service to clients for the same fee or different fees.
• Different levels of service should not be offered to clients selectively.

Application of the Standard

Example 1 (Selective Disclosure)

Bradley Ames, a well-known and respected analyst, follows the computer industry. In
the course of his research, he finds that a small, relatively unknown company whose
shares are traded over the counter has just signed significant contracts with some of the
companies he follows. After a considerable amount of investigation, Ames decides to
write a research report on the small company and recommend purchase of its shares.
While the report is being reviewed by the company for factual accuracy, Ames schedules
a luncheon with several of his best clients to discuss the company. At the luncheon, he
mentions the purchase recommendation scheduled to be sent early the following week to
all the firm’s clients.

Comment: Ames has violated Standard III(B) by disseminating the purchase

recommendation to the clients with whom he has lunch a week before the
recommendation is sent to all clients.

5 © 2020 Wiley
 STANDARD III: DUTIES TO CLIENTS

Example 2 (Fair Dealing and IPO Distribution)

Dominic Morris works for a small regional securities firm. His work consists of
corporate finance activities and investing for institutional clients. Arena, Ltd., is planning
to go public. The partners have secured rights to buy an arena football league franchise
and are planning to use the funds from the issue to complete the purchase. Because arena
football is the current rage, Morris believes he has a hot issue on his hands. He has
quietly negotiated some options for himself for helping convince Arena to do the
financing through his securities firm. When he seeks expressions of interest, the
institutional buyers oversubscribe the issue. Morris, assuming that the institutions have
the financial clout to drive the stock up, then fills all orders (including his own) and
decreases the institutional blocks.

Comment: Morris has violated Standard III(B) by not treating all customers fairly. He
should not have taken any shares himself and should have prorated the shares offered
among all clients. In addition, he should have disclosed to his firm and to his clients that
he received options as part of the deal [see Standard VI(A)—Disclosure of Conflicts].

Example 3 (Fair Dealing and Transaction Allocation)

Eleanor Preston, the chief investment officer of Porter Williams Investments (PWI), a
medium-size money management firm, has been trying to retain a client, Colby
Company. Management at Colby, which accounts for almost half of PWI’s revenues,
recently told Preston that if the performance of its account did not improve, it would find
a new money manager. Shortly after this threat, Preston purchases mortgage-backed
securities (MBSs) for several accounts, including Colby’s. Preston is busy with a number
of transactions that day, so she fails to allocate the trades immediately or write up the
trade tickets. A few days later, when Preston is allocating trades, she notes that some of
the MBSs have significantly increased in price and some have dropped. Preston decides
to allocate the profitable trades to Colby and spread the losing trades among several
other PWI accounts.

Comment: Preston has violated Standard III(B) by failing to deal fairly with her clients
in taking these investment actions. Preston should have allocated the trades prior to
executing the orders, or she should have had a systematic approach to allocating the
trades, such as pro rata, as soon as practical after they were executed. Among other
things, Preston must disclose to the client that the adviser may act as broker for, receive
commissions from, and have a potential conflict of interest regarding both parties in
agency cross-transactions. After the disclosure, she should obtain from the client consent
authorizing such transactions in advance.

Example 4 (Additional Services for Select Clients)

Jenpin Weng uses e-mail to issue a new recommendation to all his clients. He then calls
his three largest institutional clients to discuss the recommendation in detail.

Comment: Weng has not violated Standard III(B) because he widely disseminated the
recommendation and provided the information to all his clients prior to discussing it with
a select few. Weng’s largest clients received additional personal service because they

53
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

presumably pay higher fees or because they have a large amount of assets under Weng’s
management. If Weng had discussed the report with a select group of clients prior to
distributing it to all his clients, he would have violated Standard III(B).

Example 5 (Minimum Lot Allocations)

Lynn Hampton is a well-respected private wealth manager in her community with a

diversified client base. She determines that a new 10-year bond being offered by Healthy
Pharmaceuticals is appropriate for five of her clients. Three clients request to purchase
US$10,000 each, and the other two request US$50,000 each. The minimum lot size is
established at US$5,000, and the issue is oversubscribed at the time of placement. Her
firm’s policy is that odd-lot allocations, especially those below the minimum, should be
avoided because they may affect the liquidity of the security at the time of sale.

Hampton is informed she will receive only US$55,000 of the offering for all accounts.
Hampton distributes the bond investments as follows: The three accounts that requested
US$10,000 are allocated US$5,000 each, and the two accounts that requested US
$50,000 are allocated US$20,000 each.

Comment: Hampton has not violated Standard III(B), even though the distribution is not
on a completely pro rata basis because of the required minimum lot size. With the total
allocation being significantly below the amount requested, Hampton ensured that each
client received at least the minimum lot size of the issue. This approach allowed the
clients to efficiently sell the bond later if necessary.

Example 6 (Excessive Trading)

Ling Chan manages the accounts for many pension plans, including the plan of his
father’s employer. Chan developed similar but not identical investment policies for each
client, so the investment portfolios are rarely the same. To minimize the cost to his
father’s pension plan, he intentionally trades more frequently in the accounts of other
clients to ensure the required brokerage is incurred to continue receiving free research for
use by all the pensions.

Comment: Chan is violating Standard III(B) because his trading actions are
disadvantaging his clients to enhance a relationship with a preferred client. All clients are
benefiting from the research being provided and should incur their fair portion of the
costs. This does not mean that additional trading should occur if a client has not paid an
equal portion of the commission; trading should occur only as required by the strategy.

Example 7 (Fair Dealing among Clients)

Paul Rove, performance analyst for Alpha-Beta Investment Management, is describing

to the firm’s chief investment officer (CIO) two new reports he would like to develop to
assist the firm in meeting its obligations to treat clients fairly. Because many of the
firm’s clients have similar investment objectives and portfolios, Rove suggests a report
detailing securities owned across several clients and the percentage of the portfolio the

54
© 2020 Wiley
 STANDARD III: DUTIES TO CLIENTS

security represents. The second report would compare the monthly performance of
portfolios with similar strategies. The outliers within each report would be submitted to
the CIO for review.

Comment: As a performance analyst, Rove likely has little direct contact with clients
and thus has limited opportunity to treat clients differently. The recommended reports
comply with Standard III(B) while helping the firm conduct after-the-fact reviews of
how effectively the firm’s advisers are dealing with their clients’ portfolios. Reports that
monitor the fair treatment of clients are an important oversight tool to ensure that clients
are treated fairly.

Standard III(C) Suitability

The Standard
1. When Members and candidates are in an advisory relationship with a client, they
must:
a. Make a reasonable inquiry into a client’s or prospective client’s investment
experience, risk and return objectives, and financial constraints prior to making
any investment recommendation or taking investment action and must reassess
and update this information regularly.
b. Determine that an investment is suitable to the client’s financial situation and
consistent with the client’s written objectives, mandates, and constraints before
making an investment recommendation or taking investment action.
c. Judge the suitability of investments in the context of the client’s total portfolio.
2. When members and candidates are responsible for managing a portfolio to a specific
mandate, strategy, or style, they must make only investment recommendations or
take only investment actions that are consistent with the stated objectives and
constraints of the portfolio.

Guidance
• Standard III(C) requires that members and candidates who are in an investment
advisory relationship with clients consider carefully the needs, circumstances, and
objectives of the clients when determining the appropriateness and suitability of a
given investment or course of investment action.
• In judging the suitability of a potential investment, the member or candidate should
review many aspects of the client’s knowledge, experience related to investing, and
financial situation. These aspects include, but are not limited to, the risk profile of the
investment as compared with the constraints of the client, the impact of the
investment on the diversity of the portfolio, and whether the client has the means or
net worth to assume the associated risk. The investment professional’s determination
of suitability should reflect only the investment recommendations or actions that a
prudent person would be willing to undertake. Not every investment opportunity will
be suitable for every portfolio, regardless of the potential return being offered.
• The responsibilities of members and candidates to gather information and make a
suitability analysis prior to making a recommendation or taking investment action
fall on those members and candidates who provide investment advice in the course of
an advisory relationship with a client. Other members and candidates who are simply
executing specific instructions for retail clients when buying or selling securities,
may not have the opportunity to judge the suitability of a particular investment for the
ultimate client.

© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Developing an Investment Policy

• When an advisory relationship exists, members and candidates must gather client
information at the inception of the relationship. Such information includes the
client’s financial circumstances, personal data (such as age and occupation) that are
relevant to investment decisions, attitudes toward risk, and objectives in investing.
This information should be incorporated into a written investment policy statement
(IPS) that addresses the client’s risk tolerance, return requirements, and all
investment constraints (including time horizon, liquidity needs, tax concerns, legal
and regulatory factors, and unique circumstances).
• The IPS also should identify and describe the roles and responsibilities of the parties
to the advisory relationship and investment process, as well as schedules for review
and evaluation of the IPS.
• After formulating long-term capital market expectations, members and candidates
can assist in developing an appropriate strategic asset allocation and investment
program for the client, whether these are presented in separate documents or
incorporated in the IPS or in appendices to the IPS.

Understanding the Client’s Risk Profile

• The investment professional must consider the possibilities of rapidly changing
investment environments and their likely impact on a client’s holdings, both
individual securities and the collective portfolio.
• The risk of many investment strategies can and should be analyzed and quantified in
advance.
• Members and candidates should pay careful attention to the leverage inherent in
many synthetic investment vehicles or products when considering them for use in a
client’s investment program.

Updating an Investment Policy

• Updating the IPS should be repeated at least annually and also prior to material
changes to any specific investment recommendations or decisions on behalf of the
client.
o For an individual client, important changes might include the number of
dependents, personal tax status, health, liquidity needs, risk tolerance,
amount of wealth beyond that represented in the portfolio, and extent to
which compensation and other income provide for current income needs,
o For an institutional client, such changes might relate to the magnitude of
unfunded liabilities in a pension fund, the withdrawal privileges in an
employee savings plan, or the distribution requirements of a charitable
foundation.
• If clients withhold information about their financial portfolios, the suitability analysis
conducted by members and candidates cannot be expected to be complete; it must be
based on the information provided.

The Need for Diversification

• The unique characteristics (or risks) of an individual investment may become
partially or entirely neutralized when it is combined with other individual
investments within a portfolio. Therefore, a reasonable amount of diversification is
thus the norm for many portfolios.
• An investment with high relative risk on its own may be a suitable investment in the
context of the entire portfolio or when the client’s stated objectives contemplate
speculative or risky investments.

“ © 2020 Wiley
 STANDARD III: DUTIES TO CLIENTS

Members and candidates can be responsible for assessing the suitability of an

investment only on the basis of the information and criteria actually provided by the
client.

Addressing Unsolicited Trading Requests

• If an unsolicited request is expected to have only a minimum impact on the entire
portfolio because the size of the requested trade is small or the trade would result in a
limited change to the portfolio’s risk profile, the member or candidate should focus
on educating the investor on how the request deviates from the current policy
statement, and then she may follow her firm’s policies regarding the necessary client
approval for executing unsuitable trades. At a minimum, the client should
acknowledge the discussion and accept the conditions that make the recommendation
unsuitable.
• If an unsolicited request is expected to have a material impact on the portfolio, the
member or candidate should use this opportunity to update the investment policy
statement. Doing so would allow the client to fully understand the potential effect of
the requested trade on his or her current goals or risk levels.
• If the client declines to modify her policy statements while insisting an unsolicited
trade be made, the member or candidate will need to evaluate the effectiveness of her
services to the client. The options available to the members or candidates will depend
on the services provided by their employer. Some firms may allow for the trade to be
executed in a new unmanaged account. If alternative options are not available,
members and candidates ultimately will need to determine whether they should
continue the advisory arrangement with the client.

Managing to an Index or Mandate

Some members and candidates do not manage money for individuals but are responsible for
managing a fund to an index or an expected mandate. The responsibility of these members
and candidates is to invest in a manner consistent with the stated mandate.

Recommended Procedures for Compliance

Investment Policy Statement

In formulating an investment policy for the client, the member or candidate should take the
following into consideration:

• Client identification—(1) type and nature of client; (2) the existence of separate
beneficiaries; and (3) approximate portion of total client assets that the member or
candidate is managing.
• Investor objectives— (1) return objectives (income, growth in principal, maintenance
of purchasing power); and (2) risk tolerance (suitability, stability of values).
• Investor constraints— (1) liquidity needs; (2) expected cash flows (patterns of
additions and/or withdrawals); (3) investable funds (assets and liabilities or other
commitments); (4) time horizon; (5) tax considerations; (6) regulatory and legal
circumstances; (7) investor preferences, prohibitions, circumstances, and unique
needs; and (8) proxy voting responsibilities and guidance.
• Performance measurement benchmarks.

Regular Updates
• The investor’s objectives and constraints should be maintained and reviewed
periodically to reflect any changes in the client’s circumstances.

© 2020 Wiley l
PROFESSIONAL STANDARDS AND ETHICS

Suitability Test Policies

• With the increase in regulatory required suitability tests, members and candidates
should encourage their firms to develop related policies and procedures. The test
procedures should require the investment professional to look beyond the potential
return of the investment and include the following:
o An analysis of the impact on the portfolio’s diversification,
o A comparison of the investment risks with the client’s assessed risk
tolerance.
o The fit of the investment with the required investment strategy.

Application of the Standard

Example 1 (Investment Suitability—Risk Profile)

Caleb Smith, an investment adviser, has two clients: Larry Robertson, 60 years old, and
Gabriel Lanai, 40 years old. Both clients earn roughly the same salary, but Robertson has
a much higher risk tolerance because he has a large asset base. Robertson is willing to
invest part of his assets very aggressively; Lanai wants only to achieve a steady rate of
return with low volatility to pay for his children’s education. Smith recommends
investing 20% of both portfolios in zero-yield, small-cap, high-technology equity issues.

Comment: In Robertson’s case, the investment may be appropriate because of his

financial circumstances and aggressive investment position, but this investment is not
suitable for Lanai. Smith is violating Standard III(C) by applying Robertson’s investment
strategy to Lanai because the two clients’ financial circumstances and objectives differ.

Example 2 (Investment Suitability—Entire Portfolio)

Jessica McDowell, an investment adviser, suggests to Brian Crosby, a risk-averse client,

that covered call options be used in his equity portfolio. The purpose would be to
enhance Crosby’s income and partially offset any untimely depreciation in the
portfolio’s value should the stock market or other circumstances affect his holdings
unfavorably. McDowell educates Crosby about all possible outcomes, including the risk
of incurring an added tax liability if a stock rises in price and is called away and,
conversely, the risk of his holdings losing protection on the downside if prices drop
sharply.

Comment: When determining suitability of an investment, the primary focus should be

the characteristics of the client’s entire portfolio, not the characteristics of single
securities on an issue-by-issue basis. The basic characteristics of the entire portfolio will
largely determine whether investment recommendations are taking client factors into
account. Therefore, the most important aspects of a particular investment are those that
will affect the characteristics of the total portfolio. In this case, McDowell properly
considers the investment in the context of the entire portfolio and thoroughly explains
the investment to the client.

© 2020 Wiley
 STANDARD III: DUTIES TO CLIENTS

Example 3 (Following an Investment Mandate)

Louis Perkowski manages a high-income mutual fund. He purchases zero-dividend stock

in a financial services company because he believes the stock is undervalued and is in a
potential growth industry, which makes it an attractive investment.

Comment: A zero-dividend stock does not seem to fit the mandate of the fund that
Perkowski is managing. Unless Perkowski’s investment fits within the mandate or is
within the realm of allowable investments the fund has made clear in its disclosures,
Perkowski has violated Standard III(C).

Example 4 (Submanager and IPS Reviews)

Paul Ostrowski’s investment management business has grown significantly over the past
couple of years, and some clients want to diversify internationally. Ostrowski decides to
find a submanager to handle the expected international investments. Because this will be
his first subadviser, Ostrowski uses the CFA Institute model “request for proposal” to
design a questionnaire for his search. By his deadline, he receives seven completed
questionnaires from a variety of domestic and international firms trying to gain his
business. Ostrowski reviews all the applications in detail and decides to select the firm
that charges the lowest fees because doing so will have the least impact on his firm’s
bottom line.

Comment: When selecting an external manager or subadviser, Ostrowski needs to

ensure that the new manager’s services are appropriate for his clients. This due diligence
includes comparing the risk profile of the clients with the investment strategy of the
manager. In basing the decision on the fee structure alone, Ostrowski may be violating
Standard III(C).

When clients ask to diversify into international products, it is an appropriate time to

review and update the clients’ IPSs. Ostrowski’s review may determine that the risk of
international investments modifies the risk profiles of the clients or does not represent an
appropriate investment.

See also Standard V(A)—Diligence and Reasonable Basis for further discussion of the
review process needed in selecting appropriate submanagers.

Example 5 (Investment Suitability)

Andre Shrub owns and operates Conduit, an investment advisory firm. Prior to opening
Conduit, Shrub was an account manager with Elite Investment, a hedge fund managed
by his good friend Adam Reed. To attract clients to a new Conduit fund, Shrub offers
lower-than-normal management fees. He can do so because the fund consists of two top-
performing funds managed by Reed. Given his personal friendship with Reed and the
prior performance record of these two funds, Shrub believes this new fund is a winning
combination for all parties. Clients quickly invest with Conduit to gain access to the Elite
funds. No one is turned away because Conduit is seeking to expand its assets under
management.

59
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Comment: Shrub has violated Standard III(C) because the risk profile of the new fund
may not be suitable for every client. As an investment adviser, Shrub needs to establish
an investment policy statement for each client and recommend only investments that
match each client’s risk and return profile in the IPS. Shrub is required to act as more
than a simple sales agent for Elite.

Although Shrub cannot disobey the direct request of a client to purchase a specific
security, he should fully discuss the risks of a planned purchase and provide reasons why
it might not be suitable for a client. This requirement may lead members and candidates
to decline new customers if those customers’ requested investment decisions are
significantly out of line with their stated requirements.

See also Standard V(A)—Diligence and Reasonable Basis.

Standard III(D) Performance Presentation

The Standard
When communicating investment performance information, members and candidates must
make reasonable efforts to ensure that it is fair, accurate, and complete.

Guidance
• Members and candidates must provide credible performance information to clients
and prospective clients and to avoid misstating performance or misleading clients
and prospective clients about the investment performance of members or candidates
or their firms.
• Standard III(D) covers any practice that would lead to misrepresentation of a
member’s or candidate’s performance record, whether the practice involves
performance presentation or performance measurement.
• Members and candidates should not state or imply that clients will obtain or benefit
from a rate of return that was generated in the past.
• Research analysts promoting the success or accuracy of their recommendations must
ensure that their claims are fair, accurate, and complete.
• If the presentation is brief, the member or candidate must make available to clients
and prospects, on request, the detailed information supporting that communication.
Best practice dictates that brief presentations include a reference to the limited nature
of the information provided.

Recommended Procedures for Compliance

Apply the GIPS Standards

• Compliance with the GIPS standards is the best method to meet their obligations
under Standard III(D).

Compliance without Applying GIPS Standards

Members and candidates can also meet their obligations under Standard III(D) by:

• Considering the knowledge and sophistication of the audience to whom a

performance presentation is addressed.
• Presenting the performance of the weighted composite of similar portfolios rather
than using a single representative account.

© 2020 Wiley
 STANDARD III: DUTIES TO CLIENTS

• Including terminated accounts as part of performance history with a clear indication

of when the accounts were terminated.
• Including disclosures that fully explain the performance results being reported (for
example, stating, when appropriate, that results are simulated when model results are
used, clearly indicating when the performance record is that of a prior entity, or
disclosing whether the performance is gross of fees, net of fees, or after tax).
• Maintaining the data and records used to calculate the performance being presented.

Application of the Standard

Example 1 (Performance Calculation and Length of Time)

Kyle Taylor of Taylor Trust Company, noting the performance of Taylor’s common trust
fund for the past two years, states in a brochure sent to his potential clients, “You can
expect steady 25% annual compound growth of the value of your investments over the
year.” Taylor Trust’s common trust fund did increase at the rate of 25% per year for the
past year, which mirrored the increase of the entire market. The fund has never averaged
that growth for more than one year, however, and the average rate of growth of all of its
trust accounts for five years is 5% per year.

Comment: Taylor’s brochure is in violation of Standard III(D). Taylor should have

disclosed that the 25% growth occurred only in one year. Additionally, Taylor did not
include client accounts other than those in the firm’s common trust fund. A general claim
of firm performance should take into account the performance of all categories of
accounts. Finally, by stating that clients can expect a steady 25% annual compound
growth rate, Taylor is also violating Standard 1(C)—Misrepresentation, which prohibits
assurances or guarantees regarding an investment.

Example 2 (Performance Calculation and Asset Weighting)

Anna Judd, a senior partner of Alexander Capital Management, circulates a performance

report for the capital appreciation accounts for the years 1988 through 2004. The firm
claims compliance with the GIPS standards. Returns are not calculated in accordance
with the requirements of the GIPS standards, however, because the composites are not
asset weighted.

Comment: Judd is in violation of Standard III(D). When claiming compliance with the
GIPS standards, firms must meet all of the requirements, make mandatory disclosures,
and meet any other requirements that apply to that firm’s specific situation. Judd’s
violation is not from any misuse of the data but from a false claim of GIPS compliance.

Example 3 (Performance Calculation and Selected Accounts Only)

In a presentation prepared for prospective clients, William Kilmer shows the rates of
return realized over a five-year period by a “composite” of his firm’s discretionary
accounts that have a “balanced” objective. This composite, however, consisted of only a
few of the accounts that met the balanced criterion set by the firm, excluded accounts
under a certain asset level without disclosing the fact of their exclusion, and included
accounts that did not have the balanced mandate because those accounts would boost the

6,
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

investment results. In addition, to achieve better results, Kilmer manipulated the narrow
range of accounts included in the composite by changing the accounts that made up the
composite over time.

Comment: Kilmer violated Standard III(D) by misrepresenting the facts in the

promotional material sent to prospective clients, distorting his firm’s performance record,
and failing to include disclosures that would have clarified the presentation.

Example 4 (Performance Attribution Changes)

Art Purell is reviewing the quarterly performance attribution reports for distribution to
clients. Purell works for an investment management firm with a bottom-up,
fundamentals-driven investment process that seeks to add value through stock selection.
The attribution methodology currently compares each stock with its sector. The
attribution report indicates that the value added this quarter came from asset allocation
and that stock selection contributed negatively to the calculated return. Through running
several different scenarios, Purell discovers that calculating attribution by comparing
each stock with its industry and then rolling the effect to the sector level improves the
appearance of the manager’s stock selection activities. Because the firm defines the
attribution terms and the results better reflect the stated strategy, Purell recommends that
the client reports should use the revised methodology.

Comment: Modifying the attribution methodology without proper notifications to

clients would fail to meet the requirements of Standard III(D). Purred’s recommendation
is being done solely for the interest of the firm to improve its perceived ability to meet
the stated investment strategy. Such changes are unfair to clients and obscure the facts
regarding the firm’s abilities. Had Purell believed the new methodology offered
improvements to the original model, then he would have needed to report the results of
both calculations to the client. The report should also include the reasons why the new
methodology is preferred, which would allow the client to make a meaningful
comparison to prior results and provide a basis for comparing future attributions.

Example 5 (Performance Calculation Methodology Disclosure)

While developing a new reporting package for existing clients, Alisha Singh, a
performance analyst, discovers that her company’s new system automatically calculates
both time-weighted and money-weighted returns. She asks the head of client services
and retention which value would be preferred given that the firm has various investment
strategies that include bonds, equities, securities without leverage, and alternatives.
Singh is told not to label the return value so that the firm may show whichever value is
greatest for the period.

Comment: Following these instructions would lead to Singh violating Standard III(D).
In reporting inconsistent return values, Singh would not be providing complete
information to the firm’s clients. Full information is provided when clients have
sufficient information to judge the performance generated by the firm.

62
© 2020 Wiley
 STANDARD III: DUTIES TO CLIENTS

Example 6 (Performance Calculation Methodology Disclosure)

Richmond Equity Investors manages a long-short equity fund in which clients can trade
once a week (on Fridays). For transparency reasons, a daily net asset value of the fund is
calculated by Richmond. The monthly fact sheets of the fund report month-to-date and
year-to-date performance. Richmond publishes the performance based on the higher of
the last trading day of the month (typically, not the last business day) or the last business
day of the month as determined by Richmond. The fact sheet mentions only that the data
are as of the end of the month, without giving the exact date. Maggie Clark, the
investment performance analyst in charge of the calculations, is concerned about the
frequent changes and asks her supervisor whether they are appropriate.

Comment: Clark’s actions in questioning the changing performance metric comply with
Standard III(D). She has shown concern that these changes are not presenting an accurate
and complete picture of the performance generated.

Standard III(E) Preservation of Confidentiality

The Standard
Members and candidates must keep information about current, former, and prospective
clients confidential unless:

1. The information concerns illegal activities on the part of the client;

2. Disclosure is required by law; or
3. The client or prospective client permits disclosure of the information.

Guidance
• Members and candidates must preserve the confidentiality of information
communicated to them by their clients, prospective clients, and former clients. This
standard is applicable when (1) the member or candidate receives information
because of his or her special ability to conduct a portion of the client’s business or
personal affairs and (2) the member or candidate receives information that arises
from or is relevant to that portion of the client’s business that is the subject of the
special or confidential relationship.
• If disclosure of the information is required by law or the information concerns illegal
activities by the client, however, the member or candidate may have an obligation to
report the activities to the appropriate authorities.

Status of Client
• This standard protects the confidentiality of client information even if the person or
entity is no longer a client of the member or candidate. Therefore, members and
candidates must continue to maintain the confidentiality of client records even after
the client relationship has ended.
• If a client or former client expressly authorizes the member or candidate to disclose
information, however, the member or candidate may follow the terms of the
authorization and provide the information.

Compliance with Laws

• As a general matter, members and candidates must comply with applicable law.
If applicable law requires disclosure of client information in certain circumstances,
members and candidates must comply with the law. Similarly, if applicable law

«
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

requires members and candidates to maintain confidentiality, even if the information

concerns illegal activities on the part of the client, members and candidates should
not disclose such information.
• When in doubt, members and candidates should consult with their employer’s
compliance personnel or legal counsel before disclosing confidential information
about clients.

Electronic Information and Security

• Standard III(E) does not require members or candidates to become experts in
information security technology, but they should have a thorough understanding of
the policies of their employer.
• Members and candidates should encourage their firm to conduct regular periodic
training on confidentiality procedures for all firm personnel, including portfolio
associates, receptionists, and other non-investment staff who have routine direct
contact with clients and their records.

Professional Conduct Investigations by CAIA

• The requirements of Standard III(E) are not intended to prevent members and
candidates from cooperating with an investigation by the CAIA Professional
Conduct Program (PCP). When permissible under applicable law, members and
candidates shall consider the PCP an extension of themselves when requested to
provide information about a client in support of a PCP investigation into their own
conduct.

Recommended Procedures for Compliance

The simplest, most conservative, and most effective way to comply with Standard III(E) is
to avoid disclosing any information received from a client except to authorized fellow
employees who are also working for the client. In some instances, however, a member or
candidate may want to disclose information received from clients that is outside the scope of
the confidential relationship and does not involve illegal activities. Before making such a
disclosure, a member or candidate should ask the following:

• In what context was the information disclosed? If disclosed in a discussion of work

being performed for the client, is the information relevant to the work?
• Is the information background material that, if disclosed, will enable the member or
candidate to improve service to the client?

Communicating with Clients

• Members and candidates should make reasonable efforts to ensure that firm-
supported communication methods and compliance procedures follow practices
designed for preventing accidental distribution of confidential information.
• Members and candidates should be diligent in discussing with clients the appropriate
methods for providing confidential information. It is important to convey to
clientsthat not all firm-sponsored resources may be appropriate for such
communications.

Application of the Standard

Example 1 (Possessing Confidential Information)

Sarah Connor, a financial analyst employed by Johnson Investment Counselors, Inc.,

provides investment advice to the trustees of City Medical Center. The trustees have

“ © 2020 Wiley
 STANDARD III: DUTIES TO CLIENTS

given her a number of internal reports concerning City Medical’s needs for physical
plant renovation and expansion. They have asked Connor to recommend investments
that would generate capital appreciation in endowment funds to meet projected capital
expenditures. Connor is approached by a local businessman, Thomas Kasey, who is
considering a substantial contribution either to City Medical Center or to another local
hospital. Kasey wants to find out the building plans of both institutions before making a
decision, but he does not want to speak to the trustees.

Comment: The trustees gave Connor the internal reports so she could advise them on
how to manage their endowment funds. Because the information in the reports is clearly
both confidential and within the scope of the confidential relationship, Standard III(E)
requires that Connor refuse to divulge information to Kasey.

Example 2 (Disclosing Confidential Information)

Lynn Moody is an investment officer at the Lester Trust Company. She has an advisory
customer who has talked to her about giving approximately US$50,000 to charity to
reduce her income taxes. Moody is also treasurer of the Home for Indigent Widows
(HIW), which is planning its annual giving campaign. HIW hopes to expand its list of
prospects, particularly those capable of substantial gifts. Moody recommends that HIW’s
vice president for corporate gifts call on her customer and ask for a donation in the US
$50,000 range.

Comment: Even though the attempt to help the Home for Indigent Widows was well
intended, Moody violated Standard III(E) by revealing confidential information about
her client.

Example 3 (Disclosing Possible Illegal Activity)

David Bradford manages money for a family-owned real estate development

corporation. He also manages the individual portfolios of several of the family members
and officers of the corporation, including the chief financial officer (CFO). Based on the
financial records of the corporation and some questionable practices of the CFO that
Bradford has observed, Bradford believes that the CFO is embezzling money from the
corporation and putting it into his personal investment account.

Comment: Bradford should check with his firm’s compliance department or appropriate
legal counsel to determine whether applicable securities regulations require reporting the
CFO’s financial records.

Example 4 (Accidental Disclosure of Confidential Information)

Lynn Moody is an investment officer at the Lester Trust Company (LTC). She has
stewardship of a significant number of individually managed taxable accounts. In
addition to receiving quarterly written reports, about a dozen high-net-worth individuals
have indicated to Moody a willingness to receive communications about overall
economic and financial market outlooks directly from her by way of a social media

65
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

platform. Under the direction of her firm’s technology and compliance departments, she
established a new group page on an existing social media platform specifically for her
clients. In the instructions provided to clients, Moody asked them to “join” the group so
they may be granted access to the posted content. The instructions also advised clients
that all comments posted would be available to the public and thus the platform was not
an appropriate method for communicating personal or confidential information.

Six months later, in early January, Moody posted LTC’s year-end “Market Outlook.”
The report outlined a new asset allocation strategy that the firm is adding to its
recommendations in the new year. Moody introduced the publication with a note
informing her clients that she would be discussing the changes with them individually in
their upcoming meetings.

One of Moody’s clients responded directly on the group page that his family recently
experienced a major change in their financial profile. The client described highly
personal and confidential details of the event. Unfortunately, all clients that were part of
the group were also able to read the detailed posting until Moody was able to have the
comment removed.

Comment: Moody has taken reasonable steps for protecting the confidentiality of client
information while using the social media platform. She provided instructions clarifying
that all information posted to the site would be publicly viewable to all group members
and warned against using this method for communicating confidential information. The
accidental disclosure of confidential information by a client is not under Moody’s
control. Her actions to remove the information promptly once she became aware further
align with Standard III(E).

In understanding the potential sensitivity clients express surrounding the confidentiality

of personal information, this event highlights a need for further training. Moody might
advocate for additional warnings or controls for clients when they consider using social
media platforms for two-way communications.

66 © 2020 Wiley
 St andar d IV : D u t ie s t o E m pl oyer s

LESSON MAP
• Loyalty
• Additional Compensation Arrangements
• Responsibilities of Supervisors

Learning Objective: Demonstrate knowledge of Standard IV: Duties to

Employers.

Standard IV(A) Loyalty

The Standard
In matters related to their employment, members and candidates must act for the benefit of
their employer and not deprive their employer of the advantage of their skills and abilities,
divulge confidential information, or otherwise cause harm to their employer.

Guidance
• Members and candidates should protect the interests of their firm by refraining from
any conduct that would injure the firm, deprive it of profit, or deprive it of the
member’s or candidate’s skills and ability.
• Members and candidates must always place the interests of clients above the interests
of their employer but should also consider the effects of their conduct on the
sustainability and integrity of the employer firm.
• In matters related to their employment, members and candidates must comply with
the policies and procedures established by their employers that govern the employer-
employee relationship—to the extent that such policies and procedures do not
conflict with applicable laws, rules, or regulations or the Code and Standards.
• The standard does not require members and candidates to subordinate important
personal and family obligations to their work.

Employer Responsibilities
• Employers must recognize the duties and responsibilities that they owe to their
employees if they expect to have content and productive employees.
• Members and candidates are encouraged to provide their employer with a copy of the
Code and Standards.
• Employers are not obligated to adhere to the Code and Standards. In expecting to
retain competent employees who are members and candidates, however, they should
not develop conflicting policies and procedures.

Independent Practice
• Members and candidates must abstain from independent competitive activity that
could conflict with the interests of their employer.
• Members and candidates who plan to engage in independent practice for
compensation must notify their employer and describe the types of services they will
render to prospective independent clients, the expected duration of the services, and
the compensation for the services.
• Members and candidates should not render services until they receive consent from
their employer to all of the terms of the arrangement.
o “Practice” means any service that the employer currently makes available for
remuneration.

© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

o “Undertaking independent practice” means engaging in competitive

business, as opposed to making preparations to begin such practice.

Leaving an Employer
• When members and candidates are planning to leave their current employer, they
must continue to act in the employer’s best interest. They must not engage in any
activities that would conflict with this duty until their resignation becomes effective.
• Activities that might constitute a violation, especially in combination, include the
following:
o Misappropriation of trade secrets,
o Misuse of confidential information.
o Solicitation of the employer’s clients prior to cessation of employment,
o Self-dealing (appropriating for one’s own property a business opportunity or
information belonging to one’s employer),
o Misappropriation of clients or client lists.
• A departing employee is generally free to make arrangements or preparations to go
into a competitive business before terminating the relationship with his or her
employer as long as such preparations do not breach the employee’s duty of loyalty.
• A member or candidate who is contemplating seeking other employment must not
contact existing clients or potential clients prior to leaving his or her employer for
purposes of soliciting their business for the new employer. Once notice is provided to
the employer of the intent to resign, the member or candidate must follow the
employer’s policies and procedures related to notifying clients of his or her planned
departure. In addition, the member or candidate must not take records or files to a
new employer without the written permission of the previous employer.
• Once an employee has left the firm, the skills and experience that an employee
obtained while employed are not “confidential” or “privileged” information.
Similarly, simple knowledge of the names and existence of former clients is
generally not confidential information unless deemed such by an agreement or by
law.
• Standard IV(A) does not prohibit experience or knowledge gained at one employer
from being used at another employer. Firm records or work performed on behalf of
the firm that is stored in paper copy or electronically for the member’s or candidate’s
convenience while employed, however, should be erased or returned to the employer
unless the firm gives permission to keep those records after employment ends.
• The standard does not prohibit former employees from contacting clients of their
previous firm as long as the contact information does not come from the records of the
former employer or violate an applicable “noncompete agreement.” Members and
candidates are free to use public information after departing to contact former clients
without violating Standard IV(A) as long as there is no specific agreement not to do so.

Use of Social Media

• Members and candidates should understand and abide by all applicable firm policies
and regulations as to the acceptable use of social media platforms to interact with
clients and prospective clients.
• Specific accounts and user profiles of members and candidates may be created for
solely professional reasons, including firm-approved accounts for client
engagements. Such firm-approved business-related accounts would be considered
part of the firm’s assets, thus requiring members and candidates to transfer or delete
the accounts as directed by their firm’s policies and procedures.
• Best practice for members and candidates is to maintain separate accounts for their
personal and professional social media activities. Members and candidates should

- © 2020 Wiley
 STANDARD IV: DUTIES TO EMPLOYERS

discuss with their employers how profiles should be treated when a single account
includes personal connections and also is used to conduct aspects of their
professional activities.

Whistleblowing
Sometimes, circumstances may arise (e.g., when an employer is engaged in illegal or
unethical activity) in which members and candidates must act contrary to their employer’s
interests in order to comply with their duties to the market and clients. In such instances,
activities that would normally violate a member’s or candidate’s duty to his or her employer
(such as contradicting employer instructions, violating certain policies and procedures, or
preserving a record by copying employer records) may be justified. However, such action
would be permitted only if the intent is clearly aimed at protecting clients or the integrity of
the market, not for personal gain.

Nature of Employment
• Members and candidates must determine whether they are employees or independent
contractors in order to determine the applicability of Standard IV(A). This issue will
be decided largely by the degree of control exercised by the employing entity over
the member or candidate. Factors determining control include whether the member’s
or candidate’s hours, work location, and other parameters of the job are set; whether
facilities are provided to the member or candidate; whether the member’s or
candidate’s expenses are reimbursed; whether the member or candidate seeks work
from other employers; and the number of clients or employers the member or
candidate works for.
• A member’s or candidate’s duties within an independent contractor relationship are
governed by the oral or written agreement between the member and the client.
Members and candidates should take care to define clearly the scope of their
responsibilities and the expectations of each client within the context of each
relationship. Once a member or candidate establishes a relationship with a client, the
member or candidate has a duty to abide by the terms of the agreement.

Recommended Procedures for Compliance

Competition Policy
• A member or candidate must understand any restrictions placed by the employer on
offering similar services outside the firm while employed by the firm.
• If a member’s or candidate’s employer elects to have its employees sign a non-
compete agreement as part of the employment agreement, the member or candidate
should ensure that the details are clear and fully explained prior to signing the
agreement.

T ermination Policy
• Members and candidates should clearly understand the termination policies of their
employer. Termination policies should:
o Establish clear procedures regarding the resignation process, including
addressing how the termination will be disclosed to clients and staff and
whether updates posted through social media platforms will be allowed.
o Outline the procedures for transferring ongoing research and account
management responsibilities.
o Address agreements that allow departing employees to remove specific
client-related information upon resignation.

69
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Incident-Reporting Procedures
• Members and candidates should be aware of their firm’s policies related to
whistleblowing and encourage their firm to adopt industry best practices in this area.

Employee Classification
• Members and candidates should understand their status within their employer firm.

Application of the Standard

Example 1 (Soliciting Former Clients)

Samuel Magee manages pension accounts for Trust Assets, Inc., but has become
frustrated with the working environment and has been offered a position with Fiduciary
Management. Before resigning from Trust Assets, Magee asks four big accounts to leave
that firm and open accounts with Fiduciary. Magee also persuades several prospective
clients to sign agreements with Fiduciary Management. Magee had previously made
presentations to these prospects on behalf of Trust Assets.

Comment: Magee violated the employee-employer principle requiring him to act solely
for his employer’s benefit. Magee’s duty is to Trust Assets as long as he is employed
there. The solicitation of Trust Assets’ current clients and prospective clients is unethical
and violates Standard IV(A).

Example 2 (Addressing Rumors)

Reuben Winston manages all-equity portfolios at Target Asset Management (TAM), a

large, established investment counselor. Ten years previously, Philpott & Company,
which manages a family of global bond mutual funds, acquired TAM in a diversification
move. After the merger, the combined operations prospered in the fixed-income business
but the equity management business at TAM languished. Lately, a few of the equity
pension accounts that had been with TAM before the merger have terminated their
relationships with TAM. One day, Winston finds on his voice mail the following
message from a concerned client: “Hey! I just heard that Philpott is close to announcing
the sale of your firm’s equity management business to Rugged Life. What is going on?”
Not being aware of any such deal, Winston and his associates are stunned. Their internal
inquiries are met with denials from Philpott management, but the rumors persist. Feeling
left in the dark, Winston contemplates leading an employee buyout of TAM’s equity
management business.

Comment: An employee-led buyout of TAM’s equity asset management business would

be consistent with Standard IV(A) because it would rest on the permission of the
employer and, ultimately, the clients. In this case, however, in which employees suspect
the senior managers or principals are not truthful or forthcoming, Winston should consult
legal counsel to determine appropriate action.

Example 3 (Ownership of Completed Prior Work)

Emma Madeline, a recent college graduate and a candidate in the CAIA Program, spends
her summer as an unpaid intern at Murdoch and Lowell. The senior managers at

70
© 2020 Wiley
 STANDARD IV: DUTIES TO EMPLOYERS

Murdoch are attempting to bring the firm into compliance with the GIPS standards, and
Madeline is assigned to assist in its efforts. Two months into her internship, Madeline
applies for a job at McMillan & Company, which has plans to become GIPS compliant.
Madeline accepts the job with McMillan. Before leaving Murdoch, she copies the firm’s
software that she helped develop because she believes this software will assist her in her
new position.

Comment: Even though Madeline does not receive monetary compensation for her
services at Murdoch, she has used firm resources in creating the software and is
considered an employee because she receives compensation and benefits in the form of
work experience and knowledge. By copying the software, Madeline violated Standard
IV(A) because she misappropriated Murdoch’s property without permission.

Example 4 (Starting a New Firm)

Geraldine Allen currently works at a registered investment company as an equity analyst.

Without notice to her employer, she registers with government authorities to start an
investment company that will compete with her employer, but she does not actively seek
clients. Does registration of this competing company with the appropriate regulatory
authorities constitute a violation of Standard IV(A)?

Comment: Allen’s preparation for the new business by registering with the regulatory
authorities does not conflict with the work for her employer if the preparations have been
done on Allen’s own time outside the office and if Allen will not be soliciting clients for
the business or otherwise operating the new company until she has left her current
employer.

Example 5 (Competing with Current Employer)

Several employees are planning to depart their current employer within a few weeks and
have been careful to not engage in any activities that would conflict with their duty to
their current employer. They have just learned that one of their employer’s clients has
undertaken a request for proposal (RFP) to review and possibly hire a new investment
consultant. The RFP has been sent to the employer and all of its competitors. The group
believes that the new entity to be formed would be qualified to respond to the RFP and
be eligible for the business. The RFP submission period is likely to conclude before the
employees’ resignations are effective. Is it permissible for the group of departing
employees to respond to the RFP for their anticipated new firm?

Comment: A group of employees responding to an RFP that their employer is also

responding to would lead to direct competition between the employees and the
employer. Such conduct violates Standard IV(A) unless the group of employees receives
permission from their employer as well as the entity sending out the RFP.

71
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Example 6 (Externally Compensated Assignments)

Alfonso Mota is a research analyst with Tyson Investments. He works part time as a
mayor for his hometown, a position for which he receives compensation. Must Mota
seek permission from Tyson to serve as mayor?

Comment: If Mota’s mayoral duties are so extensive and time-consuming that they
might detract from his ability to fulfill his responsibilities at Tyson, he should discuss his
outside activities with his employer and come to a mutual agreement regarding how to
manage his personal commitments with his responsibilities to his employer.

Example 7 (Soliciting Former Clients)

After leaving her employer, Shawna McQuillen establishes her own money management
business. While with her former employer, she did not sign a noncompete agreement that
would have prevented her from soliciting former clients. Upon her departure, she does
not take any of her client lists or contact information and she clears her personal
computer of any employer records, including client contact information. She obtains the
phone numbers of her former clients through public records and contacts them to solicit
their business.

Comment: McQuillen is not in violation of Standard IV(A) because she has not used
information or records from her former employer and is not prevented by an agreement
with her former employer from soliciting her former clients.

Example 8 (Leaving an Employer)

Laura Webb just left her position as portfolio analyst at Research Systems, Inc. (RSI).
Her employment contract included a nonsolicitation agreement that requires her to wait
two years before soliciting RSI clients for any investment-related services. Upon leaving,
Webb was informed that RSI would contact clients immediately about her departure and
introduce her replacement.

While working at RSI, Webb connected with clients, other industry associates, and
friends through her Linkedln network. Her business and personal relationships were
intermingled because she considered many of her clients to be personal friends.
Realizing that her Linkedln network would be a valuable resource for new employment
opportunities, she updated her profile several days following her departure from RSI.
Linkedln automatically sent a notification to Webb’s entire network that her employment
status had been changed in her profile.

Comment: Prior to her departure, Webb should have discussed any client information
contained in her social media networks. By updating her Linkedln profile after RSI
notified clients and after her employment ended, she has appropriately placed her
employer’s interests ahead of her own personal interests. In addition, she has not violated
the nonsolicitation agreement with RSI, unless it prohibited any contact with clients
during the two-year period.

72
© 2020 Wiley
 STANDARD IV: DUTIES TO EMPLOYERS

Example 9 (Confidential Firm Information)

Sam Gupta is a research analyst at Naram Investment Management (NIM). NIM uses a
team-based research process to develop recommendations on investment opportunities
covered by the team members. Gupta, like others, provides commentary for NIM’s
clients through the company blog, which is posted weekly on the NIM password-
protected website. According to NIM’s policy, every contribution to the website must be
approved by the company’s compliance department before posting. Any opinions
expressed on the website are disclosed as representing the perspective of NIM.

Gupta also writes a personal blog to share his experiences with friends and family. As
with most blogs, Gupta’s personal blog is widely available to interested readers through
various Internet search engines. Occasionally, when he disagrees with the team-based
research opinions of NIM, Gupta uses his personal blog to express his own opinions as a
counterpoint to the commentary posted on the NIM website. Gupta believes this
provides his readers with a more complete perspective on these investment opportunities.

Comment: Gupta is in violation of Standard IV(A) for disclosing confidential firm

information through his personal blog. The recommendations on the firm’s blog to
clients are not freely available across the internet, but his personal blog post indirectly
provides the firm’s recommendations.

Additionally, by posting research commentary on his personal blog, Gupta is using firm
resources for his personal advantage. To comply with Standard IV(A), members and
candidates must receive consent from their employer prior to using company resources.

Example 10 (Notification of Code and Standards)

Krista Smith is a relatively new assistant trader for the fixed-income desk of a major
investment bank. She is on a team responsible for structuring collateralized debt
obligations (CDOs) made up of securities in the inventory of the trading desk. At a
meeting of the team, senior executives explain the opportunity to eventually separate the
CDO into various risk-rated tranches to be sold to the clients of the firm. After the senior
executives leave the meeting, the head trader announces various responsibilities of each
member of the team and then says, “This is a good time to unload some of the junk we
have been stuck with for a while and disguise it with ratings and a thick, unreadable
prospectus, so don’t be shy in putting this CDO together. Just kidding.” Smith is worried
by this remark and asks some of her colleagues what the head trader meant. They all
respond that he was just kidding but that there is some truth in the remark because the
CDO is seen by management as an opportunity to improve the quality of the securities in
the firm’s inventory.

Concerned about the ethical environment of the workplace, Smith decides to talk to her
supervisor about her concerns and provides the head trader with a copy of the Code and
Standards. Smith discusses the principle of placing the client above the interest of the
firm and the possibility that the development of the new CDO will not adhere to this
responsibility. The head trader assures Smith that the appropriate analysis will be
conducted when determining the appropriate securities for collateral. Furthermore, the
ratings are assigned by an independent firm and the prospectus will include full and
factual disclosures. Smith is reassured by the meeting, but she also reviews the

73
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

company’s procedures and requirements for reporting potential violations of company

policy and securities laws.

Comment: Smith’s review of the company policies and procedures for reporting
violations allows her to be prepared to report through the appropriate whistleblower
process if she decides that the CDO development process involves unethical actions by
others. Smith’s actions comply with the Code and Standards principles of placing the
client’s interests first and being loyal to her employer. In providing her supervisor with a
copy of the Code and Standards, Smith is highlighting the high level of ethical conduct
she is required to adhere to in her professional activities.

Standard IV(B) Additional Compensation Arrangements

The Standard
Members and candidates must not accept gifts, benefits, compensation, or consideration that
competes with or might reasonably be expected to create a conflict of interest with their
employer’s interest unless they obtain written consent from all parties involved.

Guidance
• Members and candidates must obtain permission from their employer before
accepting compensation or other benefits from third parties for the services rendered
to the employer or for any services that might create a conflict with their employer’s
interest.
o Compensation and benefits include direct compensation by the client and
any indirect compensation or other benefits received from third parties,
o “Written consent” includes any form of communication that can be
documented (for example, communication via e-mail that can be retrieved
and documented).

Recommended Procedures for Compliance

• Members and candidates should make an immediate written report to their supervisor
and compliance officer specifying any compensation they propose to receive for
services in addition to the compensation or benefits received from their employer.
• The details of the report should be confirmed by the party offering the additional
compensation, including performance incentives offered by clients.
• This written report should state the terms of any agreement under which a member or
candidate will receive additional compensation; “terms” include the nature of the
compensation, the approximate amount of compensation, and the duration of the
agreement.

Application of the Standard

Example 1 (Notification of Client Bonus Compensation)

Geoff Whitman, a portfolio analyst for Adams Trust Company, manages the account of
Carol Cochran, a client. Whitman is paid a salary by his employer, and Cochran pays the
trust company a standard fee based on the market value of assets in her portfolio.
Cochran proposes to Whitman that “any year that my portfolio achieves at least a 15%
return before taxes, you and your wife can fly to Monaco at my expense and use my
condominium during the third week of January.” Whitman does not inform his employer
of the arrangement and vacations in Monaco the following January as Cochran’s guest.

7.
© 2020 Wiley
 STANDARD IV: DUTIES TO EMPLOYERS

Comment: Whitman violated Standard IV(B) by failing to inform his employer in

writing of this supplemental, contingent compensation arrangement. The nature of the
arrangement could have resulted in partiality to Cochran’s account, which could have
detracted from Whitman’s performance with respect to other accounts he handles for
Adams Trust. Whitman must obtain the consent of his employer to accept such a
supplemental benefit.

Example 2 (Notification of Outside Compensation)

Terry Jones sits on the board of directors of Exercise Unlimited, Inc. In return for his
services on the board, Jones receives unlimited membership privileges for his family at
all Exercise Unlimited facilities. Jones purchases Exercise Unlimited stock for the client
accounts for which it is appropriate. Jones does not disclose this arrangement to his
employer because he does not receive monetary compensation for his services to the
board.

Comment: Jones has violated Standard IV(B) by failing to disclose to his employer
benefits received in exchange for his services on the board of directors. The
nonmonetary compensation may create a conflict of interest in the same manner as being
paid to serve as a director.

Example 3 (Prior Approval for Outside Compensation)

Jonathan Hollis is an analyst of oil-and-gas companies for Specialty Investment

Management. He is currently recommending the purchase of ABC Oil Company shares
and has published a long, well-thought-out research report to substantiate his
recommendation. Several weeks after publishing the report, Hollis receives a call from
the investor-relations office of ABC Oil saying that Thomas Andrews, CEO of the
company, saw the report and really liked the analyst’s grasp of the business and his
company. The investor-relations officer invites Hollis to visit ABC Oil to discuss the
industry further. ABC Oil offers to send a company plane to pick Hollis up and arrange
for his accommodations while visiting. Hollis, after gaining the appropriate approvals,
accepts the meeting with the CEO but declines the offered travel arrangements.

Several weeks later, Andrews and Hollis meet to discuss the oil business and Hollis’s
report. Following the meeting, Hollis joins Andrews and the investment relations officer
for dinner at an upscale restaurant near ABC Oil’s headquarters.

Upon returning to Specialty Investment Management, Hollis provides a full review of

the meeting to the director of research, including a disclosure of the dinner attended.

Comment: Hollis’s actions did not violate Standard IV(B). Through gaining approval
before accepting the meeting and declining the offered travel arrangements, Hollis
sought to avoid any potential conflicts of interest between his company and ABC Oil.
Because the location of the dinner was not available prior to arrival and Hollis notified
his company of the dinner upon his return, accepting the dinner should not impair his
objectivity. By disclosing the dinner, Hollis has enabled Specialty Investment
Management to assess whether it has any impact on future reports and recommendations
by Hollis related to ABC Oil.

75
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Standard IV(C) Responsibilities of Supervisors

The Standard
Members and candidates must make reasonable efforts to ensure that anyone subject to their
supervision or authority complies with applicable laws, rules, regulations, and the Code and
Standards.

Guidance
• Members and candidates must promote actions by all employees under their
supervision and authority to comply with applicable laws, rules, regulations, and firm
policies and the Code and Standards.
• A member’s or candidate’s responsibilities under Standard IV(C) include instructing
those subordinates to whom supervision is delegated about methods to promote
compliance, including preventing and detecting violations of laws, rules, regulations,
firm policies, and the Code and Standards.
• At a minimum, Standard IV(C) requires that members and candidates with
supervisory responsibility make reasonable efforts to prevent and detect violations by
ensuring the establishment of effective compliance systems. However, an effective
compliance system goes beyond enacting a code of ethics, establishing policies and
procedures to achieve compliance with the code and applicable law, and reviewing
employee actions to determine whether they are following the rules.
• To be effective supervisors, members and candidates should implement education
and training programs on a recurring or regular basis for employees under their
supervision. Further, establishing incentives—monetary or otherwise—for
employees not only to meet business goals but also to reward ethical behavior offers
supervisors another way to assist employees in complying with their legal and ethical
obligations.
• A member or candidate with supervisory responsibility should bring an inadequate
compliance system to the attention of the firm’s senior managers and recommend
corrective action. If the member or candidate clearly cannot discharge supervisory
responsibilities because of the absence of a compliance system or because of an
inadequate compliance system, the member or candidate should decline in writing to
accept supervisory responsibility until the firm adopts reasonable procedures to allow
adequate exercise of supervisory responsibility.

System for Supervision

• Members and candidates with supervisory responsibility must understand what
constitutes an adequate compliance system for their firms and make reasonable
efforts to see that appropriate compliance procedures are established, documented,
communicated to covered personnel, and followed.
o “Adequate” procedures are those designed to meet industry standards,
regulatory requirements, the requirements of the Code and Standards, and
the circumstances of the firm.
o To be effective, compliance procedures must be in place prior to the
occurrence of a violation of the law or the Code and Standards.
• Once a supervisor learns that an employee has violated or may have violated the law
or the Code and Standards, the supervisor must promptly initiate an assessment to
determine the extent of the wrongdoing. Relying on an employee’s statements about
the extent of the violation or assurances that the wrongdoing will not reoccur is not
enough. Reporting the misconduct up the chain of command and warning the
employee to cease the activity are also not enough. Pending the outcome of the

.
investigation, a supervisor should take steps to ensure that the violation will not be

7
© 2020 Wiley
 STANDARD IV: DUTIES TO EMPLOYERS

repeated, such as placing limits on the employee’s activities or increasing the

monitoring of the employee’s activities.

Supervision Includes Detection

• Members and candidates with supervisory responsibility must also make reasonable
efforts to detect violations of laws, rules, regulations, firm policies, and the Code and
Standards. If a member or candidate has adopted reasonable procedures and taken
steps to institute an effective compliance program, then the member or candidate may
not be in violation of Standard IV(C) if he or she does not detect violations that occur
despite these efforts. The fact that violations do occur may indicate, however, that the
compliance procedures are inadequate.
• In addition, in some cases, merely enacting such procedures may not be sufficient to
fulfill the duty required by Standard IV(C). A member or candidate may be in
violation of Standard IV(C) if he or she knows or should know that the procedures
designed to promote compliance, including detecting and preventing violations, are
not being followed.

Recommended Procedures for Compliance

Codes of Ethics or Compliance Procedures

• Members and candidates are encouraged to recommend that their employers adopt a
code of ethics, and put in place specific policies and procedures needed to ensure
compliance with the codes and with securities laws and regulations
• Members and candidates should encourage their employers to provide their codes of
ethics to clients.

Adequate Compliance Procedures

Adequate compliance procedures should:

• Be contained in a clearly written and accessible manual that is tailored to the firm’s
operations.
• Be drafted so that the procedures are easy to understand.
• Designate a compliance officer whose authority and responsibility are clearly defined
and who has the necessary resources and authority to implement the firm’s
compliance procedures.
• Describe the hierarchy of supervision and assign duties among supervisors.
• Implement a system of checks and balances.
• Outline the scope of the procedures.
• Outline procedures to document the monitoring and testing of compliance
procedures.
• Outline permissible conduct.
• Delineate procedures for reporting violations and sanctions.

Once a compliance program is in place, a supervisor should:

• Disseminate the contents of the program to appropriate personnel.

• Periodically update procedures to ensure that the measures are adequate under the
law.
• Continually educate personnel regarding the compliance procedures.
• Issue periodic reminders of the procedures to appropriate personnel.
• Incorporate a professional conduct evaluation as part of an employee’s performance
review.

© 2020 Wiley l
PROFESSIONAL STANDARDS AND ETHICS

• Review the actions of employees to ensure compliance and identify violators.

• Take the necessary steps to enforce the procedures once a violation has occurred.

Once a violation is discovered, a supervisor should:

• Respond promptly.
• Conduct a thorough investigation of the activities to determine the scope of the
wrongdoing.
• Increase supervision or place appropriate limitations on the wrongdoer pending the
outcome of the investigation.
• Review procedures for potential changes necessary to prevent future violations from
occurring.

Implementation of Compliance Education and Training

• Regular ethics and compliance training, in conjunction with the adoption of a code of
ethics, is critical to investment firms seeking to establish a strong culture of integrity
and to provide an environment in which employees routinely engage in ethical
conduct in compliance with the law.

Establish an Appropriate Incentive Structure

• Supervisors and firms must look closely at their incentive structure to determine
whether the structure encourages profits and returns at the expense of ethically
appropriate conduct. Only when compensation and incentives are firmly tied to client
interests and how outcomes are achieved, rather than how much is generated for the
firm, will employees work to achieve a culture of integrity.

Application of the Standard

Example 1 (Supervising Research Activities)

Jane Mattock, senior vice president and head of the research department of H&V, Inc., a
regional brokerage firm, has decided to change her recommendation for Timber Products
from buy to sell. In line with H&V’s procedures, she orally advises certain other H&V
executives of her proposed actions before the report is prepared for publication. As a
result of Mattock’s conversation with Dieter Frampton, one of the H&V executives
accountable to Mattock, Frampton immediately sells Timber’s stock from his own
account and from certain discretionary client accounts. In addition, other personnel
inform certain institutional customers of the changed recommendation before it is printed
and disseminated to all H&V customers who have received previous Timber reports.

Comment: Mattock has violated Standard IV(C) by failing to reasonably and adequately
supervise the actions of those accountable to her. She did not prevent or establish
reasonable procedures designed to prevent dissemination of or trading on the information
by those who knew of her changed recommendation. She must ensure that her firm has
procedures for reviewing or recording any trading in the stock of a corporation that has
been the subject of an unpublished change in recommendation. Adequate procedures
would have informed the subordinates of their duties and detected sales by Frampton and
selected customers.

7 . © 2020 Wiley
 STANDARD IV: DUTIES TO EMPLOYERS

Example 2 (Supervising Trading Activities)

David Edwards, a trainee trader at Wheeler & Company, a major national brokerage
firm, assists a customer in paying for the securities of Highland, Inc., by using
anticipated profits from the immediate sale of the same securities. Despite the fact that
Highland is not on Wheeler’s recommended list, a large volume of its stock is traded
through Wheeler in this manner. Roberta Ann Mason is a Wheeler vice president
responsible for supervising compliance with the securities laws in the trading
department. Part of her compensation from Wheeler is based on commission revenues
from the trading department. Although she notices the increased trading activity, she
does nothing to investigate or halt it.

Comment: Mason’s failure to adequately review and investigate purchase orders in

Highland stock executed by Edwards and her failure to supervise the trainee’s activities
violate Standard IV(C). Supervisors should be especially sensitive to actual or potential
conflicts between their own self-interests and their supervisory responsibilities.

Example 3 Supervising Trading Activities and Record Keeping)

Samantha Tabbing is senior vice president and portfolio manager for Crozet, Inc., a
registered investment advisory and registered broker/dealer firm. She reports to Charles
Henry, the president of Crozet. Crozet serves as the investment adviser and principal
underwriter for ABC and XYZ public mutual funds. The two funds’ prospectuses allow
Crozet to trade financial futures for the funds for the limited purpose of hedging against
market risks. Henry, extremely impressed by Tabbing’s performance in the past two
years, directs Tabbing to act as portfolio manager for the funds. For the benefit of its
employees, Crozet has also organized the Crozet Employee Profit-Sharing Plan
(CEPSP), a defined contribution retirement plan. Henry assigns Tabbing to manage 20%
of the assets of CEPSP. Tabbing’s investment objective for her portion of CEPSP’s
assets is aggressive growth. Unbeknownst to Henry, Tabbing frequently places S&P 500
Index purchase and sale orders for the funds and the CEPSP without providing the
futures commission merchants (FCMs) who take the orders with any prior or
simultaneous designation of the account for which the trade has been placed. Frequently,
neither Tabbing nor anyone else at Crozet completes an internal trade ticket to record the
time an order was placed or the specific account for which the order was intended. FCMs
often designate a specific account only after the trade, when Tabbing provides such
designation. Crozet has no written operating procedures or compliance manual
concerning its futures trading, and its compliance department does not review such
trading. After observing the market’s movement, Tabbing assigns to CEPSP the S&P
500 positions with more favorable execution prices and assigns positions with less
favorable execution prices to the funds.

Comment: Henry violated Standard IV(C) by failing to adequately supervise Tabbing

with respect to her S&P 500 trading. Henry further violated Standard IV(C) by failing to
establish record-keeping and reporting procedures to prevent or detect Tabbing’s
violations. Henry must make a reasonable effort to determine that adequate compliance
procedures covering all employee trading activity are established, documented,
communicated, and followed.

79
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Example 4 (Supervising Research Activities)

Mary Burdette was recently hired by Fundamental Investment Management (FIM) as a

junior auto industry analyst. Burdette is expected to expand the social media presence of
the firm because she is active with various networks, including Facebook, Linkedln, and
Twitter. Although Burdette’s supervisor, Joe Graf, has never used social media, he
encourages Burdette to explore opportunities to increase FIM’s online presence and
ability to share content, communicate, and broadcast information to clients. In response
to G rafs encouragement, Burdette is working on a proposal detailing the advantages of
getting FIM onto Twitter in addition to launching a company Facebook page.

As part of her auto industry research for FIM, Burdette is completing a report on the
financial impact of Sun Drive Auto Ltd.'s new solar technology for compact
automobiles. This research report will be her first for FIM, and she believes Sun Drive’s
technology could revolutionize the auto industry. In her excitement, Burdette sends a
quick tweet to FIM Twitter followers summarizing her “buy” recommendation for Sun
Drive Auto stock.

Comment: Graf has violated Standard IV(C) by failing to reasonably supervise Burdette
with respect to the contents of her tweet. He did not establish reasonable procedures to
prevent the unauthorized dissemination of company research through social media
networks. Graf must make sure all employees receive regular training about FIM’s
policies and procedures, including the appropriate business use of personal social media
networks.

See Standard III(B) for additional guidance.

Example 5 (Supervising Research Activities)

Chen Wang leads the research department at YYRA Retirement Planning Specialists.
Chen supervises a team of 10 analysts in a fast-paced and understaffed organization. He
is responsible for coordinating the firm’s approved process to review all reports before
they are provided to the portfolio management team for use in rebalancing client
portfolios.

One of Chen’s direct reports, Huang Mei, covers the banking industry. Chen must
submit the latest updates to the portfolio management team tomorrow morning. Huang
has yet to submit her research report on ZYX Bank because she is uncomfortable
providing a “buy” or “sell” opinion of ZYX on the basis of the completed analysis.
Pressed for time and concerned that Chen will reject a “hold” recommendation, she
researches various websites and blogs on the banking sector for whatever she can find on
ZYX. One independent blogger provides a new interpretation of the recently reported
data Huang has analyzed and concludes with a strong “sell” recommendation for ZYX.
She is impressed by the originality and resourcefulness of this blogger’s report.

Very late in the evening, Huang submits her report and “sell” recommendation to Chen
without any reference to the independent blogger’s report. Given the late time of the
submission and the competence of Huang’s prior work, Chen compiles this report with
the recommendations from each of the other analysts and meets with the portfolio
managers to discuss implementation.

80
© 2020 Wiley
 STANDARD IV: DUTIES TO EMPLOYERS

Comment: Chen has violated Standard IV(C) by neglecting to reasonably and

adequately follow the firm’s approved review process for Huang’s research report. The
delayed submission and the quality of prior work do not remove Chen’s requirement to
uphold the designated review process. A member or candidate with supervisory
responsibility must make reasonable efforts to see that appropriate procedures are
established, documented, communicated to covered personnel, and followed.

81
© 2020 Wiley
 S t a n d a r d V : In v e s t m e n t A n a l y s i s , R e c o m m e n d a t i o n s ,
a n d A c t io n s

LESSON MAP
• Diligence and Reasonable Basis
• Communication with Clients and Prospective Clients
• Record Retention

Learning Objective: Demonstrate knowledge of Standard V: Investment

Analysis, Recommendations, and Actions.

Standard V(A) Diligence and Reasonable Basis

The Standard
Members and candidates must:

1. Exercise diligence, independence, and thoroughness in analyzing investments,

making investment recommendations, and taking investment actions.
2. Have a reasonable and adequate basis, supported by appropriate research and
investigation, for any investment analysis, recommendation, or action.

Guidance
• The requirements for issuing conclusions based on research will vary in relation to
the member’s or candidate’s role in the investment decision-making process, but the
member or candidate must make reasonable efforts to cover all pertinent issues when
arriving at a recommendation.
• Members and candidates enhance transparency by providing or offering to provide
supporting information to clients when recommending a purchase or sale or when
changing a recommendation.

Defining Diligence and Reasonable Basis

• As with determining the suitability of an investment for the client, the necessary level
of research and analysis will differ with the product, security, or service being
offered. The following list provides some, but definitely not all, examples of
attributes to consider while forming the basis for a recommendation:
o Global, regional, and country macroeconomic conditions,
o A company’s operating and financial history.
o The industry’s and sector’s current conditions and the stage of the business
cycle.
o A mutual fund’s fee structure and management history,
o The output and potential limitations of quantitative models,
o The quality of the assets included in a securitization,
o The appropriateness of selected peer-group comparisons.
• The steps taken in developing a diligent and reasonable recommendation should
minimize unexpected downside events.

Using Secondary or Third-Party Research

• If members and candidates rely on secondary or third-party research, they must make
reasonable and diligent efforts to determine whether such research is sound.
o Secondary research is defined as research conducted by someone else in the
member’s or candidate’s firm.

a
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

o Third-party research is research conducted by entities outside the member’s

or candidate’s firm, such as a brokerage firm, bank, or research firm.
• Members and candidates should make reasonable inquiries into the source and
accuracy of all data used in completing their investment analysis and
recommendations.
• Criteria that a member or candidate can use in forming an opinion on whether
research is sound include the following:
o Assumptions used,
o Rigor of the analysis performed,
o Date/timeliness of the research.
o Evaluation of the objectivity and independence of the recommendations.
• A member or candidate may rely on others in his or her firm to determine whether
secondary or third-party research is sound and use the information in good faith
unless the member or candidate has reason to question its validity or the processes
and procedures used by those responsible for the research.
• A member or candidate should verify that the firm has a policy about the timely and
consistent review of approved research providers to ensure that the quality of the
research continues to meet the necessary standards. If such a policy is not in place at
the firm, the member or candidate should encourage the development and adoption
of a formal review practice.

Using Quantitatively Oriented Research

• Members and candidates must have an understanding of the parameters used in
models and quantitative research that are incorporated into their investment
recommendations. Although they are not required to become experts in every
technical aspect of the models, they must understand the assumptions and limitations
inherent in any model and how the results were used in the decision-making process.
• Members and candidates should make reasonable efforts to test the output of
investment models and other pre-programmed analytical tools they use. Such
validation should occur before incorporating the process into their methods, models,
or analyses.
• Although not every model can test for every factor or outcome, members and
candidates should ensure that their analyses incorporate a broad range of assumptions
sufficient to capture the underlying characteristics of investments. The omission from
the analysis of potentially negative outcomes or of levels of risk outside the norm
may misrepresent the true economic value of an investment. The possible scenarios
for analysis should include factors that are likely to have a substantial influence on
the investment value and may include extremely positive and negative scenarios.

Developing Quantitatively Oriented Techniques

• Members and candidates involved in the development and oversight of quantitatively
oriented models, methods, and algorithms must understand the technical aspects of
the products they provide to clients. A thorough testing of the model and resulting
analysis should be completed prior to product distribution.
• In reviewing the computer models or the resulting output, members and candidates
need to pay particular attention to the assumptions used in the analysis and the rigor
of the analysis to ensure that the model incorporates a wide range of possible input
expectations, including negative market events.

Selecting External Advisers and Subadvisers

• Members and candidates must review managers as diligently as they review
individual funds and securities.

© 2020 Wiley
 STANDARD V: INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTIONS

• Members and candidates who are directly involved with the use of external advisers
need to ensure that their firms have standardized criteria for reviewing these selected
external advisers and managers. Such criteria would include, but would not be
limited to, the following:
o Reviewing the adviser’s established code of ethics,
o Understanding the adviser’s compliance and internal control procedures,
o Assessing the quality of the published return information,
o Reviewing the adviser’s investment process and adherence to its stated
strategy.

Group Research and Decision Making

In some instances, a member or candidate will not agree with the view of the group. If,
however, the member or candidate believes that the consensus opinion has a reasonable and
adequate basis and is independent and objective, the member or candidate need not decline
to be identified with the report. If the member or candidate is confident in the process, the
member or candidate does not need to dissociate from the report even if it does not reflect
his or her opinion.

Recommended Procedures for Compliance

Members and candidates should encourage their firms to consider the following policies and
procedures to support the principles of Standard V(A):

• Establish a policy requiring that research reports, credit ratings, and investment
recommendations have a basis that can be substantiated as reasonable and adequate.
• Develop detailed, written guidance for analysts (research, investment, or credit),
supervisory analysts, and review committees that establishes the due diligence
procedures for judging whether a particular recommendation has a reasonable and
adequate basis.
• Develop measurable criteria for assessing the quality of research, the reasonableness
and adequacy of the basis for any recommendation or rating, and the accuracy of
recommendations over time.
• Develop detailed, written guidance that establishes minimum levels of scenario
testing of all computer-based models used in developing, rating, and evaluating
financial instruments.
• Develop measurable criteria for assessing outside providers, including the quality of
information being provided, the reasonableness and adequacy of the provider’s
collection practices, and the accuracy of the information over time.
• Adopt a standardized set of criteria for evaluating the adequacy of external advisers.

Application of the Standard

Example 1 (Sufficient Due Diligence)

Helen Hawke manages the corporate finance department of Sarkozi Securities, Ltd. The
firm is anticipating that the government will soon close a tax loophole that currently
allows oil-and-gas exploration companies to pass on drilling expenses to holders of a
certain class of shares. Because market demand for this tax-advantaged class of stock is
currently high, Sarkozi convinces several companies to undertake new equity financings
at once, before the loophole closes. Time is of the essence, but Sarkozi lacks sufficient
resources to conduct adequate research on all the prospective issuing companies. Hawke
decides to estimate the IPO prices on the basis of the relative size of each company and
to justify the pricing later when her staff has time.

© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Comment: Sarkozi should have taken on only the work that it could adequately handle.
By categorizing the issuers by general size, Hawke has bypassed researching all the
other relevant aspects that should be considered when pricing new issues and thus has
not performed sufficient due diligence. Such an omission can result in investors
purchasing shares at prices that have no actual basis. Hawke has violated Standard V(A).

Example 2 (Sufficient Scenario Testing)

Babu Dhaliwal works for Heinrich Brokerage in the corporate finance group. He has just
persuaded Feggans Resources, Ltd., to allow his firm to do a secondary equity financing
at Feggans Resources’ current stock price. Because the stock has been trading at higher
multiples than similar companies with equivalent production, Dhaliwal presses the
Feggans Resources managers to project what would be the maximum production they
could achieve in an optimal scenario. Based on these numbers, he is able to justify the
price his firm will be asking for the secondary issue. During a sales pitch to the brokers,
Dhaliwal then uses these numbers as the base-case production levels that Feggans
Resources will achieve.

Comment: When presenting information to the brokers, Dhaliwal should have given a
range of production scenarios and the probability of Feggans Resources achieving each
level. By giving the maximum production level as the likely level of production, he has
misrepresented the chances of achieving that production level and seriously misled the
brokers. Dhaliwal has violated Standard V(A).

Example 3 (Reliance on Third-Party Research)

Gary McDermott runs a two-person investment management firm. McDermott’s firm

subscribes to a service from a large investment research firm that provides research
reports. McDermott’s firm makes investment recommendations on the basis of these
reports.

Comment: Members and candidates can rely on third-party research but must make
reasonable and diligent efforts to determine that such research is sound. If McDermott
undertakes due diligence efforts on a regular basis to ensure that the research produced
by the large firm is objective and reasonably based, McDermott can rely on that research
when making investment recommendations to clients.

Example 4 (Quantitative Model Diligence)

Barry Cannon is the lead quantitative analyst at CityCenter Hedge Fund. He is

responsible for the development, maintenance, and enhancement of the proprietary
models the fund uses to manage its investors’ assets. Cannon reads several high-level
mathematical publications and blogs to stay informed of current developments. One
blog, run by Expert CFA, presents some intriguing research that may benefit one of
CityCenter’s current models. Cannon is under pressure from firm executives to improve
the model’s predictive abilities, and he incorporates the factors discussed in the online

86
© 2020 Wiley
 STANDARD V: INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTIONS

research. The updated output recommends several new investments to the fund’s
portfolio managers.

Comment: Cannon has violated Standard V(A) by failing to have a reasonable basis for
the new recommendations made to the portfolio managers. He needed to diligently
research the effect of incorporating the new factors before offering the output
recommendations. Cannon may use the blog for ideas, but it is his responsibility to
determine the effect on the firm’s proprietary models.

See Standard VII(B) regarding the violation by “Expert CFA” in the use of the CFA
designation.

Example 5 (Selecting a Service Provider)

Ellen Smith is a performance analyst at Artie Global Advisors, a firm that manages
global equity mandates for institutional clients. She was asked by her supervisor to
review five new performance attribution systems and recommend one that would more
appropriately explain the firm’s investment strategy to clients. On the list was a system
she recalled learning about when visiting an exhibitor booth at a recent conference. The
system is highly quantitative and something of a “black box” in how it calculates the
attribution values. Smith recommended this option without researching the others
because the sheer complexity of the process was sure to impress the clients.

Comment: Smith’s actions do not demonstrate a sufficient level of diligence in

reviewing this product to make a recommendation for selecting the service. Besides not
reviewing or considering the other four potential systems, she did not determine whether
the “black box” attribution process aligns with the investment practices of the firm,
including its investments in different countries and currencies. Smith must review and
understand the process of any software or system before recommending its use as the
firm’s attribution system.

Example 6 (Subadviser Selection)

Craig Jackson is working for Adams Partners, Inc., and has been assigned to select a
hedge fund subadviser to improve the diversification of the firm’s large fund-of-funds
product. The allocation must be in place before the start of the next quarter. Jackson uses
a consultant database to find a list of suitable firms that claim compliance with the GIPS
standards. He calls more than 20 firms on the list to confirm their potential interest and to
determine their most recent quarterly and annual total return values. Because of the short
turnaround, Jackson recommends the firm with the greatest total return values for
selection.

Comment: By considering only performance and GIPS compliance, Jackson has not
conducted sufficient review of potential firms to satisfy the requirements of Standard
V(A). A thorough investigation of the firms and their operations should be conducted to
ensure that their addition would increase the diversity of clients’ portfolios and that they
are suitable for the fund-of-funds product.

87
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Example 7 (Manager Selection)

Timothy Green works for Peach Asset Management, where he creates proprietary
models that analyze data from the firm request for proposal questionnaires to identify
managers for possible inclusion in the firm’s fund-of-funds investment platform. Various
criteria must be met to be accepted to the platform. Because of the number of
respondents to the questionnaires, Green uses only the data submitted to make a
recommendation for adding a new manager.

Comment: By failing to conduct any additional outside review of the information to

verify what was submitted through the request for proposal, Green has likely not
satisfied the requirements of Standard V(A). The amount of information requested from
outside managers varies among firms. Although the requested information may be
comprehensive, Green should ensure sufficient effort is undertaken to verify the
submitted information before recommending a firm for inclusion. This requires that he
go beyond the information provided by the manager on the request for proposal
questionnaire and may include interviews with interested managers, reviews of
regulatory filings, and discussions with the managers’ custodian or auditor.

Example 8 (Technical Model Requirements)

Jerome Dupont works for the credit research group of XYZ Asset Management, where
he is in charge of developing and updating credit risk models. In order to perform
accurately, his models need to be regularly updated with the latest market data.

Dupont does not interact with or manage money for any of the firm’s clients. He is in
contact with the firm’s U.S. corporate bond fund manager, John Smith, who has only
very superficial knowledge of the model and who from time to time asks very basic
questions regarding the output recommendations. Smith does not consult Dupont with
respect to finalizing his clients’ investment strategies.

Dupont’s recently assigned objective is to develop a new emerging market corporate

credit risk model. The firm is planning to expand into emerging credit, and the
development of such a model is a critical step in this process. Because Smith seems to
follow the model’s recommendations without much concern for its quality as he
develops his clients’ investment strategies, Dupont decides to focus his time on the
development of the new emerging market model and neglects to update the U.S. model.

After several months without regular updates, Dupont’s diagnostic statistics start to show
alarming signs with respect to the quality of the U.S. credit model. Instead of conducting
the long and complicated data update, Dupont introduces new codes into his model with
some limited new data as a quick “fix.” He thinks this change will address the issue
without needing to complete the full data update, so he continues working on the new
emerging market model.

Several months following the quick “fix,” another set of diagnostic statistics reveals
nonsensical results and Dupont realizes that his earlier change contained an error. He
quickly corrects the error and alerts Smith. Smith realizes that some of the prior trades he
performed were due to erroneous model results. Smith rebalances the portfolio to remove

88
© 2020 Wiley
 STANDARD V: INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTIONS

the securities purchased on the basis of the questionable results without reporting the
issue to anyone else.

Comment: Smith violated Standard V(A) because exercising “diligence, independence,

and thoroughness in analyzing investments, making investment recommendations, and
taking investment actions” means that members and candidates must understand the
technical aspects of the products they provide to clients. Smith does not understand the
model he is relying on to manage money. Members and candidates should also make
reasonable inquiries into the source and accuracy of all data used in completing their
investment analysis and recommendations.

Dupont violated Standard V(A) even if he does not trade securities or make investment
decisions. Dupont’s models give investment recommendations, and Dupont is
accountable for the quality of those recommendations. Members and candidates should
make reasonable efforts to test the output of pre-programmed analytical tools they use.
Such validation should occur before incorporating the tools into their decision-making
process.

See also Standard V(B)—Communication with Clients and Prospective Clients.

Standard V(B) Communication with Clients and Prospective Clients

The Standard
Members and candidates must:

1. Disclose to clients and prospective clients the basic format and general principles of
the investment processes they use to analyze investments, select securities, and
construct portfolios, and must promptly disclose any changes that might materially
affect those processes.
2. Disclose to clients and prospective clients significant limitations and risks associated
with the investment process.
3. Use reasonable judgment in identifying which factors are important to their
investment analyses, recommendations, or actions, and include those factors in
communications with clients and prospective clients.
4. Distinguish between fact and opinion in the presentation of investment analyses and
recommendations.

Guidance
• Members and candidates should communicate in a recommendation the factors that
were instrumental in making the investment recommendation. A critical part of this
requirement is to distinguish clearly between opinions and facts.
• Follow-up communication of significant changes in the risk characteristics of a
security or asset strategy is required.
• Providing regular updates to any changes in the risk characteristics is recommended.

Informing Clients of the Investment Process

• Members and candidates must adequately describe to clients and prospective clients
the manner in which they conduct the investment decision-making process. Such
disclosure should address factors that have positive and negative influences on the
recommendations, including significant risks and limitations of the investment
process used.

© 2020 Wiley 5
PROFESSIONAL STANDARDS AND ETHICS

• The member or candidate must keep clients and other interested parties informed on
an ongoing basis about changes to the investment process, especially newly
identified significant risks and limitations.
• Members and candidates should inform the clients about the specialization or
diversification expertise provided by the external adviser(s).

Different Forms of Communication

• Members and candidates using any social media service to communicate business
information must be diligent in their efforts to avoid unintended problems because
these services may not be available to all clients. When providing information to
clients through new technologies, members and candidates should take reasonable
steps to ensure that such delivery would treat all clients fairly and, if necessary, be
considered publicly disseminated.
• If recommendations are contained in capsule form (such as a recommended stock
list), members and candidates should notify clients that additional information and
analyses are available from the producer of the report.

Identifying Risks and Limitations

• Members and candidates must outline to clients and prospective clients significant
risks and limitations of the analysis contained in their investment products or
recommendations.
• The appropriateness of risk disclosure should be assessed on the basis of what was
known at the time the investment action was taken (often called an ex ante basis).
Members and candidates must disclose significant risks known to them at the time of
the disclosure. Members and candidates cannot be expected to disclose risks they are
unaware of at the time recommendations or investment actions are made.
• Having no knowledge of a risk or limitation that subsequently triggers a loss may
reveal a deficiency in the diligence and reasonable basis of the research of the
member or candidate but may not reveal a breach of Standard V(B).

Report Presentation
• A report writer who has done adequate investigation may emphasize certain areas,
touch briefly on others, and omit certain aspects deemed unimportant.
• Investment advice based on quantitative research and analysis must be supported by
readily available reference material and should be applied in a manner consistent
with previously applied methodology. If changes in methodology are made, they
should be highlighted.

Distinction between Facts and Opinions in Reports

• Violations often occur when reports fail to separate the past from the future by not
indicating that earnings estimates, changes in the outlook for dividends, or future
market price information are opinions subject to future circumstances.
• In the case of complex quantitative analyses, members and candidates must clearly
separate fact from statistical conjecture and should identify the known limitations of
an analysis.
• Members and candidates should explicitly discuss with clients and prospective
clients the assumptions used in the investment models and processes to generate the
analysis. Caution should be used in promoting the perceived accuracy of any model
or process to clients because the ultimate output is merely an estimate of future
results and not a certainty.

*
© 2020 Wiley
 STANDARD V: INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTIONS

Recommended Procedures for Compliance

• Members and candidates should encourage their firms to have a rigorous
methodology for reviewing research that is created for publication and dissemination
to clients.
• To assist in the after-the-fact review of a report, the member or candidate must
maintain records indicating the nature of the research and should, if asked, be able to
supply additional information to the client (or any user of the report) covering factors
not included in the report.

Application of the Standard

Example 1 (Sufficient Disclosure of Investment System)

Sarah Williamson, director of marketing for Country Technicians, Inc., is convinced that
she has found the perfect formula for increasing Country Technicians’ income and
diversifying its product base. Williamson plans to build on Country Technicians’
reputation as a leading money manager by marketing an exclusive and expensive
investment advice letter to high-net-worth individuals. One hitch in the plan is the
complexity of Country Technicians’ investment system—a combination of technical
trading rules (based on historical price and volume fluctuations) and portfolio
construction rules designed to minimize risk. To simplify the newsletter, she decides to
include only each week’s top five “buy” and “sell” recommendations and to leave out
details of the valuation models and the portfolio structuring scheme.

Comment: Williamson’s plans for the newsletter violate Standard V(B). Williamson
need not describe the investment system in detail in order to implement the advice
effectively, but she must inform clients of Country Technicians’ basic process and logic.
Without understanding the basis for a recommendation, clients cannot possibly
understand its limitations or its inherent risks.

Example 2 (Proper Description of a Security)

Olivia Thomas, an analyst at Government Brokers, Inc., which is a brokerage firm

specializing in government bond trading, has produced a report that describes an
investment strategy designed to benefit from an expected decline in U.S. interest rates.
The firm’s derivative products group has designed a structured product that will allow
the firm’s clients to benefit from this strategy. Thomas’s report describing the strategy
indicates that high returns are possible if various scenarios for declining interest rates are
assumed. Citing the proprietary nature of the structured product underlying the strategy,
the report does not describe in detail how the firm is able to offer such returns or the
related risks in the scenarios, nor does the report address the likely returns of the strategy
if, contrary to expectations, interest rates rise.

Comment: Thomas has violated Standard V(B) because her report fails to describe
properly the basic characteristics of the actual and implied risks of the investment
strategy, including how the structure was created and the degree to which leverage was
embedded in the structure. The report should include a balanced discussion of how the
strategy would perform in the case of rising as well as falling interest rates, preferably
illustrating how the strategies might be expected to perform in the event of a reasonable
variety of interest rate and credit risk-spread scenarios. If liquidity issues are relevant

9,
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

with regard to the valuation of either the derivatives or the underlying securities,
provisions the firm has made to address those risks should also be disclosed.

Example 3 (Notification of Changes to the Investment Process)

RJZ Capital Management is an active value-style equity manager that selects stocks by
using a combination of four multifactor models. The firm has found favorable results
when back testing the most recent 10 years of available market data in a new dividend
discount model (DDM) designed by the firm. This model is based on projected inflation
rates, earnings growth rates, and interest rates. The president of RJZ decides to replace
its simple model that uses price to trailing 12-month earnings with the new DDM.

Comment: Because the introduction of a new and different valuation model represents a
material change in the investment process, RJZ’s president must communicate the
change to the firm’s clients. RJZ is moving away from a model based on hard data
toward a new model that is at least partly dependent on the firm’s forecasting skills.
Clients would likely view such a model as a significant change rather than a mere
refinement of RJZ’s process.

Example 4 (Notification of Changes to the Investment Process)

RJZ Capital Management loses the chief architect of its multifactor valuation system.
Without informing its clients, the president of RJZ decides to redirect the firm’s talents
and resources toward developing a product for passive equity management—a product
that will emulate the performance of a major market index.

Comment: By failing to disclose to clients a substantial change to its investment

process, the president of RJZ has violated Standard V(B).

Example 5 (Sufficient Disclosure of Investment System)

Amanda Chinn is the investment director for Diversified Asset Management, which
manages the endowment of a charitable organization. Because of recent staff departures,
Diversified has decided to limit its direct investment focus to large-cap securities and
supplement the needs for small-cap and mid-cap management by hiring outside fund
managers. In describing the planned strategy change to the charity, Chinn’s update letter
states, “As investment director, I will directly oversee the investment team managing the
endowment’s large-capitalization allocation. I will coordinate the selection and ongoing
review of external managers responsible for allocations to other classes.” The letter also
describes the reasons for the change and the characteristics external managers must have
to be considered.

Comment: Standard V(B) requires the disclosure of the investment process used to
construct the portfolio of the fund. Changing the investment process from managing all
classes of investments within the firm to the use of external managers is one example of
information that needs to be communicated to clients. Chinn and her firm have embraced
the principles of Standard V(B) by providing their client with relevant information. The

92
© 2020 Wiley
 STANDARD V: INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTIONS

charity can now make a reasonable decision about whether Diversified Asset
Management remains the appropriate manager for its fund.

Example 6 (Notification of Risks and Limitations)

Quantitative analyst Yuri Yakovlev has developed an investment strategy that selects
small-cap stocks on the basis of quantitative signals. Yakovlev’s strategy typically
identifies only a small number of stocks (10-20) that tend to be illiquid, but according to
his backtests, the strategy generates significant risk-adjusted returns. The partners at
Yakovlev’s firm, QSC Capital, are impressed by these results. After a thorough
examination of the strategy’s risks, stress testing, historical back testing, and scenario
analysis, QSC decides to seed the strategy with US$10 million of internal capital in order
for Yakovlev to create a track record for the strategy.

After two years, the strategy has generated performance returns greater than the
appropriate benchmark and the Sharpe ratio of the fund is close to 1.0. On the basis of
these results, QSC decides to actively market the fund to large institutional investors.
While creating the offering materials, Yakovlev informs the marketing team that the
capacity of the strategy is limited. The extent of the limitation is difficult to ascertain
with precision; it depends on market liquidity and other factors in his model that can
evolve over time. Yakovlev indicates that given the current market conditions,
investments in the fund beyond US$100 million of capital could become more difficult
and negatively affect expected fund returns.

Alan Wellard, the manager of the marketing team, is a partner with 30 years of
marketing experience and explains to Yakovlev that these are complex technical issues
that will muddy the marketing message. According to Wellard, the offering material
should focus solely on the great track record of the fund. Yakovlev does not object
because the fund has only US$12 million of capital, very far from the US$100 million
threshold.

Comment: Yakovlev and Wellard have not appropriately disclosed a significant

limitation associated with the investment product. Yakovlev believes this limitation,
once reached, will materially affect the returns of the fund. Although the fund is
currently far from the US$100 million mark, current and prospective investors must be
made aware of this capacity issue. If significant limitations are complicated to grasp and
clients do not have the technical background required to understand them, Yakovlev and
Wellard should either educate the clients or ascertain whether the fund is suitable for
each client.

Example 7 (Notification of Risks and Limitations)

Brickell Advisers offers investment advisory services mainly to South American clients.
Julietta Ramon, a risk analyst at Brickell, describes to clients how the firm uses value at
risk (VaR) analysis to track the risk of its strategies. Ramon assures clients that
calculating a VaR at a 99% confidence level, using a 20-day holding period, and
applying a methodology based on an ex ante Monte Carlo simulation is extremely
effective. The firm has never had losses greater than those predicted by this VaR
analysis.

93
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Comment: Ramon has not sufficiently communicated the risks associated with the
investment process to satisfy the requirements of Standard V(B). The losses predicted by
a VaR analysis depend greatly on the inputs used in the model. The size and probability
of losses can differ significantly from what an individual model predicts. Ramon must
disclose how the inputs were selected and the potential limitations and risks associated
with the investment strategy.

Example 8 (Notification of Risks and Limitations)

Lily Smith attended an industry conference and noticed that John Baker, an investment
manager with Baker Associates, attracted a great deal of attention from the conference
participants. On the basis of her knowledge of Baker’s reputation and the interest he
received at the conference, Smith recommends adding Baker Associates to the approved
manager platform. Her recommendation to the approval committee includes the statement
“John Baker is well respected in the industry, and his insights are consistently sought after
by investors. Our clients are sure to benefit from investing with Baker Associates.”

Comment: Smith is not appropriately separating facts from opinions in her

recommendation to include the manager within the platform. Her actions conflict with
the requirements of Standard V(B). Smith is relying on her opinions about Baker’s
reputation and the fact that many attendees were talking with him at the conference.
Smith should also review the requirements of Standard V(A) regarding reasonable basis
to determine the level of review necessary to recommend Baker Associates.

Standard V(C) Record Retention

The Standard
Members and candidates must develop and maintain appropriate records to support their
investment analyses, recommendations, actions, and other investment-related
communications with clients and prospective clients.

Guidance
• Members and candidates must retain records that substantiate the scope of their
research and reasons for their actions or conclusions. The retention requirement
applies to decisions to buy or sell a security as well as reviews undertaken that do not
lead to a change in position.
• Records may be maintained either in hard copy or electronic form.

New Media Records

• Members and candidates should understand that although employers and local
regulators are developing digital media retention policies, these policies may lag
behind the advent of new communication channels. Such lag places greater
responsibility on the individual for ensuring that all relevant information is retained.
Examples of non-print media formats that should be retained include, but are not
limited to e-mails, text messages, blog posts, and Twitter posts.

Records Are Property of the Firm

• As a general matter, records created as part of a member’s or candidate’s professional
activity on behalf of his or her employer are the property of the firm.

© 2020 Wiley
 STANDARD V: INVESTMENT ANALYSIS, RECOMMENDATIONS, AND ACTIONS

• When a member or candidate leaves a firm to seek other employment, the member or
candidate cannot take the property of the firm, including original forms or copies of
supporting records of the member’s or candidate’s work, to the new employer
without the express consent of the previous employer.
• The member or candidate cannot use historical recommendations or research reports
created at the previous firm because the supporting documentation is unavailable.
• For future use, the member or candidate must re-create the supporting records at the
new firm with information gathered through public sources or directly from the
covered company and not from memory or sources obtained at the previous employer.

Local Requirements
• Local regulators and firms may also implement policies detailing the applicable time
frame for retaining research and client communication records. Fulfilling such
regulatory and firm requirements satisfies the requirements of Standard V(C).
• In the absence of regulatory guidance or firm policies, CAIA recommends
maintaining records for at least seven years.

Recommended Procedures for Compliance

The responsibility to maintain records that support investment action generally falls with the
firm rather than individuals. Members and candidates must, however, archive research notes
and other documents, either electronically or in hard copy, that support their current
investment-related communications.

Application of the Standard

Example 1 (Record Retention and Research Process)

Malcolm Young is a research analyst who writes numerous reports rating companies in
the luxury retail industry. His reports are based on a variety of sources, including
interviews with company managers, manufacturers, and economists; on-site company
visits; customer surveys; and secondary research from analysts covering related
industries.

Comment: Young must carefully document and keep copies of all the information that
goes into his reports, including the secondary or third-party research of other analysts.
Failure to maintain such files would violate Standard V(C).

Example 2 (Records as Firm, Not Employee, Property)

Martin Blank develops an analytical model while he is employed by Green Partners

Investment Management, LLP (GPIM). While at the firm, he systematically documents
the assumptions that make up the model as well as his reasoning behind the assumptions.
As a result of the success of his model, Blank is hired to be the head of the research
department of one of GPIM’s competitors. Blank takes copies of the records supporting
his model to his new firm.

Comment: The records created by Blank supporting the research model he developed at
GPIM are the records of GPIM. Taking the documents with him to his new employer
without GPIM’s permission violates Standard V(C). To use the model in the future,
Blank must re-create the records supporting his model at the new firm.

© 2020 Wiley *
 St a n d a r d V I: C o n f l ic t s o f In t er est

LESSON MAP
• Disclosure of Conflicts
• Priority of Transactions
• Referral Fees

Learning Objective: Demonstrate knowledge of Standard VI: Conflicts of

Interest.

Standard VI(A) Disclosure of Conflicts

The Standard
Members and candidates must make full and fair disclosure of all matters that could
reasonably be expected to impair their independence and objectivity or interfere with
respective duties to their clients, prospective clients, and employer. Members and candidates
must ensure that such disclosures are prominent, are delivered in plain language, and
communicate the relevant information effectively.

Guidance
• Best practice is to avoid actual conflicts or the appearance of conflicts of interest
when possible. Conflicts of interest often arise in the investment profession.
• When conflicts cannot be reasonably avoided, clear and complete disclosure of their
existence is necessary.
• In making and updating disclosures of conflicts of interest, members and candidates
should err on the side of caution to ensure that conflicts are effectively
communicated.

Disclosure of Conflicts to Employers

• When reporting conflicts of interest to employers, members and candidates must give
their employers enough information to assess the impact of the conflict.
• Members and candidates must take reasonable steps to avoid conflicts and, if they
occur inadvertently, must report them promptly so that the employer and the member
or candidate can resolve them as quickly and effectively as possible.
• Any potential conflict situation that could prevent clear judgment about or full
commitment to the execution of a member’s or candidate’s duties to the employer
should be reported to the member’s or candidate’s employer and promptly resolved.

Disclosure to Clients
• The most obvious conflicts of interest, which should always be disclosed, are
relationships between an issuer and the member, the candidate, or his or her firm
(such as a directorship or consultancy by a member; investment banking,
underwriting, and financial relationships; broker/dealer market-making activities;
and material beneficial ownership of stock).
• Disclosures should be made to clients regarding fee arrangements, subadvisory
agreements, or other situations involving nonstandard fee structures. Equally
important is the disclosure of arrangements in which the firm benefits directly from
investment recommendations. An obvious conflict of interest is the rebate of a
portion of the service fee some classes of mutual funds charge to investors.

97
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Cross-Departmental Conflicts
• Other circumstances can give rise to actual or potential conflicts of interest. For
instance:
o A sell-side analyst working for a broker/dealer may be encouraged, not only
by members of her or his own firm but by corporate issuers themselves, to
write research reports about particular companies.
o A buy-side analyst is likely to be faced with similar conflicts as banks
exercise their underwriting and security-dealing powers.
o The marketing division may ask an analyst to recommend the stock of a
certain company in order to obtain business from that company.
• Members, candidates, and their firms should attempt to resolve situations presenting
potential conflicts of interest or disclose them in accordance with the principles set
forth in Standard VI(A).

Conflicts with Stock Ownership

• The most prevalent conflict requiring disclosure under Standard VI(A) is a member’s
or candidate’s ownership of stock in companies that he or she recommends to clients
or that clients hold. Clearly, the easiest method for preventing a conflict is to prohibit
members and candidates from owning any such securities, but this approach is overly
burdensome and discriminates against members and candidates. Therefore:
o Sell-side members and candidates should disclose any materially beneficial
ownership interest in a security or other investment that the member or
candidate is recommending.
o Buy-side members and candidates should disclose their procedures for
reporting requirements for personal transactions.

Conflicts as a Director
• Service as a director poses three basic conflicts of interest.
o A conflict may exist between the duties owed to clients and the duties owed
to shareholders of the company.
o Investment personnel who serve as directors may receive the securities or
options to purchase securities of the company as compensation for serving
on the board, which could raise questions about trading actions that might
increase the value of those securities.
o Board service creates the opportunity to receive material nonpublic
information involving the company.
• When members or candidates providing investment services also serve as directors,
they should be isolated from those making investment decisions by the use of
firewalls or similar restrictions.

Recommended Procedures for Compliance

• Members or candidates should disclose special compensation arrangements with the
employer that might conflict with client interests, such as bonuses based on short-
term performance criteria, commissions, incentive fees, performance fees, and
referral fees.
• Members’ and candidates’ firms are encouraged to include information on
compensation packages in firms’ promotional literature.

9 . © 2020 Wiley
 STANDARD VI: CONFLICTS OF INTEREST

Application of the Standard

Example 1 (Conflict of Interest and Business Relationships)

Hunter Weiss is a research analyst with Farmington Company, a broker and investment
banking firm. Farmington’s merger and acquisition department has represented Vimco, a
conglomerate, in all of Vimco’s acquisitions for 20 years. From time to time, Farmington
officers sit on the boards of directors of various Vimco subsidiaries. Weiss is writing a
research report on Vimco.

Comment: Weiss must disclose in his research report Farmington’s special relationship
with Vimco. Broker/dealer management of and participation in public offerings must be
disclosed in research reports. Because the position of underwriter to a company entails a
special past and potential future relationship with a company that is the subject of
investment advice, it threatens the independence and objectivity of the report writer and
must be disclosed.

Example 2 (Conflict of Interest and Business Stock Ownership)

The investment management firm of Dover & Roe sells a 25% interest in its partnership
to a multinational bank holding company, First of New York. Immediately after the sale,
Margaret Hobbs, president of Dover & Roe, changes her recommendation for First of
New York’s common stock from “sell” to “buy” and adds First of New York’s
commercial paper to Dover & Roe’s approved list for purchase.

Comment: Hobbs must disclose the new relationship with First of New York to all
Dover & Roe clients. This relationship must also be disclosed to clients by the firm’s
portfolio managers when they make specific investment recommendations or take
investment actions with respect to First of New York’s securities.

Example 3 (Conflict of Interest and Personal Stock Ownership)

Carl Fargmon, a research analyst who follows firms producing office equipment, has
been recommending purchase of Kincaid Printing because of its innovative new line of
copiers. After his initial report on the company, Fargmon’s wife inherits from a distant
relative US$3 million of Kincaid stock. He has been asked to write a follow-up report on
Kincaid.

Comment: Fargmon must disclose his wife’s ownership of the Kincaid stock to his
employer and in his follow-up report. Best practice would be to avoid the conflict by
asking his employer to assign another analyst to draft the follow-up report.

Example 4 (Conflict of Interest and Personal Stock Ownership)

Betty Roberts is speculating in penny stocks for her own account and purchases 100,000
shares of Drew Mining, Inc., for US$0.30 a share. She intends to sell these shares at the
sign of any substantial upward price movement of the stock. A week later, her employer

99
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

asks her to write a report on penny stocks in the mining industry to be published in two
weeks. Even without owning the Drew stock, Roberts would recommend it in her report
as a “buy.” A surge in the price of the stock to the US$2 range is likely to result once the
report is issued.

Comment: Although this holding may not be material, Roberts must disclose it in the
report and to her employer before writing the report because the gain for her will be
substantial if the market responds strongly to her recommendation. The fact that she has
only recently purchased the stock adds to the appearance that she is not entirely
objective.

Example 5 (Conflict of Interest and Compensation Arrangements)

Gary Carter is a representative with Bengal International, a registered broker/dealer.

Carter is approached by a stock promoter for Badger Company, who offers to pay Carter
additional compensation for sales of Badger Company’s stock to Carter’s clients. Carter
accepts the stock promoter’s offer but does not disclose the arrangements to his clients or
to his employer. Carter sells shares of the stock to his clients.

Comment: Carter has violated Standard VI(A) by failing to disclose to clients that he is
receiving additional compensation for recommending and selling Badger stock. Because
he did not disclose the arrangement with Badger to his clients, the clients were unable to
evaluate whether Carter’s recommendations to buy Badger were affected by this
arrangement. Carter’s conduct also violated Standard VI(A) by failing to disclose to his
employer monetary compensation received in addition to the compensation and benefits
conferred by his employer. Carter was required by Standard VI(A) to disclose the
arrangement with Badger to his employer so that his employer could evaluate whether
the arrangement affected Carter’s objectivity and loyalty.

Example 6 (Conflict of Interest and Directorship)

Carol Corky, a senior portfolio manager for Universal Management, recently became
involved as a trustee with the Chelsea Foundation, a large not-for-profit foundation in
her hometown. Universal is a small money manager (with assets under management of
approximately US$100 million) that caters to individual investors. Chelsea has assets in
excess of US$2 billion. Corky does not believe informing Universal of her involvement
with Chelsea is necessary.

Comment: By failing to inform Universal of her involvement with Chelsea, Corky

violated Standard VI(A). Given the large size of the endowment at Chelsea, Corky’s new
role as a trustee can reasonably be expected to be time consuming, to the possible
detriment of Corky’s portfolio responsibilities with Universal. Also, as a trustee, Corky
may become involved in the investment decisions at Chelsea. Therefore, Standard VI(A)
obligates Corky to discuss becoming a trustee at Chelsea with her compliance officer or
supervisor at Universal before accepting the position, and she should have disclosed the
degree to which she would be involved in investment decisions at Chelsea.

100
© 2020 Wiley
 STANDARD VI: CONFLICTS OF INTEREST

Example 7 (Conflict of Interest and Requested Favors)

Michael Papis is the chief investment officer of his state’s retirement fund. The fund has
always used outside advisers for the real estate allocation, and this information is clearly
presented in all fund communications. Thomas Nagle, a recognized sell-side research
analyst and Papis’s business school classmate, recently left the investment bank he
worked for to start his own asset management firm, Accessible Real Estate. Nagle is
trying to build his assets under management and contacts Papis about gaining some of
the retirement fund’s allocation. In the previous few years, the performance of the
retirement fund’s real estate investments was in line with the fund’s benchmark but was
not extraordinary. Papis decides to help out his old friend and also to seek better returns
by moving the real estate allocation to Accessible. The only notice of the change in
adviser appears in the next annual report in the listing of associated advisers.

Comment: Papis has violated Standard VI(A) by not disclosing to his employer his
personal relationship with Nagle. Disclosure of his past history with Nagle would allow
his firm to determine whether the conflict may have impaired Papis’s independence in
deciding to change managers.

See also Standard IV(C)—Responsibilities of Supervisors, Standard V(A)—Diligence

and Reasonable Basis, and Standard V(B)—Communication with Clients and
Prospective Clients.

Example 8 (Conflict of Interest and Business Relationships)

Bob Wade, trust manager for Central Midas Bank, was approached by Western Funds
about promoting its family of funds, with special interest in the service-fee class. To
entice Central to promote this class, Western Funds offered to pay the bank a service fee
of 0.25%. Without disclosing the fee being offered to the bank, Wade asked one of the
investment managers to review the Western Funds family of funds to determine whether
they were suitable for clients of Central. The manager completed the normal due
diligence review and determined that the funds were fairly valued in the market with fee
structures on a par with their competitors. Wade decided to accept Western’s offer and
instructed the team of portfolio managers to exclusively promote these funds and the
service-fee class to clients seeking to invest new funds or transfer from their current
investments. So as to not influence the investment managers, Wade did not disclose the
fee offer and allowed that income to flow directly to the bank.

Comment: Wade is violating Standard VI(A) by not disclosing the portion of the service
fee being paid to Central. Although the investment managers may not be influenced by
the fee, neither they nor the client have the proper information about Wade’s decision to
exclusively market this fund family and class of investments. Central may come to rely
on the new fee as a component of the firm’s profitability and may be unwilling to offer
other products in the future that could affect the fees received.

(See also Standard 1(B)—Independence and Objectivity.)

101
© 2020 Wiley
PROFESSIONAL STANDARDS AND ETHICS

Example 9 (Disclosure of Conflicts to Employers)

Yehudit Dagan is a portfolio manager for Risk Management Bank (RMB), whose clients
include retirement plans and corporations. RMB provides a defined contribution
retirement plan for its employees that offers 20 large diversified mutual fund investment
options, including a mutual fund managed by Dagan’s RMB colleagues. After being
employed for six months, Dagan became eligible to participate in the retirement plan,
and she intends to allocate her retirement plan assets in six of the investment options,
including the fund managed by her RMB colleagues. Dagan is concerned that joining the
plan will lead to a potentially significant amount of paperwork for her (e.g., disclosure of
her retirement account holdings and needing preclearance for her transactions),
especially with her investing in the in-house fund.

Comment: Standard VI(A) would not require Dagan to disclosure her personal or
retirement investments in large diversified mutual funds, unless specifically required by
her employer. For practical reasons, the standard does not require Dagan to gain
preclearance for ongoing payroll deduction contributions to retirement plan account
investment options.

Dagan should ensure that her firm does not have a specific policy regarding
investment—whether personal or in the retirement account—for funds managed by the
company’s employees. These mutual funds may be subject to the company’s disclosure,
preclearance, and trading restriction procedures to identify possible conflicts prior to the
execution of trades.

Standard VI(B) Priority of Transactions

The Standard
Investment transactions for clients and employers must have priority over investment
transactions in which a member or candidate is the beneficial owner.

Guidance
• This standard is designed to prevent any potential conflict of interest or the
appearance of a conflict of interest with respect to personal transactions.
• Client interests have priority. Client transactions must take precedence over
transactions made on behalf of the member’s or candidate’s firm or personal
transactions.

Avoiding Potential Conflicts

• Although conflicts of interest exist, nothing is inherently unethical about individual
managers, advisers, or mutual fund employees making money from personal
investments as long as (1) the client is not disadvantaged by the trade, (2) the
investment professional does not benefit personally from trades undertaken for
clients, and (3) the investment professional complies with applicable regulatory
requirements.
• Some situations occur in which a member or candidate may need to enter a personal
transaction that runs counter to current recommendations or what the portfolio
manager is doing for client portfolios. In these situations, the same three criteria
given in the preceding paragraph should be applied in the transaction so as to not
violate Standard VI(B).

© 2020 Wiley
 STANDARD VI: CONFLICTS OF INTEREST

Personal Trading Secondary to Trading for Clients

• The objective of the standard is to prevent personal transactions from adversely
affecting the interests of clients or employers. A member or candidate having the
same investment positions or being co-invested with clients does not always create a
conflict.
• Personal investment positions or transactions of members or candidates or their firm
should never, however, adversely affect client investments.

Standards for Nonpublic Information

• Standard VI(B) covers the activities of members and candidates who have
knowledge of pending transactions that may be made on behalf of their clients or
employers, who have access to nonpublic information during the normal preparation
of research recommendations, or who take investment actions.
• Members and candidates are prohibited from conveying nonpublic information to
any person whose relationship to the member or candidate makes the member or
candidate a beneficial owner of the person’s securities.
• Members and candidates must not convey this information to any other person if the
nonpublic information can be deemed material.

Impact on All Accounts with Beneficial Ownership

• Members or candidates may undertake transactions in accounts for which they are a
beneficial owner only after their clients and employers have had adequate
opportunity to act on a recommendation.
• Personal transactions include those made for the member’s or candidate’s own
account, for family (including spouse, children, and other immediate family
members) accounts, and for accounts in which the member or candidate has a direct
or indirect pecuniary interest, such as a trust or retirement account.
• Family accounts that are client accounts should be treated like any other firm account
and should neither be given special treatment nor be disadvantaged because of the
family relationship. If a member or candidate has a beneficial ownership in the
account, however, the member or candidate may be subject to preclearance or
reporting requirements of the employer or applicable law.

Recommended Procedures for Compliance

• Members and candidates should urge their firms to establish such policies and
procedures.
• The specific provisions of each firm’s standards will vary, but all firms should adopt
certain basic procedures to address the conflict areas created by personal investing.
These procedures include the following:
o Limited participation in equity IPOs,
o Restrictions on private placements,
o Establish blackout/restricted periods,
o Reporting requirements, including:
■ Disclosure of holdings in which the employee has a beneficial
interest.
■ Providing duplicate confirmations of transactions.
■ Preclearance procedures,
o Disclosure of policies to investors.

© 2020 Wiley
m
PROFESSIONAL STANDARDS AND ETHICS

Application of the Standard

Example 1 (Personal Trading)

Research analyst Marlon Long does not recommend purchase of a common stock for his
employer’s account because he wants to purchase the stock personally and does not want
to wait until the recommendation is approved and the stock is purchased by his
employer.

Comment: Long has violated Standard VI(B) by taking advantage of his knowledge of
the stock’s value before allowing his employer to benefit from that information.

Example 2 (Trading for Family Member Account)

Carol Baker, the portfolio manager of an aggressive growth mutual fund, maintains an
account in her husband’s name at several brokerage firms with which the fund and a
number of Baker’s other individual clients do a substantial amount of business.
Whenever a hot issue becomes available, she instructs the brokers to buy it for her
husband’s account. Because such issues normally are scarce, Baker often acquires shares
in hot issues but her clients are not able to participate in them.

Comment: To avoid violating Standard VI(B), Baker must acquire shares for her mutual
fund first and acquire them for her husband’s account only after doing so, even though
she might miss out on participating in new issues via her husband’s account. She also
must disclose the trading for her husband’s account to her employer because this activity
creates a conflict between her personal interests and her employer’s interests.

Example 3 (Trading Prior to Report Dissemination)

A brokerage’s insurance analyst, Denise Wilson, makes a closed-circuit TV report to her

firm’s branches around the country. During the broadcast, she includes negative
comments about a major company in the insurance industry. The following day,
Wilson’s report is printed and distributed to the sales force and public customers. The
report recommends that both short-term traders and intermediate investors take profits by
selling that insurance company’s stock. Seven minutes after the broadcast, however,
Ellen Riley, head of the firm’s trading department, had closed out a long “call” position
in the stock. Shortly thereafter, Riley established a sizable “put” position in the stock.
When asked about her activities, Riley claimed she took the actions to facilitate
anticipated sales by institutional clients.

Comment: Riley did not give customers an opportunity to buy or sell in the options
market before the firm itself did. By taking action before the report was disseminated,
Riley’s firm may have depressed the price of the calls and increased the price of the puts.
The firm could have avoided a conflict of interest if it had waited to trade for its own
account until its clients had an opportunity to receive and assimilate Wilson’s
recommendations. As it is, Riley’s actions violated Standard VI(B).

104
© 2020 Wiley
 STANDARD VI: CONFLICTS OF INTEREST

Standard VI(C) Referral Fees

The Standard
Members and candidates must disclose to their employer, clients, and prospective clients, as
appropriate, any compensation, consideration, or benefit received from or paid to others for
the recommendation of products or services.

Guidance
• Members and candidates must inform their employer, clients, and prospective clients
of any benefit received for referrals of customers and clients.
• Members and candidates must disclose when they pay a fee or provide compensation
to others who have referred prospective clients to the member or candidate.
• Appropriate disclosure means that members and candidates must advise the client or
prospective client, before entry into any formal agreement for services, of any benefit
given or received for the recommendation of any services provided by the member or
candidate. In addition, the member or candidate must disclose the nature of the
consideration or benefit

Recommended Procedures for Compliance

• Members and candidates should encourage their employers to develop procedures
related to referral fees. The firm may completely restrict such fees. If the firm does
not adopt a strict prohibition of such fees, the procedures should indicate the
appropriate steps for requesting approval.
• Employers should have investment professionals provide to the clients notification of
approved referral fee programs and provide the employer regular (at least quarterly)
updates on the amount and nature of compensation received.

Application of the Standard

Example 1 (Disclosure of Interdepartmental Referral Arrangements)

James Handley works for the trust department of Central Trust Bank. He receives
compensation for each referral he makes to Central Trust’s brokerage department and
personal financial management department that results in a sale. He refers several of his
clients to the personal financial management department but does not disclose the
arrangement within Central Trust to his clients.

Comment: Handley has violated Standard VI(C) by not disclosing the referral
arrangement at Central Trust Bank to his clients. Standard VI(C) does not distinguish
between referral payments paid by a third party for referring clients to the third party and
internal payments paid within the firm to attract new business to a subsidiary. Members
and candidates must disclose all such referral fees. Therefore, Handley is required to
disclose, at the time of referral, any referral fee agreement in place among Central Trust
Bank’s departments. The disclosure should include the nature and the value of the
benefit and should be made in writing.

Example 2 (Disclosure of Referral Arrangements and Informing Firm)

Katherine Roberts is a portfolio manager at Katama Investments, an advisory firm

specializing in managing assets for high-net-worth individuals. Katama’s trading desk
uses a variety of brokerage houses to execute trades on behalf of its clients. Roberts asks

© 2020 Wiley §
PROFESSIONAL STANDARDS AND ETHICS

the trading desk to direct a large portion of its commissions to Naushon, Inc., a small
broker/dealer run by one of Roberts’s business school classmates. Katama’s traders have
found that Naushon is not very competitive on pricing, and although Naushon generates
some research for its trading clients, Katama’s other analysts have found most of
Naushon’s research to be not especially useful. Nevertheless, the traders do as Roberts
asks, and in return for receiving a large portion of Katama’s business, Naushon
recommends the investment services of Roberts and Katama to its wealthiest clients.
This arrangement is not disclosed to either Katama or the clients referred by Naushon.

Comment: Roberts is violating Standard VI(C) by failing to inform her employer of the
referral arrangement.

Example 3 (Disclosure of Referral Arrangements and Outside Organizations)

Alex Burl is a portfolio manager at Helpful Investments, a local investment advisory

firm. Burl is on the advisory board of his child’s school, which is looking for ways to
raise money to purchase new playground equipment for the school. Burl discusses a plan
with his supervisor in which he will donate to the school a portion of his service fee from
new clients referred by the parents of students at the school. Upon getting the approval
from Helpful, Burl presents the idea to the school’s advisory board and directors. The
school agrees to announce the program at the next parent event and asks Burl to provide
the appropriate written materials to be distributed. A week following the distribution of
the fliers, Burl receives the first school-related referral. In establishing the client’s
investment policy statement, Burl clearly discusses the school’s referral and outlines the
plans for distributing the donation back to the school.

Comment: Burl has not violated Standard VI(C) because he secured the permission of
his employer, Helpful Investments, and the school prior to beginning the program and
because he discussed the arrangement with the client at the time the investment policy
statement was designed.

Example 4 (Disclosure of Referral Arrangements and Outside Parties)

The sponsor of a state employee pension is seeking to hire a firm to manage the pension
plan’s emerging market allocation. To assist in the review process, the sponsor has hired
Thomas Arrow as a consultant to solicit proposals from various advisers. Arrow is
contracted by the sponsor to represent its best interest in selecting the most appropriate
new manager. The process runs smoothly, and Overseas Investments is selected as the
new manager.

The following year, news breaks that Arrow is under investigation by the local regulator
for accepting kickbacks from investment managers after they are awarded new pension
allocations. Overseas Investments is included in the list of firms allegedly making these
payments. Although the sponsor is happy with the performance of Overseas since it has
been managing the pension plan’s emerging market funds, the sponsor still decides to
have an independent review of the proposals and the selection process to ensure that
Overseas was the appropriate firm for its needs. This review confirms that, even though
Arrow was being paid by both parties, the recommendation of Overseas appeared to be
objective and appropriate.

106 © 2020 Wiley

 STANDARD VI: CONFLICTS OF INTEREST

Comment: Arrow has violated Standard VI(C) because he did not disclose the fee being
paid by Overseas. Withholding this information raises the question of a potential lack of
objectivity in the recommendations Overseas is making; this aspect is in addition to
questions about the legality of having firms pay to be considered for an allocation.

Regulators and governmental agencies may adopt requirements concerning allowable

consultant activities. Local regulations sometimes include having a consultant register
with the regulatory agency’s ethics board. Regulator policies may include a prohibition
on acceptance of payments from investment managers receiving allocations and require
regular reporting of contributions made to political organizations and candidates. Arrow
would have to adhere to these requirements as well as the Code and Standards.

107
© 2020 Wiley
 In t r o d u c t i o n t o
A l t e r n a t i v e In v e s t m e n t s

© 2020 Wiley
 Wha t Is a n Al t e r na t iv e Inv e st me nt ?
This lesson describes large categories and subcategories of alternative investments, and
provides a broad overview of how alternative investments differ from traditional
investments.

LESSON MAP
• Demonstrate knowledge of the view of alternative investments by exclusion.
• Demonstrate knowledge of various alternative investment types.
• Demonstrate knowledge of the defining characteristics of alternative investments.
• Demonstrate knowledge of the history of alternative investments in the United States.
• Demonstrate knowledge of how alternative and traditional investments are
distinguished by return characteristics.
• Demonstrate knowledge of how alternative and traditional investments are
distinguished by methods of analysis.
• Demonstrate knowledge of other characteristics that distinguish alternative
investments from traditional investments.
• Demonstrate knowledge of the goals of alternative investing.
• Demonstrate knowledge of the two pillars of alternative investment management.

KEY CONCEPTS
Four major alternative investment categories are covered in the CAIA curriculum: real
assets, hedge funds, private equity, and structured products. Relative to traditional
investments, alternative investments may require (1) different return computation methods,
(2) different statistical methods, (3) different valuation methods, and (4) different portfolio
management methods due to the many factors that distinguish the two. Relative to
traditional investments, (1) alternative investments often have more information
asymmetries, (2) trading structures in some alternative investments can intensify problems
associated with incomplete markets and moral hazards, and (3) alternative investments are
more innovative, necessitating constantly evolving methods of analysis.

Relative to traditional investments, the goals of alternative investing are often tilted toward
active management (in pursuit of superior risk/retum combinations) and away from passive
management (where portfolio returns are designed to mimic an index or target benchmark).
Four return characteristics (diversification, illiquidity, inefficiency, non-normality) help
distinguish alternative investments from traditional investments. Eight other characteristics
help distinguish alternative investments from traditional investments: (1) regulatory factors,
(2) structuring, (3) trading strategies, (4) compensation structures, (5) institutional factors,
(6) information asymmetries, (7) incomplete markets, and (8) innovation. Two pillars of
alternative investment management are empirics and economic reasoning.

Learning Objective: Demonstrate knowledge of the view of alternative

investments by exclusion.

MAIN POINT: One way to define alternative investments is by what they do not include,
but that method of definition (by exclusion) is too broad for the purposes of the CAIA
curriculum, which focuses on “institutional quality” investments. By defining alternative
investments as those that are not traditional stocks and bonds, all kinds of esoteric
investments could be included that may not be of institutional quality.

Typically, traditional investments include publicly traded equities, fixed-income securities,

and cash.

in
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

• A good definition of an investment is that it is deferred consumption.

• An institutional-quality investment is the type of investment that financial
institutions such as pension funds or endowments might include in their holdings
because they are expected to deliver reasonable returns at an acceptable level of risk.

It is acknowledged that some may well argue that real estate is also a traditional investment.
However, for the purposes of this curriculum, real estate is included as an alternative
investment.

Learning Objective: Demonstrate knowledge of various alternative investment

types.

MAIN POINT: Four major alternative investment categories are covered in the CAIA
curriculum: real assets, hedge funds, private equity, and structured products. This is how
CAIA Association defines alternative investments (by inclusion), but CAIA notes that the
list is not exhaustive and rather focuses on institutional-quality assets.

• Real assets are investments in which the underlying assets involve direct ownership
of nonfinancial assets rather than ownership through financial assets, such as the
securities of manufacturing or service enterprises. Real assets may include intangible
assets such as intellectual property as well as tangible assets. The opposite of real
assets is financial assets, such as stocks or bonds, which represent a claim to cash
flows.
• Commodities are homogeneous goods available in large quantities, such as energy
products, agricultural products, metals, and building materials.

For the purposes of the CAIA curriculum, operationally focused real assets include real
estate, land, infrastructure, and intellectual property.

• Real estate focuses on land and improvements that are permanently affixed, like
buildings.
• Land comprises a variety of forms, including undeveloped land, timberland, and
farmland: Timberland includes both the land and the timber of forests of tree species
typically used in the forest products industry. Farmland consists of land cultivated
for row crops (e.g., vegetables and grains) and permanent crops (e.g., orchards and
vineyards).
• Infrastructure investments are claims on the income of toll roads, regulated
utilities, ports, airports, and other real assets that are traditionally held and controlled
by the public sector (i.e., various levels of government).
• CAIA defines a hedge fund as a privately organized investment vehicle that uses its
less regulated nature to generate investment opportunities that are substantially
distinct from those offered by traditional investment vehicles, which are subject to
regulations such as those restricting their use of derivatives and leverage.

The term private equity is used in the CAIA curriculum to include both equity and debt
positions that, among other things, are not publicly traded.

• Venture capital refers to support via equity financing to start-up companies that do
not have a sufficient size, track record, or desire to attract capital from traditional
sources, such as public capital markets or lending institutions.

„2
© 2020 Wiley
 WHAT IS AN ALTERNATIVE INVESTMENT?

• Leveraged buyouts (LBOs) refer to those transactions in which the equity of a

publicly traded company is purchased using a small amount of investor capital and a
large amount of borrowed funds in order to take the firm private.
• Mezzanine debt derives its name from its position in the capital structure of a firm:
between the ceiling of senior secured debt and the floor of equity.
• Distressed debt refers to the debt of companies that have filed or are likely to file in
the near future for bankruptcy protection.
• Structured products are instruments created to exhibit particular return, risk,
taxation, or other attributes.

Learning Objective: Demonstrate knowledge of the defining characteristics of

alternative investments.

MAIN POINT: There are many assets that are referred to as both traditional and alternative
assets. The distinction between the two is not always clear.

The Blurred Line

Alternative Asset Often Characterized as

Investment Traditional or Alternative Analogous Traditional Asset
Real assets Public real estate and public equities Public equities of corporations
(37%) of corporations with performance with performance dominated
dominated by stable positions in real by managerial decisions
assets
Hedge funds Liquid alternative mutual funds Ordinary mutual funds
(27%)
Private equity Closed-end funds with illiquid Public equity
(27%) holdings
Complex Simple structured products offering Simple derivative used as a
structured relatively stable and common risk and part of a strategy with stable
products (9%) return characteristics risk exposures

Source: CAIA Level I, 4th ed., 2020. Exhibits 1.1 and 1.2. Copyright © 2009, 2012, 2015 by The CAIA
Association.

Following the introductory lessons, the CAIA curriculum covers each of the four major
alternative investment types in the first column of the table “The Blurred Line.” The
percentages in parentheses represent the relative proportion of the four categories by market
size. Importantly, in the second column we can see that there are some types of investments
within each category that are sometimes characterized as alternative and sometimes as
traditional investments. Also, CAIA acknowledges that there are ways to categorize
alternative investments other than how they have done so for the curriculum.

Learning Objective: Demonstrate knowledge of the history of alternative

investments in the United States.

MAIN POINT: The advent of modem portfolio theory in the 1950s and 1960s led to
changes in the law that allowed investments to be evaluated as a portfolio “as a whole”
rather than as a stand-alone basis. When considered on a stand-alone basis many alternative
investments are risky, but due to low return correlation with traditional investments they are

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

diversifiers and actually lower the risk of the “portfolio as a whole.” Thus, institutional
investment in alternatives began increasing only after the advent of modem portfolio theory.

In 1902, the Dow Jones Index consisted of just 12 stocks and virtually all were commodity
producers (e.g., copper, sugar, paper, rubber, steel). What is now considered an alternative
investment was then considered a traditional investment. Prior to the 1920s, most
institutions held real assets rather than common stocks. They held preferred stocks, real
estate, mortgages, and government bonds.

From 1920 to 1950 institutions added high quality bonds, domestic equities, and agricultural
debt to their portfolios. Institutions evaluated each investment individually and only safe
investments were allowed in the portfolios. On a stand-alone basis many investments were
considered too risky. The advent of modem portfolio theory in the 1950s and 1960s led to
changes in the law that allowed investments to be evaluated within the context of
diversification and their impact on the overall portfolio risk.

From 1950 to 1980 institutions added average quality corporate bonds and international
equities to their portfolios. By 1950 the top companies in the United States were General
Motors, Standard Oil, Ford Motor, General Electric, US Steel, Mobile, and Gulf oil. This
illustrates the changing components of an economy necessitates a dynamic approach to
portfolio management. Now service and technology companies dominate. From 1980 to the
present, institutions added high-yield debt, small stocks, structured products, private equity,
hedge funds, and real assets.

Learning Objective: Demonstrate knowledge of how alternative and traditional

investments are distinguished by return characteristics.

MAIN POINT: Four return characteristics (diversification, illiquidity, inefficiency, non-

normality) help distinguish alternative investments from traditional investments. In contrast
to traditional stock and bond investments, many alternative investments are relatively
uncorrelated with traditional assets (and thus diversifiers); they may have illiquid
investments, return strategies designed to exploit inefficiencies, and non-normal
distributions requiring different methods of analysis.

Non-normal distributions are discussed in the statistics section. Here we note that the
securities and trading structures of some alternative investments can cause non-normal
returns. For example, some structured products (influenced by the securities structure) may
have nonlinear payoffs from the use of derivatives, and some hedge funds (influenced by the
trading structure) with many short-term trades in and out of long and short positions may
produce non-normal returns. In addition, infrequently traded securities may exhibit non-
normal returns. Thus, many alternative investments cannot be analyzed with the same
statistical methods that are based on the assumption of normal returns such as is the case
with most traditional investments.

• A diversifier is an investment with a primary purpose of contributing diversification

benefits to its owner.
• Absolute return products are investment products viewed as having little or no
return correlation with traditional assets, and have investment performance that is
often analyzed on an absolute basis rather than relative to the performance of
traditional investments.
• Illiquidity means that the investment trades infrequently or with low volume
(i.e., thinly).

© 2020 Wiley
 WHAT IS AN ALTERNATIVE INVESTMENT?

• Lumpy assets are assets that can be bought and sold only in specific quantities, such
as a large real estate project.

Lumpy assets are illiquid. While most stocks are liquid, some individual stocks are not.
Illiquid securities, in any asset class, have more risk than liquid securities because there are
fewer prices to observe due to few transactions. In addition, the lack of trading means that
one trade can move the price more, relative to a liquid security, all else equal.

• Efficiency refers to the tendency of market prices to reflect all available information.
• Inefficiency refers to the deviation of actual prices from valuations that would be
anticipated in an efficient market.

Learning Objective: Demonstrate knowledge of how alternative and traditional

investments are distinguished by methods of analysis.

MAIN POINT: Relative to traditional investments, alternative investments may require

(1) different return computation methods (e.g., the internal rate of return [IRR] in the case of
private equity due to infrequent trading), (2) different statistical methods (e.g., due to non-
normal returns), (3) different valuation methods (e.g., appraisal methods for real estate), and
(4) different portfolio management methods owing to the many factors that distinguish the
two.

Various computational, statistical, valuation, and portfolio management methods are

detailed later in the curriculum. Here, we just note that when analyzing alternative
investments these methods often need to differ from the methods used to analyze traditional
investments.

Learning Objective: Demonstrate knowledge of other characteristics that

distinguish alternative investments from traditional investments.

MAIN POINT: Structures help distinguish alternative investments from traditional

investments, and the five primary types of structures are (1) regulatory, (2) securities,
(3) trading, (4) compensation, and (5) institutional structures. For example, the primary
structure impacting hedge funds is the trading structure due to their use of “active, complex,
and proprietary” trading strategies, whereas the primary structure defining private equity is
the institutional structure, as the securities are not publicly traded. These structures help us
less to define alternative investments than to understand how alternative investments are
distinguished from traditional investments in terms of return computation, methods of
analysis, and other aspects covered next. The five structures are:

1. Regulatory structure refers to the role of government, including both regulation

and taxation, in influencing the nature of an investment.
2. Securities structure refers to the structuring of cash flows through leverage and
securitization.
3. Trading structure refers to the role of an investment vehicle’s investment managers
in developing and implementing trading strategies.
4. Compensation structure refers to the ways that organizational issues, especially
compensation schemes, influence particular investments.
5. Institutional structure refers to the financial markets and financial institutions
related to a particular investment, such as whether the investment is publicly traded.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Relative to traditional investments, (1) alternative investments often have more information
asymmetries (less information is available in private markets); (2) trading structures in some
alternative investments can intensify problems associated with incomplete markets and
moral hazards; and (3) alternative investments are more innovative, necessitating constantly
evolving methods of analysis.

• Information asymmetries refer to the extent to which market participants possess

different data and knowledge.
• Incomplete markets refer to markets with insufficient distinct investment
opportunities.
• Moral hazard is that risk that the behavior of one or more parties will change after
entering into a contract.

A manager that takes excessive risks to increase the performance fee is an example of a
moral hazard.

Learning Objective: Demonstrate knowledge of the goals of alternative

investing.

MAIN POINTS: Relative to traditional investments, the goals of alternative investing are
often tilted toward active management (in pursuit of superior risk/retum combinations) and
away from passive management (where portfolio returns are designed to mimic an index or
target benchmark). Alternative investment portfolio returns may be either (1) a relative
return standard whereby they are compared to a benchmark to determine active risk
(deviations from the benchmark caused by active management) and active return (return
difference from the benchmark due to skill); or (2) an absolute return standard where they
are compared to a zero return or a fixed rate. Sometimes trading strategies designed to
exploit mispricing through the simultaneous purchase and sale of similar positions are
referred to loosely as arbitrage, but this is not pure arbitrage because the strategies are not
risk-free. Finally, alternative strategies and investments may be considered either return
enhancers or diversifiers.

Alternative investments have most of the following five goals of alternative investing:

1. Add value through active management

o Active management refers to efforts of buying and selling securities in
pursuit of superior combinations of risk and return,
o Passive investing tends to focus on buying and holding securities in an effort
to match the risk and return of a target, such as a highly diversified index,
o An investor’s risk and return target is often expressed in the form of a
benchmark, which is a performance standard for a portfolio that reflects the
preferences of an investor with regard to risk and return,
o The returns of the fund would typically be compared to the benchmark
return, which is the return of the benchmark index or benchmark portfolio,
o Active risk is that risk that causes a portfolio’s return to deviate from the
return of a benchmark due to active management,
o Active return is the difference between the return of a portfolio and its
benchmark that is due to active management.
2. Achieve absolute or relative returns
o An absolute return standard means that returns are to be evaluated relative
to zero, a fixed rate, or relative to the riskless rate, and therefore

© 2020 Wiley
 WHAT IS AN ALTERNATIVE INVESTMENT?

independently of performance in equity markets, debt markets, or any other

markets.
o A relative return standard means that returns are to be evaluated relative to
a benchmark.
3. Enhance returns through arbitrage-like strategies or other return-enhancing strategies
o Pure arbitrage is the attempt to earn risk-free profits through the
simultaneous purchase and sale of identical positions trading at different
prices in different markets.
o If the primary objective of including an investment product in a portfolio is
the superior returns that it is believed to offer, then that product is often
referred to as a return enhancer.
4. Diversify risk
o If the primary objective of including the product is the reduction in the
portfolio’s risk that it is believed to offer through its low correlation with the
portfolio’s other assets, then that product is often referred to as a return
diversifier.
5. Avoid obsolescence
o What an institution thinks is appropriate at one point in time may not be in
another.

Learning Objective: Demonstrate knowledge of the two pillars of alternative

investment management.

MAIN POINT: The two pillars of alternative investment management are empirical analysis
and economic reasoning.

Although we say past performance does not represent future performance, most decision
making is based on historical observations—empirics. Note that empirical results are less
reliable for alternative investments than for traditional investments. Empirics should not be
relied upon without the support of economic reasoning.

One useful framework for discussing the appropriateness of an allocation to an investment is

a 2-by-2 framework. On one axis is the clear-cut distinction between whether it is publicly
or privately traded. On the other is an admittedly less clear-cut, albeit still useful, distinction
as to whether its purpose is as a return enhancer or diversifierA

© 2020 Wiley
 T h e E n v i r o n m e n t o f A l t e r n a t i v e In v e s t m e n t s :
F u n d s a n d P a r t i c i pa n t s

This lesson introduces several key terms that help to describe the environment of alternative
investments.

LESSON MAP
• Demonstrate knowledge of participants in the alternative investing environment.
• Demonstrate knowledge of the legal structures in alternative investing.
• Demonstrate knowledge of the key features of fund structures.

KEY CONCEPTS
There are several types of participants in the financial markets: buy-side and sell-side
participants and outside service providers. Funds are structured so that investors have
limited liability. In practice, general managers can also receive limited liability through
structuring, even though in theory an active manager does not receive limited liability.
Key features of fund structures include partnership documents, corporate governance
arrangements, investment objectives, fund size, and terms such as fees. Fund structures
globally vary in terms of flexibility according to local regulations.

Learning Objective: Demonstrate knowledge of participants in the alternative

investing environment.

MAIN POINTS: There are nine types of buy-side participants (including private investment
pools such as hedge funds, which buy large quantities of securities for the portfolios they
manage; two sell-side participants that act as agents for investors when they trade securities
(large dealer banks and retail brokers); and eight outside service providers (prime brokers,
accountants and auditors, attorneys, fund administrators, hedge fund infrastructures,
consultants, depositories and custodians, banks). On the buy side, mutual funds are
contrasted with separately managed accounts (SMAs), and have several advantages over
mutual funds in terms of providing investors with direct ownership and transparency,
satisfying their individual needs, and controlling fund flows.

Each of the market participants in the Categories of Market Participants table is defined in
the Section Glossary that follows. This is followed by a discussion of a few participants that
warrant some special attention beyond the glossary definition.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Categories of Market Participants

Buy Side (9) Sell Side (2) Outside Providers (8)

Institutions and entities that buy Institutions that act as Service providers that
large quantities of securities for agents for investors when support operations for
portfolios they manage. they trade securities. buy-side institutions
(CAIA exam focus).
Plan sponsors Large dealer banks Prime brokers
Foundations and endowments Brokers Accountants and auditors
Family offices and private wealth Attorneys
Sovereign wealth funds Fund administrators
Private limited partnerships Hedge fund infrastructures
Private investment pools Consultants
Separately managed accounts Depositories and custodians
Mutual funds (’40 Act funds) Banks
Master limited partnerships

SECTION GLOSSARY (PARTICIPANTS)

Buy-Side Participants
• A plan sponsor is a designated party such as a company or an employer that
establishes a health care or retirement plan (pension) that has special legal or taxation
status, such as a 401(k) retirement plan in the United States for employees.
• A foundation is a not-for-profit organization that donates funds and support to other
organizations for its own charitable purposes.
• An endowment is a fund bestowed on an individual or institution (e.g., a museum,
university, hospital, or foundation) to be used by that entity for specific purposes and
with principal preservation in mind.
• A family office is a group of (high- or ultra-high-net-worth) investors joined by
familial or other ties who manage their personal investments as a single entity,
usually hiring professionals to manage money for members of the office.
• Sovereign wealth funds are state-owned investment funds held by that state’s central
bank for the purpose of future generations and/or to stabilize the state currency.
• Private limited partnerships are a form of business organization that potentially
offers the benefit of limited liability to the organization’s limited partners (similar to
that enjoyed by shareholders of corporations) but not to its general partner.
• Private investment pools include hedge funds, funds of funds, private equity funds,
managed futures funds, commodity trading advisers (CTAs), and the like; they are
private investment pools that focus on serving as intermediaries between investors
and alternative investments.
• Separately managed accounts (SMAs) are individual investment accounts offered
by a brokerage firm and managed by independent investment management firms.
• Mutual funds, or ’40 Act funds, are registered investment pools offering their
shareholders pro rata claims on the fund’s portfolio of assets.
• Master limited partnerships (MLPs) are publicly traded investment pools that are
structured as limited partnerships and that offer their owners pro rata claims.

Sell-Side Participants
• Large dealer banks are major financial institutions, such as Goldman Sachs,
Deutsche Bank, and the Barclays Group, that deal in securities and derivatives.

© 2020 Wiley
 THE ENVIRONMENT OF ALTERNATIVE INVESTMENTS: FUNDS AND PARTICIPANTS

Although based on the same economic principles as typical retail banks, dealers are
much bigger and generate significant income from trading rather than lending.
• Retail brokers receive commissions for executing transactions and have research
departments that make investment recommendations.

Outside Service Providers

• The prime broker has the following primary functions: clearing and financing trades
for its client, providing research, arranging financing, and producing portfolio
accounting.
• The attorney takes care of filing any documents required by federal, state, and local
agencies and creates the legal documents necessary for establishing and managing the
pool.
• The fund administrator maintains a general ledger account, marks the fund’s books,
maintains its records, carries out monthly accounting, supplies its monthly profit and
loss (P&L) statements, calculates its returns, verifies asset existence, independently
calculates fees, and provides an unbiased, third-party resource for price confirmation
on security positions.
• Depositories and custodians are very similar entities that are responsible for holding
their clients’ cash and securities and settling clients’ trades, to maintain the integrity
of clients’ assets and ensure that trades are settled quickly.
• Banks: A commercial bank focuses on the business of accepting deposits and
making loans, with modest investment-related services. An investment bank focuses
on providing sophisticated investment services, including underwriting and raising
capital, as well as other activities such as brokerage services, mergers, and
acquisitions.

The candidate should be familiar with three additional types of outside brokers (see the
discussion that follows).

1. Consultants
2. Accountants and auditors
3. Hedge fund infrastructure

DISCUSSION
In the discussion that follows here, we emphasize features about market participants that
warrant some special attention beyond the glossary definitions, as well as present some more
key terms.

Buy Side
It is important to note that most U.S. private investment pools (hedge funds, private equity
funds, etc.) are structured as limited partnerships: investors are limited partners and the fund
manager is a general manager.

It is also important to understand that most of the buy-side participants pool investments,
offering simplicity and convenience for the fund manager. These pooled investment
structures (e.g., mutual funds) may also offer investors some limited liability. This contrasts
with separately managed accounts (SMAs) whereby losses may be greater than the capital
contribution when leverage or derivatives are used. There are, however, four advantages to
investors in SMAs relative to pooled investments (funds): (1) ownership (SMA investors
directly own the invested assets, whereas fund investors own a share of the fund that invests
assets) and generally hold the assets in their own depository accounts; (2) individual needs
(managers can tailor portfolios to the unique needs of individual SMA investors, whereas all
investors in a fund have common investments); (3) transparency (the SMA investor has

© 2020 Wiley
,2,
INTRODUCTION TO ALTERNATIVE INVESTMENTS

access to position information, whereas a fund may be opaque for the purposes of
confidentiality); and (4) control o f fund flows (unlike with SMAs, funds may be adversely
impacted by other investors’ fund flows, i.e., redemptions and subscriptions).

Sell Side
There were only two sell-side participants listed: dealer banks and retail brokers. These are
institutions that act as brokers when they serve as agents for investors when they trade
securities. They act as dealers or as principals when they serve as the counterparties on
trades. Large dealer banks also engage in “proprietary trading” where they trade for
themselves—to execute trades and carry positions primarily to make a profit rather than to
trade with customers.

“Universal banking” where banks engage in both commercial banking and investment
banking is common in Germany. Note that both commercial banks and investment banks
provide other outside services, discussed later.

Outside Service Providers

Consulting conflicts of interest can arise when consultants are more apt to please the
manager that is paying them than being independent concerning performance evaluation.
Thought should be given to compensation arrangements and incentives.

1. Financial platforms are systems that provide access to financial markets, portfolio
management systems, accounting and reporting systems, and risk management
systems.
2. Financial software may consist of prepackaged software programs and computer
languages tailored to the needs of financial organizations.
3. Financial data providers supply funds primarily with raw financial market data,
including security prices, trading information, and indices.

In addition, index providers can assist with fund marketing efforts. Historically, hedge funds
were not allowed to advertise, but could report returns to index and data providers. This
allows potential investors to have access to performance data without creating a marketing
relationship.

• An additional term associated with depositories and custodians is the Depository

Trust Company (DTC): the principal holding body of securities for traders all over
the world and part of the Depository Trust and Clearing Corporation (DTCC), which
provides clearing, settlement, and information services.

Learning Objective: Demonstrate knowledge of the legal structures in

alternative investing.

MAIN POINTS: Many investment funds are housed within structures that are designed to
protect investors and managers with limited liability. Bankruptcy remote entities are special
vehicles that provide protections in the case of bankruptcy. Entities facilitating investor
taxation differences from different jurisdictions are called master feeder funds.

Liability and Passive Investments

If the investor is passive—that is, not actively managing the investments—liability is limited
to his or her investment amount.

Probity is the quality of exercising strong principles such as honesty, decency, and integrity.

122
© 2020 Wiley
 THE ENVIRONMENT OF ALTERNATIVE INVESTMENTS: FUNDS AND PARTICIPANTS

Balance between encouraging widespread investment through limited lability structures and
the possibility of huge potential profits with limited losses and probity is needed. Yet the
lines between what constitute passive ownership and active management differ between
jurisdictions.

Corporations and Limited Liability Companies

Owners in both corporations and limited liability companies (LLCs) enjoy limited liability.
The difference is that unlike corporations’ dividends, LLCs can be structured such that
distributions are made without regard to the percentage ownership in the company.

Many investment vehicles are structured as LLCs, corporations, or limited partnerships in

order to provide limited liability.

Limited Partnership Structures

A simplified view of limited partnerships in alternative investments is that there are several
limited partners (passive investors in a fund) with limited liability and a general partner that
serves as the manager without limited liability. In practice, general partners are likely to
form a parent LLC that creates two more LLCs: (1) a general partner (GP) and (2) an
advisor to the partnership; the same manager may be involved in all three LLCs.

Bankruptcy Remote Entities

Bankruptcy remote entities are designed to protect owners from losses and delays from
bankruptcy proceedings. They are often structured as special purpose entities or vehicles
(SPE or SPY) that are formed as LLCs in which assets are placed for protection.

Entities Facilitating Investor Taxation Differences

Sometimes a fund is only onshore, but to accept both foreign and domestic investors with
tax neutrality, a master-feeder structure can be established.

The master trust is the legal structure used to invest the assets of both onshore investors and
offshore investors in a consistent if not identical manner, so that both funds share the benefit
of the fund manager’s insights.

A feeder fund is a legal structure through which investors have access to the investment
performance of the master trust.

Together, the master trust and feeder funds are referred to as a master-feeder structure.

This structure ensures that investors are subject to the tax codes of only their own home
country.

Learning Objective: Demonstrate knowledge of the key features of fund

structures.

MAIN POINTS: The two main categories of clauses in limited partnership agreements
(LPAs) are investor protection clauses and economic terms clauses; in general, LPAs are
designed to mitigate moral hazard and adverse selection. The LP Advisory Committee
(LPAC) and fund reporting/disclosures are key elements of corporate governance of LPAs.
Investment objectives and fund size should be compatible. Management fees should cover
basic expenses, but managers are mainly incentivized by carried interest (in PE funds) or
incentive fees.

123
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

The Four Key Partnership Documents

The four key partnership documents are: (1) private-placement memoranda (a.k.a. offering
documents), which are formal descriptions of an investment opportunity that comply with
federal securities regulations and make risk disclosures; (2) a partnership agreement, which
is a formal written contract creating a partnership; (3) a subscription agreement, which is an
application submitted by an investor who desires to join a limited partnership; and (4) a
management company operating agreement, which is an agreement between members
related to a limited liability company and the conduct of its business as it pertains to the law.

Clauses
The limited partnership agreement (LPA) defines the legal framework of a private equity
fund and its terms and conditions. LPAs contain (1) investor protection clauses and
(2) economic terms clauses.

Investor protection clauses cover the investment strategy, restrictions on investments, if any,
key-person provisions, termination and divorce, the investment committee, the LP advisory
committee, exclusivity, and conflicts.

Economic terms clauses cover management fees and expenses, the GP’s contribution, and
the distribution waterfall.

Adverse Selection
The LPA is designed so that the manager’s focus is on maximizing performance and not on
exploiting contractual loopholes. In economics, the holdup problem occurs when two parties
refrain from cooperating due to a perceived possibility of giving the other party more
bargaining power, resulting in lower profits for themselves. Adverse selection and moral
hazard can result when there is asymmetric information.

Adverse selection takes place before a transaction is completed, when the decisions made
by one party cause less desirable parties to be attracted to the transaction.

Moral hazard takes place after a transaction is completed and can be defined as the
changes in behavior of one or more parties because of incentives that come into play once a
contract is in effect.

The LPA is designed to mitigate the holdup problem (engaging in opportunism), adverse
selection (e.g., an LP seeking a GP that charges low fees will likely get a poorly performing
GP), and moral hazard (e.g., the manager taking excessive risks to increase incentive fee).

Corporate Governance in Private Funds

The degree of control LPs have over the activities of GPs is outlined in the LPA and include
things like whether investment restrictions can be waived and LP advisory committee
(LPAC) participation details.

LPAC responsibilities are defined in the LPA and normally relate to dealing with conflicts
of interest, reviewing valuation methodologies, and any other consents predefined in the
LPA.

LPs may be invited to serve on the investment committee, but this can blur the delineation
between the responsibilities of the LP and GP and risk the limited liability status of the LP.

LPs can decide on changes such as extending the fund life with either a simple majority or a
qualified majority.

© 2020 Wiley
 THE ENVIRONMENT OF ALTERNATIVE INVESTMENTS: FUNDS AND PARTICIPANTS

A qualified majority is generally more than 75% of LPs as opposed to the 50% required for
a simple majority.

In addition to decisions made by the LPAC, fund reporting is another important element of
corporate governance in PE funds. Disclosure guidelines are provided by various PE
associations and industry boards,3 but the level of detail provided by GPs varies, often
according to the type of investor.

Investment Objectives, Size, and Term

It has been argued that PE funds are blind pools for a good reason: it provides investment
flexibility to managers. The size of the funds should support the investment objectives.
Typical fund terms are 7 to 10 years but may be extended. In the case that a fund’s life is
extended, the management fees are reduced or eliminated in order to promote quick exits.
Normally realizations are distributed to LPs as soon as possible but LPs may, at times, grant
the GP discretion to reinvest proceeds during the reinvestment period.

Management Fees and Expenses

Management fees based on committed capital help to pay for due diligence efforts before
committed capital is invested. These management fees are not the primary performance
motivator, but should be high enough to retain talent and low enough such that the carried
interest is the primary motivator.

Global Regulations and Fund Structures

Regulation of hedge funds in Europe centers on the concept of Undertakings for Collective
Investment in Transferable Securities (UCITS). UCITS are carefully regulated (with
restrictions on the use of leverage, liquidity, and concentration of assets in the fund’s
portfolio) European fund vehicles that allow retail access and marketing of hedge-fund-like
investment pools.

SIC AVs are open-end funds and SICAFs are closed-end funds; both are publicly traded,
organized as UCITs often domiciled in Luxembourg.

The Markets in Financial Instruments Directive (MiFID) is an EU law that establishes

uniform regulation for investment managers in the European Economic Area (the EU plus
Iceland, Norway, and Liechtenstein).

The MiFID addresses several issues, including the lack of transparency in dark pools. A
dark pool refers to non-exchange trading by large market participants that is hidden from the
view of most market participants.

A 2011 regulation in the EU is the Alternative Investment Fund Managers Directive

(AIFMD), which governs non-UCITs retail funds and private investment pools (hedge
funds, private equity, real estate, infrastructure). An AIF is any collective investment that is
not a UCITS fund. That would include hedge funds, private equity, real estate, and
infrastructure funds, whether listed or not, and whether closed end or open end.

UCITS are available in Ireland but the newly launched (2015) Irish Collective Asset
Management Vehicles (ICAVs) are as well. They are relatively more flexible and
encompass both open-end and closed-end funds.

a
These include the European Private Equity and Venture Capital Association (EVCA), the Institutional Limited Partners Association
(ILPA), the International Private Equity and Venture Capital Valuation Board (IPEV Valuation Bard), and the Private Equity Industry
Guidelines Group (PEIGG).

125
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

SICAVs and SICAFs are publicly traded open-end funds and closed end funds, respectively.
Most are domiciled in Luxembourg under the UCITS framework but some are Specialized
Investment Funds (SIFs) with more flexibility for hedge funds and PE funds.

While a variety of structures are seen in the Cayman Islands, master-feeder fund structures
are common. The Cayman Islands Monetary Authority (CIMA) places no restrictions on
leverage or transparency. Minimum investments are generally $100,000.

126 © 2020 Wiley

 T h e E n v i r o n m e n t o f A l t e r n a t i v e In v e s t m e n t s : M a r k e t s

This lesson introduces several key terms that help to describe the environment of alternative
investments.

LESSON MAP
• Demonstrate knowledge of the financial markets involved in alternative investments.
• Demonstrate knowledge of the regulatory environment of alternative investments.
• Demonstrate knowledge of liquid alternative investments.
• Demonstrate knowledge of taxation of investments.
• Demonstrate knowledge of short-selling processes and mechanics.

KEY CONCEPTS
The first, second, third, and fourth markets are terms that are used to describe how and where
securities are traded, such as on an exchange or over the counter (OTC). There are five general
types of hedge fund regulations stipulating restrictions and requirements. Liquid alternatives
provide retail access to investment vehicles offering returns that are designed to be like those
of private investment pools. They include real estate investment trusts (REITs) and hedge
fund clones, among other publicly traded vehicles. Investment income treatment is organized
around short-term and long-term gains, with the former treated as ordinary income and the
latter taxed at a reduced rate. Short selling is important to understand because it is used in
many alternative investment strategies. It involves borrowing a security to sell and then
buying it back at a lower price and returning it to the lender.

Learning Objective: Demonstrate knowledge of the financial markets involved

in alternative investments.

MAIN POINT: This section defines four types of markets: first or primary (new
placements), second (trading of previously existing securities), third (OTC), and fourth
(electronic) markets. The fourth market is a private non-regulated market that offers low
transaction costs but little transparency. It is often used by high frequency traders, as well as
retail brokers and small institutional traders.

• A primary market refers to the methods, institutions, and mechanisms involved in

the placement of new securities to investors.

The best-known example of a new placement is the initial public offering (IPO) where a
private company issues stock for the first time and becomes public. (Private equity firms
often use the public market as an exit strategy.) However, other sources of securities in the
primary market include secondary issues (of additional shares by a company that already
made an IPO), and the creation and issuance of securitized assets.

Tip: Part Five of the text discusses structured products. An example of a structured product
is a securitized asset.

• Securitization involves bundling assets, especially unlisted assets, and issuing

claims on the bundled assets.

Note: American depositary receipts (ADRs) and global depositary receipts (GDRs) allow
foreign firms to list their stocks on U.S. or other countries’ exchanges.

,27
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

• A secondary market facilitates trading among investors of previously existing

securities.

The bid-ask spread is the price difference between the highest bid price (the best bid price)
and the lowest offer (the best ask price). Market making is a practice whereby an
investment bank or another market participant deals securities by regularly offering to buy
securities and sell securities. Market orders are executed immediately at the best available
price. Participants that place market orders are market takers, which buy at ask prices and
sell at bid prices, generally paying the bid-ask spread for taking liquidity.

See the Standard III(A): Duties to Clients. Part of this standard requires that candidates
and members seek “best price” and “best execution” to maximize the value of the client’s
portfolio when trading.

The candidate should be aware of some of the major listing exchanges globally. In the
United States two are the (centralized) New York Stock Exchange and the (electronic
network) NASDAQ. Exchanges in other countries include the London Stock Exchange
(LSE), Euronext, and the Tokyo Stock Exchange.

• Third markets are regional exchanges where stocks listed in primary and secondary
markets can also be traded.

This is a segment of the OTC market: In the United States, firms that are not exchange
members can make a market and trade exchange-listed securities using the NASDAQ
Intermarket rather than the exchange.

• Fourth markets are electronic exchanges that allow traders to quickly buy and sell
exchange-listed stocks via the electronic communications systems offered by these
markets.

The fourth market is a private, nonregulated market that offers low transaction costs but
little transparency. It is often used by high-frequency traders, as well as retail brokers and
small institutional traders.

Learning Objective: Demonstrate knowledge of the regulatory environment

as it applies to alternative investments.

MAIN POINT: The five primary forms of hedge fund regulation involve either
“requirements” or “restrictions.”

This section focuses primarily on the regulation of hedge funds (in the United States and
globally), although some discussion also applies to broader investments—other alternative
investment pools.

Importantly, while hedge funds were in the past often described as “loosely regulated,”
regulators have become more concerned about systematic risk since the financial crisis of
2007/2008. In addition, anti-money laundering and terrorism-related activities have received
increased attention from regulators in recent years.

128
© 2020 Wiley
 THE ENVIRONMENT OF ALTERNATIVE INVESTMENTS: MARKETS

There are two areas involving requirements:

1. Establishing a hedge funds (registration), and

2. Ongoing reporting.

Broadly there are three areas involving restrictions involving:

1. Investment advisors and hedge fund managers (registration—see ‘40 Act later on),
2. Operations (use of leverage, liquidity, outside service providers), and
3. Marketing and distribution.

Non-U.S. Hedge Fund Regulation

• Regulation of hedge funds in Europe centers on the concept of Undertakings for
Collective Investment in Transferable Securities (UCITS). UCITS are carefully
regulated European fund vehicles that allow retail access and marketing of
hedgefund-like investment pools.
• The Markets in Financial Instruments Directive (MiFID) is an EU law that
establishes uniform regulation for investment managers in the European Economic
Area (the European Union plus Iceland, Norway, and Liechtenstein).

This law addresses several issues, including the lack of transparency in dark pools.

• A dark pool refers to non-exchange trading by large market participants that is

hidden from the view of most other market participants.

A relatively new (2011) regulation in the European Union is the Alternative Investment
Fund Managers Directive (AIFMD) governing non-UCITS retail funds and private
investment pools (hedge funds, private equity, real estate, infrastructure).

Learning Objective: Demonstrate knowledge of liquid alternative investments.

MAIN POINTS: Liquid alternative assets provide retail access to investment vehicles
offering returns that are designed to be like those of private investment pools such as real
estate (e.g., REITs) and hedge funds (e.g., clones and replication products). They are
becoming increasingly important to individual investors as they seek to diversify their
portfolios and are forced to use defined contribution plans for retirement savings. Relative to
private placements, liquid alts face regulatory constraints on leverage (300% limit),
concentration, and illiquid investments (15% limit). Returns differ due to differences in
(1) flexibility and (2) fees.

• Liquid alternatives are investment vehicles that offer alternative strategies in a form
that provides investors with liquidity through opportunities to sell their positions in a
market.

REITs are a well-known example. These are funds that invest in real estate or mortgages
that trade like stocks—offering investors liquidity. (They are covered in more detail in
lessons on real estate.)

There are five major types of liquid alternative investments across a spectrum from those
most like privately placed alternative investments to those least like private placements.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Spectrum of Liquid Alternatives

Unconstrained Constrained Clone Liquidity-Based Skill-Based Absolute Return or

Replication Diversified
Clone Similar strategy Replication
Product Products
but with some Product
constraints (e.g., Mimics strategy M ay offer
Follows virtually Mimics strategy
leverage, with liquid proxies, diversification, but
same strategy. mechanically.
concentration, generally not
liquidity). innovative, and
very constrained.

Most Like Least Like

Privately Placed Alternative Investments

FACTORS DRIVING EXPLOSIVE GROWTH IN LIQUID ALTERNATIVES

Liquid alternatives had about $100 billion in assets under management (AUM) before the
2007-9 financial crisis. By the end of 2015, there were more than $500 billion in assets, and
the growth rate is expected to be in the double digits going forward. The AUM of the hedge
fund industry at the end of 2014 was $2.8 trillion, having grown from under $500 billion in
2000. The annualized growth rate for liquid alternatives is nearly double that for hedge
funds over these time periods.

Reason 1: Due to low interest rates and high equity valuations, investors are seeking to
diversify away from traditional stocks and bonds.

Reason 2: The continued shift in retirement assets from defined benefit plans (employer
chooses investments) to defined contribution plans (employee chooses investments) creates
demand for retail access to alternative investments.

Liquid alternatives have more leverage limits, concentration limits, and illiquidity
constraints than privately placed alternatives.

Constraints on Liquid Alternatives

Three Constraints Liquid Alts Have Relative to
Privately Placed Alts

,30
© 2020 Wiley
 THE ENVIRONMENT OF ALTERNATIVE INVESTMENTS: MARKETS

• Hedge fund replication is the attempt to mimic the returns of an illiquid or highly
sophisticated hedge fund strategy using liquid assets and simplified trading rules.
• Closed-end mutual fund structures provide investors with relatively liquid access
to the returns of underlying assets even when the underlying assets are illiquid.

Returns from liquid alternatives versus private placement vehicles differ due to:

• Flexibility: Private placement funds have more flexibility in their strategies (fewer
constraints).
• Fees: Private placement funds generally have fee structures (often including
incentive fees) that attract more talented managers.

Learning Objective: Demonstrate knowledge of taxation of investments.

MAIN POINT: This section on taxation takes a global perspective; therefore, only general
concepts are covered rather than specifics. If one is in a certain tax bracket3 and pays, for
example, 34% income tax on earnings, then generally that is the person’s “ordinary income
rate” for certain investment types of investment income. Tax-exempt accounts hold large
portions of institutional alternative investment vehicles. Taxable investors are subject to
taxes on capital gains and dividends, which are generally taxed at ordinary income rates in
the United States, depending on current regulations. Taxable investors prefer strategies that
can generate long-term gains taxed at a reduced rate in the United States.

Taxation of Investments

U.S. (General: Can Other

change with changes Countries and
Investment Income Tax Conventions in laws3) Jurisdictions
Capital gains— short-term Ordinary income rate
Capital gains—long-term Reduced rate
Capital gains: Often taxed when
realized, but may be deferred when in
qualified retirement accounts, for
example.
Depending on the country, the rates may
be relatively higher, lower, or exempt.
Dividends Ordinary income rate
Interest Some exempt (e.g.,
municipal bonds)
Dividends and interest: Usually taxed when distributed.

a Furthermore, investment income taxation can be both complex and also important in affecting total return
and investment strategies. An example is Section 1256 contracts, which include many futures and options
contracts; they have potentially enormous tax advantages in the United States, including having their income
treated as 60% long-term capital gain and 40% short-term capital gain regardless of holding period.

Non-income tax conventions (e.g., real estate tax, estate tax, value-added tax) can also have
an impact on investment returns, and conventions vary across countries.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Learning Objective: Demonstrate knowledge of short-selling processes and

mechanics.

MAIN POINTS: The returns to short selling differ from returns to long positions in a few
different ways. Short sellers sell stock that they borrow from a securities lender and
therefore must post collateral in the form of cash or a long position in a stock. When posting
cash, the short seller earns interest in the form of a rebate. Short sellers need to pay any
dividends to the lender of the stock.

THE INSTITUTIONAL MECHANICS OF SHORT SELLING

Brokerage firms hold the legal securities in street name for their clients that are economic
owners of the securities. They may lend the securities to speculators. The short-selling
speculators then sell the stock with hopes of buying it back at a lower price and then
returning the borrowed stock to the lending brokerage. If the company of the stock pays a
dividend while it has been sold, the broker must still provide the customer with the dividend.
Therefore, the short seller must provide the dividend to the brokerage firm. These cash flows
coming from the short seller to the brokerage firm are called substitute dividends.

MECHANICS AND RISKS OF SHORT SELLING

The mechanics and risks of short selling differ from those of taking long positions in a few
ways. First, the theoretical losses to short positions are unlimited and the potential gain is
equal to the price it’s sold short at. Conversely, the profits to long positions are theoretically
unlimited and the potential maximum loss is limited to the price at which it was purchased.
Second, short selling can raise liquidity problems because collateral is required. Typically,
a long/short manager can post long positions as collateral. However, consider the following
scenario:

Initial position
Long A 100 Posted as collateral for B
Short B 100_________________________
Next day both move 10% against manager
Long A 90
Short B 110

After the adverse price movements, the manager does not have enough collateral posted and
may need to liquidate at poor prices.

Third, the lender of the short security has the right to demand it back. Usually the broker
will simply find another lender. Yet in a short squeeze (upward pressure on prices of short
positions), it may be difficult to find others willing to loan shares if the original lender
demands the short position be returned. In this case the manager would need to close out the
short at an unattractive price.

Return to Short Position

When a manager posts cash as collateral for borrowing shares they generally receive a rebate
of, for example, 1% of the initial short position as interest on the collateral. This is one
component of the total return on a short position. Additionally, short sellers do not receive
dividends, but rather must pay them to the lender of the security.

132
© 2020 Wiley
 THE ENVIRONMENT OF ALTERNATIVE INVESTMENTS: MARKETS

SPECIAL SITUATIONS INVOLVING SHORT SELLING

The previous example was illustrative of a general collateral stock that is not facing heavy
borrowing demand. In contrast, a special stock has heavy borrowing demand and
corresponding higher net fees associated with it so that a short seller may receive a smaller
rebate than in the example, or maybe even a negative rebate. For very crowded short trades
(when there are many similar large short positions), borrowing costs can be as high 20%.

When the inventory of a stock available to borrowers is very low, the broker may revoke
borrowing privileges for that stock and require the trader to cover the short position. This is
referred to as being bought in. When many short sellers need to cover their positions due to
limited liability, the buying pressure will increase the price of stocks; this is referred to as a
short squeeze. Lenders have the right to demand that a stock be returned at any time.
Usually a borrower can turn to other lenders, but it can become difficult during a short
squeeze.

133
© 2020 Wiley
 Qua nt it a t iv e Fo unda t io ns : Ca l c ul a t ing Re t ur ns
NOTE FROM THE AUTHOR
The CAIA topic of quantitative foundations is divided into two parts for candidates’ use in
preparing for the exam. This lesson focuses on rate of return calculations and special
challenges that can come up with their application to alternative investments. A second part
will focus on net present value, internal rate of return (IRR), and how returns are allocated
between the manager and the investor.

LEARNING OBJECTIVES
This lesson is one of several lessons that are a bit quantitative. Nearly all of the quantitative
material in the exam involves returns, and this lesson focuses on calculating those returns.
Expect some mathematical problems from this material. Become familiar with the formulas
presented in this lesson. Be prepared to apply them with one of the permitted calculators.

Fees affect an investor’s return. Calculating fees can be somewhat challenging. Candidates
should understand how provisions interact.

LESSON MAP
• Demonstrate knowledge of return and rate mathematics.
• Demonstrate knowledge of returns based on notional principal.

KEY CONCEPTS
Candidates will learn several ways to calculate return on an investment. Formulas define the
return involving one cash outflow (investment) and one cash inflow. The internal rate of
return (IRR) measures return on three or more cash flows and can be either dollar-weighted
(based on actual cash flows, which may include intervening additions or withdrawals of
principal) or time-weighted (based on a hypothetical $1 investment with no intervening
additions or withdrawals of principal).

The IRR is adapted for instruments that have only a notional principal. Candidates should
take care in evaluating investments that switch between cash inflows and cash outflows,
because each sign change creates an additional IRR solution.

Fees can significantly affect investment return. Hedge funds and private equity funds
usually charge a management fee (a flat percentage of the assets under management) and an
incentive fee. A hedge fund pays incentive fees on the net investment return after other fees,
usually collected monthly or quarterly. The incentive fee on a private equity fund is called
carried interest and is charged when the fund liquidates its investment.

Additional provisions can make the calculations more complicated. A hurdle rate, also
called a preferred return, sets a minimum return that the fund must achieve before incentive
fees are assessed. A catch-up rate diverts part of an investor’s returns to the manager to
replace fees not collected because of a hurdle rate. Generally, incentive fees are not collected
on returns that make back a loss. A manager may be required to return previously collected
fees (clawback) in the event of a loss. The interaction of all of these provisions is described
as the “waterfall.”

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Learning Objective: Demonstrate knowledge of return and rate mathematics.

MAIN POINTS: The simplest return calculations involve a cash outflow or investment
matched with an inflow or return on that investment. The assumed compounding frequency
affects the calculated return. More frequent compounding produces a lower calculated return
for a given pair of cash flows.

Compounding Frequency
Simple interest assumes no compounding of returns. Candidates are likely familiar with the
impact that compounding frequency can have on a present value (PV) or future value
calculation. The Equivalent Compounded Rate figure shows the rates with several different
compounding frequencies that are equivalent to an 8% annual or uncompounded rate. The
chart lists the same equivalent rate over discrete compounding periods per year (1, 2, or
more—up to but not including continuous compounding).

Equivalent Compounded Rate

8 .00 %

7.95%

£ 7.90%
GC
| 7.85%

'5 7.80%
LLI

7.75%

7.70% Log Return = 7 . 7 0 % ----------------------- >

1
Periods per Y ear

The Future Value at 8% Quoted Rates figure shows the future value one year later if an 8%1
rate is compounded annually, semiannually, and up to monthly.

Future Value at 8% Quoted Rates

1.0835
Continuous = 1.08329
1.0830

1.0825

1.0820

1.0815

1.0810

1.0805

1.0800

1.0795
1 2 3 4 5 6 7 8 9 10 11
Periods per Y ear

1The impact of compounding frequency is much smaller at interest rates prevailing in 2017.

© 2020 Wiley
 QUANTITATIVE FOUNDATIONS: CALCULATING RETURNS

The log return or continuously compounded rate represents the most frequent that rates can
be compounded. The relevant present value and future value formulas are:

— £? ^ ^ C°nti,uwus

— pt X f Continuous

where e is the mathematical constant equal to approximately 2.718, t is the time in years,
and rContinuous is the log return.

Candidates should be prepared to calculate a compound equivalent rate from a given rate
with a particular compounding frequency. The following equation provides a formula that
converts from one compounding frequency, i, to another frequency, j.

The following equation converts a rate compounded i times per year to continuous
compounding, the log return.

To convert from log return to a rate compounded i times per year, the following equation
could be used:

Rather than memorizing the preceding equations, candidates should note that the future
value is equal whether using either the starting rate or the equivalent rate. The following
equation lays out all of the possibilities:

This equation is a general condition—that saying the rates are equivalent is also saying that
they have the same future value. The idea is to fill in two relevant terms in the equation and
ignore the remaining term. Then solve for the equivalent rate. This approach may be easier
than memorizing if a candidate is more comfortable making these manipulations.

Using the Calculator to Find Equivalent Rates

The calculator can find equivalent rates. The following is an example using the Texas
Instruments BA II Plus calculator.

m
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Using the Texas Instruments BA II Plus Calculator to Find an Equivalent Rate

Find the annually compounded rate equivalent to a 10% semiannual return.

1. Enter {2ND} {QUIT}—optional; returns the calculator to normal operating

mode.
2. Enter {2ND} {CLR TVM}—optional; clear financial registers.
3. Enter 2 {N}—number of semiannual periods.
4. Enter 10 {I/Y}—annualized semiannual rate (do not enter .10, .05, or 5).
5. Enter 0 {PMT}—this may be necessary if one previously entered a value in the
PMT register.
6. Enter 1 {FV}—future value can be anything, but entering 1 gives a check on the
reasonableness of the interim answer in step 8.
7. Enter {2ND} {P/Y} 2 {ENTER}—two payments per year for semiannual.
8. Enter {CEIC} {CPT} {PV}—this fills the PV register with an interim PV
consistent with the assumptions so far.
9. Enter {2ND} {P/Y} 1 {ENTER}—change setup to annual.
10. Enter {CEIC} 1 {N}—change to one annual period.
11. Enter {CEIC} {CPT} {I/Y}—calculate annual rate for one annual period.

The display should show 10.25. A 10% semiannual rate is equivalent to a 10.25%
annually compounded rate.

Using the same procedure in steps 1 to 7 and then using 1000 in steps 8 and 9 produces
9.758%, a very good approximation to the log return.

A very similar procedure is used to calculate an equivalent rate on an HP 12-C calculator.

Using the HP 12-C Calculator to Find an Equivalent Rate

1. Enter {REG}—optional; clear financial registers.

2. Enter 2 {n}—number of semiannual periods.
3. Enter 5 {i}—de-annualized semiannual rate (do not enter .10, .05, or 10).
4. Enter 0 {PMT}—this is not necessary if the financial registers have been cleared.
5. Enter 1 {FV}—future value can be anything, but entering 1 gives a check on the
reasonableness of the interim answer in step 6.
6. Enter {PV}—this fills the PV register with an interim PV consistent with the
assumptions so far.
7. Enter 1 {N}—change to one annual period.
8. Enter {i}—calculate annual rate for one annual period.

Arithmetic and Geometric Returns

To see how returns combine over multiple periods, it would be helpful to calculate an
average return. The returns compound, meaning that a return is earned in the second period
on the original investment and on the first period return. To allow for this compounding, it is
generally necessary to calculate a geometric average. See the following equation:

138
© 2020 Wiley
 QUANTITATIVE FOUNDATIONS: CALCULATING RETURNS

Suppose the returns" on an asset over five periods were 11%, 7%, -4%, 8%, and 12%. The
value at the end of that time would be (1.11) x (1.07) x (0.96) x (1.08) x (1.12) or 1.379
per initial $1 invested. If these returns occurred over five years, the geometric average return
is (1.3791/5- 1) or 6.64%. Simply adding up the five values and dividing by 5 produces
6.80%.

Applying the same procedure to log returns is not necessary. To see this, assume that the
rates in the previous example are log rates observed annually. The future value is *11%x
e1%x e~4%x es%x e l2%. This future value also equals ^ 11%+7%-4%+8%+12%) or $1,400 per
initial $1 invested. Finding the average log return: ln(1.400)/5 equals 6.80%. This result
demonstrates that it is okay to take the arithmetic average of log returns.

Learning Objective: Demonstrate knowledge of returns based on notional

principal.

MAIN POINTS: The preceding formulas may not work for certain derivative investments.
For derivatives that are initiated at zero value (for example, most interest rate swaps), it
might be desirable to substitute the notional value for the beginning value. For trades
requiring collateral, the value of the collateral may serve as the beginning value.

Frequently with derivatives, the terms apply to a notional principal balance that doesn’t
correspond to the cash investment. In fact, many types of derivatives (e.g., interest rate swap
contracts and most forward contracts) are frequently initiated with neither party paying to
enter the transaction. Suppose, for example, a forward contract commits to buying crude oil
at a date in the future at a price of $60 per barrel, the acknowledged forward price. The
forward contract may not require any initial cash payment by either the buyer or the seller.
Calculating a gain or loss is problematic because the standard formula puts zero in the
denominator:

V alueending ValueBegjnnjng
Return =
Value Beginning

One solution is to substitute the notional value of the trade in the denominator. If the trade is
fully collateralized, it is possible to substitute the value of the collateral. However, the return
on the derivative includes interest on the collateral as in the following equation.

RFully Collateralized Derivative ln(l + Return) + R Risk-free

The log return begins with the nominal return on notional principal and adds the return on
the collateral.

Where positions are levered, either by the terms of a derivative or by partial

collateralization, then the return may be multiplied by the leverage ratio.

^Partially Collateralized [Leverage * ln(l + Return)] + RRisk-free

Here, the notional return is converted to a log return, levered, and adjusted by the risk-free
rate.

9 • •
The returns in this example are nominal (not annualized) returns.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Quantitative Foundations Continues

The candidate should continue to the second part of Quantitative Foundations, which covers
net present value and IRR and how they are used to determine hedge fund returns. The
second part will explore how some fee provisions such as hurdle rates affect how hedge
fund returns are allocated between the investor and the manager.

,40
© 2020 Wiley
 Q u a n t i t a t i v e F o u n d a t i o n s : N PV , IR R , a n d
t h e Ca s h F l o w W a t e r f a l l

NOTE FROM THE AUTHOR

The CAIA topic of quantitative foundations is divided into two parts for candidates’ use in
preparing for the exam. This lesson will focuses on net present value (NPV), internal rate of
return (IRR), and how returns are allocated between the manager and the investor. The
previously presented lesson focused on rate of return calculations and special challenges that
can come up with their application to alternative investments.

LEARNING OBJECTIVES
This lesson is one of several lessons that are a bit quantitative. Nearly all of the quantitative
material in the exam involves returns, and this lesson focuses on calculating those returns.
Expect some mathematical problems from this material. Become familiar with the formulas
presented in this lesson. Be prepared to apply them with one of the permitted calculators.

Fees affect an investor’s return. Calculating fees can be somewhat challenging. Candidates
should understand how provisions interact.

LESSON MAP
• Demonstrate knowledge of the internal rate of return (IRR) approach to alternative
investment analysis.
• Demonstrate knowledge of the problems associated with the internal rate of return
(IRR).
• Demonstrate knowledge of other performance measures associated with illiquid
investments.
• Demonstrate knowledge of illiquidity, accounting conservatism, IRR, and the
J-Curve as they relate to the valuation of alternative investments.
• Demonstrate knowledge of the distribution of cash waterfall.

KEY CONCEPTS
Candidates will learn several ways to calculate return on an investment. Formulas define the
return involving one cash outflow (investment) and one cash inflow. The internal rate of
return (IRR) measures return on three or more cash flows and can be either dollar-weighted
(based on actual cash flows, which may include intervening additions or withdrawals of
principal) or time-weighted (based on a hypothetical $1 investment with no intervening
additions or withdrawals of principal).

The IRR is adapted for instruments that have only a notional principal. Candidates should
take care in evaluating investments that switch between cash inflows and cash outflows,
because each sign change creates an additional IRR solution.

Fees can significantly affect investment return. Hedge funds and private equity funds
usually charge a management fee (a flat percentage of the assets under management) and an
incentive fee. A hedge fund pays incentive fees on the net investment return after other fees,
usually collected monthly or quarterly. The incentive fee on a private equity fund is called
carried interest and is charged when the fund liquidates its investment.

Additional provisions can make the calculations more complicated. A hurdle rate, also
called a preferred return, sets a minimum return that the fund must achieve before incentive
fees are assessed. A catch-up rate diverts part of an investor’s returns to the manager to
replace fees not collected because of a hurdle rate. Generally, incentive fees are not collected
on returns that make back a loss. A manager may be required to return previously collected

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

fees (clawback) in the event of a loss. The interaction of all of these provisions is described
as the “waterfall.”

Learning Objective: Demonstrate knowledge of the internal rate of return (IRR)

approach to alternative investment analysis.

MAIN POINTS: Basic time value of money formulas provide a way to value a series of cash
flows. When there are both cash outflows (investing) and inflows (returns), that value is
called the net present value (NPV). The IRR is the rate that sets the value of the inflows
equal to the value of the outflows and provides a way to calculate return for a set of two or
more cash flows.

Net Present Value

The concept of net present value is important to corporate finance. The same methodology
forms the basis of performance evaluation. Start by enumerating the relevant cash flows.
One way to assemble cash flows is to gather up all cash flows, including the cash outflow
required to make the initial investment, subsequent investments (delayed investment is
common in some types of private equity funds), dividends, return of principal, and forecasts
of future cash flows indefinitely into the future. This horizon is called a lifetime horizon and
will be the basis of the lifetime IRR. The Lifetime Time Line figure stylistically shows the
cash flows to include.

Lifetime Time Line

◄---------------------------------------------- ►

A second set of cash flows is described as cash flows since inception. This set of cash flows
applies to a fund, in which case the cash flows included may predate the investor’s
investment in the fund. The Since-Inception Time Line figure illustrates the cash flows since
inception.

Since-Inception Time Line

◄---------------------- •

The figure emphasizes that cash flows from the past are included but the cash flows stop at
the present and assume a liquidation value (the larger circle) based on, among other things, a
forecast of future cash flows (illustrated as a dashed line but not included in the cash flows).

A third set of cash flows (not illustrated but similar to the preceding figure) is described as
interim cash flows and the associated interim IRR. These are similar to since-inception cash
flows, except that they apply to a particular asset, rather than to a fund or portfolio.

Finally, a point-to-point interval includes valuation at some starting date, valuation at some
ending date (usually the latest available), and intervening cash flows. This pattern is shown
in the Point-to-Point Time Line figure.

Point-to-Point Time Line

© 2020 Wiley
 QUANTITATIVE FOUNDATIONS: NPV, IRR, AND THE CASH FLOW WATERFALL

Each of these sets of cash flows is present value adjusted at some interest rate. The
following equation shows how these cash flows are adjusted for annual cash flows
discounted at annually compounded rates:

With the NPV calculation, the discounting rate, R, in the preceding equation is known and is
set commensurate with the risk present with the cash flows. The NPV versus Discount Rate
figure shows the sensitivity of the NPV calculation of a simple investment.

NPV versus Discount Rate

3.500

3.000

2.500

2.000
1.500

1,000

500

0
-500

- 1,000

The calculations rely on the NPV equation and the cash flows in the Cash Flows for Capital
Budgeting Example table. This pattern is called the “borrowing type” cash flow because the
pattern resembles a loan (all of the cash outflows precede all of the cash inflows).

Cash Flows for Capital Budgeting Example

Year Cash Flow
0 -1,000
1 -1,000
2 -1,000
3 1,000
4 1,000
5 1,000
6 1,000
7 1,000
8 1,000

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Using the TI BA II Calculator to Find NPV

1. Enter {CF} {2ND} {CE/C}—enters the cashflow worksheet and clears it.
2. Enter 1000 {+1-} {ENTER} {j} —enters cash flow for t = 0.
3. Enter 1000 {+1-} ENTER {j} {2} {ENTER} {j} — enters cash flow for t = 1,
sets frequency to 2.
4. Enter 1000 {ENTER} {j} {6} {ENTER}—enters cash flow for t = 3, sets
frequency to 6.
5. Enter {NPV} 10 {ENTER}—use 10% discount rate.
6. Enter {$} {CPT}— calculate NPV.

The calculator displays 863.85.

Internal Rate of Return

The IRR is another one of the standard tools of corporate finance. Start by accumulating all
of the cash flows that have been associated with an investment. For assets that are still
owned and viable, the potential liquidation value is included as an additional cash flow.

The yield on a bond can be described as an IRR. Likewise, the return on an investment is
analogous to a bond yield corresponding to one of the four types of cash flows discussed
earlier (lifetime IRR, since-inception IRR, interim IRR, and point-to-point IRR).

Notice that the discount rate that sets the NPV equal to zero in the NPV versus Discount
Rate figure is 17.40%. This rate is described as the IRR of the cash flows in the preceding
table. The investment of $3,000 spread over three years and returning $6,000 spread over
the remaining six years earns a 17.40% annually compounded return. Alternatively, if the
investor borrowed each of the $1,000 investments at 17.40% and repaid the loan from the
cash flows received, the loan balance and interest payments would exactly be satisfied after
the eighth year.

Using the TI BA II Calculator to Find IRR

Follow steps 1 to 3 in the previous section and then enter {CPT} {IRR}. The calculator
displays 17.40.

,44
© 2020 Wiley
 QUANTITATIVE FOUNDATIONS: NPV, IRR, AND THE CASH FLOW WATERFALL

Using the HP 12-C Calculator to Find IRR

Follow steps 1 to 4 in the previous section and then enter {f} {IRR}. The calculator
displays 17.40.

Candidates should keep in mind that an investor cannot necessarily reinvest the cash flows
at a rate equal to the IRR. Depending on reinvestment opportunities, an investor may prefer
an asset with a high return that has cash flows that occur well in the future to an asset that
should provide a similar return over a much shorter horizon.

Time-Weighted and Dollar-Weighted Returns

When the IRR technique is applied to actual cash flows, including, potentially, several
incremental investments over time or partial withdrawal, the IRR is called dollar-weighted
return. When applied to a continuing investment over an interval, the measure is called time-
weighted return. As with corporate capital budgeting, the IRR provides an important but
potentially incomplete way of comparing investments.

Suppose a parent had established 529 college savings accounts for two children. Due to
fortunate luck, the assets of the elder child were moved into money market accounts just
before the market decline of 2007-9. The younger child’s assets declined during those years
and were moved to money market accounts before valuations recovered. The timing of the
investments and withdrawals can affect the size of an investment.

Time-weighted returns measure performance without considering the timing of investments.

It would be more intuitive to say that returns over time are unweighted or equally weighted.
It is convenient to think of time-weighted returns as the performance on a $1 investment
with the return in earlier periods reinvested each subsequent period to the end. Time-
weighted returns are used to evaluate managers. Use the geometric average to calculate
time-weighted returns.

Dollar-weighted returns account for the impact to cash flows on realized return. Use the IRR
method to produce dollar-weighted returns. The dollar-weighted return could be used in the
preceding vignette to measure the impact of timing on the returns available to the two
college savings plans.

Learning Objective: Demonstrate knowledge of the problems associated with

the internal rate of return (IRR).

MAIN POINTS: IRR ignores several considerations that may be useful in comparing hedge
fund returns. In addition, derivatives and option-like payoffs create cash flows that are
difficult to evaluate.

Scale Differences
Although the IRR provides a way to measure return, the measure ignores several factors that
might be relevant in making an investment decision. Some of these differences are called
scale differences. For example, sometimes investors must decide between mutually
exclusive alternatives (this is analogous to a capital budgeting problem, where making one
investment precludes making another investment). An investor may not prefer a very small
investment with a higher IRR to a larger investment that still has a satisfactory IRR. Also, a
pattern of cash flows that returns much of the cash flow early sounds desirable, all things

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

being equal, but it also means that the investor doesn’t earn that IRR for much time, so the
financial gain may be small.

Multiple IRRs
One of the problems with using an IRR to calculate return is in defining the relevant cash
flows. Second, for some sets of cash flows, it is possible to calculate more than one IRR
consistent with that set of cash flows.

One fundamental problem with IRR is there can sometimes be more than one rate that sets
the NPV to zero. Suppose that the investment in a previous example required a $2,000
expenditure to shut down the investment in year 9. An example of a back-loaded investment
would be environmental remediation at the end of the useful life of a mine. This would be
an example of a complex cash flow pattern because the flows switch twice (from out to in
and back to out). Now the NPV of the investment appears in the NPV versus Discount
Rate—Two IRRs figure.

NPV versus Discount Rate—Two IRRs

4.000

3.000

2.000

1,000

0 —
- 1,000

- 2,000

-3,000

-4,000
-40%

The cash flows are consistent with an IRR of 10.20% but are also consistent with an IRR of
-27.80%. This ambiguous outcome occurs because there are both negative flows
(investment) and positive cash flows (return on investment). The cash flows shown in the
Cash Flows for Capital Budgeting Example table produce a single IRR, but an investment
that includes these cash flows plus a $2,000 outflow in year 9 is consistent with two possible
returns. In general, there is a potential solution for each sign change—for each time the cash
flows switch from negative to positive or from positive to negative. The investor might
decide to ignore the -27.80% IRR result and conclude that the investment return equals
10.20 %.

Candidates are warned that it is generally not possible to average IRRs. For example, even if
the same amount is invested in different assets, the return on the combined cash flows does
not equal the average of the returns on the separate cash flows. For example, in the
Averaging IRRs table the IRR of the sum of two sets of cash flows does not equal the
average of the two IRRs.

,46
© 2020 Wiley
 QUANTITATIVE FOUNDATIONS: NPV, IRR, AND THE CASH FLOW WATERFALL

Averaging IRRs

Averaging IRRs

T CF1 CF2 C F 1 + CF2

0 -100 -100 -200
1 30 20 50
2 30 20 50
3 30 20 50
4 30 20 50
5 0 20 20
6 0 20 20
IRR 7.71% 5.47% 6.42%
Average 6.59%

A technique called the modified IRR can create a unique return where more than one IRR is
possible. The technique also applies a consistent assumption about the reinvestment rate to
multiple projects. The technique both discounts all cash flows back to the start of the investment
and calculates the forward value of the cash flows based on an assumed reinvestment
assumption. The modified IRR is the return consistent with these two starting and ending values.

Time-Weighted Returns versus Dollar-Weighted Returns

Time-weighted returns estimate the returns to an initial dollar amount invested over a
horizon. The calculation ignores the size of the fund at each point in time and instead
measures the impact of what is often a hypothetical investment.

Dollar-weighted returns account for flows in and out of the investment. Returns when more
dollars were invested weigh more heavily than returns when the investment is small.

Learning Objective: Demonstrate knowledge of other performance measures

associated with illiquid investments.

CAIA presented several measures of performance in addition to IRR that might be helpful in
evaluating performance on illiquid investments:

Distribution to Paid-in Ratio (DPI) or realized return - sums all payments received by
investors (D) and divides by all capital investments (C) without consideration of the timing:

Residual Value to Paid-in Ratio (RVPI) or unrealized return - divides the current estimated
value of the investment by all capital investments (C) without consideration of the timing:

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Total Value to Paid-in (TVPI) ratio - value received by investors plus current estimated
value divided by all capital investments:

Public Market Equivalent (PME) method - the PME compares the return on a private
investment to a benchmark return from a public index. When a published index provides a
suitable comparison, the difference in return between the private investment and the public
index is used to evaluate the performance of the private investment.

Learning Objective: Demonstrate knowledge of illiquidity, accounting

conservatism, IRR, and the J-Curve as they relate to the valuation of alternative
investments.

Conservative accounting practices lead to early recognition of expected expenses and losses
but postponement in recognizing expected but uncertain revenues and gains. Conservative
account would not capitalize early expenses as an asset and would defer recognition of
many gains. The DPI, RVPI, and TVPI ratios can be evaluated conservatively.

Conservative account tends to lower interim IRR values early in the life of a private
investment. A plot of the interim IRR frequently turns negative then rises over time as the
impact of deferred revenues/gains and accelerated expenses/losses reverses. This pattern is
called the J-curve. The illustration presents a typical J-curve pattern.1

Learning Objective: Demonstrate knowledge of the distribution of cash

waterfall.

MAIN POINTS: Apply a management fee first. Incentive fees and carried interest are
charged on the net return after management fees. Other provisions, such as hurdle rates,
high-water marks, catch-up rates, and clawback provisions, can influence how an
incremental dollar of return is allocated.

Ratios as Performance Measures

Another performance measure, the distribution to paid-in (DPI) ratio, divides the
cumulative distribution by the cumulative paid-in capital. The formula for the DPI ratio is:

1Exhibit 3.8, Alternative Investments, Level 1, 4th edition, page 77.

© 2020 Wiley
 QUANTITATIVE FOUNDATIONS: NPV, IRR, AND THE CASH FLOW WATERFALL

An additional measure focusing on the unrealized return is called the residual value to
paid-in (RVPI) ratio, which divides the latest NAV by the cumulative capital
contributions:

NA VT
RVP I T =

The TVPI ratio or total return, divides all cash flows and current value by the cumulative
paid-in capital:

The TVPI and the RVPI ratios do not account for time so are a measure of nominal return.
The DPI ratio is seen as the most reliable index because it is not subject to optimistic biases
in appraisal. Investors and managers supplement these quantitative measures with qualitative
measures.

The Public M arket Equivalent (PME)

A public m arket equivalent (PME) establishes a required return for PE investments based
upon the cost of capital divined from a public market index. The PME tracks a “but for”
investment in public securities that corresponds with the specific capital calls and
distributions. The PME does not adjust for a liquidity premium that a private investment
would command over a public investment.

© 2020 Wiley
 St a t ist ic a l Fo unda t io ns : Ba sic St a t ist ic s Appl ie d t o Re t ur ns
NOTE FROM THE AUTHOR
The CAIA topic of statistics is divided into two lessons for candidates’ use in preparing for
the exam. This lesson focuses on some basic statistics—mean, standard deviation, skewness,
and kurtosis. A second lesson will focus on correlation, testing whether returns are normally
distributed, and time-series models used to forecast volatility.

LEARNING OBJECTIVES
CAIA commits to no specific weighting for questions related to statistics because their
disclosed weightings are listed primarily by asset class. However, statistical concepts are
linked to many of the topics. As explained more thoroughly later, the exam will not likely
ask the candidate to apply any of the statistical formulas in this lesson to actual data. For
example, a review question in the CAIA review material asks for the formula for beta but
not the results of any calculation. Candidates should also be prepared to calculate the beta
from known values of covariance, variances, and correlations rather than from any actual
underlying data.

This lesson presents specific formulas for the key statistics discussed. The formulas will be
presented in ways to aid easy recall. Many of the calculations in these formulas are
demonstrated visually. The candidate should follow the sequential examples to understand
what the formulas are actually doing.

A candidate with a strong background in statistics can skip much of this material. This
lesson is ideal for the typical candidate who has studied statistics but wants a clearer
understanding of what these formulas measure.

LESSON MAP
• Demonstrate knowledge of the characteristics of return distributions.
• Demonstrate knowledge of moments of return distributions (i.e., mean, variance,
skewness, and kurtosis).

Learning Objective: Demonstrate knowledge of the characteristics of return

distributions.

Although all of the statistical formulas can be applied to a wide range of data, candidates
should expect that most statistical questions will relate to returns. For this reason, the
variable X commonly seen in statistics textbooks will be replaced by R for returns in this
lesson, though the statistical techniques apply to all types of data. These returns are either
backward-looking returns (ex post returns) or expected returns (ex ante returns). The
statistical formulas rely on ex post returns (that is, actual data), but valuation is usually tied
to expected returns.

Returns may be nominal. For example, a stock moving from $10 to $14 could be described
as having gone up 40% nominally, as in the following equation:

, _ PEnd , _ AP
Nominal p t
i Beginning •* Beginning

The price changes occur over some interval of time, but the nominal return calculation is not
annualized.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Returns may be annualized, whereby a nominal return is converted from how much an asset
changed in value into how fast it changed in value. Often, the timing of cash flows
determines how frequently the returns are assumed to compound. Bond yields are usually
semiannual (compounding twice per year) or annual (compounding once per year).
Specifying the compounding period is important because more frequent compounding
provides more so-called interest on interest. More frequent compounding produces more
nominal growth, all other things held equal. The most frequent compounding possible
assumes that interest (or returns) can be reinvested each infinitesimally small increment in
time. Many textbooks call this continuous compounding. CAIA calls it log returns.

Note that CAIA’s statistics readings provide no explanation of how compound returns are
calculated, so it is not likely that candidates will need to calculate a compound return or
convert a return from one compounding convention to another as part of a statistical
question.

Some Advantages of Log Returns

The following formula for calculating log returns relies on the natural logarithm function to
calculate an annualized return:

where In represents this natural logarithm function and T is the interval of time in years
between when the beginning price is observed and when the ending price is observed.

Many financial models rely on log returns for several reasons. First, for many types of
assets, it is impossible to observe a negative price. Log returns will not produce a negative
asset price even from a large negative log return. For example, if a $10 stock drops by 500%
nominally, it would be -$40. The same log return would take the stock close to zero.1 For
this reason, log returns are often assumed to be normally distributed, permitting unlimited
upside potential and their downside limited to a complete loss of the entire investment.

Log returns treat the compounding frequency the same regardless of how frequently cash
flows are observed. In contrast, stocks that pay quarterly dividends, mortgages that receive
monthly cash flows, and bonds that may pay semiannual coupons present challenges in
comparing returns calculated with different compounding frequencies.

Log returns have an additional advantage for statistical analysis. Much of the CAIA
statistical reading treats returns as if they are normally distributed (that is, resembling the
familiar bell curve). The cumulative return on an asset measured by multiple nominal returns
is shown in the following equation:

Rcum is n°t normally distributed even if R u R2, ..., Ryv are normally distributed.

$10 x e~500% or about $0.07.

152
© 2020 Wiley
 STATISTICAL FOUNDATIONS: BASIC STATISTICS APPLIED TO RETURNS

Now suppose that each of the returns is a log return. See the following equation:

The cumulative return tends toward being normally distributed even if the individual returns
are not normally distributed.

Log Return versus Nominal Return

1 oo%

50%

0%

-50%

I -100%
CD
cr
g> -1 5 0 %

- 200 %

-2 5 0 %

-300%

-350%
-1 5 0 % -1 0 0 % -50% 0% 50% 100% 150%
Annual Return

The Log Return versus Nominal Return figure compares nominal return to log return. For
returns frequently observed (for example, between -25% and +25%), the returns do not
significantly differ. As rates rise, log returns eventually are notably below equivalent
nominal returns. In contrast, extreme losses as measured with log returns are equivalent to,
at the extreme, a -100% nominal return.

Learning Objective: Demonstrate knowledge of moments of return distributions

(i.e., mean, variance, skewness, and kurtosis).

Four statistical measures are useful in analyzing a pattern of returns. These moments are not
always presented in college statistical textbooks, so candidates should be certain to become
familiar with this discussion of standard statistical calculations as moments. Further, these
moments provide a set of formulas that are much easier to memorize than standard textbook
definitions of variance, skew or skewness,2 and kurtosis.3

The formulas for all statistics in the lesson will match the formulas presented by CAIA.
Candidates may notice that the formulas for skew, kurtosis, and several others are not
specified precisely, but candidates who have seen a precise definition of skew or kurtosis
will note that these formulas are much easier to memorize. It seems likely that candidates

*7Skewness is. often called skew.

3 Excess kurtosis and kurtosis have distinct meanings in this text, as described later.

153
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

will not be expected to calculate these statistics from data. They may, however, be asked to
calculate the skew from the second and third central moments.

The Mean Is the First Raw Moment

The mean or average will be described by the Greek letter mu (p). The first raw moment is
presented in the following equation:

Here, Rj represents a series of returns, p is the mean of those returns, and N is the number of
observations of Rj. The E in the formula instructs the user to take the “expected value” of the
data in the series, which requires a division by N. The candidate should note that this
formula is the familiar formula for average—add up all the observations and divide by the
number of observations. (The upper case sigma symbol, S, indicates that each Rj is summed
as i goes from 1 to N.) The mean is in the same units as the underlying data. Because the
data in the Returns figure are returns, the mean is also in percentage units.

Returns

5%

Returns

Average

- 2%
1 2 3 4 5 6 7 8 9 10 11 12
Month

The Returns figure presents 12 monthly returns along with the average of those returns.

Central Moments Are the Building Blocks

Variance, standard deviation, skew, and kurtosis can all be derived from the mean and three
central moments.

where j = 2, 3, or 4

© 2020 Wiley
 STATISTICAL FOUNDATIONS: BASIC STATISTICS APPLIED TO RETURNS

Deviations

3%
2%
1%
0% . 1
■ __________________________ ■ , _ 1 1 . 1

- 1%
- 2%
> 1
1 1
-3%
-4%
1 2 3 4 5 6 7 8 9 10 11 12

M onth

The Deviations figure presents the deviations from the mean, the individual observations
contained in the parentheses in the corresponding equation.

Variance and the Second Central Moment

The formula for variance, represented by the lower case Greek letter sigma squared (rrR ),
equals the second central moment.

Squared Deviations

0 . 100 %
C/5

Sq. Deviations

Variance

Month

The deviations seen in the Deviations figure are squared in the Squared Deviations figure.
Because all of these particular deviations are less than 1.00, the squares of the deviations are
closer to 0 than the deviations before squaring. Also, the squared deviations in the Squared
Deviations figure are positive, while some of the deviations in the Deviations figure are
positive and others are negative. Finally, notice that the deviations in the Deviations figure
that are furthest from the mean (months 1, 4, 8, 10, and 12) produce significantly higher
squared deviations relative to the others in the Squared Deviations figure. These five outliers
have a larger impact on variance than the impact they had in determining the average.

The variance that is shown on the Squared Deviations figure is the expected value of the
terms being summed. It is not quite equal to the average squared deviation. The denominator
contains N - 1 instead of N. This familiar detail makes this equation an unbiased measure of
variance.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Standard Deviation and the Second Central Moment

The square root of the variance is usually represented by the Greek lower case letter sigma
(rr). As seen in this next equation, the standard deviation can be calculated from the second
central moment or the variance.

Like the mean, the standard deviation is measured in the same units as the underlying data.
Because the data in the Asset Prices and Different Volatilities figure are returns, the standard
deviation is also in percentage units.

The standard deviation is used in many ways that are relevant to the CAIA candidate. The
standard deviation of returns is also called volatility. It is an important input for most option
pricing models. It is also an important input for risk management models. The standard
deviation is important because it controls the second central moment of the distribution of
possible future returns. That is, if one assumes a normal distribution, the standard deviation
is the most important parameter that controls whether returns are expected to be in a narrow
band around the forecasted mean or significantly different and scattered throughout a wide
band around the mean.

Asset Prices and Different Volatilities

200

80
O L O O L O O L O O L O O L O O L O O L O O L O O L O O L O O
t — t— OJC\lCOCO'\t"'^j"LOLOCDCDI N CO CO O) O) O

Day

The Asset Prices and Different Volatilities figure shows the possible path of an asset under
different volatility assumptions. The prices move up and down in lockstep, but volatility
determines the magnitude. Higher volatility is associated with a greater likelihood of
extreme outcomes.

The Probabilities on the Cumulative Density Function table shows that being within one
standard deviation of the mean (between the mean less one standard deviation and the mean
plus one standard deviation) can be expected about 68% of the time. If the range is
expanded to plus or minus two standard deviations, the chance of being in that range grows
to a bit more than 95%. If the return is actually normally distributed, there is very little
chance that an observed return will be outside a three standard deviation range (plus and
minus).

,56
© 2020 Wiley
 STATISTICAL FOUNDATIONS: BASIC STATISTICS APPLIED TO RETURNS

The one-tail probabilities in the Probabilities on the Cumulative Density Function table show
that the probability of being one standard deviation below the mean equals about 16%. The
probability of being more than two standard deviations below the mean is about 2%%. The
probability of being more than three standard deviations below the mean is nearly 0%.
Because the normal distribution is symmetric, the same probabilities of being outside the
range on the downside equal the probabilities of being outside the range on the upside.

Candidates are advised to be able to recall the approximate contents of the Probabilities on
the Cumulative Density Function table. It is not necessary to memorize both the inside
probabilities and the one-tail probabilities. Rather, note that, for example, the inside
probability of a one standard deviation move (68.27%) plus the probability of being below
that range (15.87%) plus the probability of being above that range (15.87%) sum to 100%.

Probabilities on the Cumulative Density Function

No. of Standard Deviations Inside Probaility One-Tail Probability

1.00 68.27% 15.87%
1.96 95.00% 2.50%
2.00 95.45% 2.428%
3.00 99.73% 0.13%

Confidence Bands
Confidence bands provide an opportunity to present an example using the standard
deviation. If the returns in the future are uncertain but consistent with the past mean and
standard deviation, then a confidence band provides a range that should contain that future
return with an assumed chance that, if fact, the return will fall outside the band. The
definition of the confidence band is shown in

Lower Level < /u > Upper Level

where:

Lower Level = pi — a x Number of Standard Deviations

Upper Level = /i + a x Number of Standard Deviations

Suppose the return on a hedge fund has averaged 10% annually over a period in the past and
the annual returns had a standard deviation of return of 3% per year. A future year’s return
should fall within the 4% to 16% range 95.45% of the time. The Confidence Bands table
lists the probabilities of several confidence bands.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Confidence Bands

Probability Lower End Upper End

68.27% 7% 13%
95.45% 4% 16%
99.73% 1% 19%

The upper and lower band values in the Confidence Bands table are also used with the one-
tail probabilities shown in the Probabilities on the Cumulative Density Function table. For
example, there is a 15.87% probability that the return will be below 7% (and hence an
84.13% probability that the return will be above 7%). There is also a 15.87% probability
that the return will exceed 13% (and an 84.13% probability that the return will be above
7%).

Skewness
This next equation shows the formula for the skewness as presented by CAIA.

3rd Central Moment E(Rj —juR)3

Skewness/? = -------------~----------- = -------- r------
° R O r

Recall that the expected value of the mean summed the data and divided by the number of
observations, N. The expected value of the second central moment or variance summed the
squared deviations and divided by N - 1. The precise formula for the expected value of the
numerator in this equation is a bit more complicated and is not provided by CAIA. For this
reason, CAIA appears to not expect candidates to calculate either the third central moment
or the skew from individual data points. Candidates might be given the third central moment
(the numerator) and either the second central moment (variance) or the standard deviation.

Cubed Deviations

0 .002 %
0 .001 %
(/)
B05 o.ooo% _

-o -0.001%
CD
-O
O
- 0 . 002 %

-0.003%
1 2 3 4 5 6 7 8 9 10 11 12
M onth

Candidates should understand the skew statistic because the exam will test the candidate’s
understanding of the meaning of the statistic. The Cubed Deviations figure shows the cubed
deviations from the data shown in the Returns figure. The transformation weights the larger
deviations more than the smaller deviations in the calculation, both relative to an equal
weighting used to calculate the mean and relative to the change in weighting used to
calculate variance. The individual cubed deviations can be positive or negative. Therefore,
the numerator can be either positive or negative because the sum can be either positive or

158
© 2020 Wiley
 STATISTICAL FOUNDATIONS: BASIC STATISTICS APPLIED TO RETURNS

negative. Of course, the denominator must be positive because all squared deviations are
positive. Therefore, the skewness statistic can be either positive or negative.

The skewness statistic does not carry the unit of the underlying data. Notice that the
numerator and the denominator are both measured in the same cubed units (e.g., return ). So
it doesn’t matter if the data are returns, gallons, volts, or pounds. Even if the data are returns
presented as percentages, the skew will be a positive or negative decimal number.

The normal distribution has a skew equal to 0. The familiar bell curve or standard normal
(mean of 0 and standard deviation of 1) distribution shown in the Normal versus Right-
Skewed Distribution figure is symmetric around the mean. A series of data with a skew
close to 0 is also described as unskewed.

Data with a positive skew is described as skewed right. The Normal versus Right-Skewed
Distribution figure includes a plot of distribution with a mean of zero, standard deviation of
1, and skew of 4.00. Notice that, relative to the unskewed distribution, there is a higher
probability of observing outliers on the right and a smaller probability of observing outliers
on the left than the standard normal distribution.

Normal versus Right-Skewed Distribution

45%

40%

35%

30%

25%
Normal
20 % ---- - Skew = 4

15%
10%
5%

0%
1

The Normal versus Left-Skewed Distribution figure shows a distribution that is skewed left.
Note that, compared to the standard normal distribution, the left-skewed distribution has a
higher probability of extreme outcomes on the left and a lower probability of extreme
outcomes on the right.

159
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Normal versus Left-Skewed Distribution

Normal

------Skew = -4

Kurtosis and Excess Kurtosis

The normal distribution attaches a higher probability of observing data near the center of the
distribution than to observations far from the mean. Observations farther from the mean
become more and more unlikely to be observed. Kurtosis measures whether a set of data has
a greater tendency to cluster observations near the mean compared to the normal
distribution.

4th Central Moment E[(Rj —juR)4]

Kurtosis =
oR oR

Like the formula for skew in the earlier equation, the formula for kurtosis places greater
weight on the observations farther from the mean because all of the deviations are raised to
the fourth power before summing. See the Deviations Raised to the Fourth Power figure.

Deviations Raised to the Fourth Power

0 .00010 %
0.00008%

0.00006%

0.00004%

0 .00002 %
0 .00000 %

Month

The kurtosis of a normal distribution is 3. Excess kurtosis equals the kurtosis minus 3, so the
center point becomes zero; a larger excess kurtosis is greater than zero, while a smaller
excess kurtosis is less than zero. The Definitions of Excess Kurtosis Conditions table defines
the three possible conditions.

© 2020 Wiley
 STATISTICAL FOUNDATIONS: BASIC STATISTICS APPLIED TO RETURNS

Definitions of Excess Kurtosis Conditions

Excess Statistical
Kurtosis Kurtosis Description Description
Less than 3 Less than 0 Platykurtic Flat bell curve with thin tails
Equal to 3 Equal to 0 Mesokurtic Normal
Greater than 3 Greater than 0 Leptokurtic Thin (narrow) bell curve with fat tails

The statistical descriptions are not commonly used but are fair game for testing. The
meaning of each word is clear if one knows the Greek origin of each prefix. For example,
“platy” means flat,4 and the candidate might recall the notable flatness of the bill and tail of
the platypus. The Greek terms describe the shape of the bell curve rather than the tails. A flat
bell curve implies more (wider) area in the middle of the bell and thin tails. The prefix
“meso” means middle,5 appropriately applied to a measure of kurtosis that is neither flatter
nor heavier than the tails of a normal distribution. Finally, “lepto” comes from the Greek
leptos,6 meaning fine or thin. A leptokurtotic distribution is thin (narrow) in the middle, but
since the area under the curve still adds up to a 100% probability, the tails are pushed up.
When we are discussing return distributions, we are most interested in the size of the tails,
particularly avoiding a fat left tail. The candidate also can recall that the words would be
alphabetized as leptokurtic, mesokurtic, and then platykurtic, and the numerical values
would run from positive to zero to negative.

The Normal and Kurtotic Distributions figure shows a normal distribution and a distribution
with excess kurtosis equal to 5. Investors frequently observe that many assets have returns
that have a fat tail distribution.

Normal and Kurtotic Distributions

45%

40%

35%

> , 3 0 %

I 25%

o 20% Normal
CL
15% Fat Tails

10%
5%

0%
- 5 - 3 - 1 1 3 5
Number of Standard Deviations

Autocorrelation
Autocorrelation is calculated using the standard correlation presented above. The first
variable is a series of returns on a particular asset. The second variable is the same series,
lagged one or more periods. For example, with daily data, lag the second input one day or
one week for weekly data. Autocorrelation measures the extent that positive returns in one

4 http://www.thefreedictionary.com/platy-, accessed October 17, 2016.

5 http://encyclopedia.thefreedictionary.com/Meso, accessed October 17, 2016.
6 http://www.thefreedictionary.com/lepto-, accessed October 17, 2016.

© 2020 Wiley
,6,
INTRODUCTION TO ALTERNATIVE INVESTMENTS

period are more likely to lead to positive returns in the next period (for positive
autocorrelation) or more likely to lead to a reversal the next period (negative
autocorrelation).

If the data is lagged one period, the result is called first order autocorrelation. If the data is
lagged two periods, the result is called second order autocorrelation. Realize that if data
points lagged one period are positively autocorrelated, then, all else being equal, this
dependency shows up in the second order autocorrelation because the positive (negative)
return from one period affects the chance for a positive (negative) return in the second
period, which affects the chance of a positive (negative) return in the third period. The
impact on more deferred returns usually diminishes rapidly.

The partial autocorrelation coefficient isolates the second order correlation from the impact
of earlier returns. The formula for the partial autocorrelation is:

Partial Autocorrelation Coefficient = (p2 —P i) /{1 —Pi)

162 © 2020 Wiley

 S t a t i s t i c a l F o u n d a t i o n s : D e pe n d e n c y , N o r m a l i t y , a n d
V o l a t il it y Fo r e c a s t in g

NOTE FROM THE AUTHOR

The CAIA topic of statistics is divided into two lessons for candidates’ use in preparing for
the exam. This lesson focuses on correlation, testing whether returns are normally
distributed, and time-series models used to forecast volatility. A previous lesson focused on
some basic statistics—mean, standard deviation, skewness, and kurtosis.

LEARNING OBJECTIVES
CAIA commits to no specific weighting for questions related to statistics because their
disclosed weightings are listed primarily by asset class. However, statistical concepts are
linked to many of the topics. As explained more thoroughly later, the exam will not likely
ask the candidate to apply any of the statistical formulas in this section to actual data. For
example, a review question in the CAIA review material asks for the formula for beta but
not the results of any calculation. Candidates should also be prepared to calculate the beta
from known values of covariances, variances, and correlations rather than from any actual
underlying data.

This lesson presents specific formulas for the key statistics discussed. The formulas will be
presented in ways to aid easy recall. Many of the calculations in these formulas are
demonstrated visually. The candidate should follow the sequential examples to understand
what the formulas are actually doing.

A candidate with a strong background in statistics can skip much of this material. This
lesson is ideal for the typical candidate who has studied statistics but wants a clearer
understanding of what these formulas measure.

LESSON MAP
• Demonstrate knowledge of various measures of correlation of returns.
• Demonstrate knowledge of standard deviation (volatility) and variance.
• Demonstrate knowledge of methods used to test for normality of distributions.
• Demonstrate knowledge of time-series return volatility models.

Learning Objective: Dem onstrate knowledge o f various m easures of

correlation o f returns.

The following formulas for covariance look very similar, except the first requires two inputs,
R 1 and R2 (or X and F)- In fact, if one used the Excel function for covariance CO VAR but
provided it the same data for R 1 and R2, the function would return the same value as the
variance function VAR.1 That is, the covariance of a variable with itself is its variance.

1To match exactly, use the Excel function VAR.P and COVAR because Excel uses N rather than N - 1 in the denominator.

,63
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

The Greek letter sigma (rr) is usually used to represent the covariance (the same letter is also
used for variance and the standard deviation). Notice that the sigma in the first equation
contains two subscripts, while the second and third equations for variance and standard
deviation, respectively, include only one subscript. Candidates who observe a letter sigma
with no subscript can probably assume that the letter refers to variance or the standard
deviation unless the context suggests otherwise.

Consider returns on two assets, R 1 and R2. The data making up R\ has appeared as R in the
previous figures. The R 1 Deviations versus R2 Deviations figure presents the deviations for
the means for each return series. The equation sums the products of the pairs of returns in
the R 1 Deviations versus R2 Deviations figure. Note that the values plotted in the upper
right quadrant are positive, so their products are positive. Likewise, the values in the lower
left quadrant are both negative, so their products are positive. There are few observed data
points where one return is negative and one is positive, so the sum of the products in the first
equation is positive (.001949). The products of pairs where one is near zero contribute very
little to the sum. The sum weights more heavily the products of pairs with two high positive
deviations or a pair of significantly negative deviations. Other data sets may observe data
that lines up to some degree from upper left to lower right. This covariance will sum many
products that include one negative and one positive value, so the sum may be negative. A
positive covariance indicates that the two values tend to move in the same direction
generally, while a negative covariance indicates a tendency to move in opposite
directions.

R1 Deviations versus R2 Deviations

3%

2%

1%
S' 0%
I
-1 %

- 2%

-3%

-4%
-4% -3% -2% -1% 0% 1% 2% 3% 4% 5%

It is difficult to understand the importance of a particular covariance result. If both data

points being compared are returns, the unit of a covariance calculation is arguably return
squared, a concept that isn’t clear. If the return on an airline stock is compared to the price of

© 2020 Wiley
 STATISTICAL FOUNDATIONS: DEPENDENCY, NORMALITY, AND VOLATILITY FORECASTING

crude oil, then the covariance is made up of returns multiplied by oil prices. This is not
meaningless but it is hard to understand. The next equation scales the covariance by the
standard deviation of both of the data inputs, to create a standardized measure. This measure
is called the Pearson correlation coefficient, a statistic that is frequently called just the
correlation coefficient.

<*Rl,R2 E [ ( R h - ^ i ) ( « 2 , -ngj)]
P r 1,R2 —
& R l X &R2 & R \ X &R2

The Pearson correlation coefficient is usually represent by the Greek letter rho {p) and
generally has two subscripts documenting the two data series compared. The statistic ranges
from +1.00 (the two data series move exactly in lockstep both in direction and in relative
magnitude) to -1.00 (the two data series move perfectly together but in opposite directions).
A Pearson correlation coefficient of 0.00 reports that there is no tendency to move together
or in opposite directions.

This equation can be rearranged to emphasize the nature of the scaling built into the
correlation calculation. Each of the deviations is standardized (mean equals 0 and standard
deviation equals 1). The two standardized deviations are multiplied together and the
products “averaged.”2

This equation can be rewritten as the equation that follows, which the candidate would use
to calculate a covariance from a correlation. Note that the standard rules of algebra apply to
the formulas, so the candidate can memorize the formula that seems easier to recall.

0 R \ja = P r \, r i x c r \ x °R 2

Spearman Rank Correlation

The Spearman rank correlation seeks to find a relationship when data series contain outliers,
extreme observations that may show very little association with the Pearson correlation
coefficient but may still have an association. The calculation involves several steps:

• Separately rank the different data series from lowest to highest, labeling each 1 ,2 ,..., N.
• Calculate the difference between the ranks for each pair of data.
• Apply the equation that follows:

The correlation coefficient is usually described as the “expected value” of the products, not the “average,” because the formula
divides by N - 1 instead of N.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Correlation and Diversification

The CAIA exam will test candidates on the value of the risk reduction that comes from
combining two assets that are not perfectly correlated. An example of two highly correlated
assets would be two broad stock index exchange-traded funds (ETFs). In many cases,
combining the two ETFs into a portfolio would provide very little diversification beyond
what had already been built into both portfolios.

However, combining traditional assets with an alternative asset that is not highly correlated
can create a combined portfolio with either less risk or higher return, or both. The frontier
provided in the review materials and reproduced in the Diversification between Two Assets
figure shows the benefit of diversification with relatively uncorrelated assets.

Diversification between Two Assets

This figure can be created using a formula in the following equation:

which is a simplified form of a more general formula that will be introduced later. This
equation is presented so that candidates can understand what is behind the figure and the
questions that follow from it. The equation provides the standard deviation of returns on a
portfolio, calculated from the standard deviation of each asset, the covariance between those
assets, and the weight of each asset in the portfolio.

For assets A and B that are highly correlated, the portfolio standard deviation is not
significantly reduced by combining them. The three terms in the equation are not less than
the components. But if the correlation between A and B is low, then the covariance in the
middle term is near zero and combining the assets produces more risk reduction.

The important points to take away are:

• Diversification can lead to significant risk reduction if the correlation between the
assets is small. Combining two assets that are more correlated offers less risk
reduction.
• Alternative assets may be the best place to look for assets that are not highly
correlated with traditional investment assets.
• Alternative assets combined with traditional assets can possibly raise the combined
return on the portfolio and lower the risk as measured by the standard deviation of
return.

© 2020 Wiley
 STATISTICAL FOUNDATIONS: DEPENDENCY, NORMALITY, AND VOLATILITY FORECASTING

• The greatest risk reduction occurs when a portfolio is an intermediate blend of two
types of assets compared to a heavy weighting of either one of the two assets.

Beta
Beta measures the risk contributed to a well-diversified portfolio that cannot be diversified
away. The following equation is the definition of beta.

Covariance^Marto>/?,- g r ^arket, R,
V a ria n c e ^ , "

If the asset in question is a well-diversified ETF or mutual fund, it may be highly correlated
with the overall market. In this case, the covariance of that asset could closely approximate
the variance of the market. The formula in this equation would have a result of 1.00. Assets
that are about as risky as the overall market have a beta of 1.00.

Assets can have lower betas either because they are less volatile than the market or because
the returns on that asset are not highly correlated with the market. Mixing that asset with the
market portfolio lowers the risk of the combination below the risk of the market.

Assets can have betas higher than 1.00 because their returns are more volatile than the
market returns. Adding these kinds of stocks to a market portfolio raises the risk of the
blended portfolio.

Autocorrelation
Autocorrelation is a measure of returns on an asset over time. Positive autocorrelation occurs
when there is a tendency to experience positive returns following a positive return and a
tendency to experience negative returns following a negative return. Autocorrelation is also
frequently called serial correlation.

CAIA presents a formula for autocorrelation that is reproduced as the following equation.

^ t ^ E[(Rj —fi)(Rr-t ~
Autocorrelation = -----------------------

This equation is a straightforward application of the following equation, applied to a

particular set of data:

That data set includes the series of returns plus a second set of returns created by lagging the
first series and matching up returns separated by a fixed interval of time.

If no autocorrelation is present, the equation will return a result close to zero. If the
autocorrelation is positive, then later returns will reinforce earlier positive or negative
returns. If the autocorrelation is negative, then later returns will tend to retrace prior gains or
losses. Positive autocorrelation might show up if prices don’t fully reflect market forces
immediately, which is found, for example, with some private equity returns, where changes
in market conditions may not be immediately incorporated into fund valuations.

,67
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

The formula for autocorrelation reflects a gap of time between data pairs. First-order
autocorrelation compares data lagged one observation interval, A t = 1. Suppose, for
example, that the candidate is given monthly returns for some alternative investment. A
first-order autocorrelation calculation begins by lining up the return for the second month
with the first monthly return. Continuing, the return for the third month is paired with
the second point. This continues until the return for last month is paired with the second-
to-last month. If the returns are available daily, the returns are paired with returns one day
earlier.
A second-order autocorrelation pairs data with returns two periods prior, A t = 2. The
third monthly return is paired with the return for the first month. The fourth month is
paired with the second month. This continues until the return for the last month is
paired with the return two months prior. For daily returns, the pairings are separated by two
days.

Autocorrelation can be measured over longer intervals—third-order autocorrelation

(three periods), fourth-order autocorrelation (four periods), or longer. Autocorrelation
can be used in trading models—both trend-following trading models and range-trading
models.

DURBIN-WATSON STATISTIC
The Durbin-Watson statistic (DW) was created to test the errors in fitting linear regression
lines to data. For this reason, the formula presented by CAIA used the variable e to represent
the data being analyzed. The purpose was to test whether the regression errors were
autocorrelated. The formula is reproduced as this equation:

Applied to returns, DW accumulates the period-to-period changes in return squared and

divides by the sum of returns squared. Calculating the DW statistic is time-consuming and
subject to human error. Candidates who have memorized the formula could calculate DW
on a handheld calculator.

It is much more likely that candidates will be asked questions about DW results provided as
part of the question. Bear in mind a couple of facts about DW. A DW equal to 2 exhibits no
evidence of autocorrelation. DW below 2 begins to provide evidence of positive
autocorrelation. DW above 2 beings to show evidence of negative autocorrelation. The
Meaning of Durbin-Watson Results table summarizes the range of possible DW values.

Meaning of Durbin-Watson Results

DW Result Interpretation
Above 0 but below 2 Indication of positive autocorrelation
2 No autocorrelation detected
Above 2 Indication of negative autocorrelation

168
© 2020 Wiley
 STATISTICAL FOUNDATIONS: DEPENDENCY, NORMALITY, AND VOLATILITY FORECASTING

Many factors (for example, the sample size, the confidence level assumed, the lag amount, and
the DW value) go into determining whether it is possible to statistically prove the presence or
absence of autocorrelation. Usually, critical values are listed in tables. If a DW result is below
the lower critical value, the data are deemed to be autocorrelated. If the DW is above the lower
critical value but below the upper critical value, then the data are likely to be autocorrelated. If
the DW is above the upper critical value, it is deemed to not be autocorrelated.

Learning Objective: Demonstrate knowledge of standard deviation (volatility)

and variance.

Square Root Rule for Standard Deviation

The standard deviation of returns is greater over a longer horizon than a shorter
horizon because more time allows more things to occur that can influence the return.
Market practitioners frequently rely on time to scale up or down predicted standard
deviations.

An example will illustrate the point. If the expected standard deviation of returns on a
portfolio is 15% for a year, then the expected standard deviation over three months is 7.5%
[15% x SQRT(.25)].

Autocorrelation has an impact on the risk expected with an investment over a longer
horizon. If autocorrelation is positive, the standard deviation of returns will be larger
than the estimate produced using the provided equation. If autocorrelation is negative,
the standard deviation of returns will be less than the estimate produced using this
equation.

Portfolio Variance
As mentioned in the previous CAIA figure illustrating the benefits of diversification derives
from some mathematics that can build up the variance of a portfolio from some statistics
about components of the portfolio and information about the weights. CAIA presents the
following formula, reproduced as the equation below:

N N
_2
° Portfolio w‘wJau
i'=i j= i

This formula is not nearly as complicated as it looks. Consider a specific example. A

portfolio consists of 4 assets, with the following weights.

Composition of Sample Portfolio

Asset Weight Stand. Dev.

Stock 1 10% 10%
Stock2 20% 14%
Stock3 30% 16%
Stock4 40% 18%

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

For this example, assume the following correlations exist between the individual stocks.

Corelation Matrix

Stock1 1.000 0.600 0.400 0.200

Stock2 0.600 1.000 0.350 .250
Stock3 0.400 0.350 1.000 0.450
Stock4 0.200 0.250 0.450 1.000

The Covariance Matrix table calculates the covariance of each stock pair, using the
following equation:

For example, the covariance between Stock 1 and Stock2 equals the product of the
correlation (.600), the standard deviation of Stock 1 (12%) and the standard deviation of
Stock2 (14%) or 1.01%.

Covariance Matrix

Stock1 1.44% 0.01% 0.77% 0.43%

Stock2 0.01% 1.96% 0.78% 0.63%
Stock3 0.77% 0.78% 2.56% 1.30%
Stock4 0.43% 0.63% 1.30% 3.24%

Next, calculate the weight to apply to each of these covariance amounts in the Risk Weights
table.

Risk Weights

10% 1.00% 2.00% 3.00% 4.00%

20% 2.00% 4.00% 6.00% 8.00%
30% 3.00% 6.00% 9.00% 12.00%
40% 4.00% 8.00% 12.00% 16.00%

These 16 entries represent each combination of the weights wj, w2, w3, w4 multiplied by the
same four weights. Multiply the 16 covariances in the Covariance Matrix table times the 16
weights in the Risk Weights table and add them up. The result is a variance of 1.468% or a
standard deviation of 12.12%. The four stock portfolio has about the same level of risk as
the least risky stock in the portfolio, even though 90% of the portfolio is made up of riskier
stocks when viewed individually.

,70
© 2020 Wiley
 STATISTICAL FOUNDATIONS: DEPENDENCY, NORMALITY, AND VOLATILITY FORECASTING

Learning Objective: Dem onstrate knowledge o f m ethods used to test for

norm ality o f distributions.

Jarque-Bera Test for Normality

The Jarque-Bera (JB) test is a fairly intuitive test for whether a series of data closely
resembles the normal distribution. The test begins with the knowledge that the normal
distribution has a skew equal to 0 and kurtosis equal to 3 (excess kurtosis equal to 0).
Samples of normal data will not exactly match these values unless the data includes a very
large sample size. Instead, sampling error can produce measures of skew and kurtosis that
differ from the expected skew and kurtosis because of sampling noise.

The following equation provides the formula for the JB test.

The statistic is easy to calculate if the skew and the kurtosis or excess kurtosis are provided.
The formula is not very intuitive, and the candidate is invited to develop some mnemonic
hint to recall the formula. Once the result has been calculated or if the JB statistic is
provided to the candidate, the question remains when to reject the assumption that data are
normally distributed.

Based on the expectation of skew and excess kurtosis both equal to zero, the JB should
return a value of 0 for the normal distribution and higher (always positive) values otherwise.
The test result follows the chi-square distribution with two degrees of freedom. CAIA
provides a simple way to perform the JB test. Refer to the Critical Levels for the Jarque-
Bera Test table, which lists the critical values for the JB test.

Critical Levels for the Jarque-Bera Test

Confidence Level 0.900 0.950 0.975 0.990 0.999

Critical JB 4.61 5.99 7.38 9.21 13.82

Source: Alternative Investments, CAIA Level I, 3rd ed., p. 97. Reproduced with
permission from Wiley.

Test results that exceed the critical level on the Risk Weights table fail the test for normality.

Learning Objective: Dem onstrate knowledge o f tim e-series return volatility

models.

GARCH Models
Generalized autoregressive conditional heteroskedasticity (GARCH) models are used to
analyze the volatility of returns over time. It may be helpful to note that GARCH models
replace exponential smoothing, where recent past data are blended to make short-term
forecasts.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

These four words describe the problem and the technique:

Heteroskedasticity refers to changing levels of variance within a series of data. This

inconsistency is a problem for linear regression, where candidates have probably heard of
the term because the data during the periods with higher variance are weighted more heavily
than data during periods when the variance is lower. Here, the concern is in predicting the
variance of returns in the near future when it is generally understood that volatility is not
constant.

Autoregressive refers to the type of model used for these forecasts. Students of the efficient
market might be surprised that there is some persistence in levels of volatility. But, at least
after the fact, we know that there are periods of uncertainty that last for a while. There may
be economic or political news that continues to move markets days at a time. Perhaps high
levels of volatility lead to thinness in trading that permits more volatility to persist. These
models seek to predict the extent that volatile markets will remain volatile (referred to as
volatility clustering) or revert to a base level of price discovery.

Conditional reflects the differences in the way volatility plays out across different assets.
Unconditional variance is the variance measured by the standard formula for variance based
on the second central moment, a single measure over the entire range of data. The GARCH
prediction reflects the impact of returns as they are observed. Further, volatility seems to
persist in some types of assets but not others, so these models predict different patterns for
different assets.

Generalized describes the type of predictive model where the analyst relies on past levels of
variance, whereas ARCH models (not generalized) rely on the series of past returns but not
levels of variances.

Candidates will not be expected to perform a GARCH calculation. They should be able to
describe what GARCH models are used for (nearby forecasts of variance) and what data
they use (past returns and variances of returns). They should be able to make investment
decisions based on some information about GARCH forecasts that have been given to the
candidate.

172
© 2020 Wiley
 F o u n d a t io n s o f F in a n c ia l E c o n o m ic s : T im e V a l u e o f M o n ey

This topic introduces several concepts that are referred to or covered in more detail in
subsequent lessons. For that reason, in most cases, it is only important to become familiar
with the terminology and understand the intuition behind the various concepts. In other
cases, as noted, there are some computational exercises that candidates should be able
to complete. Foundations of financial economics is one of the longest chapters in the
curriculum, and therefore is broken into two parts. This first part is focused on time value
of money.

LESSON MAP
• Demonstrate knowledge of the concept of informational market efficiency.
• Demonstrate knowledge of the time value of money, prices, and rates.
• Demonstrate knowledge of the three primary theories of the term structure of interest
rates.
• Demonstrate knowledge of forward interest rates.
• Demonstrate knowledge of arbitrage-free financial models.

KEY CONCEPTS
In efficient markets, it is not possible to earn abnormal returns or risk-free (arbitrage)
returns. Some markets are more efficient than others. Ex ante asset pricing models assume
that markets are efficient.

Arbitrage-free models are relative pricing models. A common method of solving for the
value of an asset with arbitrage-free models is to set equivalent but different strategies equal
to each other and solve for the price. An example is to solve for a forward rate by setting the
spot rate of a bond with a maturity that ends when a shorter-maturity forward contract ends
equal to the results of a strategy that invests in a shorter-term spot rate that ends when the
forward contract begins and then rolls proceeds into the forward contract. Another type of
arbitrage-free model is the binomial tree models.

Learning Objective: Dem onstrate knowledge o f the concept o f inform ational

m arket efficiency.1*

MAIN POINT: There are three levels of informational market efficiency corresponding to
increasingly more restrictive information sets. Some asset markets are more efficient than
others.

Informational m arket efficiency refers to the extent to which asset prices reflect available
information.

We will be more precise about the preceding definition and first note that other common
definitions of “efficiency” include four closely related concepts (1 and 2 are more like
implications of informational market efficiency, not definitions):

1. Net present value = 0.

2. In efficient markets, superior returns are not possible.
3. Prices follow a random walk. (But informationally inefficient asset prices can also
follow a random walk and vice versa.)
4. The efficient frontier or efficient portfolios refer to the best risk-return trade-off, so
an “informationally efficient” market is a distinctly different concept.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

There are three levels of informational market efficiency, from weak form to strong form,
corresponding to progressively wider information sets.

• Weak form informational market efficiency (or weak level) refers to market prices
reflecting available data on past prices and volumes. Weak form efficiency addresses
the issue of whether technical analysis can be useful in earning consistent and
superior risk-adjusted returns.
• The concept of semistrong form informational market efficiency (or semistrong
level) refers to market prices reflecting all publicly available information (including
not only past prices and volumes but also any publicly available information such as
financial statements and other underlying economic data).
• Finally, the concept of strong form informational market efficiency (or strong
level) refers to market prices reflecting all publicly and privately available
information. Strong form efficiency is designed to address the issue of whether any
attempts to earn consistent and superior risk-adjusted returns can be successful,
including insider trading.

Markets are more efficient if the value of the asset is relatively high, trading is frequent, and
there is free access to information. Markets are less efficient when there are trading frictions,
regulatory constraints, and uncertainty about valuation.

Six factors driving market efficiency are:

1. Value of assets being traded (+): When the value of assets being traded is higher,
they are often more efficient (hence the + sign) because higher profit potential
requires that more participants analyze more information to arrive at a more accurate
value.
2. Trading frequency (+): This positive relationship with efficiency is driven by greater
competition. Low trading frequency results in higher bid-ask spreads.
3. Trading frictions (-): Lower levels of trading frictions result in higher efficiency.
4. Regulatory constraints (-).
5. Access to information (+): Alternative investments often have less transparency
than traditional markets and are therefore less efficient.
6. Uncertainty about valuation (-): Alternative investments are often harder to value
(there is more uncertainty) than traditional markets and consequently less efficient.

Learning Objective: Dem onstrate knowledge of the time value o f m oney, prices,
and rates.

MAIN POINT: A zero-coupon bond has just one cash flow sometime in the future: its face
value. Assume a face value of $1,000. If you have to wait 10 years to receive the cash flow,
would you loan the entire face value today? Probably not—you would discount the single
cash flow by some interest rate, and the size of the discount factor would be higher for
longer loan maturities (i.e., the longer it takes to receive the cash flow, the greater the
discount.) For one year, the increase is the length of time it takes to receive the cash flow.

Assume an annual interest rate of 10%. What is the price of a zero-coupon bond (B)
maturing in one year? Two years? t years?

B = $1,000/(1 + 10%) = $909.09; note that 1/(1 + 10%) is the discount factor.

© 2020 Wiley
 FOUNDATIONS OF FINANCIAL ECONOMICS: TIME VALUE OF MONEY

The price would lower if one had to wait two years for the cash flow. In that case, we can
calculate the price the same as above but use the $909.09 in the numerator of the equation:

• B = $909.09/(1 + 10%) = $826.44

• Equivalently, B = $1,000/[(1 + .10)(1 + .10)] = $826.44
• Therefore if the maturity = t years, the formula is B = $1,000/(1 +.10)f
• Or more generally B = FV/(1 + r)t

Let m = the frequency of compounding. We are assuming annual compounding above (m = 1).
Let’s next assume semiannual compounding (m = 2), and find the price of a zero-coupon bond
with a maturity of one year.

Lirst, find its value six months from today:

B6_months = $1,000/(1 + .10/2) = $952.38

Notice that the annual interest rate is cut in half. Discounting that the same way, we can find
the price today:

• Btoday = $952.38/(1 + .10/2) = $907.03

• Equivalently, B = $1,000/[(1 + .10/2)0 + .10/2)] = $907.02.
• Therefore if the maturity = m, the formula is B = $1,000/(1 +.10/2)ra
• Or more generally B = LV/(1 + rhn)m

Now we put the two results together for the price of a zero-coupon bond with maturity, t,
and compounding, m:

B = EV/(1 + rlm jm equivalently, B = LV(1 + r/m)~tm

Divide by LV on both sides and take the exponent M—tm on both sides, (B/FV)1/_mi = (1 + rim).
Next, subtract 1 on both sides and then multiply by m on both sides: r = [(B/FV)17-"” - 1]m.

Let’s check the formula with LV = $100, t = 3, m = 2, and r = 8%.

B = $100/(1 + .04)6 = $79.03

r = [(79.03/100) 1/-6 - 1]2 = 0.08, as expected.

Candidates should be able to find bond prices and derive interest rates from zero-coupon
bond prices assuming different compounding frequencies: annual to continuous.

Lor continuous compounding (m is infinity), the formulas change as follows:

B = LVe~rt and r = -(l/f)ln(B/FV)

Check that, assuming continuous compounding, t = 4, and r = 9%, B = $69.77 and use the
formula to get back to 9%.

Determination of the Short-Term Interest Rate

Inflation is a measure of the rate of change in the value of a currency. Positive inflation
means the value is declining.

Lisher Effect: Nominal interest rate = real interest rate + expected inflation

,75
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Modified Fisher effect accounts for taxes:

r = (real rate + expected inflation)/(l - tax rate)

The term structure o f interest rates plots the spot rate on the y-axis and the time to maturity
on the x-axis. In a normal economy, it is usually upward-sloping, with longer maturities
corresponding to higher interest rates.

For zero-coupon bonds, yield to maturity = spot rate (i.e., the r that we calculated earlier).

The yield to maturity is the rate that discounts all cash flows such that the sum of the
discounted cash flows is the same as the market price of the bond. For coupon bonds, the
formula for the price of a bond P, with annual coupons C, and yield y is

Solving for y helps to estimate the term structure of interest rates for cases when there is no
zero-coupon bond available. There is no formula for y in this case (it is solved by iteration)
and it assumes the same rate for each time period. With only one cash flow, zero-coupon
bonds provide a more pure estimate that doesn’t average rates across time periods.

Bootstrapping the term structure with coupon bonds is possible. It is a recursive process. As
a simple example, suppose you know the following:

• The 6-month spot rate, which is the same as the zero-coupon yield
• The price of a one-year coupon bond with semiannual coupons (and the coupon rate)

Then you can determine the one-year spot rate.

It is a recursive process because you want to fill out the term structure. Next you use the
one-year spot rate you just calculated with information on an 18-month coupon bond to get
the 18-month spot rate.

Bootstrapping the term structure utilizes short term spot rates with medium and long term
coupon bonds. The mathematics is similar to computing forward interest rates (covered
elsewhere in the curriculum).

Learning Objective: Dem onstrate knowledge of the three prim ary theories o f the
term structure o f interest rates.

MAIN POINT: There are three primary theories of the term structure: the unbiased
expectations theory, the liquidity preference or liquidity premium theory, and the market
segmentation theory.

Recall that the term structure o f interest rates plots the spot rate on the y-axis and the time to
maturity on the jc-axis. In a normal economy, it is usually upward-sloping, with longer
maturities corresponding to higher interest rates. But its shape is sometimes downward-
sloping, and this could indicate an impending depression because the market thinks that
interest rates are going to be lower in the future. The term structure theories try to explain
the shape of the term structure.

,76
© 2020 Wiley
 FOUNDATIONS OF FINANCIAL ECONOMICS: TIME VALUE OF MONEY

The unbiased expectations theory is that interest rates of different maturities are driven
purely by market expectations rather than partly by risk aversion. It does not explain why
the term structure is upward-sloping more often than not. It suggests that decisions should
be focused on convenience such as matching cash flows since on average the expected
return to lenders is the same as the cost for borrowers across maturities.

The liquidity preference theory (also called the liquidity premium theory) maintains that
bonds with longer maturities are less liquid than shorter-term bonds so that their return
should include a liquidity premium over shorter-term bonds that have riskiness that is
otherwise the same. This does explain an upward-sloping curve. The implications are that
investors (lenders) will seek longer-term securities for higher returns to the extent that they
are comfortable with and borrowers will prefer shorter-term loans, all else equal.

The market segmentation theory (also called the preferred habitat theory) maintains that
interest rates with different longevities are different due to differences in supply and demand
for different maturities.

Learning Objective: Dem onstrate knowledge o f forward interest rates.•*

Forward Contracts and Hedging

• A forward contract is simply an agreement calling for deferred delivery of an asset
or payoff.

The contract requires some details: minimally, the asset to be delivered, in which quantity, at
what price, and at what time it will be delivered.

In arbitrage-free modeling, we seek to find two identical assets or strategies and set them
equal to each other to solve for a price. A hedged trade would involve being long one
strategy and short the other strategy. All risk is hedged, and the expected return is zero.

Consider the following two equivalent strategies:

1. Buy a 12-month Treasury bill.

2. Invest in a nine-month T-bill and roll the proceeds into a three-month T-bill using a
forward contract.

Notation:

The /i-month maturity riskless (spot) security trades for Pn, and the -month forward
22

deliverable in N months trades for Fn,N.

Let W = gross return or wealth ratio [e.g., if r = 10%, W = 1 + 10%, so if P0 = $100, P{ =

P0(W) = $110].

Example
• Nine-month riskless (spot) security trades at P9 = $97,000.
• Three-month forward contract with a delivery of nine months is F39 — $99,000.

Question: What is the arbitrage-free 12-month riskless spot price?

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Example of No Arbitrage Pricing with Forward Contracts

P12= ? W9 = 100,000/97,000
W 3t9 = 100,000/99,000
F 3 9 = 99,000
P 9 = 97,000
r~ \[

= 0
t = 3 mos. t =6 mos. t =9 mos. t = 12 mos.

The wealth ratio of buying and holding the nine-month T-bill to maturity is $100,000/P12.
The wealth ratio of the second strategy is the product of (1) the wealth ratio of buying and
holding the nine-month T-bill to maturity, and (2) the wealth ratio of reinvesting in the
three-month T-bill using the forward contract. Setting the wealth ratios of the two strategies
equal generates:

Notice that we could also solve for the forward price if we knew the 12-month spot price:

$100,000/96,030 = ($ 100,000/ $97,000) ($100,000/$F)

Using our notation, we could also write it this way:

Using any of the rates, we can find the price. For example, to find $F, we simply discount
the face value by W3 9 = 1%: $100,000/(1.01) = $99,000. (We are slightly off due to
rounding; the actual three-month rate is 0.010101.)

Notice that if we assume continuous compounding (ert), the rates (r) are additive:

.04 = .03 + .01

rn = r9 + r 3 ,9

Before looking at a general equation, consider an example that is more than one year.
Previously, our subscripts represented months. Now they will represent years. We still
assume continuous compounding so that the rates are additive.•

• r3 = 3.4% This is the annual spot rate of a three-year riskless security.

• ^ = 2.4% This is the annual rate on a two-year riskless security that settled in three
2 ,3

years.

What is r5, the annual spot rate for a five-year riskless security?

We earn 3.4% for three years and 2.4% for two years, so that we have 3(3.4%) + 2(2.4%) =
15%. On an annual basis, this is r5 = 15%/5 years = 3%.

,78
© 2020 Wiley
 FOUNDATIONS OF FINANCIAL ECONOMICS: TIME VALUE OF MONEY

We can write this as r{T+t) = [(T x rT) + (r x rt)]/(T + t).

In our previous example, T = 3, t = 2.

Replace r with R so that we have the same formula format as presented by CAIA for the
forward rate, FT_t.

Now rearrange, and here is the general formula.1

F (j-t) = [(T x Rt ) - ( l x Ft )]/(T - t)

Let’s return to another example of the first problem where we were looking for the price of
the forward contract.

Example 2

The price of a two-year Treasury with a $100,000 face value is $95,000.

The price of a one-year Treasury with a $100,000 face value is $98,000.

What is the forward price for a one-year Treasury to be delivered in one year, F 1?1?

Solution

100,000/95,000 = (100,000/98,000)(100,000/F1,1)

F\ i = $100,000(95,000/98,000) = $96,938.77

1How might we apply this formula to our earlier case when we had rates that were not annualized? Recall that we found r 12 = r9 + r2 9,
where the subscripts were for months and, specifically, .04 = .03 + .01. The rates would need to be annualized. In our earlier
example, all the rates were in fact 4% on an annual basis. A 3% return over nine months is equivalent to a 4% annual return, and 1%
over one quarter is equivalent to 4% annually. Then in the formula, T = 3/4 = .75 and t — 1/4 = .25. Working with annual rates, .04 =
,75(.04) + ,25(.04).

179
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Learning Objective: Dem onstrate knowledge of arbitrage-free financial models.

MAIN POINTS: Arbitrage-free models are one type of model that can be used to find the
value of an asset. A common method of solving for the value of an asset with arbitrage-free
models is to set equivalent strategies equal to each other and solve for the price. An example
is to solve for a forward rate by setting the spot rate of a bond with a maturity that ends
when the forward contract ends equal to the results of a strategy that invests in a shorter-
term spot rate that ends when the forward contract begins and then rolls proceeds into the
forward contract. The cost of carry model illustrates that a forward contract is the same as
the underlying asset plus the cost of maintaining the position through time (e.g., the carrying
costs). Another type of arbitrage-free model is the binomial tree models.

• Arbitrage is the attempt to earn riskless profits (in excess of the risk-free rate) by
identifying and trading relatively mispriced assets.

Underlying Concept of Arbitrage-Free Models

• An arbitrage-free model is a financial model with relationships derived by the
assumption that arbitrage opportunities do not exist, or at least do not persist.

Simple Arbitrage-Free Pricing Model

Given:

• 1 Euro = 1 . 1 Canadian dollars [i.e., the rate is (1.1 CAD)/EUR]

• 1 Canadian dollar =1. 1 U.S. dollars [i.e., the rate is (1.1 USD)/CAD]
• Question: What is the price of a euro in terms of U.S. dollars?

Solution

In the absence of transaction costs, one can take one euro and buy 1.1 Canadian dollars
and convert that to 1.21 U.S. dollars.

We can always multiply two rates so that the rate we are seeking (USD/EUR in this case) is
found by canceling out one currency (CAD is in both the denominator and the numerator, so
it cancels out):

[(1.1 USD)/CAD] [(1.1 CAD)/EUR] = 1.21 USD/EUR

If it were the case that the USD/EUR rate were something else, there would be arbitrage
opportunities.

Note
“Pure arbitrage” assumes no risk, whereas “arbitrage” is often loosely used to describe
strategies that attempt to take little risk by trading what are believed to be mispriced
assets.

Applications of Arbitrage-Free Models

• A relative pricing model prescribes the relationship between two prices.
 FOUNDATIONS OF FINANCIAL ECONOMICS: TIME VALUE OF MONEY

• An absolute pricing model attempts to describe a price level based on its underlying
economic factors.

Arbitrage-free models are relative pricing models. These tend to be more precise than
absolute pricing models. They are commonly used for analyzing cash and carry trades,
interest rates, foreign exchange rates, and derivatives.

Arbitrage-Free Pricing in Spot M arkets

• The spot m arket or cash m arket is any market in which transactions involve
immediate payment and delivery: The buyer immediately pays the price, and the
seller immediately delivers the product.

The simple arbitrage-free pricing model for exchange rates we just covered occurred in the
spot market. Next, we discuss trades that are “carried” through time.

C arry Trades with and without Hedging

• C arry trades can be either hedged or not hedged, and generally involve a set of long
and short positions intended to generate perceived benefits through time as the
positions are carried.

A carry trade that is not hedged is one that is still exposed to risk. An example is being long
a default-free bond in one country and short a default-free bond in another country. While
there may be an interest rate spread to be gained, there is still currency risk exposure.

A term structure of implied forward rates can be computer with the method shown in this
section. Interest rate analysis will commonly plot a term structure of implied forward rates
superimposed over a term structure of interest rates.

Cost of C arry Models

Forward contracts are financed positions.

• Financed positions enable economic ownership of an asset without the posting of

the purchase price.
• A cost-of-carry model specifies a relationship between two positions that must exist
if the only difference between the positions involves the expense of maintaining the
positions.
• The carrying cost is the cost of maintaining a position through time and includes
direct costs, such as storage or custody costs, as well as opportunity costs, such as
forgone cash flows.

One does not need to put up cash to purchase the forward contract as when one purchases a
stock. Therefore, higher interest rates will increase the value of forward contracts.

A security in the cash market and a forward contract on the same security are identical
positions except for the cost of carry and the interest rate.

© 2020 Wiley
 Fo unda t io ns o f Fina nc ia l Ec o no mic s : Mo de l s
LESSON MAP
• Demonstrate knowledge of binomial tree models.
• Demonstrate knowledge of single-factor default-free bond models.
• Demonstrate knowledge of single-factor equity pricing models.

KEY CONCEPTS
A binomial tree model projects possible outcomes in a variable by modeling uncertainty as
two movements: an upward movement and a downward movement. In this lesson we use a
binomial model to value a stock. The type of reasoning behind the model is applied several
places throughout the curriculum.

Duration is a single-factor default-free bond model of interest rate risk. More specifically,
duration is a linear approximation of a nonlinear curve that assumes the term structure shifts
in an additive (i.e., parallel manner.) Some properties about duration are: duration is the
weighted average of the longevities of the cash flows; the duration of a zero-coupon bond is
equal to its maturity; and the duration of a portfolio of bonds is the weighted average of the
durations of the individual bonds where the weights are determined by the market value of
the bonds.

A single-factor asset pricing model specifies the return of an asset based on a single risk.
The capital asset pricing model (CAPM) is a special case that specifies the single risk as a
“market portfolio” that is a hypothetical portfolio containing all tradable assets and is an
equilibrium model. In an ex ante model, expected excess return is defined as a function of its
systematic risk. In an ex post CAPM model, realized return is defined as a function of both
its systematic risk and its idiosyncratic risk. That is, idiosyncratic risk is assumed not to be
zero in the ex ante model.

Learning Objective: Demonstrate knowledge of binomial tree models.

MAIN POINT: A binomial tree model is very useful type of arbitrage-free model.

Consider an option on a stock that has a strike price of $12. Since an option provides the
right, but not the obligation, to buy the stock for $ 12 at some point in the future (at or before
maturity of the option contract1), the payoff to the option holder at expiration is positive
only if the price of the stock exceeds $12; otherwise, it is zero. Suppose the stock price is
$16 at expiration. The option would be exercised because the stock could be bought for $12
and sold for $16, providing a $4 payoff. The option payoff is 1/4 of the stock price at
expiration. If we make a few other simplifying assumptions, we can calculate the price of
the call option.

1European options are exercised at expiration whereas American options can be exercised any time up until expiration. Yet it’s
generally not optimal to exercise early.

183
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

We use the binomial tree to illustrate the main assumptions as described above, adding that
the stock price could also go to zero, and then the call option payoff is also zero. The option
payoff is still 1/4 of the stock price at expiration in this scenario: 1/4 of 0 is 0.

We assume there are no dividends. We do not need to know the probabilities of the up and
down movements in our trees to figure out the call price. Since in both instances (up and
down stock price movements) the call payoff or payout is 1/4 of the stock price, the call
price today must be 1/4 of the current stock price: (l/4)$8 = $2. The idea is that four call
options are economically equivalent to one stock.

Example

Current stock price = $20, but can go up to either $60 or fall to $0 in one year.

An option on the stock has a strike price of $25.

What is the value of the option?

Solution

The payout on the option is $60 - $25 = $35 in the up-movement scenario. This is
58.333% of the up-movement stock price. The 58.333% ratio also holds in the down-
movement scenario since the price and payout are zero (i.e., 58.33%(0) = 0. Therefore,
the current option price must be 58.33% of the current stock price, or .58333($20) =
$11.67.

This example did not depend on interest rates or probabilities. Such models are called
risk-neutral models. They appear several places in the curriculum. The main advantage
of the binomial model is its flexibility.

Learning Objective: Demonstrate knowledge of single-factor default-free

bond models.

MAIN POINTS: The most popular measure of risk for bonds is duration, which measures
the bond's price sensitivity to changes in a single factor: interest rates. There are various
definitions or interpretations of duration: (1) as a bond's elasticity, (2) as the weighted
average of the longevities of the cash flows, and (3) as the longevity of a zero-coupon bond
of equivalent risk. Candidates should be able to calculate the duration of a fixed coupon
bond, and of a portfolio of bonds. Candidates should then be able to use duration to

© 2020 Wiley
 FOUNDATIONS OF FINANCIAL ECONOMICS: MODELS

immunize a portfolio containing a long-only portfolio of bonds as well as a long-short

portfolio of bonds. Other important concepts are the duration for floating-rate bonds and the
concept of convexity.

We will deal with convexity right up front by discussing a bond's elasticity. Convexity can
be measured and used in conjunction with duration for more accuracy. Another lesson deals
with the computation of and further discussion of convexity. Here, it is illustrated in the
figure “Prices of equal-coupon bonds with different maturities at different interest rates.”
A careful inspection of this figure illustrates duration, its limitation, and how convexity can
improve accuracy when measuring interest rate risk. Note that:

• The lines are all downward-sloping: as interest rates rise, bond prices drop.
• Duration can be thought of as the negative of the slope of these lines (elasticity).
• Some lines are very curved so that the slope changes as interest rates change.

Prices of equal-coupon bonds with different

maturities at different interest rates
(face value = $100)
120.00

100.00

80.00

60.00

40.00

20.00

0.00
0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0.11 0.12 0.13 0.14 0.15 0.16

----- 1 ----- 5 ----- 10 ----- 20 ----- 30

For instance, let's examine the top line corresponding to a maturity of one year. At 1%
interest, the price is $99.01. At 2% interest, the price is $98.04. The change in price with
respect to the change in the interest rate is -$97. Recall that the slope of a line is the rise
over the run. We have a negative rise of .97 ($) and positive run of 1 (%) or a slope of
-0.97, which corresponds to a duration of about 1. The purpose of this exercise is to give
you intuition for duration as an imprecise measure of how much price drops for a “ 1%”
increase in interest rates. This intuition corresponds to the somewhat more precise definition
of duration as the elasticity of a bond price with respect to a shift in its yield (or a uniform
shift in the spot rates corresponding to each prospective cash flow.) You won't need to
calculate this, but this elasticity is expressed as:

185
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

While the top line in the figure above (with a maturity of one year and duration of about one
year) looks like a straight line, it isn't: the slope and duration changes as interest rates
change.

Look at the line for bond with 30 years to maturity. Clearly the line is curved, and the slope
is not constant across interest rates. The curvature is called convexity. Measuring convexity
along with duration improves the accuracy of interest rate risk estimates. Therefore, duration
by itself is still very important, but it is also why, in its discussions of duration, the CAIA
curriculum emphasizes that it is assumed that the single risk being measured is “of an
instantaneous, parallel (or additive), and infinitesimal shift in the term structure of interest
rates”— not a 1% change as given in the example above that was only to provide intuition.
The slope to the left of a point on a curved, downward-sloping line is different than the
slope to the right of that same point. Therefore, duration is only relevant for very small
(“infinitesimal”) changes in interest rates.

Next, let's examine the other interpretation/definition of duration as the weighted average of
the longevities of the cash flows:

^ -\T tC{t)
L , = 1(1+>,y
Po

Let's start with applying this to a zero-coupon bond. C(t) in the equation above refers to cash
flows, which include coupons and the final cash flow consisting of the face value and any
coupons. Zero-coupon bonds have only one final cash flow equal to the face value. When
discounted by the yield, that is equivalent to the price (P0). Therefore, the numerator is equal
to the denominator when maturity T equals 1, so for a zero-coupon bond everything but T
cancels out. For zero-coupon bonds, t is always equal to zero until maturity when t — T.

• The duration of a zero-coupon bond is always equal to its maturity.

Let's consider a coupon bond that provides cash flows prior to maturity. These cash flows
are discounted and weighted as a percentage of the bond price as shown in the equation
above. Consider a 10% coupon bond with a maturity of two years paying annual coupons
with a face value of $100 and a yield of 10%. (This makes the math easy: if the coupon and
yield are equal, then the price in the denominator will always equal the face value.)

rC(r)
^ = ' ( i + yy ( 1* 10) / ( 1. 10)‘ (2 * 110) / ( 1. 10)2
= 1.0901 < 2
Pn ioo + Too

• A coupon bond has a lower duration than a zero-coupon bond of the same maturity.

Similarly, all else equal, the higher the coupon, the lower the duration. Another way to
understand this is that a coupon bond is equivalent to a portfolio of zero-coupon bonds.
Next, we compute the duration of a portfolio of two bonds.

• The duration of a portfolio of bonds is the weighted average of the durations of the
individual bonds where the weights are determined by the market value of the bonds.

© 2020 Wiley
 FOUNDATIONS OF FINANCIAL ECONOMICS: MODELS

One bond has a duration of 4 and a market value of $600,000. The other has a duration of 8
and a market value of $400,000. The duration of the portfolio is 4(.6) + 8(.4) = 5.6. We can
use this information to immunize a portfolio against interest rate risk. For example, suppose
that a pension fund holding this same portfolio of two bonds and has a large liability of
$1,000,000 due in six years. Then the pension fund will be immunized by matching the
duration of its assets to the duration of its liabilities. The weight in the bond with a duration
of 8 needs to increase. The basic formula is

• Target duration = w(Duration 1) + (1 - w)(Duration 2)

6 = w(4) + (1 - w)(8)
w = .5
Check:
.5(4) + .5(8) = 6

Notice that after a year, the target duration will decrease to 5 and the durations of the two
bonds also decrease such that the portfolio does not need to be rebalanced: .5(3) + .5(7) =
1.5 + 3.5 = 5. (Changes in the interest rate environment could impact the durations so that
this would not be a strict equality.)

The example above is immunizing a portfolio of assets and liabilities by managing the
duration of a long-only bond portfolio. The same concept can be applied to immunize a
long-short bond portfolio. For example, a $1,000,000 portfolio of long bonds with a
duration of 5 can be immunized by shorting a $1,000,000 portfolio with a duration of 5.
In this case the target duration is zero:

• 0 = (Value long portfolio)(duration_long) + (Value short portfolio that is negative)

(duration_short)

The portfolio could also be immunized by shorting fewer bonds (less than $ 1,000,000) if the
bonds have a higher duration.

There is an important difference between the two approaches of the long-only bond portfolio
immunizing a portfolio containing liabilities and the long-short bond portfolio. That
difference is in how they behave over time, in the absence of intervening cash flows. The
long-only bond portfolio's duration shortens over time roughly at the same rate the duration
of the liabilities shortens over time. That may not be true of the long-short portfolio.
Consider a 2-1 hedge in which a $1,000,000 long portfolio with a duration of 8 is hedged
with a $500,000 short portfolio with a duration of 4. After a year the long portfolio will have
a duration closer to 7 and the short portfolio will have duration closer to 3 so that the long-
short portfolio would need to be rebalanced.

A floating-rate bond has no interest rate risk except when their coupons adjust slowly or
partially to interest rate changes. A floating-rate bond that adjusts with a delay to t years has
the same interest rate sensitivity as a zero-coupon bond with t years to maturity.

• Duration of a floating-rate bond = the time to the next reset

Interpreting duration as the longevity of a zero-coupon bond of equivalent risk can simplify
bond risk manager's job. Duration only measures interest rate risk, not default risk. If the
default risk of two bonds—zero-coupon and coupon—is roughly similar and they have the
same duration, then they can be considered roughly equally risky.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

In this section we examined duration as a linear approximation of a nonlinear curve that

assumes the term structure shifts in an additive (i.e., parallel) manner. The term structure
does not always change in a parallel manner, so in addition to adjusting duration for
convexity, risk managers use other measures to account for nonparallel term structure shifts.
Adjustments are also required for securities with different features such as those with
embedded options.

Remember that in this discussion of duration, the CAIA curriculum emphasizes that it is
assumed that the single risk being measured is “of an instantaneous, parallel (or additive),
and infinitesimal shift in the term structure of interest rates.” This is repeated here because it
is strongly emphasized in the curriculum.

Learning Objective: Demonstrate knowledge of single-factor equity pricing

models.

MAIN POINTS: A popular single-factor model is the capital asset pricing model (CAPM).
It is a single-factor, single-period equilibrium model that relies on several assumptions. For
example, it assumes that investors can hold a market-weighted portfolio of all assets. The ex
ante CAPM shows that an asset's return is driven by one systematic risk factor: the market
portfolio. Empirical, ex post models allow for both systematic risks and idiosyncratic risks
unrelated to the market portfolio. Bearing idiosyncratic risk may lead to abnormal returns.
The CAPM may be useful for traditional assets but is less appropriate for alternative
investments. One reason is that it is difficult for investors to hold a market-weighted
portfolio of alternative investments, because many are privately held. Alternative
investments may be better described by a multifactor model. Multifactor models are covered
in the Level II curriculum.

An asset pricing model is a framework for specifying the return or price of an asset based
on its risk, as well as future cash flows and payoffs.

SINGLE-FACTOR ASSET PRICING

The capital asset pricing model (CAPM) provides one of the easiest and most widely
understood examples of single-factor asset pricing by demonstrating that the risk of the
overall market index is the only risk that offers a risk premium.

CAPM: E (ft) = f t + f t [E(ft„) - Rf ]

Where E(R{) is the expected return on asset i, /?, is the market beta of asset i, E(R,„) is the
expected return on the market portfolio, and Rf is the riskless rate of return.

The market portfolio is a hypothetical portfolio containing all tradable assets in the world.

A single-factor asset pricing model explains returns and systematic risk using a single risk
factor.

The following equation represents a REIT-based single-factor asset pricing model that
differs in important ways from the CAPM:

188
© 2020 Wiley
 FOUNDATIONS OF FINANCIAL ECONOMICS: MODELS

Where E(/?/) is the expected return on REIT/, at is a constant, /?, is the beta of REIT/, and
E(Rindex) is the expected return on an index of REITs.

The single index model above differs from the CAPM primarily because it uses an index of
REITs rather than the “market portfolio” as the systematic risk factor. The CAPM is a
special case of a single index model: all investors are perfectly diversified among all assets
such that it is an equilibrium model.

EX ANTE AND EX POST ASSET PRICING

The CAPM is an ex ante equilibrium model. Ex ante means before. That is why the returns
in the equations were expected returns, written as E(R). In the CAPM world, there are many
assumptions. There is no alpha because the returns of all assets are driven by one systematic
(market) risk. Risk-averse investors invest mostly in the risk-free asset and those with more
tolerance invest in the same diversified market portfolio, but nobody tries to beat the market.
For there to be a need for the analysis of alternative investments, the CAPM must be an
insufficient model. While it is very useful, it relies on too many assumptions, such as no
transactions costs. In reality, we relax many of the assumptions are relaxed. For example,
the ex ante single index model allows for an alpha. The following discussion treats the
portion of realized return that is not due to systematic risk as idiosyncratic risk rather than as
alpha: it is an ex post version of the CAPM. In a different lesson the curriculum discusses
the difficulty of separating skill (alpha) from luck.

Ex post means after—when the return is actually realized. It is no longer expected. The
realized return of an asset differs from its expected return due to systematic and
idiosyncratic effects.

Idiosyncratic return is the portion of an asset's return that is unique to an investment and
not driven by a common association.

Idiosyncratic risk is the dispersion in economic outcomes caused by investment-specific

effects.

The first term on the right side of the ex post version of the CAPM below, fti(Rmt — Rf),
represents the systematic risk of the realized return of asset i in time period t, and the second
term on the right, eit, represents the idiosyncratic risk.

189
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Rit _ Rf is the excess return of asset i at time t and refers to the excess or deficiency of the
asset's return relative to the periodic risk-free rate.

The ex ante form of the CAPM can be found by taking the expected value of each side of
the ex post CAPM equation and rearranging the terms. In part, this is because the expected
value (average) of the idiosyncratic term is zero.

The total variance of an asset's returns can be divided into systematic and idiosyncratic
portions using the following formula.

Total = Systematic + Idiosyncratic

Risk Risk Risk

190 © 2020 Wiley

 D e r i v a t i v e s a n d R i s k -N e u t r a l V a l u a t i o n :
Fo r w a r d s a n d Fu t u r e s

LESSON MAP
• Demonstrate knowledge of forward contracts.
• Demonstrate knowledge of forward contracts on rates.
• Demonstrate knowledge of forward contracts on equities.
• Demonstrate knowledge of forward contracts on assets with benefits and
cost of carry.
• Demonstrate knowledge of forward contracts versus futures contracts.
• Demonstrate knowledge of managing long-term futures exposures.

KEY CONCEPTS
Several concepts on derivatives and risk-neutral valuation are covered in this lesson. In most
cases, it is only important to become familiar with the terminology and understand the
intuition behind the various concepts. In other cases, there are some computational exercises
that you should be able to complete. This coverage may be useful as a reference when
applications to alternative investments in upcoming lessons rely on the concepts discussed
here. For example, many alternative investment strategies are referred to as having payoffs
similar to short puts. Familiarity with the payoff exposure of writing a put helps to
understand why such strategies generate negatively skewed distributions.

A forward contract is an agreement for deferred or future delivery of an asset. The cost of
carry model illustrates that a price of a forward contract on a financial asset is the same as
the underlying asset plus the cost of maintaining the position through time (e.g., the carrying
costs). Carrying costs include the cost of financing the deferred asset (generally the risk-free
rate, r) and distributions (i.e., dividends, d, that are paid during the deferral period). The
term structure of forward rates is upward sloping when r > d, flat when r = d, and
downward sloping otherwise.

Many alternative investment strategies use options or can be analyzed using options because
they have option-like (nonlinear) payoffs. Here, we review several exposure diagrams of
calls, puts, the underlying asset, and various combinations of these three elements. A call
option provides the right to purchase (and a put option provides the right to sell) an asset at a
specific price at or up to some point in the future.

Put-call parity is an arbitrage free model that states that the value of a call minus a put plus
the present value of a bond with a face value equal to the strike price of the options in the
formula is equal to the value of the underlying asset.

Finally, we briefly review several option pricing models and the topic of option sensitivities, or
“Greeks,” that show how an option value changes if the underlying asset price changes (delta),
or if other variables that impact prices change. These may be viewed as price elasticities.

Learning Objective: Demonstrate knowledge of forward contracts.

FORWARD CONTRACTS
MAIN POINT: A forward contract is an agreement for deferred or future delivery of an
asset. The two determinants of forward prices on a risky financial security are the cost of
financing the deferred asset (generally the risk-free rate, r) and distributions (i.e., dividends,
d, that are paid during the deferral period). The future price path of the underlying asset has
no impact on the forward price: The current price is adjusted for these two determinants r

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

and d based on time until expiration, T. The pricing of forward contracts on commodities
may vary from the pricing of forward contracts on financial securities because they are also
dependent on some additional factors like the cost of storage.

A forward contract is simply an agreement calling for deferred delivery of an asset or a

payoff at a prespecified time, a prespecified date (i.e., the settlement or delivery date), and at
a fixed price or rate for an economically equivalent cash settlement. In the case of settlement
by delivery, the party holding the short side of the contract promises to deliver a specified
asset to the party holding the long side of the contract, in exchange for the prespecified price
(i.e., the forward contract price).

Alternatively, the two parties may agree to cash settle the contract by exchanging the
difference between the forward price and the market price at the settlement date in the case
of a forward contract on a price.

The long side of the contract is the party that is obligated to buy the specified asset at the
specified and fixed price (the forward price) on the delivery or settlement date. The short
side of the contract is obligated to deliver the asset in exchange for receiving the forward
price set in the contract.

Forward contracts are usually created with no immediate cash exchange between the two
sides (although parties may negotiate posting of collateral). In these cases, the forward
contract price is established so that the value of the contact is zero.

The No-Arbitrage Approach to Determining Forward Prices

Investors holding a forward contract do not pay for the underlying asset until delivery and
do not receive cash distributions from holding the asset. Therefore, the forward price is
dependent on the current underlying asset price, and just (1) the riskless rate (or relevant
financing rate) and (2) the rate of distributions (e.g., dividend yield), adjusted for the time
until the contract expires.

Since investors don’t have to pay for the stock until later, the forward price should be higher
than the current price by the amount of interest charged, and because they miss the
distributions that would be received if they otherwise held the underlying asset, the forward
price should be lower than the current price by the amount of the expected distributions.

Example

Consider the following information: The current stock price is $100, the dividend to be
received just before the year ends is $2, and cost to finance the purchase of the stock is
$5. If the forward price is equal to $104, how could an arbitrageur profit?

Solution

If there were no arbitrage opportunities, the price of the forward contract would be equal
to $103 (i.e., $100 (current stock price) + $5 (interest) - $2 (dividend).

Since the forward price ($104) is too high relative to the no-arbitrage condition ($103),
the arbitrageur would short the forward contract and buy the underlying stock today.
There is no risk because the arbitrageur borrows $100 today, collects the $2 dividend,
and then pays back $105 and sells back the forward contract for $104, making a riskless
$1 profit.

192
© 2020 Wiley
 DERIVATIVES AND RISK-NEUTRAL VALUATION: FORWARDS AND FUTURES

If the forward price is too low relative to the no-arbitrage condition, the arbitrageur
would buy the forward contract and short sell the stock, collect $5 interest on proceeds
from short selling, and then cover the short position for less than the $103. Again, the
total profit is the difference between the current forward price and $103.

Adapted from CAIA Level I, 4th ed., 2020. Application 6.5.1 A. Copyright © 2009,
2012, 2015 by The CAIA Association.

Learning Objective: Demonstrate knowledge of forward contracts on rates.

FORWARD CONTRACTS ON RATES

Determining the Forward Contract Price of a Zero-Coupon Default-Free Bond

MAIN POINT: The forward price of a default-free zero-coupon bond is a function of the
spot prices of two (default-free) zero-coupon bonds corresponding to the inception and
termination of the forward contract.

If two identical strategies can be identified with identical payoffs and returns they must have
identical market prices; otherwise, there would be an arbitrage opportunity in which the
arbitrageur could profit from shorting the relatively overpriced asset and buying the
relatively underpriced asset.

Equation 6.1 indicates that, in an efficient market, a relatively long-term zero-coupon bond
will offer the same total return as a strategy consisting of (1) investing in a shorter zero-
coupon bond, and (2) using a forward contact to lock in the return from the maturity of the
shorter bond to the maturity of the longer bond. There will be no arbitrage opportunities
because both strategies offer riskless returns from time 0 to T (their prices must be such in a
perfectly competitive market that the total returns will be equal).

Example

Nine-month riskless securities trade for $97,000, and 12-month riskless securities sell for
P (both with $100,000 face values and zero coupons). A forward contract on a three-
month, riskless, zero-coupon bond, with a $100,000 face value and a delivery of nine
months, specifies a forward price of $99,000. What is the arbitrage-free price of the
12-month zero-coupon security (i.e., P)1

Solution

The 12-month bond offers a ratio of terminal wealth to investment of ($100,000/P).

The nine-month bond reinvested for three months using the forward contract offers a
12-month wealth ratio of: ($100,000/$97,000)($100,000/$99,000) = 1.0413. Setting the
two wealth ratios equal and solving for P generates P = $96,030 [i.e., (1/1.0413) x
$100,000]. The 12-month bond must sell for $96,030 to prevent arbitrage.

Adapted from CAIA Level I, 4th ed., 2020. Application 6.5.3A. Copyright © 2009,
2012, 2015 by The CAIA Association.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Forward Prices, Expected Spot Prices, and Risk Neutrality

In a risk-neutral world investors do not require risk premiums for bearing risks. In such a
world, the forward price will be the same as the expected spot price, because any other
relation would allow trading at abnormal expected returns. In a risk-neutral world there is no
concern regarding risk.

Forward Prices, Expected Bond Prices, and Term Structure Theories

In an unbiased expectations world, forward bond prices are unbiased estimates of
subsequent spot or cash market prices.

In a liquidity premium world, investors are offered higher expected returns to compensate
for bearing the risks of rising interest rates. Therefore, forward bond prices will understate
expected spot prices in order to provide an expected risk premium to the long side for
bearing the risk of rising rates.

The m arket segmentation or preferred habitat theory assumes that forward prices and
rates cannot be perfectly arbitraged because there are limits to the ability of arbitrageurs to
form hedges across different sections of the term structure.

Forward Rate Agreements

MAIN POINT: Forward contracts on interest rates and foreign exchange rates enable risk
management of funding costs and currency conversions by operating firms and others. They
are also essential to many alternative investment strategies that use the contracts to create
desired risk exposures.

A reference rate is a market rate specified in contracts that fluctuates with market
conditions.

A forward rate agreement (FRA) is a cash-settled contract in which one party agrees to
offer a specified or fixed rate (known as the FRA rate) on a certain principal amount and
over a stated time in the future (or a currency exchange rate at a certain time in the future)
while the other party agrees to provide that rate.

In a perfect market, the FRA rate will be equal to:

•••

Example

A three-year riskless security trades at a yield of 4.3%, whereas a forward contract on a

two-year riskless security that settles in three years trades at a forward rate of 3.1%.
Assuming that the rates are continuously compounded, what is the no-arbitrage yield of a
four-year riskless security?

Solution

FT-t = [(T x rT) - (t x rt)\l{T - t) (6.2)

3.1% = [(5 x rT) - (3 x 4.3%)]/(5 - 3)

Solving for rT = 3.82%

,94
© 2020 Wiley
 DERIVATIVES AND RISK-NEUTRAL VALUATION: FORWARDS AND FUTURES

Adapted from CAIA Level I, 4th ed., 2020. Application 6.2.2A. Copyright © 2009,
2012, 2015 by The CAIA Association.

Forward Rates and Their Extensions

A swap can be regarded as a string of forward contracts grouped together that vary by time to
settlement. For example, instead of bearing the risk of fluctuating oil prices, an oil refinery
may decide to lock in the purchase price of the oil it needs by entering various forward
contracts to purchase the oil at known prices (i.e., the refinery is swapping cash for oil).

However, instead of entering a series of separate forward contracts, the oil refinery may
decide to enter into a single swap that calls for regular (quarterly or monthly) exchanges
through time at prices set at the initiation of the swap. Swaps are discussed in greater detail
in Chapter 24.

Learning Objective: Demonstrate knowledge of forward contracts on equities.

FORWARD CONTRACTS ON EQUITIES

Financed positions enable economic ownership of an asset without the posting of the
purchase price. Long positions in forward contracts are usually described as financed
positions.

The formula for the forward value for a financial asset with no dividends (or other
distributions) is:

• • • (6.4)

The relation between the forward price and the spot price depicted in Equation 6.4 is
justified by the potential for arbitrage if the relation did not hold.

The forward price is established at time 0 and in the case of Equation 6.4 is the risk-neutral
future value of P, because it is compounded forward at a riskless rate (r) as if market
participants were risk-neutral.

Example

Consider a stock that does not pay dividends and is currently trading at $12 per share.
Calculate the price of a six-month forward contract on the stock if the risk-free rate is 6%
per year (continuously compounded return) and the yield curve is flat.

Solution

Using Equation 6.4: FT = 12 e006x0'5 = $12.37

A six-month forward contract on the stock must trade at $12.37. At settlement, a long
position in the forward contract requires the holder to pay $12.37 in exchange for
delivery of the stock. The $12 investment will allow the purchase of the stock at the end
of the semester without additional cash if the holder of the forward contract places the
stock's initial value ($12) in an account offering 6% continuously compounded return for
six months. A flat yield curve implies that the six-month risk free rate is 6% x 0.5 = 3%
per semester (with continuously compounded return rates).

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Forward Contract Price of a Stock with Dividends

The forward price of a forward contract on a stock with dividends is:

F t = P0e{r~q)T

Where q is the dividend yield on the forward contract's underlying asset (e.g., on a dividend-
paying stock), expressed as a continuously paid annual dividend rate. The anticipated
dividend of the stock lowers the forward price.

Example

Consider a stock that pays a continuous dividend yield of 2% per year and that is
currently trading at $23 per share. Calculate the price of a one-year forward contract on
the stock if the continuously compounded risk-free rate is 3%.

Solution

Using Formula 6.5:

Ft = ()T6.5)
P , / r~q

F t = 23 e<0'03-0-02)x 1 = $23.23

Cases of the Forward Curves of Financial Asset Prices

For forward contracts on financial securities the term structure of forward prices (the
forward curve) is defined by its slope and curvature, which is in turn driven completely by
the relationship between the underlying security's dividend yield and the riskless interest
rate. The following are four possible cases of forward curves of financial asset prices:

• Case 1: No Dividends and No Interest. In this case Equation 6.5: FT = P0e{r~q)1 —

Pa —>All forward prices are equal to the spot price, and the term structure of forward
prices is flat.
• Case 2: Interest Rates Equal the Dividend Rate. This case is similar to Case 1.
When r - q = 0, Equation 6.5 becomes: FT —P()e{r~q)T = P() —>All forward prices are
equal to the spot price, and the term structure of forward prices is flat.
• Case 3: Interest Rates Exceed the Dividend Rate. If r > q, then e{> q)l > 1, and FT >
P0e(r~q)T. Forward prices will increase with T, and the term structure of forward prices
will be upward sloping.
• Case 4: The Dividend Rate Exceeds the Interest Rate. When r< q, then eir~q)T < 1,
and FT < Pae(r~q)T. Forward prices will decrease with T, and the term structure of
forward prices will be downward sloping.

Learning Objective: Demonstrate knowledge of forward contracts on assets

with benefits and cost of carry.

FORWARD CONTRACTS ON ASSETS W ITH BENEFITS AND COSTS OF CARRY

This is a relatively short section that simply points out that the forward pricing for
commodities needs to consider some additional factors beyond the cost of carry when
compared to forward contracts for financial securities.

,96
© 2020 Wiley
 DERIVATIVES AND RISK-NEUTRAL VALUATION: FORWARDS AND FUTURES

For example, the cost of storing commodities needs to be considered. Furthermore, while it
is stressed that the shape of the term structure of forward prices for financial securities does
not reflect expected future spot price changes, the forward price for commodities may be
impacted by forecasts of supply and demand changes.

Furthermore, forward prices for commodities may also be affected by convenience yield
differentials. Further discussion of forward prices for commodities is deferred until coverage
in the lessons “Commodity Forward Pricing” and “Commodities: Applications and
Evidence” in the section on real assets.

Cost of carry (or carrying cost) is any direct financial difference between maintaining a
position in the cash market and maintaining a position in the forward market.

Convenience yield (y) is the economic benefit that the holder of a physical inventory (e.g., a
commodity) receives from directly holding the inventory (rather than having a long position
in a forward contract on the physical assets).

Storage costs of physical assets (e.g., commodities) involve such expenditures as

warehouse fees, insurance, transportation, and spoilage. Storage costs are the opposite of
dividends, since they are costs of holding the underlying asset rather than benefits.

Replacing the costs and benefits of carrying a cash position of a financial asset with the
costs and benefits of carrying physical inventory (the left side of the figure) generates the
formula for a forward contract on a commodity:

•••

Where r is the spot interest rate corresponding to a time-to-maturity of years, c is the

commodity's storage cost, and y is the commodity's convenience yields, all expressed as
continuously compounded annual rates.

The < sign comes about because developed markets for lending physical assets (e.g.,
commodities) do not exist. Without commodity lending, the arbitrageurs cannot short sell
commodities to form a hedge against a long position in a forward contact.

Benefits and Costs of Direct Ownership

Real Assets Financial Assets
Benefits Convenience (y) Dividends and Coupons (d)
Costs Interest (r) + Storage (c) Interest (r) + Custody (zero)

Taken from CAIA Level I, 4th ed., 2020. Exhibit 6.3. Copyright © 2009, 2012, 2015 by The CAIA
Association.

Example

Consider a three-month forward contract on a commodity that trades at a spot price of

$40. The commodity has market-wide convenience yields of 2%, storage costs of 1%,
and financing costs (interest rates) of 5%. What is the price of the three-month forward
contract on the commodity?

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Solution

The forward price is $40.40, found by placing 0.25 x (5% + 1% - 2%) as the exponent
of Equation 6.6, $40 as PO, and solving for FT.

Adapted from CAIA Level I, 4th ed., 2020. Application 6.4.2A. Copyright © 2009,
2012, 2015 by The CAIA Association.

The marginal market participant to a derivative contract is defined as any entity with
individual costs and benefits that makes the entity indifferent between physical positions and
synthetic positions.

Forward Contracts with Non-Zero Market Value

It is expected that forward contracts will take on various values (positive or negative) to each
side of the agreement after the contract is initiated, reflecting the up and down movements
of the market price (or rate) of the contact’s underlying asset (or rate). Equation 6.8
describes the value of a long position in a forward contract at time t:

( 6 . 8)

Example

Consider a forward contract with a delivery date in six months on a commodity that
currently trades at a spot price of $80. The commodity has current market-wide
convenience yields of 3%, storage costs of 1%, and financing costs (interest rates) of 5%.
If the forward price in the contract is $81, what is the value of the contract to the long
side assuming that the underlying commodity can be readily short sold?

Solution

Value of Long Position in Forward Contract at Time t = 80 e«>.05+o.oi-o.o3)xo.5 _ 81 =

$0.21 (and a value of $0.21 to the short side).

Adapted from CAIA Level I, 4th ed., 2020. Application 6.4.4A. Copyright © 2009,
2012, 2015 by The CAIA Association.

Learning Objective: Demonstrate knowledge of forward contracts versus

futures contracts.

FORWARD CONTRACTS VERSUS FUTURES CONTRACTS AND MANAGING

LONG-TERM FUTURES EXPOSURES
Forward contracts are contracts between two parties that contain the terms and conditions
agreed on by the two parties. Futures contracts are exchange traded, whereas forward
contracts are typically over-the-counter (OTC) contracts. By being traded on organized
exchanges, futures contracts share the same advantages as other listed securities: transparent
pricing and a central marketplace. Futures contracts also enjoy uniform contract size and
terms, clearinghouse security, and daily liquidity.

© 2020 Wiley
 DERIVATIVES AND RISK-NEUTRAL VALUATION: FORWARDS AND FUTURES

At any point in time, the long futures position holder can close a position by entering an
offsetting short position (so that the long position and short position net to zero). Similarly,
the short futures position can close a position by establishing an identical long position.
Open interest is defined as the outstanding quantity of unclosed contracts. Only a very
small percentage of futures contracts result in delivery of the underlying asset.

The term marked-to-market is used for futures contracts and means that the party of a
futures contract that benefits from a price change receives cash from the other party of the
contract (and vice versa) throughout the contract’s life.

Example

Assume that a trader establishes a short position of 10 contracts in crude oil futures at the
then-current futures market price of $60 per barrel. Both the trader on the long side of the
contract and the trader on the short side of the contract post collateral (margin) of, say,
$10 per barrel. At the end of the day, the market price of the futures contract falls to $59.
How much money would each side of the contract have, assuming that the required
collateral was the only cash and that there were no other positions? Note: Assume that
the futures contracts on crude oil are denominated in 1,000-barrel sizes.

Solution

The 10 contracts call for delivery of 10,000 barrels (10 contracts x 1,000 barrels). The
short side of the contract gains $10,000 as a result of the decline in price of $1 per barrel.
Each side posted collateral of $100,000 (10,000 barrels x $10 per barrel). Considering
that the market price of the futures contract fell $1 to $59, the long side experienced a
decline in collateral position (cash) to $90,000 ($100,000 - $10000); and the short side
experienced an increase in collateral position (cash) to $110,000 ($100,000 + $10,000).

Adapted from CAIA Level I, 4th ed., 2020. Application 6.5.2A. Copyright © 2009,
2012, 2015 by The CAIA Association

A crisis at maturity occurs when the party required to deliver the asset at the original price
is forced (at the last moment) to expose that it cannot deliver the asset, or when the party
owing a payment is forced to reveal that it cannot afford to make the payment.

If interest rate changes and the spot price underlying the contracts are uncorrelated then
there should be no difference between the price of a forward contract and an otherwise
identical futures contract at T = 0.

The collateral deposit made at the initiation of a long or short futures position is called the
initial margin (or margin requirement). The initial margin is a small percentage of the full
purchase price of the underlying commodity (usually less than 10%).

199
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Example

An investor wishes to take long positions in 20 gold futures contracts. What is the
investor's total initial margin requirement if the initial margin requirement is $1,000 per
contract?

Solution

The investor must have $20,000 of available collateral to establish the positions.

A maintenance margin requirement is a minimum collateral requirement imposed on an

ongoing basis until a position is closed. If the collateral of a market participant falls
below the maintenance margin requirement, a margin call is issued whereby the market
participant is obliged to post additional collateral (to meet the initial margin
requirement).

The futures commission merchant has the right to liquidate the market participant's
positions in the account if the participant cannot meet the margin call. This daily process
ensures that promises to make and take delivery have reduced counterparty risk.

Learning Objective: Demonstrate knowledge of managing long-term futures

exposures.

Managing Long-Term Futures Exposures

Futures and forward positions expire at settlement (as opposed to long positions in equities
and real assets). To maintain a long-term exposure (using futures or forward contracts),
market participants need to roll the positions over at or prior to their settlement dates.

Rolling contracts is the process of closing positions in short-term futures contracts and
simultaneously replacing the exposure by entering similar positions with longer terms.

The front month contract (also referred as the front contract, the nearby contract, or the
spot contract) is the futures contract with the shortest time to settlement on an exchange.

Distant contracts (also referred as deferred contracts, or back contracts) are contracts with
longer times to settlement.

200
© 2020 Wiley
 D e r iv a t iv e s a n d R is k -N eu t r a l V a l u a t io n : O p t io n s

LESSON MAP
• Demonstrate knowledge of option exposures.
• Demonstrate knowledge of option pricing models.
• Demonstrate knowledge of option sensitivities.

KEY CONCEPTS
Several concepts on derivatives and risk-neutral valuation are covered in this lesson. In most
cases, it is only important to become familiar with the terminology and understand the
intuition behind the various concepts. In other cases, there are some computational exercises
that you should be able to complete. This coverage may be useful as a reference when
applications to alternative investments in upcoming lessons rely on the concepts discussed
here. For example, many alternative investment strategies are referred to as having payoffs
similar to short puts. Familiarity with the payoff exposure of writing a put helps to
understand why such strategies generate negatively skewed distributions.

Many alternative investment strategies use options or can be analyzed using options because
they have option-like (nonlinear) payoffs. Here, we review several exposure diagrams of
calls, puts, the underlying asset, and various combinations of these three elements. A call
option provides the right to purchase (and a put option provides the right to sell) an asset at a
specific price at or up to some point in the future.

Put-call parity is an arbitrage free model that states that the value of a call minus a put plus
the present value of a bond with a face value equal to the strike price of the options in the
formula is equal to the value of the underlying asset.

Finally, we briefly review several option pricing models and the topic of option sensitivities,
or “Greeks,” that show how an option value changes if the underlying asset price changes
(delta), or if other variables that impact prices change. These may be viewed as price
elasticities.

Learning Objective: Demonstrate knowledge of option exposures.

OPTION EXPOSURES
MAIN POINT: An option contract confers its owner the right (but not the obligation) to
execute a specified transaction in the future. CAIA’s curriculum assumes familiarity with the
netting of individual risk exposure diagrams to form diagrams of the net exposures of
portfolios of options and/or underlying assets.

Note
CAIA’s curriculum assumes knowledge of the terminology and mechanics of options,
including call options, put options, American options, European options, strike (exercise)
prices, intrinsic value, time value, moneyness, option writing, and the expiration/exercise
process.

The following profit and loss graphs illustrate the risk exposure of long and short positions
in call options (c) and put options (d). Graphs (a) and (b) illustrate the risk exposures of long
and short stock positions, respectively.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

-Profit ($) 7\

/ Long stock

Loss ($) Loss

Loss

Adapted from CAIA Level I, 4th ed., 2020. Exhibit 6.6. Copyright © 2009, 2012, 2015 by
The CAIA Association.

A naked option is a short option position that is unhedged.

A covered call combines being long an asset (e.g., stock, bond) with being short a call
option on the same asset (graph e).

A protective put combines being long an asset with a long position in a put option on the
same asset (graph f).

Adapted from CAIA Level I, 4th ed., 2020. Exhibit 6.6. Copyright © 2009, 2012, 2015 by
The CAIA Association.

202
© 2020 Wiley
 DERIVATIVES AND RISK-NEUTRAL VALUATION: OPTIONS

An option spread (1) has either call options or put options (not both), and (2) contains both
long and short positions in options having the same underlying asset, but different strike
prices, expiration dates (termed calendar spreads or horizontal spreads), or both. Option
spreads having different expiration dates are termed calendar spreads or horizontal spreads.

A bull spread is an option combination in which the long option position is at the lower of
two exercise prices. A bull spread offers bullish exposure to the underlying asset. A bear
spread is an option combination in which the long option position is at the higher of two
exercise prices. A bear spread offers bearish exposure to the underlying asset.

Bull Spread Using Call Options

Bear Spread Using Call Options

Adapted from CAIA Level I, 4th ed., 2020. Exhibit 6.7. Copyright © 2009, 2012, 2015 by
The CAIA Association.

Ratio spreads are spread positions in which the number of options in each position differ.

203
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

An option combination contains both calls and puts on the same underlying asset. The two
major option combinations containing two positions each: option straddles and option
strangles.

An option straddle is a position in a call and put with the same sign (i.e., long or short), the
same underlying asset, the same strike price, and the same expiration date.

Long Straddle

Adapted from CAIA Level I, 4th ed., 2020. Exhibit 6.7. Copyright © 2009, 2012, 2015 by
The CAIA Association.

An option strangle is a position in a call and put with the same sign, the same underlying
asset, the same expiration date, but different strike prices.

Long Strangle

Adapted from CAIA Level I, 4th ed., 2020. Exhibit 6.7. Copyright © 2009, 2012, 2015 by
The CAIA Association.

204
© 2020 Wiley
 DERIVATIVES AND RISK-NEUTRAL VALUATION: OPTIONS

A risk reversal is a long out-of-the-money call combined with a short out-of-the-money put
on the same asset and with the same expiration date.

An option collar uses positions in options to limit the upside and downside exposure of a
position to a price or rate. An example of an option collar is when the risk of a price or rate
is limited by establishing a long position in a put option (with a strike price K \) and a short
position in a call option (with a strike price or rate of K2) in which K { < K2.

The put-call parity is one of the most important relations within option analysis. It is an
arbitrage-free relation among the values of an asset, a riskless bond, a call and a put option
on the asset. Equation 6.9 illustrates one arrangement of the put-call parity:

Call + Bond —Put = Underlying Asset

The payoff exposure of the put-call parity relationship shows that the risk exposure of a
covered call (a long call and a short put with equal strike prices and maturity) is equivalent
to the risk exposure of the underlying asset.

The payoff exposure of the put-call parity relationship also shows that the risk exposure of a
protective put (a long put with the underlying asset) is equivalent to the risk exposure of a
call with the same strike price and maturity of the put. These parity relationships ignore the
bond in the put-call parity relationship because the bond has no risk exposure.

Learning Objective: Demonstrate knowledge of option pricing models.

Learning Objective: Demonstrate knowledge of option sensitivities.

OPTION PRICING MODELS AND OPTIONS SENSITIVITIES

Note
CAIA’s curriculum assumes basic knowledge on how to apply the Black-Scholes option
pricing model, including application of the cumulative normal distribution.

The Black-Scholes call option formula expresses the price of a call option as a function of
five variables: the strike price, the price of the underlying asset, the return volatility of the
underlying asset, the riskless rate, and the time to the option’s expiration, as follows:

c = SoN idi) - X e~rTN(d2)

p =X e~rT N ( - d 2)- S0 N ( - d i)

W here-dl - ln{So/X') + {r + 01/2)7

os/T

A , h<w*> + ( ; - =
G\jT

205
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Where c is the call option price, T is the time to the option’s expiration, r is the riskless rate,
and os is the constant volatility of the returns of S. The Black-Scholes model assumes that
the risk-free rate and the volatility of the returns on the stock, vs, are constants.

The intuition behind the Black forward option pricing model is that since neither the
forward contract nor the strike price on an option requires an initial investment, both
variables need to be discounted, and therefore r drops out of the model.

Biger and Hull (1983) derived a currency option pricing model in which there are two
risk-free interest rates corresponding to the two currencies being exchanged.

The five most popular sensitivities with respect to call options (c) are:

• Delta = dc/dS (sensitivity of an option’s price with respect to changes in the price of
the underlying asset)
• Vega = dc/dos (sensitivity of an option’s price with respect to changes in the
volatility of the returns of the underlying asset)
• Theta = dc/dT (sensitivity of an option’s price with respect to changes in time to
expiration)
• Rho = dc/dr (sensitivity of an option’s price with respect to changes in the risk-free
rate)
• Gamma = d2c/dS2(second derivative of an option’s price with respect to changes in
the underlying asset)

Delta, vega, theta, and gamma are discussed in more detail in the lessons on hedge fund
strategies.

Omicron is the partial derivative of an option or a position containing an option to a change

in the credit spread. Omicron is useful for analyzing option positions on credit-risky assets.

Elasticity is defined as the percentage change in a value with respect to a percentage change
in another value.

Lambda or omega for a call option is the elasticity of an option price with respect to the
price of the underlying asset.

206
© 2020 Wiley
 M ea su r es o f R is k a n d P er fo r m a n c e

LEARNING OBJECTIVES
Analysts measure risk and return from historical data to provide an indication of the
expected risk and expected return going forward. It is important to believe that past returns
provide a reasonable basis for the range of possible future returns.

A candidate should be able to calculate and understand several measures of risk, including
the standard deviation of return, tracking error, drawdown, and value at risk (VaR).

LESSON MAP
• Demonstrate knowledge of measures of risk.
• Demonstrate knowledge of methods for estimating value at risk (VaR).
• Demonstrate knowledge of benchmarking and performance attribution.
• Demonstrate knowledge of ratio-based performance measures used in alternative
investment analysis.
• Demonstrate knowledge of risk-adjusted performance measures used in alternative
investment analysis.

KEY CONCEPTS
An important step in reviewing the risk of an investment in an alternative asset is to study
past returns. The standard deviation of returns is a widely used measure of risk applied to
common stocks. Analysts add several measures that may provide information when returns
are not necessarily normally distributed.

Candidates should be familiar with standard deviation as a measure of risk, plus

semivariance, semistandard deviation, target variance, target standard deviation, VaR,
Sharpe ratio, Treynor ratio, Sortino ratio, and information ratio.

A second step in reviewing hedge fund performance involves a review of past returns.
Candidates should be able to calculate and interpret several measures of risk-adjusted return,
including return on VaR, Jensen’s alpha, M-squared, and average tracking error.

Learning Objective: Dem onstrate knowledge o f m easures o f risk.

MAIN POINT: Standard deviation and several variations are built around the expected value
of squared deviations from some central value. Variance and standard deviation rely on the
arithmetic mean return. Semivariance and semistandard deviation accumulate only the
negative deviations from that central return. Target semi variance and semistandard deviation
replace the mean with a user-selected return.

In contrast, tracking error calculates the expected deviation from a benchmark without
squaring the differences. Shortfall risk predicts the probability that any particular return will
be below some targeted input. Drawdown focuses on the size of cumulative loss sequences
and the time required to recover.

Standard Deviation as a Measure of Risk

The standard deviation is one of the most important measures of risk used to measure risks
with investments. The standard deviation of returns is frequently called volatility, reflecting
the statistic as a measure of the distribution of data around some central point. Volatility is a
way to measure the amount of this dispersion to measure risk.

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

The standard deviation is used to specify the level of uncertainty in future prices, yields, or
other levels to calibrate models that value that uncertainty. The standard deviation is also
very useful for classic hypothesis testing. But as a measure of risk for alternative
investments, some practitioners review other measures of risk, often in conjunction with the
standard deviation. Some practitioners worry that the standard deviation may not be the best
measure of risk for investments that have potential returns that differ meaningfully from the
normal or bell-shaped distribution.

ADDITIONAL MEASURES OF RISK

Semivariance and Semistandard Deviation

Semivariance begins with the premise that returns that exceed some threshold do not
constitute risk. Rather, risk should measure the returns below a threshold. This measure of
risk begins with the standard formula for variance (the second central moment) and includes
only the observations that it classifies as risky. See the next equation for a definition of
semi variance:

In this equation, N refers to the number of observations. The formula for variance adds up
all of the squared deviations. Semivariance includes only the negative observations, when
the return is below the mean. Semivariance is smaller than variance because the positive
deviations are excluded.1

Semistandard deviation equals the square root of the semivariance.

Semivolatility is a more specific version of semivariance. The N in the formula for

semivariance sometimes denotes all observations and sometimes denotes the observations
below the mean. Furthermore, sometimes the denominator is A - 1 (to increase the measure
for samples) and sometimes just N (theoretical version). In contrast, the semivolatility is
based unambiguously on the number of observations below the mean or threshold, 7*, and
subtracts 0.5 in the denominator.

Semivolatility =

Target semivariance and target semistandard deviation are similar to the measures just
introduced except that some target return is substituted for the mean return in each equation
to change the cutoff point for including or excluding a deviation in the calculations. For
example, if the mean return is 6%, setting the target return to 4% includes some returns that
are lower than the average return but are nevertheless included. Setting the return target to
0% includes only the periods where losses are observed.

Tracking Error
Tracking error measures how closely returns track a benchmark. Not all alternative
investments seek to closely track a benchmark. Having a low tracking error is important
when corresponding to the benchmark is important.

Recall that both semivariance and variance sum the deviations, so all included observations are positive, and excluding any
observation lowers the total.

208
© 2020 Wiley
 MEASURES OF RISK AND PERFORMANCE

Begin by calculating the average difference from the benchmark in the following equation:

The average error sums the difference between the fund returns and the benchmark divided
by the number of observations.

Next, calculate the tracking error statistic, which closely resembles the formula for the
standard deviation. See the equation for tracking error:

N
J Z (Ri - Benchmark/ - RErrorError)2
Tracking Error — ^ 1=1
N -l

Note that the third term in the numerator is a constant calculated to adjust for the average
difference between the asset’s return and the benchmark return. The constant generally
lowers the tracking error statistic a bit so that the statistic focuses on the tendency to move
together.

Shortfall Risk
Shortfall risk is simply the probability that the return will be less than the investor’s target
rate of return. Candidates should be prepared to find the one-tailed probability for a
particular return on the normal distribution. Analysts may make adjustments for fat-tailed or
skewed distributions.

Drawdown
Drawdown measures the percentage loss from a point in the series of returns. Generally,
analysts are interested in the maximum drawdown. Calculating the maximum drawdown
takes several steps.

Calculating Maximum Drawdown

• Begin with net asset values (NAVs) for each period.
• If instead of NAVs you have returns, calculate a generic NAV from a starting value
such as 1.00 or 100.
• Calculate the high-water mark for each period. If the current NAV is higher than the
previous high-water mark, the high-water mark is the current NAV; otherwise, the
high-water mark remains the same.
• Calculate the return from the high-water mark to the current NAV for each month.
• Identify the largest loss observed in the range of data.

A larger drawdown is indicative of greater risk. The size of the drawdown statistic is
affected by the frequency of observation. More frequent observations increase the chance
that both the lowest and the highest NAVs are observed. As a result, maximum drawdowns
are larger for more frequently observed data.

209
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Learning Objective: Dem onstrate knowledge o f m ethods for estim ating value at
risk (VaR).

MAIN POINT: Value at risk is a risk measure that relies on many standard statistics. Losses
are assumed to follow a probability distribution, often the normal distribution. Assume a
critical value, a frequency such as 5%. VaR presents a loss amount where losses of that
magnitude or larger can be expected to be observed at that frequency. Losses less than that
amount (including gains) occur otherwise (95% in the assumed case).

Refer to the VaR Illustration figure. The figure assumes that the fund is expected to make
$120,000 over the relevant time with a standard deviation of $100,000. If that outcome
follows a normal distribution, all the possible outcomes and probabilities are consistent with
those assumptions.

VaR Illustration

-400 -300 -200 -100 0 100 200 300 400 500 600
Gain/Loss ($000)

Two points are labeled on the VaR Illustration figure. The solid vertical line identifies a loss
of approximately $45,000, a point where 95% of the time the observed outcome will be no
worse than a loss of $45,000. The dashed vertical line identifies a loss of approximately
$112,000, a point where 99% of the time the observed outcome will be no worse than a loss
of $112,000. Each of these probabilities is a confidence level, a concept and label borrowed
from statistics.

Each of these points provides far less information than the mean and standard deviation
because a complete set of probabilities can be calculated. However, VaR presents the risk in
a convenient and intuitive way.

To use VaR, it is necessary to know the confidence level. A higher confidence level will
always report a higher level of risk because more infrequent outliers are included in the
range of considered outcomes.

2,0
© 2020 Wiley
 MEASURES OF RISK AND PERFORMANCE

It is also necessary to know the standard deviation or volatility of future returns. One way to
forecast the standard deviation is to measure the standard deviation of returns observed
recently^ Alternatively, the pricing of options reveals the consensus forecast of volatility.
Certainly, this value can change daily whenever positions change. However, it is also
important to determine the length of time in the risk period. If VaR measures the risk over a
one-day horizon, a standard deviation measured over that interval is appropriate. If the risk
analysis wants to know the risk over a two-day horizon, the measured standard deviation for
one day must be scaled upward.3

It is not necessary to calculate the VaR from the normal distribution. The example illustrated
takes advantage of readily available routines to calculate probabilities for outcomes, but the
analyst is free to make any assumption about the distribution. The analyst may look at several
confidence levels and run the analysis over short and longer holding periods.

Advantages of VaR
• Relatively easy to calculate
• Intuitive
• Can be used for a single security, portfolio, group of traders, or more.

Disadvantages of VaR

• Oversimplifies risk

Calculating VaR
The following equation shows the VaR using the normal distribution:

V C lR parametric — N X (JDaily X y^No. of Days

In this equation, N is the number of standard deviations to use, based on the confidence
level. See the Points on the Normal Distribution of VaR table. The standard deviation is
calculated from daily returns. The daily standard deviation is scaled by the square root of
time to provide an estimate for the standard deviation over longer intervals.4

Points on the Normal Distribution for VaR

Probability N
99% 2.33
95% 1.65

The standard deviation is described as parametric, meaning that it relies on the normal
distribution along with parameters to calibrate the distribution. Nonparametric methods are
not significantly covered in the study materials, but candidates should be aware that some
risk analysts do not use the normal distribution and seek out other ways to define
probabilities of a range of returns.

y
See the preceding lesson on GARCH models.
3 As described elsewhere, it is common to scale the standard deviation by the square root of the time. So doubling the horizon raises the
one-day standard deviation to a two-days value by multiplying by the square root of 2 or approximately 1.414.
4 A more thorough explanation of this adjustment and the implied assumptions is in the preceding lesson. See The Square Root Rule for
Standard Deviation.

© 2020 Wiley 2 , 1
INTRODUCTION TO ALTERNATIVE INVESTMENTS

For example, suppose the one-day standard deviation for an investment is expected to be
.60%. The one-day VaR at the 99% confidence level is .60% x 2.33 or approximately 1.4%.
This means that 99% of the time, you can expect to lose less5 than $14,000 per $1,000,000.
The one-week6 VaR at the 95% confidence level is .60% x 1.65 x ^5, which is
approximately 2.1% or $21,000 per $1,000,000 invested.

Conditional VaR
Conditional VaR (CVaR) is the expected loss amount for outcomes that exceed the VaR
amount. While VaR presents this range of outcomes as a single, critical value, the CVaR
provides some information about these relatively extreme events.

Estimating o for VaR

Many factors go into whether to rely on one-day VaR or longer and whether to rely on 95%
confidence of 99%. But once the interval and the confidence are specified, the values to
include in the parametric equation for VaR are determined. Choosing the right value for the
standard deviation is not so straightforward. Analysts struggle to specify the standard
deviation for an option or a security that does not have a daily closing value. See associated
box for several ways to specify a.

Ways to Specify a
• Use historical prices to calculate daily returns and calculate the historical standard
deviation from the returns.
• Use ARCH or GARCH models to forecast the standard deviation from past prices or
returns (see preceding lesson).
• Use implied standard deviation input from recent options trades. That is, observe an
option price and use an option model to determine what forecast of the standard
deviation is consistent with that price.

VaR for Leptokurtic (Fat-Tailed) Distributions

The returns on securities, especially portfolios of securities, are fairly close to a normal
distribution. Many alternative assets can differ more from a normal distribution.
Nevertheless, the frequently observed outcomes (in particular, plus or minus two standard
deviations, which incorporate about 68% of all observations) probably don’t deviate too
much from normal. For more extreme observations, the difference can be more important.

The VaR analysis described earlier assumes a classic normal distribution. For returns that
have fat tails, called leptokurtic distributions, one approach is to use a distribution that
deviates from the classic normal distribution. There are ways to produce a distribution that
resembles the normal distribution but with skew and excess kurtosis equal to nonzero
values. These methods are not part of the exam curriculum, but candidates should be aware
that it is possible to use VaR with these customized distributions. The obvious advantage of
using non-normal distributions is that the other assumptions (standard deviation, confidence
level, and time horizon) remain the same and the output (worst loss stated in percentage or
dollar terms) follows the same format as VaR as originally described.

There is a much simpler adjustment for fat tails. Since VaR focuses on the tail, just raise the
N in the VaR equation a bit. Instead of using 2.33 from the Points on the Normal
Distribution for VaR table, use 2.5, 2.6, or 2.7. Historical data can help to find a value that
produces a more accurate level of tail outcomes.

5
This 99% includes those outcomes when the investment has a positive return.
6
Analysts generally scale the standard deviation by the number of business days, not the number of calendar days.

212
© 2020 Wiley
 MEASURES OF RISK AND PERFORMANCE

A third strategy is to build up a distribution from the frequency of past returns of different
magnitudes. One obvious advantage of this approach is that it makes no distributional
assumptions at all. Also, it is the one and only distribution linked to the selected past
behavior of this asset. On the other hand, imposing some plausible distribution on past
returns may smooth out some of the roughness caused by sampling. Further, it is important
to consider whether past returns are relevant in predicting the range of possible future
returns. In some examples, this is certainly not the case. For example, returns on an option at
one point in time may provide a highly misleading distribution of future returns for a
number of reasons.

A fourth strategy for creating a VaR distribution is to create a Monte Carlo simulation. The
idea behind this simulation is there are one or several variables that can’t be predicted. But
the analyst may be able to predict an outcome that follows from a particular combination of
those inputs. The simulation tweaks each of the inputs at the same time over and over and
uses the Monte Carlo outcome to understand the distribution of predicted outcomes.

Aggregating VaRs
The aforementioned procedures pertain to individual assets. In some cases, the asset might
be a single security. In other cases, the asset itself is a portfolio (a hedge fund, a private
equity fund, a REIT) where information on the composition of the portfolio is not available.
To aggregate VaR on individual assets, it is appropriate to sum the individual VaR numbers
only if the correlation between all of the assets is 1.00. In all other cases, summing the VaR
values results in a portfolio VaR that is too large. In fact, with assets that are relatively
uncorrelated or negatively correlated, the true VaR on the portfolio could be close to zero.

Learning Objective: Dem onstrate knowledge o f benchm arking and

perform ance attribution.

MAIN POINT: There are two major types of benchmarks: peer groups and indexes. When a
manager’s performance is compared to a benchmark, we want to know that the benchmark
is appropriate, whether underperformance or outperformance is statistically or economically
significant, and if so, why?

Benchmarking, often referred to as performance benchmarking, is the process of selecting an

investment index, an investment portfolio, or any other source of return as a standard
(or benchmark) for comparison during performance analysis.

There are two main types of benchmarks: peer groups and indexes.

The peer group is typically a group of funds with similar objectives, strategies, or portfolio
holdings. Rankings and percentiles are often used when a peer group is the benchmark.

Performance Attribution
Performance attribution is also called return attribution. Active return is the difference
between the portfolio return and the benchmark return. Therefore, performance can be
attributed to two components: the benchmark return and the active return.

213
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Learning Objective: Demonstrate knowledge of ratio-based performance

measures used in alternative investment analysis.

MAIN POINT: Candidates should be able to calculate and interpret a Sharpe ratio, Treynor
ratio, Sortino ratio, information ratio, and return on VaR. Each ratio includes a measure of
expected return and a measure of risk.

Sharpe Ratio
The Sharpe ratio measures risk-adjusted excess return. The ratio is applied to a well-
diversified portfolio, traditionally interpreted as any portfolio containing only trivial
amounts of diversifiable risk.

Examine the following equation:

Note that the numerator is the incremental expected return on an asset or portfolio over the
risk-free rate. The denominator is the risk of that asset or portfolio, using the most common
measure of risk used in investment analysis, the standard deviation of return.

Recall that the return is expected to fall within a range of plus or minus one standard deviation
about two-thirds of the time. The ratio in the Sharpe ratio equation provides a measure of how
likely an asset or portfolio is to provide a return greater than the risk-free rate.

The Sharpe ratio is used to compare different assets in making portfolio selections. Some
assets may be riskier and others less risky. The Sharpe ratio provides a basis for comparing
these assets even if they differ in expected risk.

Note that the inputs in the numerator and denominator should all relate to the same time
horizon—if annualized returns and the annualized risk-free rate are used in the numerator, an
annualized standard of deviation of returns should be used in the denominator. It is possible
to calculate the Sharpe ratio using annualized inputs, monthly inputs, or over other time
horizons, but the resulting Sharpe ratios are not comparable because the inputs in the
numerator are proportional to time and the input in the denominator is proportional to the
square root of time. See the Sharpe Ratio versus Horizon table for an asset with a 12% annual
expected return, 4% risk-free annual rate, and 12% annualized standard deviation of returns.

Sharpe Ratio versus Horizon

Periods R (asset) R (risk-free) Sigma Sharpe
Annual 1 12.00% 4.00% 12.00% 0.667
Semiannual 2 6.00% 2.00% 8.49% 0.471
Quarterly 4 3.00% 1.00% 6.00% 0.333
Monthly 12 1.00% 0.33% 3.46% 0.192
Weekly 52 0.23% 0.08% 1.66% 0.092
Daily 252 0.05% 0.02% 0.76% 0.042

7
To annualize a monthly standard deviation of returns, multiply by the square root of 12. To annualize a daily standard deviation of
# # # # #

returns, multiply by the square root of the number of business days in the year, generally about 250 to 253.

2,4
© 2020 Wiley
 MEASURES OF RISK AND PERFORMANCE

The Sharpe ratio is sensitive to returns that are not normal. Returns on options, for example,
can deviate significantly from the normal distribution. The ratio may be affected by
autocorrelation of returns, because the standard deviation will appear to be different over
different horizons.

Another criticism of the Sharpe ratio is that the standard deviation of returns is not a perfect
measure of risk. It includes both systematic (undiversifiable) risk and unsystematic
(diversifiable) risk. The higher moments, skew and kurtosis, are ignored. The standard
deviation is also influenced by returns that are extremely good but are not necessarily
indicative of future downside risk.

Treynor Ratio
The Treynor ratio removes a measure of total risk (standard deviation of returns) from the
equation and replaces it with nondiversifiable risk (beta). See the following equation:

rri . R Asset RRisk -Free

Treynor Ratio = -------- -------------
P Asset

Recall that beta equals the covariance between an asset or portfolio and the market divided
by the variance of the market.

The numerator contains return, generally as a percentage. The denominator can be thought
of as units of risk. The Treynor ratio can therefore be viewed as the risk premium per unit of
risk. Investors prefer to take risk in the assets that offer the best compensation for that risk.

Because the measure of risk used in the Treynor ratio includes only systematic risk, use this
ratio only on a portfolio where the unsystematic risk should be diversified.

Properly interpreted, the Treynor ratio should not be very sensitive to the time horizon used
to calculate the ratio. The beta should not change systematically when measured with
weekly, monthly, or annual data, although the beta measured from historical data will likely
differ as different samples are measured. The excess return in the numerator will be
proportional to the time interval, and the risk-adjusted excess return per unit of risk will also
be related to the time horizon.

Sortino Ratio
The Sortino ratio exchanges several inputs in the Sharpe ratio for inputs that are similar
replacements but potentially more appropriate for reviewing alternative assets. Consider the
following equation:

T arget
Sortino Ratio =
Semistandard Deviation,^,

The numerator in the Sortino ratio substitutes a targeted rate of return for the risk-free rate.
That targeted return is chosen by the analyst and might be zero, the return on an average of
similar assets, expected stock market returns, or some other benchmark.

The denominator substitutes the semistandard deviation for the standard deviation. The
semistandard deviation is calculated using the target return that is used in the numerator.
Notice that the standard deviation is not a special case of the Sortino ratio, where the target
return equals the average return. In this instance, the numerators are the same but the Sortino

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

measure of risk will include only the squared downside deviations whereas the standard
deviation will rely on all squared deviations.

Information Ratio
The information ratio measures whether the expected return on an asset or fund exceeds
the return on a relevant benchmark by a meaningful amount. See the following equation:

RAsset RBenchmark
Information Ratio =
Tracking E r ro r ^ , v.v. Benchmark

The numerator of the information ratio continues to resemble the Sharpe ratio, except that
return on a benchmark asset replaces the risk-free rate. This value is sometimes called the
average tracking error. The denominator replaces the standard deviation with tracking error.
Tracking error, in turn, resembles the standard deviation, except that the squared deviations
from the benchmark8 replace squared deviations from the average. As such, it can be
thought of as a typical amount by which the return exceeds the benchmark.

Return on VaR
The return on VaR ratio measures the return expected from an asset relative to the risk
exposure associated with holding the asset. See the following equation:

Return on VaR =
VaRA,sset

The numerator contains the expected return. The denominator contains the VaR measure.
Both the numerator and the denominator may be measured in percentages or dollars but the
units should be the same.

Learning Objective: Demonstrate knowledge of risk-adjusted performance

measures used in alternative investment analysis.

The ratios in the previous section can be used to identify alternative assets that appear to
have a desirable combination of risk and return. Candidates should be familiar with Jensen’s
alpha and M-squared, which provide a comparison measured in excess return.

Jensen’s Alpha
Jensen’s alpha measures excess return over the risk-free rate versus the excess return that
could have been expected for the risk assumed in holding the asset. See the following
equation:

The first and second terms to the right of the equal sign calculate the ex post return above
the risk-free rate. The remaining term adjusts up or down the amount by which the return
on the market will exceed the benchmark. The resulting alpha (positive or negative) reports
whether the asset produced returns in excess of the return on a hypothetical asset that is as
risky as the asset being held.

8 That is, deviations net of an adjustment for the average difference between the returns on the asset and the returns on the benchmark.
Again, refer back to the formula presented near the beginning of this chapter for the mathematical definition of tracking error.

216 © 2020 Wiley

 MEASURES OF RISK AND PERFORMANCE

Investors do not know the expected return of an asset that appears in the equations in this
lesson. In addition, the betas of most stocks are not stable over time. As a performance
review statistic, the alpha can be found from historical data. Rearrange the Jensen’s alpha
equation and then fit the alpha and p using linear regression.

where the excess return of the asset (the two terms in the parentheses left of the equal sign)
is the dependent variable (F) and the excess return of the market (the two terms in
parentheses to the right of the equal sign) is the independent variable (X). This regression
alpha provides an after-the-fact measure of whether the asset produced sufficient return for
the risk imposed by holding the position.

M-Squared
M-squared (M ) performance review adjusts the actual performance of an asset or portfolio
up or down so that the risk on the position matches the risk in the market portfolio, as
measured by the standard deviation of returns. See the following equation:

In this equation, the risk premium in the market (the terms in parentheses) is scaled up or
down by the relative riskiness of the asset compared to the market.

Notice that, like the Sharpe ratio, the measure of risk used is the standard deviation of
returns on both the asset and the market. So, this measure as described here shares one of the
criticisms as the Sharpe ratio, that the risk of the assets is overstated to the extent the
unsystematic risk can be reduced by diversification.

It may be intuitive to think of the M“ measure as a performance metric based on a levered or

diluted investment in the asset. Suppose, for example, that the asset is twice as risky as the
market. The leverage factor would equal .50, so the excess return would be reduced by 50%.
This metric acts as if there is a hypothetical asset that is levered or delevered to match
market risk.

Average Tracking Error

Most references to tracking error are in terms of the standard deviation of the differences of
the returns from the benchmark. However, sometimes it is in terms of the average return less
the benchmark, that is, the numerator of the information ratio.

2,7
© 2020 Wiley
 Al ph a , Be t a , a nd Hy po t h e sis Te s t ing : Re g r e ssio n
LESSON MAP
• Demonstrate knowledge of beta and alpha.
• Demonstrate knowledge of the concepts of ex ante and ex post alpha.
• Demonstrate knowledge of single-factor regression models.
• Demonstrate knowledge of empirical approaches to inferring ex ante alpha from ex
post alpha.

KEY CONCEPTS
Beta measures systematic risk and generally leads to higher returns. Excess return after
being adjusted for the time value of money (the risk-free rate) and for the effects of bearing
systematic (beta) risk(s) is called alpha. In the search for alpha, a, it is important to
distinguish between abnormal returns that are due to luck and those that are due to skill.
Theoretically, ex ante alpha is due to skill and the difference between ex post alpha and ex
ante alpha is due to luck. To the extent that abnormal return persists over time (idiosyncratic
risks are serially correlated) alpha may be indicative of skill (ex ante alpha).

Despite the quantitative sound of this lesson title, the material in this section makes only
general reference to statistics. Several topics, such as heteroskedasticity, are covered in the
advanced portion of a statistics class. Candidates are encouraged to learn enough about these
advanced topics to answer nontechnical questions related to the topics.

Single-factor models rely on a single factor to drive returns. An example of a one-factor

model is the capital asset pricing model (CAPM), which was introduced in the chapter
Measures of Risk and Performance and discussed in the chapter Alpha, Beta, and
Hypothesis Testing. Recall that CAPM uses a measure of risk to predict the expected return
of a stock. The regression equation summarizes the relationship between risk (/?,-) and
expected return (R,-):

The risk-free rate (Rf) and the expected return on the market (R mt) are given, although it is
impossible to know exactly what the consensus expected rate on a broad stock market index
will be. For this analysis, the past returns on individual stocks usually substitute for expected
returns (R,) on the individual stock.

The regression equation is analyzed for a particular stock over time. There would be many
observations of market return and the return on the stock, and regression chooses a (alpha)
and p (beta) that fit the data best. Specifically, choose the parameters to minimize the sum of
the squared error terms.

The Fama-French factor model relies on three factors: risk, the size of the company, and a
measure of value:

+ bmi (R m t — R f) + b 1i (Rst — Rbt) + b 2 i(R h t — R It) + ?it

Multiple regression is used to find oh the intercept or excess return. The three regression
coefficients link three independent variables (bmh blh and b2l) to the expected return on the
stock (Rit). The risk factor is (Rmt - Rf) from CAPM. The size factor is (Rst - Rbt). The value

© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

factor is (Rht - R/t). These three factors are often called X {, X2, and X3 in statistics textbooks,
and Rit is labeled Y.

Regression assumes that: (1) the error terms are normally distributed, (2) the error terms are
not correlated with each other, and (3) the error terms have the same variance throughout the
data sample (homoskedastic). Each of these assumptions is discussed later.

Some risks present in some assets differ greatly at different market levels or over time.
Assets with nonlinear risk exposure include calls, puts, many mortgage-backed securities,
and callable bonds. Nonlinear regression models and dummy variables may better describe
these potential returns.

When correlations between returns on two or more assets are not constant, it may be helpful
to analyze this dependency in a rolling subset of the data. Alternatively, splitting the data
(for example, data from rising markets versus data from declining markets) may help to
understand market behavior.

Learning Objective: Demonstrate knowledge of beta and alpha.

MAIN POINT: Beta measures systematic risk and generally leads to higher returns. Excess
return after being adjusted for the time value of money (the risk-free rate) and for the effects
of bearing systematic (beta) risk(s) is called alpha.

• Alpha refers to any excess or deficient investment return after the return has been
adjusted for the time value of money (the risk-free rate) and for the effects of bearing
systematic (beta) risk(s).

Particularly in the case of alternative investments, an asset can have multiple betas because
it has multiple systematic risks. Bearing beta risks generally leads to higher returns. Higher
returns that are unrelated to systematic risks must come from idiosyncratic risk, also known
as alpha. (In some contexts, alpha is represented by the idiosyncratic risk term e, and others
as the intercept of a regression, a. These specific instances are outlined later.) The
measurement of alpha is tricky. A central goal concerning return attribution is to determine
what part of the return is being driven by alpha versus beta, and skill versus luck.

Learning Objective: Demonstrate knowledge of the concepts of ex ante and

ex post alpha.•*

MAIN POINT: The ex ante alpha is given by the Greek letter alpha (a f) in the equation for
the ex ante theoretical market model, whereas the ex post alpha is given by the Greek letter
epsilon (eijt) for the idiosyncratic term of the ex post theoretical market model.

• Ex ante alpha is the expected superior return if positive (or inferior return if
negative) offered by an investment on a forward-looking basis after adjusting for the
riskless rate and for the effects of systematic risks (beta) on expected returns.

Ex ante alpha is not an observable variable. It is a concept.

220
© 2020 Wiley
 ALPHA, BETA, AND HYPOTHESIS TESTING: REGRESSION

In the context of the theoretical (not estimated) single-factor market model,1

oti is the ex ante alpha of asset i.

In a perfectly efficient market, a t (alpha) in this equation would be zero for all assets.

Ex ante alpha is often thought of as positive superior excess return, but it can be
negative. For example, consider a fund with a beta of 1 and an expense ratio of 1%. We
can see that using the preceding equation, the ex ante alpha would be -1% (since beta is
1, R(f Rmf).

• Ex post alpha is the return, observed or estimated in retrospect, of an investment

above or below the risk-free rate and after adjusting for the effects of beta (systematic
risks).

ei t is the ex post (theoretical) alpha of asset i in the following equation:-

Note that the equation refers to theoretical values rather than actual values estimated (e.g.,
using a linear equation).

In the next topic on regression analysis, we will see that an estimate o f the ex post alpha is
given by the intercept, a, in the following ex post market model:21

1The use of a single-factor market model throughout most of this lesson is for simplicity. Recall that an asset may have many
systematic risks and corresponding betas.
2There is considerable disagreement in calling this an alpha, as recognized by the CAIA Association: the rationale is that it helps
understanding that alpha can be generated from luck as well as skill. We closely follow source materials as presented by the CAIA
Association.

! 2,
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Learning Objective: Demonstrate knowledge of single-factor regression models.

MAIN POINT: A single-factor asset pricing model specifies the return of an asset based on
a single risk. The CAPM is a special case that specifies the single risk as a “market
portfolio,” which is a hypothetical portfolio containing all tradable assets and is an
equilibrium model. This lesson uses equity factor models to explain regression. Candidates
should also review the content on regression techniques, focusing significantly on statistical
problems with many regression models.

An asset pricing model is a framework for specifying the return or price of an asset based on
its risk, as well as future cash flows and payoffs.

SINGLE-FACTOR ASSET PRICING

The capital asset pricing model (CAPM) provides one of the easiest and most widely
understood examples of single-factor asset pricing by demonstrating that the risk of the
overall market index is the only risk that offers a risk premium.

where E(/?,•) is the expected return on asset i, /?, is the market beta of asset i, E{R,n) is the
expected return on the market portfolio, and Rf is the riskless rate of return.

The market portfolio is a hypothetical portfolio containing all tradable assets in the world.

A single-factor asset pricing model explains returns and systematic risk using a single risk
factor.

The following equation represents a real estate investment trust (REIT)-based single-factor
asset pricing model that differs in important ways from the CAPM:

E (Ri) — + fi\E(Rindex)]

where E(R,) is the expected return on REIT,, at is a constant, /?, is the beta of REIT,, and
E(Rindex) is the expected return on an index of REITs.

The single-index model differs from the CAPM primarily because it uses an index of REITs
rather than the market portfolio as the systematic risk factor. The CAPM is a special case of
a single-index model: all investors are perfectly diversified among all assets such that it is an
equilibrium model.•*

Example

If:

• If, the market beta of asset /, = 1.25,

• E(R,„), the expected return on the market portfolio, = 10% = .10,
• and Rf, the riskless rate of return, = 2% = .02,

then what is E(/?,•), the expected return on asset /?

222
© 2020 Wiley
 ALPHA, BETA, AND HYPOTHESIS TESTING: REGRESSION

Solution

E(Ri) = .02 + 1.25(. 10 - .02) = .02 + 1.25(.08) = .02 + .1 = .12 = 12%

Adapted from CAIA Level I, 4th ed., 2020. Application 6.2.2A. Copyright © 2009,
2012, 2015 by The CAIA Association.

ORDINARY LEAST SQUARES

• Coefficient—The values of cq and pv
• Independent variable—The value in the one-factor regression {Rmt - Rf) is the
independent variable, used to predict expected return, and is frequently labeled X.
• Error term—The error terms (eit) or the residuals measure the amount that the
regression line fails to exactly match individual data points after choosing cq and /?,.
• Dependent variable—In classical statistics, Rh the return on individual securities, is
called the dependent variable and is frequently called Y, because the regression seeks
to predict this value based on another variable.
• Intercept—The intercept (a) is an estimate of the excess return for the level of
riskiness of the stock.
• Simple linear regression—Ordinary least squares or simple linear regression
analysis provides a way to estimate ad and pi.
• Slope—The slope measures the amount of undiversifiable risk in the returns of a
particular stock.

DATA PROBLEMS
Because regression minimizes the sum of squared deviations, observations that lie far from
the fitted regression line carry more weight than observations close to the line. It is hard to
determine if the large deviation reflects noise or a pattern that should influence the
regression results. These are called outliers and should be examined to see if they are
errors and should be removed. If they are not errors, judgment is needed to determine
whether they should be removed or not. They should not be discarded if they are likely to
be repeated in the future. Frequent outliers are the cause of leptokurtosis (fat-tailed
distributions).

Non-normality o f returns—Outliers occur frequently in return data, where extreme values

are observed more frequently (leptokurtosis or fat tails) than would be expected if the errors
were normally distributed. These extreme observations have a magnified impact on the
regression parameters because the errors are squared. It is often possible to observe these
outliers by plotting the data. If outliers appear to be present, the candidate should decide if
they overly influence the regression results.

Autocorrelation or serial correlation—Apply the standard Pearson’s correlation coefficient

to sequential data. Autocorrelation is present when there is a correlation between error terms
and the same error terms lagged. The Durbin-Watson statistic is a common measure of
autocorrelation.

Autocorrelation shows up, for example, where the impact of market forces is not fully
incorporated into prices immediately. This may happen when not all assets are properly
valued at each observation point. Autocorrelation can occur in real estate prices, hedge
fund net asset values, and elsewhere. Candidates do not need to know the specific
corrections that are applied to handle autocorrelation but they should realize that

223
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

corrections need to be applied to measure the true relationship between the dependent and
independent variables.

Heteroskedasticity describes a data set that does not have constant variance over the range.
This can occur with return data, when market conditions might lead to wide swings at one
point and narrow movements later. Data from the volatile portions of the data set exhibit a
greater impact on the regression parameters. Candidates are not expected to be familiar with
specific tests for heteroskedasticity. However, they should know that a common way to
adjust for this overweighting is to use weighted least squares, where volatile observations
are weighted less and less volatile data are weighted more.

Nonstationary—This characteristic means that the regression parameters are different for
subsets of data. If the beta of a stock differs over time, the regression is non stationary.

The statistical approach should be adjusted before using estimated parameters when there
are outliers, autocorrelation, or heteroskedasticity.

GOODNESS OF FIT
Goodness o f fit—The most important measure of the goodness of fit is the r-squared
statistic, which measures the extent that the regression matches the dependent variable using
the independent variable.

R-squared—The r-squared statistic is a measure of how well a regression result fits the
data. This statistic is also called the coefficient of determination. For regression with
only one independent variable, the r-squared statistic also equals the square of the
correlation coefficient between the dependent and the independent variables. R-squared
ranges from 0.0 to 1.0 and can be interpreted as the portion of variability in returns
explained by the regression. In the single-factor equation, the r-squared is a measure of
the portion of return variability explained by broad market forces (systematic risk). The
remaining variability (1 - r-squared) is the portion of variability of return that is not
explained by market return, called unsystematic risk, idiosyncratic risk, or diversifiable
risk.

Note that the significance of the parameters is not a measure of the goodness of fit. An
independent variable can significantly explain a small part of the behavior of a dependent
variable and leave unexplained much of the movement in the dependent variable.

CALCULATE THE J-STATISTIC

t-statistic—The student’s /-statistic equals the regression parameter (a, or /?,•) divided by the
standard error of that parameter.

The /-test provides a measure of the statistical significance of a regression result—that is,
whether the regression results (the constant, alpha, and one or more betas) are statistically
significant. A /-statistic is the value of the parameter divided by the standard error of that
parameter. The following equations list several /-statistics:

/-Statistic Alpha = Alpha/Standard Error Alpha

/-Statistic Beta 1 = Beta 1/Standard Error Beta 1
/-Statistic Beta 2 = Beta 2/Standard Error Beta 2

224
© 2020 Wiley
 ALPHA, BETA, AND HYPOTHESIS TESTING: REGRESSION

Example

A regression produces a beta of 1.05 with a standard error of .45. The r-statistic would be
1.05/.45 or 2.333.

^-statistic t-test—The parameter is significant if the r-statistic is above a critical point

(see Table of Critical t-Values).

Table of Critical t- Values

Confidence
10% 5% 1%

The regression contains 25 monthly market and stock returns. At the 5% confidence
level, the critical r-statistic is 1.708. Since the r-statistic (2.333) is greater than the critical
level, the beta is significant.

Learning Objective: Demonstrate knowledge of empirical approaches to

inferring ex ante alpha from ex post alpha.1*

MAIN POINT: There are two steps to inferring ex ante alpha from ex post alpha: (1) specify
an asset pricing model to separate idiosyncratic risks from the return to the risk-free rate and
systematic risks, and (2) statistically analyze the idiosyncratic risks to determine if they are
due to skill or to luck.

There are two steps to inferring ex ante alpha from ex post alpha (historical performance):

1. Specify an asset pricing model to separate idiosyncratic risks from the return to the
risk-free rate (time value of money) and systematic risks (e.g., market risk, and other
risks that may be unique to the fund’s strategy such as illiquidity risk).
2. Statistically analyze the idiosyncratic risks to determine if they are due to skill or to luck.

An analyst or researcher may face a host of potential problems in performing these two
steps, and we continue to discuss them in the following sections. One is model
misspecification.

Model misspecification is any error in the identification of the variables in a model

or any error in identification of the relationships between the variables.

225
© 2020 Wiley
 A l ph a , B et a , a nd H y p o t h e s is T e s t in g : R et u r n A t t r ib u t io n

LESSON MAP
• Demonstrate knowledge of return attribution.
• Demonstrate knowledge of ex ante alpha estimation and return persistence,
• Demonstrate knowledge of return drivers.
• Demonstrate knowledge of statistical methods for locating alpha,
• Demonstrate knowledge of sampling and testing problems,
• Demonstrate knowledge of statistical issues in analyzing alpha and beta.

KEY CONCEPTS
Alpha is the focus of many alternative investments—they are often alpha drivers. In seeking
high returns independent of the market, alpha drivers also help to diversify risks when added
to a portfolio of traditional investments, because their returns are less correlated with the
market. At one end of a spectrum there are product innovators that are alpha drivers, and the
other end of the spectrum contains beta drivers with passive index strategies, also known as
asset gatherers.

Empirical results are found through hypothesis testing. In locating alpha, the null hypothesis
is that alpha equals zero. The null hypothesis is rejected if the /7-value (corresponding to a
test statistic) that the test generated is smaller than the level of significance that the
researcher chose. If the researcher chooses a significance level, for example, of 5%, then
when the null hypothesis is true, there is a 5% chance that a type I error (a false positive)
will be committed (incorrectly rejecting the null hypothesis), and a 95% chance that a
correct decision was made by failing to reject the null hypothesis. This interpretation holds
only if the null hypothesis is in fact true.

There are four common problems with using inferential statistics: (1) misinterpretation of
low p-values, (2) failure to distinguish between statistical significance and economic
significance, (3) violation of distributional assumptions, and (4) misinterpretation of the
level of confidence. There are also several data issues: the sample being statistically
analyzed is often not representative of the population (e.g., selection bias), results are not
analyzed in the context of how many tests have been performed in the past (e.g., data
dredging), backfill bias can be introduced when backfilling involves overfitting, or results
are advertised to the exclusion of poor results (e.g., cherry-picking).

When making conclusions about statistical results, it is important to consider several issues
about how the test was performed and the distributional characteristics of the data and how
the data were collected.

Learning Objective: Demonstrate knowledge of return attribution.

MAIN POINTS: Return due to luck can be described as the difference between ex post
alpha and ex ante alpha, where ex ante alpha is the return due to skill. However, in
estimating these components of ex post alpha, beware that there are three types of model
misspecifications: omitted systematic risk factors (which will result in overestimated alpha);
misestimated betas, and nonlinear risk-return relationships. Model misspecification can
result if, for example, a linear model is used to estimate a nonlinear relationship.
Misestimated betas can result from types of beta nonstationarity, including beta creep, beta
expansion, and market timing. Therefore, in reality, sometimes alpha and beta can be
commingled and not easily separated, and thus distinguishing skill from luck is extremely
difficult.

227
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Given information such as the market rate of return, risk-free rate of return, the asset’s beta,
the asset’s expected return, the asset’s realized return, and the market’s realized return, you
should be able to calculate the ex ante and ex post alphas and determine the portion of alpha
due to skill relative to luck.

where expected return, E(Rit), is given,1 and required return, E(RA*), is calculated using the
theoretical single-factor market model (with a zero alpha):

so that the required return is: E(R*A) = Rf + p im[E(Rml) - Rf ]

We could just use the market model and calculate the ex ante alpha directly as follows, but
the preceding treatment allowed us to introduced the concept of the required return.

Next, we need the ex post alpha. To apply the ex post market model, Rit —R f = Pi(Rmt —/?/)+
eit, we need to know the actual return, Rit, and the return on the market for the year, Rmt,
instead of the expected returns E(R)s.

Skill versus Luck

Ex ante information given at the beginning of the year: Ex post information given at the end of the year:
E(Ra), the expected return on Fund A, is 12%. R/f, the realized return on Fund A, is 16%.
E(Rm), the expected return on the market, is 8%. R,„„ the realized return on the market, is 10%.
Rf, the risk-free rate, is 4%. Rf, the risk-free rate, is 4%.
($4 , the beta for fund A, is .8. (3a, the beta for fund A, is .8.
E(Rit) - R f = a i + ^[E(R mt) - R f ] Rit ~ R f = P/ ( R mr ~ R f ) + e it

. 12 - .04 = ex ante alpha + .8(.08 - .04) .16 - .04 = .8(.10 - .04) + ex post alpha
.08 = ex ante alpha + .032 .12 = .048 + ex post alpha
Ex ante alpha = .048 = 4.8% Ex post alpha = .072 = 7.2%
Portion of ex post return due to skill would be 4.8%. Return due to luck = 7.2% - 4.8% = 2.4%

Beware that there are three types of model misspecifications that can invalidate results:
omitted systematic risk factors (which will result in overestimated alpha), misestimated
betas, and nonlinear risk-return relationships.

The expected return must be estimated, and we continue to discuss issues involved in estimating the expected return, but for this
section, it is just provided to emphasize the concept. That is, we assume it was already estimated and then given to us.

228
© 2020 Wiley
 ALPHA, BETA, AND HYPOTHESIS TESTING: RETURN ATTRIBUTION

Omitted systematic risk factors result from the failure to include all risk factors (which can
be done in a multiple-factor regression, covered in CAIA Level II).

Misestimated betas result from econometric errors, such as the failure to correct for
heteroskedasticity.

Nonlinear risk-return relation error results from modeling a nonlinear relationship

incorrectly, such as with a linear regression that assumes a linear relationship (unless a
variable is transformed).

• Beta nonstationarity is a general term that refers to the tendency of the systematic
risk of a security, strategy, or fund to shift through time.

There are three types of beta nonstationarity:

1. Increased fund flows, which can lead to beta creep, due to managers’ pressures to
maintain expected returns.
2. Changing market conditions, which can lead to beta expansion (typically in down
market cycles when, for example, hedge fund returns become more correlated with
market returns).
3. Market timing.

• Beta creep is when hedge fund strategies pick up more systematic market risk over
time.
• Beta expansion is the perceived tendency of the systematic risk exposures of a fund
or asset to increase due to changes in general economic conditions.
• A full market cycle is a period containing a large representation of market
conditions, especially up (bull) markets and down (bear) markets.

The possibility of successful market timing poses the interesting question of whether
abnormal returns would represent alpha or beta. Skill is required to time the market, but the
return comes from full beta exposure during up markets and the lack of beta exposure during
down markets.

By including a full market cycle in the analysis of returns, one can partially mitigate
estimation errors associated with differing fund exposures during different types of market
conditions.

Learning Objective: Demonstrate knowledge of ex ante alpha estimation and

return persistence.•*

MAIN POINT: One method of identifying ex ante alpha is to estimate the idiosyncratic
returns, or ex post alpha, and see if this abnormal return persists over time (returns are
serially correlated). To the extent that it does, then this abnormal return persistence may be
indicative of skill (ex ante alpha).

• Abnormal return persistence is the tendency of idiosyncratic performance in one

time period to be correlated with idiosyncratic performance in a subsequent time
period.

229
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

Learning Objective: Demonstrate knowledge of return drivers.

MAIN POINTS: Alpha is the focus of many alternative investments—they are often alpha
drivers. In seeking high returns independent of the market, alpha drivers also help to
diversify risks when added to a portfolio of traditional investments, because their returns are
less correlated with the market. At one end of a spectrum there are product innovators that
are alpha drivers, and the other end of the spectrum contains beta drivers with passive index
strategies, also known as asset gatherers. Now, there are also many process drivers that offer
exposure to specific systematic risks. Examples include sector-specific exchange-traded
funds (ETFs). While (equity) beta drivers do very well because of the equity risk premium
puzzle, due to their passive nature, the market demands that fees for beta drivers must be
lower than those of alpha drivers.

Alpha Drivers
Many alternative investments are alpha drivers. These are active strategies and can provide
diversification.

• An investment that seeks high returns independent of the market is an alpha

driver.
• At one end of the spectrum are product innovators, which are alpha drivers that seek
new investment strategies offering superior rates of risk-adjusted return.

Beta Drivers
While (equity) beta drivers do very well because of the equity risk premium puzzle, due to
their passive nature, the market demands that fees for beta drivers must be lower than those
of alpha drivers.

• An investment that moves in tandem with the overall market or a particular risk factor
is a beta driver.
• The equity risk premium (ERP) is the expected return of the equity market in excess
of the risk-free rate.
• The equity risk premium puzzle is the enigma that equities have historically
performed much better than can be explained purely by risk aversion, yet many
investors continue to invest heavily in low-risk assets.

Beta Drivers as Pure Plays on Beta

A pure play on beta provides a simple, low-cost, linear risk exposure. It is achieved with
passive investing.•

• A linear risk exposure means that when the returns to such a strategy are graphed
against the returns of the market index or another appropriate standard, the result
tends to be a straight line.
• A passive beta driver strategy generates returns that follow the up-and-down
movement of the market on a one-to-one basis.
• Asset gatherers are managers striving to deliver beta as cheaply and efficiently as
possible, and include the large-scale index trackers that produce passive products tied
to well-recognized financial market benchmarks.
• Process drivers are beta drivers that focus on providing beta that is fine-tuned or
differentiated.

230
© 2020 Wiley
 ALPHA, BETA, AND HYPOTHESIS TESTING: RETURN ATTRIBUTION

Learning Objective: Demonstrate knowledge of statistical methods for locating

alpha.

MAIN POINT: The null hypothesis (generally that a value such as alpha is zero) is rejected
if the p-value that the test generated is smaller than or equal to the level of significance that
the researcher chose. In the case of examining the statistical significance of regression
coefficients, the researcher can conclude (with caveats) that the intercept is statistically
different from zero, representing superior abnormal return. Caveats include four common
problems with using inferential statistics: (1) misinterpretation of low /7-values, (2) failure to
distinguish between statistical significance and economic significance, (3) violation of
distributional assumptions, and (4) misinterpretation of level of confidence. Candidates need
to be able to recognize correct and incorrect interpretations.

There are four basic steps involved in hypothesis testing: (1) state the hypothesis,
(2) formulate a statistical test, (3) use sample data to perform the test, and (4) interpret test
results.

Step 1. State the hypothesis.

• Hypotheses are propositions that underlie the analysis of an issue.

A hypothesis statement consists of the null hypothesis and its alternative.

• The null hypothesis is usually a statement that the analyst is attempting to reject,
typically that a particular variable has no effect or that a parameter’s true value is
equal to zero. It is often denoted as H0.
• The alternative hypothesis is the behavior that the analyst assumes would be true if
the null hypothesis were rejected. It is often denoted as HA.

Step 2. Formulate a statistical test and define the test statistic.

• The test statistic is the variable that is analyzed to make an inference with regard to
rejecting or failing to reject a null hypothesis.

Test Statistic = (Estimated Value - Hypothesized Value)/(Standard Error of the Estimated

Value)

In the next section on regression analysis you will see a specific example of evaluating the
significance of regression parameters (e.g., beta estimates). Within this context, the
hypothesized value is zero in the previous equation for the test statistic. In other words, the
null hypothesis is that the regression parameter is zero (there is no abnormal return if testing
alpha or no relationship if testing beta), and the alternative hypothesis is that the parameter is
not zero. To reject the null hypothesis, the test statistic is compared to a critical value

2!,
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

(or equivalently, a /7-value corresponding to the test statistic is compared to the significance
level). The critical values are available in statistical tables corresponding to the assumed
distribution,~ and they vary according to the desired significance level of the test. This
standardization creates a test statistic that has zero mean and unit standard deviation under
the null hypothesis. The assumptions of the model are used to derive a probability
distribution for the test statistic. Using that distribution, a p-value is estimated based on the
data. (See the definition of p-value in step 3.)

The researcher chooses a significance level prior to performing the test.

• The significance level reflects the probability level of making an inferential error that
the researcher is willing to tolerate.

For example, a significance level of 5% means that there is a 5% likelihood of rejecting a

true null hypothesis. That is, when the null hypothesis is true, there is a 5% chance that a
type I error (a false positive) will be committed, and a 95% chance that a correct decision
will be made by failing to reject the null hypothesis. The symbol a is used to denote the
significance level but should not be confused with the alpha intercept of the market model as
described earlier.

• A confidence interval is a range of values within which a parameter estimate is

expected to he with a given probability. For example, one might expect a mean return
to fall between 2% and 6% with a probability of 95%.
• Confidence Level = 1 - Significance Level
• This quantity, (1 - a:), is also called the “specificity of the test.”

Step 3. Use sample data to perform the test.

Sample data (e.g., a cross-sectional set or time series of returns) are used to generate the
estimated value and the standard error of the estimated value. These two values, along with
the hypothesized value, are used to calculate the test statistic that was formulated in step 2.
This test statistic is associated with a p-value in published statistical tables.

The p-value is a result generated by the statistical test that indicates the probability
of obtaining a test statistic by chance that is equal to or more extreme than the one
that was actually observed (under the condition that the null hypothesis is true).

Step 4. Interpret test results.

There are two possible outcomes: (1) Reject the null hypothesis in favor of the alternative
hypothesis. (2) Fail to reject the null hypothesis. Note: It is not possible to accept the null
hypothesis; rather, you can only fail to reject it.

The null hypothesis is rejected if the p-value that the test generated is smaller than or equal
to the level of significance that the researcher chose. In the case of examining the statistical
significance of regression (beta) coefficients, the researcher can conclude (with caveats
covered in this lesson) that there is a relationship between the dependent variable, such as a
fund’s returns, and the independent variable, such as the market return or other systematic

If the population sampled is normally distributed, then the test statistic follows a t-distribution, which is symmetrical, bell-shaped, and
with a zero mean. More generally, a probability distribution for the test statistic is based on the assumptions of the model. Using that
'X
distribution for the test statistic, a 1p-value is estimated from the data.# #
' The CAIA source material does not get into this detail, but for two-tailed tests (as in our example and with confidence intervals) the
significance level is divided by 2 when finding the critical value. In addition, the critical value depends on the “degrees of freedom”
number, which in turn is dependent on the sample size and the number of parameters being estimated.

232
© 2020 Wiley
 ALPHA, BETA, AND HYPOTHESIS TESTING: RETURN ATTRIBUTION

risk factor. For locating alpha, if the /7-value of the regression intercept is smaller than the
level of significance chosen by the researcher, the conclusion (with caveats) is that the
intercept is statistically different from zero, representing superior abnormal return.

The researcher is looking for a large absolute value for the r-value test statistic (larger than
the critical values) and a small /7-value (smaller than the significance levels); otherwise, the
researcher fails to reject the null hypothesis.

There are four common problems with using inferential statistics: (1) misinterpretation of
low /7-values, (2) failure to distinguish between statistical significance and economic
significance, (3) violation of distributional assumptions, and (4) misinterpretation of levels
of confidence or significance. Candidates need to be able to recognize correct and incorrect
interpretations. Several examples follow.

Common Problem #1: M isinterpretation of Low p -Values

INCORRECT: Lower /7-values indicate a stronger relationship between a dependent and an
independent variable than independent variables that have higher /7-values.

CORRECT: If the null hypothesis is true, one has a a% chance of making the error of
rejecting the null hypothesis. A /7-value equal to or lower than the significance level
indicates only there is a low chance of making a type I error (false positive). It does not
indicate the strength of any relationships.

Common Problem #2: Failure to Distinguish between Statistical Significance and

Economic Significance
INCORRECT: Low /7-values indicate economic significance.

CORRECT: Low /7-values indicate statistical significance. Economic significance may be

inferred if the absolute value of a coefficient is large relative to the explanatory variable’s
dispersion.

• Economic significance describes the extent to which a variable in an economic

model has a meaningful impact on another variable in a practical sense.

Common Problem #3: Violation of Distributional Assumptions

INCORRECT: The /7-value from a r-statistic should be used when the underlying data
exhibits leptokurtosis.

CORRECT: Inferences may not be valid if assumptions of the model do not hold.
The test statistic follows a ^-distribution if the underlying data are normally distributed.
If the data exhibit leptokurtosis, the data are not normally distributed. There are many other
model assumptions and potential violations. Many statistical tests assume that the
underlying data are normal, but there are also techniques and alternate statistical tests that
can be used when the data are not normally distributed. Some of these are covered later
in the curriculum.

Common Problem #4: M isinterpretation of Level of Significance

Consider the following scenario. The null hypothesis is that traders are honest—they do not
cheat using inside information. The true proportion of cheaters in the trader population is
0.01% (i.e., 1 out of every 10,000 traders is a cheater). A statistical model to detect cheaters
is developed with a 1% level of significance. (Type I error is 1%, and further assume a type
II error of 0.) Suppose the model identifies a cheater—the null hypothesis is rejected.

233
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

INCORRECT: Then the probability that the model has correctly identified a cheater is 99%.

CORRECT: There is actually a whopping 99% chance the researcher has incorrectly
identified the trader as a cheater. Why? Because out of 100,000 traders, only 0.01%, or 10
traders cheat. At a 1% significance level, 1,000 traders will be identified as cheaters, when
990 of them are honest.

A type I error was mentioned several times previously. Here we repeat the definition and
define the type II error.

• A type I error, also known as a false positive, is when an analyst makes the mistake
of falsely rejecting a true null hypothesis.

Type I error example: Assume the null hypothesis is that beta equals zero and that since the
null hypothesis is true there is no relationship. However, mistakenly the researcher
concludes there is a relationship.

Note: As illustrated in the cheater example above, the confidence level, that is (1 -
significance level), is not an unconditional probability. It is conditional on the underlying
population.

• A type II error, also known as a false negative, is failing to reject the null hypothesis
when it is false.

Type II error example: Assume the null hypothesis is that beta equals zero and that since the
null hypothesis is false there is a relationship. However, the researcher mistakenly does not
conclude there is a relationship, and believes the resulting coefficient is not statistically
significant.

Learning Objective: Demonstrate knowledge of sampling and testing problems.•*

MAIN POINT: Oftentimes the sample being statistically analyzed is not representative of
the population (e.g., selection bias), results are not analyzed in the context of how many
tests have been performed in the past (e.g., data dredging), backfill bias can be introduced
when backtesting or backfilling involves overfitting, or results are advertised to the
exclusion of poor results (e.g., cherry-picking). It is important to be aware of these potential
issues that may impact the accuracy of any statistical conclusions.

Unrepresentative Data Sets

Unrepresentative data sets can introduce biases that overestimate alphas.

• Selection bias is a distortion in relevant sample characteristics compared to the

characteristics of the population, caused by the sampling method of selection or
inclusion.
• If the selection bias originates from the decision of fund managers to report or not to
report their returns, then the bias is referred to as a self-selection bias.
• Survivorship bias is a common problem in investment databases in which the
sample is limited to those observations that continue to exist through the end of the
period of study.

Data Mining versus Data Dredging

Data mining can be a valid method of uncovering relationships, but results must be
interpreted in the context of how many similar tests have been performed by others in the

234
© 2020 Wiley
 ALPHA, BETA, AND HYPOTHESIS TESTING: RETURN ATTRIBUTION

past. Overuse of statistical tests for relationships among variables, particularly when there is
no a priori economic reason to believe there is a relationship, devolves testing into data
dredging. The danger is that results are interpreted as being economically significant when
they are not.

• Data mining typically refers to the vigorous use of data to uncover valid
relationships.
• Data dredging, or data snooping, refers to the overuse and misuse of statistical tests
to identify historical patterns.

Backtesting and Backfilling

Backtesting and backfilling data can be valid methods of representing the risk and return
characteristics of a strategy if biases are not introduced and there is full disclosure, but they
can be dangerous because they may not represent future returns accurately, particularly if
combined with overfitting.

• Backtesting is the use of historical data to test a strategy that was developed
subsequent to the observation of the data.
• Overfitting is using too many parameters to fit a model very closely to data over
some past time frame.
• In alternative investments, backfilling typically refers to the insertion of an actual
trading record of an investment into a database when that trading record predates the
entry of the investment into the database.
• Backfill bias, or instant history bias, is when the funds, returns, and strategies being
added to a data set are not representative of the universe of fund managers, fund
returns, and fund strategies.

Cherry-Picking and Chumming

A firm advertising the results of winning funds without disclosing the number of failed
funds is guilty of misleading investors by cherry-picking. A manager that broadcasts a
number of different market opinions to different investors and follows up with only those
investors that received correct predictions, asserting the predictions were correct, is guilty of
chumming. Advertised investment results need to be viewed with skepticism to see if they
are free from cherry-picking or chumming behaviors.

• Cherry-picking is the concept of extracting or publicizing only those results that

support a particular viewpoint.
• Chumming is a fishing term used to describe scattering pieces of cheap fish into the
water as bait to attract larger fish to catch.

Learning Objective: Demonstrate knowledge of statistical issues in analyzing

alpha and beta.

MAIN POINT: When making conclusions about statistical results, it is important to consider
several issues about how the test was performed and the distributional characteristics of the
data and how the data were collected.

There are several issues to be aware of when estimating alpha: non-normal returns, outliers,
and biased selection of subjects or data dredging.

235
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

If one observes more abnormal returns in the tail of a distribution than would be expected in
a normal distribution, then it is likely that the distribution is not normal and would not be
indicative of skill or luck.

• An outlier is an observation that is markedly farther from the mean than almost all
other observations.

Outliers can distort reported results. For example, an outlier may be the result of a data
recording error, or a one-time event that is unlikely to repeat itself. When data are squared,
the impact of outliers is magnified.

Two issues involving biased testing in the search for alpha are (1) biased selection of
subjects (e.g., a favorite, recently well-performing hedge fund) to study and (2) data
dredging. It is important to set up a hypothesis and model, select data, and specify the
significance level prior to conducting the tests to avoid manipulating these parts of the test in
an effort to obtain a more favorable result.

The issues just mentioned also apply to estimating betas, but there is the additional problem
that correlations and betas are less stable over time. It is particularly important to apply
economic reasoning when modeling to find causation rather than simple correlation or,
worse yet, spurious correlation.

• The difference between spurious correlation and true correlation is that spurious
correlation is idiosyncratic in nature, coincidental, and limited to a specific set of
observations.

The difference between true correlation and causality is that causality reflects that one
variable’s correlation with another variable is determined by or due to the value or change in
value of the other variable.

Summary

Three Major Fallacies of Alpha Estimation

1. Assume an analyst is examining a set of funds to find alpha and they all have similar
systematic risk. Twelve managers out of 100 are found to have positive alphas at a
5% significance level.
INCORRECT: The conclusion is that these managers are skilled.

CORRECT: It is more likely that the returns are not normally distributed, because
if they were normal, less than 5% of the funds should have a positive alpha.
Returns should be analyzed on a risk-adjusted basis, and the distribution should be
examined for non-normality and outliers.

2. An analyst estimates a statistically significant alpha as the intercept of a multifactor

model using a time series of returns.
INACCURATE: The conclusion is that the alpha represents superior risk-adjusted
returns.

CORRECT: The test may have omitted risk factors. The test is a joint hypothesis of
whether the fund has ex ante alpha and the appropriateness of the particular model.

3. Assume that a correctly specified model indicates a positive alpha at a 1%

significance level.

236
© 2020 Wiley
 ALPHA, BETA, AND HYPOTHESIS TESTING: RETURN ATTRIBUTION

INCORRECT: There is a 99% chance that the fund had a positive ex ante alpha.

CORRECT: A fund that has zero alpha has a 1% chance of being incorrectly
identified as having a nonzero alpha. This interpretation applies to beta estimation
as well.

Two Major Fallacies of Beta Estimation

1. A factor model finds that the beta coefficient is found to be zero; that is, the null
hypothesis cannot be rejected.
INACCURATE: The conclusion is that the fund returns are not related to the
factor.

CORRECT: The returns may be nonlinear, for example with option-like payouts.
Sophisticated nonlinear statistical techniques may be required.

2. A factor model finds that the beta coefficient is found to be nonzero; that is, the null
hypothesis can be rejected.
INACCURATE: The conclusion is that the changes in the fund returns are caused
by changes in the factor.

CORRECT: Correlation is not the same as causation. Economic intuition should be

used alongside statistical tests.

237
© 2020 Wiley
INTRODUCTION TO ALTERNATIVE INVESTMENTS

© 2020 Wiley
 Re a l Asse t s

© 2020 Wiley
 N a t u r a l R eso u r c es a nd L a nd

LESSON MAP
• Demonstrate knowledge of natural resources other than land.
• Demonstrate knowledge of land as an alternative asset.
• Demonstrate knowledge of timber and timberland as alternative assets.
• Demonstrate knowledge of farmland as an alternative asset.
• Demonstrate knowledge of valuation and volatility of real assets.
• Demonstrate knowledge of pricing and historic data analysis.
• Demonstrate knowledge of contagion, price indices, and biases in real estate values.
• Demonstrate knowledge of observations regarding historical returns of timberland.
• Demonstrate knowledge of observations regarding historical returns of farmland.

KEY CONCEPTS
The topics addressed here primarily involve land and timber although the concepts are
applicable to any resource that could be developed into a commodity. These assets are
valuable to the extent that they can be converted or developed into an asset that has value.
Option analysis qualitatively describes how uncertainty about the value of such
development affects valuation of undeveloped assets. Difficulties in pricing—particularly
the use of stale prices—make measures of volatility and correlation suspect.

Learning Objective: Demonstrate knowledge of natural resources other than

land.•*

NATURAL RESOURCES OTHER THAN LAND

MAIN POINT: Natural resources are undeveloped real (physical) assets. They are valuable
if they can be converted into something (such as a commodity) with marketable value.
Natural resources that cannot currently be profitably developed may nevertheless have value
if there is a reasonable probability that market conditions will change to allow a profit.

Governments in most countries of the world own mineral rights on land and the owner has
only the right to occupy the surface of the land. The owner of land in the United States
generally owns both the surface rights and the mineral rights. Some states permit split
estates where different parties can own the surface rights and the mineral rights. In contrast,
a pure play introduces risks and provides returns linked to a single exposure.

An exchange option gives the holder the right but not the obligation to swap one asset for
another. One common exchange asset is a convertible bond, where the holder of the bond
also has an option to surrender the bond for common stock. When convertible bonds are
issued to finance a start-up company, the success of the company affects both the value of
the stock and the value of the company’s debt.

Natural resources require effort and expense to extract and develop. To the extent these costs
move up and down, the potential payoff is influenced by the value of the asset that can be
developed (residential real estate, petroleum products, metals, etc.) and the conversion costs.

• Volatility in the ending value or the cost of production makes the option more
valuable.
• If the price of the asset and the cost to produce move in the same direction, the
volatility of the payoff is lower and the option value is less. Higher correlation
reduces the option value and lower correlation increases the value.
• Frequently, this is a perpetual option, an option having no expiration date.

24,
© 2020 Wiley
REAL ASSETS

• An asset that can be profitably developed is “in-the-money” and one that cannot is
“out-of-the-money” (called the level of “moneyness”).
• The value that can be recovered by immediately developing the asset is called
intrinsic value, while any additional option value created by possible future payoffs is
called time value.
• It is not sensible to exercise the option (develop the resource) when it is out-of-the-
money (that is, when it is unprofitable to develop).
• If time value is significant, it may not be optimal to immediately develop assets that
can profitably be developed. However, if the option is deeply in-the-money, it makes
sense to develop (that is, exercise the option) because additional delays reduce the
payoff due to the time value of money.
• Options that are in-the-money (resources that can be profitably developed) are
exposed to changes in the value of the end products which exposes the owner to
short-term financial risk.

Learning Objective: Demonstrate knowledge of land as an alternative asset.

LAND AS AN ALTERNATIVE ASSET

MAIN POINT: Investing in land involves the purchase of tracts of land near existing and
growing regions. Raw land is illiquid and a bit speculative, especially if the right to develop
the land is not certain. Development puts in place roads, sewers, and other improvements
and includes fees and filing to create buildable parcels. The value of land can be viewed as
an option and modeled much like options on securities.

Land Development
Land banking is the buying and holding of undeveloped land or vacant lots. Developers
have traditionally developed land that they owned. More recently, investors own the land
banks, which frees up capital from the developer. Investors will buy land that they believe
will be attractive to future developers now or in the future.

Developers generally develop the most profitable parcels first. This strategy is called the
low-hanging fruit principal.

Three Types of Lots

Mature communities may contain a few vacant lots. Builders can tear down an existing
house to free up a buildable lot. Developers can also create buildable lots from raw land.
They may acquire this land in one of several stages.

Paper lots have been approved for development but no significant development has begun.
No roads are present. Utilities have not been laid.

Blue top lots have been rough graded. Roads and drainage work has been partially
completed. The owner has subdivided and paid certain fees to create parcels eligible to
receive building permits.

Finished lots include finished grading, landscaping, completion of common areas, and all
utilities. The lots can be built upon and occupied. All fees except building permits have
been paid.

Land as an Option
Undeveloped land has option-like characteristics. The strike price includes the cost of the
land (acquisition, developing, improving). There is generally no expiration date. The value of

242
© 2020 Wiley
 NATURAL RESOURCES AND LAND

the completed property (including the building) corresponds to the stock price. The potential
for significant increase in the value of completed properties is analogous to volatility.

This option should be exercised when it is sufficiently in-the-money (when it is profitable to

develop the property). As with other option-like incentives, delaying development subjects
the owner to financial risk and delays the payback on the investment.

The binomial option pricing model provides a basis for calculating the time value of this
type of option. Consider the example following. This example considers only one pair of
up-down steps, although more steps would improve the model. In this example, a property
that is comparable to your planned project is worth $1 million now, would be worth
$1.5 million (discounted to the present) in an optimistic scenario and would be worth
$700,000 (also time-value adjusted) in a pessimistic scenario.

$1,000,000 = PV(PUp x $1,350,000 + PDown x $750,000)

Assume that the present value factor, PV, equals .90.1 The two probabilities sum to 100%,
so Poown = 1 - Pup• These probabilities are called risk-neutral probabilities if the expected
value of the land equals the current value. The probability of the optimistic case should be
approximately 60% and the pessimistic case is 40%.

Now if the cost of developing the project is $1 million in the optimistic scenario and
$800,000 under the pessimistic case, the project would return $350,000, 60% of the time,
and be worthless,12 40% of the time. This means the land is worth $189,000.3

The same binomial model provides a way to calculate the expected return:

350,000- 189,000
RExpected = 60% X ---- - , ^ ^ ----- + 40% X - 100% = 11.11%
p 190ooo

Impact of Survivor Bias on Land Return Indexes

Many return indexes show positive survivor bias. For example, a hedge fund index that
includes historical performance of existing funds may omit performance on unsuccessful
funds. Land returns may observe negative survivor bias. If index returns on land include
only the parcels that were not developed, it will exclude many or most of the profitable land
investments.

Example

Given:

Expected return on undeveloped land = 6%.

Expected return on developed land = 24%.

Portion of land in a database that is developed in a particular year = 30%.

1Since the time to exercise here is uncertain, the present value factor in this example is also not observable.
2 Perhaps it would be possible to abandon the project and recover something by selling it but this analysis assumes that the developer
needs to donate the land to a preservation group.
3 $189,000 = .90 x (60% x $350,000 + 40% x $0).

243
© 2020 Wiley
REAL ASSETS

Historical returns based on land that that remained undeveloped = 4%.

What is the survivorship bias?

Solution

(.30)(.24) + (.7)(.06) = 11.4%

4% - 11.4% = -7.4%

Therefore the index has a negative survivorship bias of 7.4%.

Learning Objective: Demonstrate knowledge of timber and timberland as

alternative assets.4321

TIMBER AND TIMBERLAND AS ALTERNATIVE ASSETS

MAIN POINT: Timber is primarily owned by institutional investors. Individual investors
can invest in timber ETFs and REITs. These investments are not strongly correlated with
stock and bond returns and so provide good diversification benefits.

Ownership Structure
Timber is investment in existing forestland for long-term harvesting of wood. The United
States differs from much of the world in that private corporations and investors own much of
the timber in this country. Nearly everywhere else, timber is primarily owned by governments.

There are two factors driving changes in the industry structure.

Previously, the forest industry owned timber, sawmills, pulping operations, and other
facilities. Since leveraged buyouts in the 1970s and 1980s, there is reduced integration in
the forests products industry: a separation of ownership of timber and related facilities.

A second reason for changes in the structure of ownership is the rise of timber investment
management organizations (TIMOs), which assist pension funds, insurance companies,
endowments, and foundations in investing in and managing timber acreage.

Rotation measures the time from planting until harvest. This horizon is shorter in warmer
climates and for certain tree species but generally spans decades. In contrast, farmland may
have one or more rotations per year.

There are four publicly traded methods to gain exposure to timber returns:

1. Investors can own shares of timber-related firms.

2. Investors can also buy ETFs (e.g., WOOD and CUT).
3. REITs with timber exposure.
4. Random Length Lumber futures contract trading on the CME.

There are three key benefits:

1. Good diversification versus stocks and bonds

2. Flexibility (timing option) about when to harvest
3. Acts as an inflation hedge

244
© 2020 Wiley
 NATURAL RESOURCES AND LAND

There are three key disadvantages:

1. Forest industries are cyclical

2. Exposed to natural risk such as fire
3. Long rotation cycle renders its value susceptible to changes in technology

Learning Objective: Demonstrate knowledge of farmland as an alternative asset.

FARMLAND AS AN ALTERNATIVE ASSET

MAIN POINT: Investing in farmland generally involves leasing the land to farmers in return
for cash rent. If expected return or cap rate is constant, then programs to increase crop prices
and crop yields lead to higher land prices. Similarly, land that can produce more valuable crops
is more valuable. Land that can be used for different purposes (different crops or non-
agricultural uses) tends to be more valuable than land committed to one purpose.

Background
Unlike many real asset investments, farmland offers annual cash returns. Unlike timber,
which can be harvested flexibly in response to market conditions, farmers follow an annual
production cycle regardless of market conditions. The cash returns and the value of
farmland are correlated with the value of the agricultural commodity prices.

Valuation
Investors may borrow to finance the purchase of farmland. They are interested in the return
on their investment, the return on equity (ROE). The numerator is net income (i.e., net
revenues less operating expenses and the interest on the mortgage. The denominator is the
value of their equity.

Revenues —Taxes —Insurance —Interest

Value of Land —Debt

The cap rate or return on assets (ROA) is frequently used to value farmland, so the value of
land doesn’t depend on the financing decision an investor makes. The numerator includes
operating income (which excludes the mortgage interest). The denominator includes the full
value of the farmland, ignoring the mortgage.

_ 4 ^ _ Revenues —Taxes —Insurance

RoA = Cap Rate = ---------------------------------------
Value of Land

The cap rate equation can be rearranged to provide a valuation equation for farmland:

Operating Income
Value of Land = — ------------------
Cap Rate

The Structure of Farm land Ownership and Management

The structure of farmland can be divided into:1

1. Row cropland that produces row crops that need to be replanted each year, such as
soybeans, com and wheat
2. Perm anent cropland that produces long-term vines and trees yielding crops, such
as grapes, nuts and fruit

245
© 2020 Wiley
REAL ASSETS

The NCREIF Farmland Index is a major U.S. index of farmland values with about 55% row
cropland and 45% permanent cropland.

Farmland owners typically lease the land to a farmer and the annual cash rent provides a steady
stream of payments unaffected by crop seasonality. Agency risk involves some agent acting
according to self-interest and not in the interest of the (land) owner. In the case of farmland, this
is the risk that a farmer does not maximize the net economic benefits to the owner.

Farmland has far less flexibility in harvesting than does timberland. Recall that the long
growing cycle of timberland can provide a timing option in terms of harvesting to take
advantage of favorable prices. This is not possible with farmland crops that have a short
growing cycle and often a very short window for harvesting, such as a few weeks.

Farmland investing is subject to political risks from changes in government policies. In the
United States, this might involve changes in crop price supports, ethanol subsidies, or
foreign exchange targeting. Some farms face risk of government expropriation.

Farm land Demand and Supply Factors

Growing world population results in increased demand for more food, suggesting higher
agricultural commodity prices over time. As people get more affluent and consume more meat,
the demand for animal feed increases—which, on a calorie basis, requires much more land than
is needed to produce plants for direct human consumption. The use of agricultural products for
biofuels has been controversial and may also increase the price of food due to increased demand.

Three major factors affecting demand are:

1. Population growth
2. Changing incomes and increasing diet preferences for animal protein
3. Non-food use of agricultural products such as biofuels.

Growth in agricultural yields impact supply factors and are the result of four types of
advancements:

1. Improved technology (e.g., seed stock)

2. Improved agronomy
3. Increasing use of inputs (e.g., fertilizer)
4. Increasing use of capital assets (e.g., machinery and agricultural infrastructure

Agronomy is the science of soil management, cultivation crop production, and crop
utilization.

Three major factors affecting supply are:

1. Changing agricultural yields

2. Changing qualities and quantities from agricultural infrastructure changes
3. Quantity of cultivated land and/or changing use of aquaculture

Three Key Benefits and Three Key Disadvantages of Farm land Investment
Benefits include:1

1. Inflation hedge (because linked to food and energy prices)

2. Diversification (not linked to financial markets in the short run)
3. Demand often exceeds supply

246
© 2020 Wiley
 NATURAL RESOURCES AND LAND

Disadvantages include:

1. Illiquid, with exposure to natural disasters

2. High transaction costs (broker fees of 3% to 5%)
3. High levels of agency costs

Gaining Exposure to Farmland Returns

The most direct way to gain exposure to farmland returns is to invest in farmland. Farm
managers can find farmers to lease the land and to provide the day-to-day management. Of
course, even small farms may be too large for many individual investors to consider, but
pension funds, endowments, and foundations can and do maintain portfolios of farmland.

Three approaches to gaining farmland exposure are:

1. Direct ownership of farmland (as discussed above)

2. Investing in listed equities of agricultural firms or pooled equities like ETFs
3. Futures (which provide exposure to agricultural prices rather than land).

An ETF called the Market Vectors Agribusiness ETF replicates the DAX Global
Agribusiness Index. Its ticker is MOO. REITs include Gladstone land (LAND) and
Farmland Partners (FPI).

To benchmark performance or trade derivatives linked to farmland indices, several indices

for specific sectors of the agribusiness exist: agricultural products, seed and fertilizer, farm
machinery, and packaged foods.

Three Factors of Multiple Use Option Values

A variation on the standard call option is helpful in describing why some farmland is more
valuable than other land. Some land has inherent advantages—better soil, more reliable rain,
and access to transportation. The potential to use the land for two or more alternatives
makes some land more valuable.

Consider first land that is best suited for wheat. For many reasons (rainfall, temperature),
this land will always be better for wheat than for com, soybeans, or other major crops. Other
land can economically produce com, soybeans, sorghum, and barley. As the prices of each
of these commodities moves about, the farmer has the option to shift production from one
commodity to another. The option allows the farmer to earn a higher return.

The multiple use option is more valuable the more the alternative uses diverge from each
other. This divergence is related to both the volatility of prices and the correlation of prices.
Non-agricultural use of the land may create additional value if that use is not correlated with
agricultural prices.

In addition to moneyness, three factors driving the value of multiple uses are the:

1. Current closeness of the profitability of each alternative to each other

2. Volatility of the profitability of each alternative
3. Lack of correlation between the alternatives as to profitability

247
© 2020 Wiley
REAL ASSETS

Learning Objective: Demonstrate knowledge of valuation and volatility of real

assets.

VALUATION AND VOLATILITY OF REAL ASSETS

MAIN POINT: Real assets do not trade frequently and transactions that do occur involve
unique parcels. Regular appraisals are used to estimate the value of real assets. Due to the
cost of creating these valuations, real assets are usually incrementally adjusted from periodic
appraisals. Even new appraisals appear to fully reflect valuation factors only gradually. As a
result, the volatility of real asset prices appears to be much lower than the volatility
observed in securities and commodities markets, where assets are valued at recent trading
prices.

• If the valuation of the assets has been trending higher (lower), the appraised value of
the assets may be low (high).
• The measured volatility will be too low.
• The measured correlations to other returns will be too low.

Managers may do several things to further smooth real asset returns. Some applications
might produce valid but smoothed prices. Some of these techniques could create fraudulent
returns:

• Using favorable marks—Assets that are not regularly traded may be priced by a
commercial service or by trading counterparties. A manager may seek prices from
two or more sources and choose one (generally the higher one). The manager may
rely on sources that cooperate in providing favorable marks.
• Selective appraisals—A manager may strategically decide which assets to reappraise
and which assets to adjust. Not valuing certain assets may truncate bad returns.
Choosing when to value assets thought to be undervalued gives the manager some
ability to offset bad results elsewhere.
• Model manipulation—Most derivatives and many real assets can only be valued with
quantitative models. The models require inputs that the manager supplies. This form
of manipulation uses the inputs to affect the return on assets that can only be valued
by model.
• Market manipulation—Assets marked at recent trade prices are affected when
players enter into trades to affect the end-of-period valuation.

Following is an example demonstrating how smoothing can affect measured volatility:

Raw Return Smoothed Return

-5.89% -5.89%
6.19% 6.19%
-4.60% -4.60%
10.25% 8.25%
5.40% 5.40%
-9.75% -7.75%
8.04% 7.09%

248
© 2020 Wiley
 NATURAL RESOURCES AND LAND

Impact of Smoothing on Volatility

In this example, four returns are not smoothed. The highest return (10.25%) and the lowest
return (-9.75%) have been truncated by 2%. The volatility measures 7.09% instead of
8.04%, making the returns appear more consistent. A larger sample size would be less
affected by smoothing of just two returns, but a larger data set could also contain more
smoothed observations.

Appraisals and Return Smoothing Due to Behavioral Biases

An expert’s opinion of the value of a real asset is an appraiser. The anchoring effect is a
behavioral bias exhibited by appraisers who tend to value real estate in a manner that
matches past prices and price changes. For example, in 2007 when commercial real estate
had seen almost continuous quarterly price changes for 12 years, appraisers were
“anchored” to their belief that values should be increasing despite the abundance of
evidence that the market had reversed. In general, this anchoring effect results in smoothed
returns that exhibit lower volatility and a higher Sharpe ratio than true, unsmoothed returns.

Four Causes of Return Smoothing Due to Reliance on Infrequent Transactions or

Stale Data
1. In illiquid real asset markets, there can be a large gap in time between when a deal is
made and the transaction is completed.
2. Transactions can be biased indications of changes in the broader market. For
example, during a slowdown, transaction data may be more heavily weighted
toward high-end properties.
3. Managerial discretion may be used to select appraisals and manage returns.
4. Appraisals may be based on dated information about cash flows.

Smoothing and Correlation

Note: This section is from the 3rd edition o f the CAIA Level 1 handbook and has been
moved to Level II in the 4th edition. Level I candidates may safely skip this section but may
also find it helpful.

Another source of smoothing is the lag in incorporating data in the valuations that are used
to calculate returns. Consider two sets of returns. Asset A earns the raw returns shown
earlier. Asset B is similar but due to stale pricing, observes these returns one period late.

Return Asset A Return Asset B

-5.89% N.A.
6.19% -5.89%
^1.60% 6.19%
10.25% -4.60%
5.40% 10.25%
-9.75% 5.40%
Correlation -0.53

249
© 2020 Wiley
REAL ASSETS

Impact of Smoothing on Correlation

In the absence of the lag, these assets would be perfectly correlated (1.00). The correlation
measured above (-0.53) is negative. In fact, the order that these six returns occur produces
measured correlations ranging from close to -1.00 to close to 1.00. With a larger sample
size, the measured correlation would be close to 0.00 even though, by assumption, they are
perfectly correlated.

Learning Objective: Demonstrate knowledge of pricing and historic data

analysis.

PRICING AND HISTORIC DATA ANALYSIS

MAIN POINT: Stale prices do not really bias estimates of mean returns but significantly
understate volatility relative to true returns.

A Model of Stale Prices

A simple model of stale prices is a model for return based on an appraiser's stale prices. This
is a simple two-period model:

Let r*t be the return for asset i based on appraisal prices at time t,

ri4 be the true return for asset i at time t, and

and be the true return for asset i at time t - 1.

Then the return based on appraised prices is a weighted average of the two true returns
where the weights are given by a and (1 —a):

r* j = an,, +(1 -

This assumes the appraiser observes true prices with a delay.

This two-period model can, of course, be extended to include many periods from 1 to T.

The Effect of Stale Pricing on Historical Mean Returns

Using the notation established above, we define the mean of true returns, p from period 1 to
period T as:

The mean of stale returns from the appraiser, is defined similarly:

250
© 2020 Wiley
 NATURAL RESOURCES AND LAND

It can be shown that the relationship between the two is given by:

ju* = ju + (1/r )[(l - ot)ruo - a r UT\

Note how this equation can explain the difference between the mean returns of the true and
stale returns without knowing the true returns from periods 1 to T - 1. Note also how stale
return data will overweight the beginning return (t = 0) and underweight the oldest returns
(T), since the sign of the last term in the brackets is negative. Key point: This turns out to be
a relatively minor error that decreases in magnitude as the sample size increases and thus
has little effect on long-term mean return estimates.

The Effect of Stale Pricing on Volatility

If the mean return of a series of stale prices is equally weighted as above, and the returns are
not autocorrelations, the following relationship between the standard deviation for stale and
true returns can be shown as follows:

For N = 4, the stale price series will exhibit only half of the volatility of the true return
series. (Recall the stale return series is denoted by the *.) Where the impact of smoothing on
the mean is negligible, the impact on the volatility is economically significant.

Learning Objective: Demonstrate knowledge of contagion, price indices, and

biases in real estate values.

CONTAGION, PRICE INDICES, AND BIASES

Publicly traded REITs are more volatile than non-traded real estate indexes. This higher
volatility supports the conclusion that smoothing dampens measured volatility. However, at
least part of the additional volatility of REITs may come from the influence of other
markets. Contagion occurs when markets affect other markets. At least part of the increased
volatility of these traded markets may come from contagion from equity, commodity, or
fixed income markets. Since REITs are often highly leveraged, that can also explain some
of the differences in volatility.

Learning Objective: Demonstrate knowledge of observations regarding

historical returns of timberland.

Learning Objective: Demonstrate knowledge of observations regarding

historical returns of farmland.

KEY OBSERVATIONS REGARDING HISTORICAL RETURNS OF TIMBER AND

FARMLAND
MAIN POINT: Although CAIA presents several return statistics, candidates are not
expected to memorize specific numbers but rather general relationships among asset classes
and sub-classes. Here we compare the performance statistics of timberland and farmland
based on quarterly returns for 18 years ending in the last quarter of 2018.

251
© 2020 Wiley
REAL ASSETS

Timber Farm land

Historic Fow Fow
volatility
relative to
equities
Sharpe ratio Attractive 0.7 Very attractive 1.4
Skew Modestly positive Markedly positive
Excess kurtosis Markedly positive Markedly positive
Drawdown Mild (-6.5%) Near 0%!
Autocorrelation Markedly high fourth order partial High fourth order partial a
auto-correlation indicated a large uto-correlation indicated a large
one-year lag in recognizing one-year lag in recognizing
changes in value changes in value
Cluster around Very tight Very tight
the mean

The autocorrelation present in NCREIF timber returns probably reflects the impact of
appraisal on the timing of returns. Although the correlations between timber returns,
farmland returns, and traditional assets are not presented here, the maximum drawdown
returns suggest that these assets appear to have avoided the sharp correction in equity
markets that occurred in 2007-2009.

Although the returns span 18 years, candidates should be careful in extrapolating these
specific results. For example, government support for synthetic fuels probably drove up
farmland returns during this period. Equity returns were perhaps more volatile than would
be typical going forward.

252
© 2020 Wiley
 Co mmo d it ie s

LEARNING OBJECTIVES
Candidates should learn several ways to gain exposure to commodity returns, expectations
for risk and return, and portfolio-based reasons to invest in commodities. Candidates should
study key words used by commodity traders and investors.

LESSON MAP
• Demonstrate knowledge of investing in commodities without futures.
• Demonstrate knowledge of the term structure of forward prices on commodities.
• Demonstrate knowledge of rolling of forward and futures contracts.
• Demonstrate knowledge of normal backwardation and normal contango.
• Demonstrate knowledge of commodity exposure and diversification.
• Demonstrate knowledge of expected returns on commodities.
• Demonstrate knowledge of commodity indices.
• Demonstrate knowledge of commodity risk attributes.
• Demonstrate knowledge of observations regarding historical commodity returns.

KEY CONCEPTS
Companies that use commodities are active in the cash or spot market, forwards, and
futures. The case for investing in commodities looks poor based upon historical returns and
volatility levels. However, investing in forwards, futures, and other derivatives (but not spot)
looks more appealing as a strategy to diversify to reduce risk.

Learning Objective: Demonstrate knowledge of investing in commodities

without futures.

INVESTING IN COMMODITIES WITHOUT FUTURES

MAIN POINT: The text will describe gaining exposure to commodities through the
purchase of physical assets, equity-related assets, ETFs, and commodity-linked notes.

Three Disadvantages of Direct Investment in Physical Commodities

Disadvantages
• Storage and transportation—institutional investors are generally not prepared to take
physical delivery.
• Convenience yield suggests that some will pay a premium for immediate access to a
commodity. Institutional investors may not get any benefit from timely access and
may be better owning commodities in some other form.
• Owning cash commodities requires cash outflow that is avoided with some forms of
commodity exposure.

The Hotelling Theory and Attractive Direct Commodity returns

The Hotelling theory holds that the future price of a commodity should rise with an
appropriately risk-adjusting rate, r.

The expected price of a commodity at time T in the future is tied to the spot price with the
rate. This formulation ignores storage cost because it is not calculating a current forward
price but rather is predicting the anticipated spot price. Note that r could be below prevailing

253
© 2020 Wiley
REAL ASSETS

rates if owning the commodity has risk-reducing properties (an inflation hedge or low
correlation).

Hotelling’s theory applies to energy and metals but not agricultural products because energy
and metals have an exhaustible supply. An unleveraged position in energy or metals could
be expected to produce a long-term risk-free return plus a risk premium.

Simon and Unattractive Direct Commodity Returns

Stanford biologist Paul Ehrlich believes we have reached peak extraction rates and that it
will be impossible to maintain the level of extraction. Julian Simon argues that innovation
will force down the price of commodities. The two made a 10-year bet on a basket of five
commodities. All five prices declined.

Support for Hotelling is based on the common sense argument that producers will extract the
cheapest sources of a commodity first and need to rely on more expensive supplies over
time. Technical innovation suggests that the earlier equation should state that the expected
price will be less than or equal to the price predicted on the right-hand side.

If the expected price at time T is greater than would be expected from the spot price, traders
can buy the spot commodity until it is bid up to fair value. If the spot price is too high, it is
difficult to borrow the commodity to short it, so the spot price can be too expensive. This
potential argues against investing in delivered commodities.

The Idiosyncratic Risks and Two Betas of Commodity-Related Equities

It is tempting to invest in a producer of a commodity as an indirect way to invest in the
commodity. Most producers are involved in more than one commodity, so it is difficult
to make this a pure play. Even a pure play producer might not be correlated with the
commodity price if the producer hedges or if it doesn't own the rights. To the extent
stock price and the commodity are correlated, the stock has a commodity beta and also
an equity beta linked to broad stock returns. Like any company, the producer will have
idiosyncratic risks tied to specific accidents, management issues, or labor. The producer
may have other unrelated business risks, producing impacts not correlated with the
commodity.

Broad market indexes have substantial exposure to energy, metals, and materials. For
example, nearly 10% of the Russell 1000 index is in commodity production.

Commodity-Linked Exchange-Traded Funds and Notes

ETFs invest in a single commodity or a basket as futures, equities, and physical ownership.
Most ETFs offer unlevered exposure to commodities but others use leverage and some
create negative exposure through short positions. ETFs are cost effective for individual
investors but not most institutions.

Exchange-traded notes are bonds issued by banks or investment banks whose coupon is tied
to the price of a commodity or index. Investors are exposed to the credit risk of the issuer.

Returns on commodity ETFs may not be closely correlated to commodity returns. They may
invest in futures that may not closely track spot commodity prices. Other ETFs invest in
equities tied to one or more commodities. Their stock investments may decline along with
equity markets even while commodity prices stay the same or rise.

254
© 2020 Wiley
 COMMODITIES

Three Advantages and One Disadvantage of Commodity-Linked Notes

Pluses
• Investor does not need to roll expiring futures contracts.
• They are debt that most investors can buy without special approval.

Minuses
• Idiosyncratic risks including default of the issuer.

Commodity-Linked Notes Example

A commodity-linked note may be subject to a cap or call. In this case, the principal payment
rises and falls with the associated commodity, up to limit amount. Above this limit,
investors do not benefit from further increases in the price of the commodity.

Learning Objective: Demonstrate knowledge of the term structure of forward

prices on commodities.

TERM STRUCTURE OF FORWARD PRICES ON COMMODITIES

MAIN POINT: The section called “Derivatives and Risk Neutral Valuation” described the
shape and slope of the forward curve for financial contracts. Similarly, for commodities,
forward curve is affected by borrowing costs, storage costs, and convenience yield. The
commodity forward curve can also be influenced by changes in demand and supply (such as
the impact of harvests).

Cost of C arry for Commodities

The equation following summarizes the factors that impact the shape of a commodities
forward curve:

The riskless rate, r, tends to raise the forward price, as does storage cost, and other optional
costs, including spoilage costs and inventory shortage.

Harvests, Supply Elasticity, and Shifts in Demand

Perfectly elastic supply means that suppliers quickly respond to changes in price. Inelastic
demand refers to potential buyers who do not quickly change the amount they would buy if
the price changes.

Changes in forecasted supply or demand can change the spot price and shape and slope of
the forward curve.

Backwardation and Contango

Commodity forward prices that are in contango trade at prices above the price at later
delivery. Commodity forward prices that are in backwardation trade at prices below the
price for later delivery. The chart illustrates backwardation and contango. The term structure
is influenced by short-term interest rates, storage cost, and convenience yield and may not
resemble the consistent illustration of backwardation and storage costs.

255
© 2020 Wiley
REAL ASSETS

Commodity Term Structures

85.00

Contago

Backwardation *•

All other things equal, a commodity is likely to be in contango when the riskless rate of
interest exceeds the asset’s dividend yield and in backwardation when the dividend yield
exceeds the risk-free rate.

How Backwardation and Contango Reflect Cost of Carry in a Perfect M arket

The term structure prices in the impact of the risk-free rate, storage, and convenience. If the
pricing is efficient and these costs have not changed, then the return should be the same for
each commodity in the term structure.

Backwardation and Contango in an Imperfect M arket

Factors Interfering with Efficiency
• Storage costs differ over time and between different investors.
• Convenience yield can vary over time and over market participants.
• Illiquidity in the commodity lending market inhibits arbitrage that involves shorting
the spot and buying the forward.

The Basis of Forward and Futures Contracts

The basis of a forward or futures trade is the difference between the spot or physical price
and the future/forward. The basis for some commodities equals the future/forward minus the
spot. Since the forward becomes the spot eventually, the basis experiences convergence,
that is, the basis gradually declines to zero.

Calendar Spreads on Forward Contracts

A calendar spread involves a long position in one forward asset and a long position in
another forward asset.

The Return on a Calendar Spread

The return on a calendar spread depends on changes in interest rates, holding costs, and the
convenience yield.

The Risks of a Calendar Spread

The price of the underlying commodity has little impact on a calendar spread. Instead,
changes in interest rates, holding costs, and convenience yield affect the calendar spread.

256
© 2020 Wiley
 COMMODITIES

Learning Objective: Demonstrate knowledge of rolling of forward and futures

contracts.

ROLLING OF FORWARD AND FUTURES CONTRACTS

MAIN POINT: The return on a position in forwards and futures can differ substantially from
the return on physical commodities. Operational details like the timing of rolls can also
affect results.

Why Returns on a Futures Contract Can Differ from the Spot Return Components
of Futures Returns
Returns on futures may differ substantially from returns on a spot investment:

• The returns on a future might be leveraged.

• The basis between spot and futures may change.
• The markets may be inefficient.
• The cost built into the basis may be different than the costs of a particular investor.
• The convenience yield is not equal to the storage costs.

Components of Futures Returns

The return on an unleveraged but fully collateralized futures position is summarized with
two factors:

RFully Coiiaterized = Collateral Yield + Excess Return

Since the buyer of futures doesn't pay for the asset, the first component is a short-term return
on the uninvested cash. The second term is the return on the future, including gains or losses
from changes in market levels.

Alternatively, the return can be explained with the spot return:

RFuiiy Collateralized = Spot Return + Collateral Yield + Roll Yield

The spot return is the return on an unhedged position in the physical commodity. The
collateral is, again, return on a short-term asset where the investor parks cash not required
for the future investment. The roll return is the change in the basis over time. The roll return
experienced is a mixture of returns associated with rolling down the term structure plus
changes in the term structure (linked to changes in short rates, storage costs, convenience
yield, dividend on the asset, and other factors).

Two Interpretations of Rolling Contracts

The roll can refer to:1

1. Moving along a possibly changing term structure with a static position. In this case,
the roll return involves the impact of convergence and other changes in the basis
(economist’s perspective).
2. Closing out one future and replacing it with a similar position in a later contract.
This measures the gain/loss recognized when moving from one contract to another
(accountant’s view).

257
© 2020 Wiley
REAL ASSETS

Roll Yield and the Slope of the Forward Curve

Holding a long in a contract in backwardation is seen as being profitable. Convergence
upward to the spot price appears to add to the return. However, in an efficiently priced
forward market, this convergence will not contribute toward excess return. Rather, the
term structure is priced so that the convergence and the commodity return together provide
a fair (not excess) return.

Roll Yield, Carrying Costs, the Basis, Alpha

Three equivalent ways describe the difference between spot and forward:

1. The basis
2. Carrying costs (including convenience yield)
3. Roll yield

The Strategy of Rolling Contracts Affects Return Expectations

Long-term investors in a commodity choose between investing in a nearby contract and
rolling several times or instead buying a deferred contract. The returns will differ some,
depending on the path of interest rates and other factors during the holding period.

The Impact of Rolling Contracts on Alpha

A particular rollover strategy can affect ex post returns. However, in an efficiently priced
term structure, this is equivalent to predicting future levels of calendar spreads. It is difficult
to predict most of these changes because they are caused by changes in external factors,
like interest rates or convenience yield.

Markets are not always efficient. Also, transaction costs will vary for different strategies.

Three Propositions Regarding Roll Return

• Proposition 1: Roll returns are earned over time via convergence and changes to the
term structure. This view rejects the accountant's view that roll returns are earned
when gains are realized.
• Proposition 2: Roll returns are not necessarily positive in backwardation.
Convergence contributes profits but changes to market factors could cause a change
in the term structure that results in a loss.
• Proposition 3: A position that generates roll return is not necessarily generating alpha.
Positive roll return is a component of total return but, if efficiently priced, is part of
the return necessary to earn a market return.

Learning Objective: Demonstrate knowledge of normal backwardation and

normal contango.

NORMAL BACKWARDATION AND CONTANGO

MAIN POINT: The term structure of forward prices can be upward sloping, contango, or
downward sloping, backwardation. Several factors affect the shape of this curve.

Normal Backwardation
In normal backwardation, either the spot or forward price is not observable but the missing
price is deemed to be in a backwardation term structure. The missing price is imputed based
upon an assumed level of backwardation.

258
© 2020 Wiley
 COMMODITIES

Normal Contango
In normal contango, either the spot or forward price is not observable but the missing price
is deemed to be in a contango term structure. The missing price is imputed based upon an
assumed level of contango.

Interpreting Normal Backwardation and Normal Contango

Not all writers use the concept of normal backwardation or normal contango. Expected spot
prices at a later point in time are not equal to forward or future prices.

Keynes and Normal Backwardation

Keynes argued that commodity markets should generally be in backwardation. Producers
are natural sellers of deferred futures and users are a natural buyer of front settled
commodities. But arbitrageurs should compete away any such efficiency.

Commodity Forward Curves, Storage Costs, and Inventory Variation

It is generally held that a commodity market will be in contango when there is an adequate
or excessive supply and will be in backwardation when the supply is tight.

Backwardation is more likely when orders to buy are seasonal.

Less steep contango or maybe backwardation is more likely if inventories are low.

Commodity Forward Prices and the M arket Segmentation Hypothesis

Different sellers/buyers have a preference for nearby or back month forwards that may not
be sensitive to calendar spreads. This might explain a hump-shaped term structure in crude
oil futures, reflecting different net supply and demand conditions at different settlement
points. This argument is similar to the market segmentation (or preferred habitat) hypothesis
used in fixed income markets.

Option-Based Models of the Forward Curve for Commodities

Two real options exist in the commodity term structure:

1. The option to extract a natural resource—Short-term excessive supplies may push

the price below replacement costs in the spot market but producers will shut down
before producing at a loss. Forward markets, where products sell, will not be under
pressure to drop below replacement cost.
2. The volatility asymmetry—Volatility rises on commodities when prices rise and
decline when prices decline because shortages are more disruptive than surpluses.
This will flatten contango curves or may create backwardation.

Learning Objective: Demonstrate knowledge of commodity exposure and

diversification.

COMMODITY EXPOSURE AND DIVERSIFICATION

MAIN POINT: The primary reason to invest in commodities is to diversify investment
returns and thereby reduce risk.

Four Explanations of Commodities as Diversifiers

Several reasons why commodities are negatively correlated or at least not highly correlated
to traditional financial assets:

259
© 2020 Wiley
REAL ASSETS

1. Commodities are not valued as discounted future cash flows.

2. Commodities are correlated to inflation because commodity prices are a major
component of inflation indexes.
3. High and low points for commodities are tied to a different phase of the business
cycle than are stocks.
4. As a cost of goods, a rise in commodity prices results in a decline in corporate
profits.

Commodities as Diversifiers in a Perfect M arket Equilibrium

An efficiently diversified portfolio contains a wide variety of assets weighted the same as
the weights in the market portfolio.

Commodities as Diversifiers in the Presence of M arket Imperfections

Markets are not in perfect equilibrium and are likely to remain imperfect. For example,
oil wealth is highly concentrated in a few countries. Since they are overweighted in oil,
the rest of the market participants must collectively be underweighted.

Commodities as Diversifiers against Unexpected Inflation

Commodity returns tend to match nominal inflation. Bonds perform badly when facing
unanticipated inflation. Real assets, especially commodities, offer inflation protection.

Learning Objective: Demonstrate knowledge of the expected returns on

commodities.•*

EXPECTED RETURNS ON COMMODITIES

MAIN POINT: The return on a cash investment in many commodities does not argue
for investment in commodities as an asset class. Other ways to create commodity
exposure offer higher expected returns and very powerful diversification effects.

Empirical Evidence on Long-Run Commodity Price Changes

The long-term real return on most spot commodities is negative over 50 to 150 years.
Over the same period, prices of come commodities have risen but generally less than
prevailing nominal interest rates.

Theoretical Evidence on Expected Commodity Returns

Arguments against investing in physical commodities include:

• No risk premium—Because commodities are uncorrelated with traditional assets,

the equilibrium return should be close to the risk-free rate but commodities have
fallen behind that hurdle.
• Technological progress—We have developed ways to extract commodities cheaper
with mechanisms to speed the process and remove production costs. Technology
has supported extraction from sources previously impossible or uneconomic.
• Convenience yield—Users of commodities may get a convenience yield that justifies
ownership of commodities. Few investors share that benefit, so the convenience
yield is lost.

Irrelevancy of Commodity Price Expectations to Returns on Futures Contracts

It is possible, even likely, to earn positive returns on futures and forwards even while the
spot price is expected to decline. If producers sell commodities forward at prices above spot
and find ways to lower production or extraction costs, they can lock in prices before
equilibrium prices decline.

260 © 2020 Wiley

 COMMODITIES

Further, futures prices tend to anticipate these technical advances so are often fully priced to
a lower expected price. Investors can earn fair returns if forward markets correctly anticipate
spot price decreases.

Producers are natural deferred sellers of commodities as hedges. If there are too few buyers,
these future/forward prices may settle at levels that offer an incentive to investors to take the
other side.

Learning Objective: Demonstrate knowledge of commodity indices.

COMMODITIES FUTURES INDICES

MAIN POINT: This section reviews investible indexes focused on commodities. These
indexes are composed of only commodities that investors can legally and practically own
and the composition of the index is sufficiently disclosed to allow replication.

Construction and Uses of Commodity Futures Indices

Commodity indexes are based upon futures or forwards because they standardize the
description of the products and are traded in central locations with high transparency.
Indexes are generally based on unleveraged investments, so they need to account for the
return on uninvested cash and are long only.

Investors can use commodities indexes as a benchmark to measure their performance in the
sector. The indexes can be a starting point to actively take exposure different from the index
weightings to try to add value. Finally, the indexes can be used to create passive commodity
return, either by buying individual components of the indexes directly or investing in
derivatives based on an index.

Commodity Futures Indices

To construct a futures index, you must decide when to roll the futures, what commodities to
include, and how they should be weighted. Several hundred commodities futures indexes are
published worldwide.

Production-Weighted Long-Only Commodity Indexes

Production weighting seeks to match the index to world GDP. The S&P GSCI index uses
the first futures contract. The CME trades a future based on this index. It contains 24
physical commodities, 70% in energy, but also includes precious metals, industrial metals,
livestock, and agriculture.

M arket Liquidity-Weighted Long-Only Commodity Indexes

The Bloomberg Commodity Index uses market liquidity to determine weights. It is also long
only, composed of 23 commodities in six sectors: energy, grains, precious metals, industrial
metals, livestock, and softs. Sector weightings are bounded between 2% and 15% of the
total.

Tier-Weighted Long Only Commodity Indices

This type of index collects commodities into groups based upon similar characteristics, then
weights the groups. The Thomson Reuters/Core Commodity CRB Index was the first widely
recognized index and is composed of 19 commodities. Four groups include petroleum
(33%), agriculture (42%), precious metals (20%), and base or industrial metals (5%). The
index is described as representative of global commodities markets.

© 2020 Wiley
REAL ASSETS

Learning Objective: Demonstrate knowledge of commodity risk attributes.

COMMODITY RISK ATTRIBUTES

MAIN POINT: Commodities generally have favorable risk profiles, especially with
respect to event risk that traditional assets may experience.

Four Favorable Characteristics of Commodities with Respect to Event Risks

Four favorable risk features of commodities include the following:

1. Global events tend to increase the price of commodities.

2. Upward price shocks are faster and larger than downward price shocks.
3. Returns on various commodities are frequently uncorrelated with each other.
4. Price shocks in commodities are uncorrelated with price shocks in traditional
assets.

Commodities as a Defensive Investment

Correlation between equities in different parts of the world rises during periods of market
distress, lowering the value of diversification within global equities. Investments in
commodities are especially helpful in truncating downside risk.

Commodity Prices and Institutional Investing Demand

Institutional investors have significantly raised their allocation to long-only investments in
commodities. Commodities prices declined in 2007-2008, perhaps in part from institutional
reaction to the overall decline in their portfolios. Other factors could account for this decline,
such as changes in USD exchange rates, and flagging demand for commodities by China
and other emerging economies.

Institutional investing may have increased the volatility of commodities prices but
academics are not in agreement. Some academics argue that index investing damps
volatility.

Learning Objective: Demonstrate knowledge of observations regarding

historical commodity returns.•*

HISTORICAL COMMODITY RETURNS

MAIN POINT: The following points summarize CAIA’s description of commodity
investing:

• Volatility of unleveraged returns on commodities slightly exceeds equity returns.

• The Sharpe ratio for commodities investing is generally negative.
• Commodity returns exhibit moderate positive autocorrelation.
• The maximum monthly loss in commodities is 50% higher than equity losses
(around 30%).
• Commodities have produced very large drawdown returns (80%).

262
© 2020 Wiley
 COMMODITIES

Historical Commodities Returns

Index (January 2000 to December 2018) 1.4%
Annualized Arithmetic Mean 22.4%
Annualized Semivolatility 15.9%
Annualized Median 4.1%
Skewness -0.4
Excess Kurtosis 1.2
Sharpe Ratio -0.05
Sortino Ratio -0.07
Annualized Geometric Returns -1.1%
First-Order Autocorrelation 19.3%
Annualized Standard Deviation3 27.3%
Maximum 19.7%
Minimum -28.2%
Max Drawdown -80.9%

“Adjusted for autocorrelation.

Adapted from CAIA Level I, 4th ed., 2020. Copyright © 2009, 2012, 2015
by The CAIA Association.

263
© 2020 Wiley
 Ot h e r Re a l A s s e t s

The performance of the first two types of investments covered in this section, while related
to real assets, is driven by operations and not by the underlying real asset: the stocks of
commodity producers (e.g., gold miners, oil refineries), and master limited partnerships
(MLPs) that are related primarily to operations involved with energy commodities. The third
type of real asset discussed is infrastructure investments which share commonalities with
fixed income, private equity, and real estate investments. The fourth real asset covered is
investment in an intangible asset: intellectual property.

LESSON MAP
• Demonstrate knowledge of commodity producers.
• Demonstrate knowledge of liquid alternative real assets.
• Demonstrate knowledge of infrastructure in the alternative investment space.
• Demonstrate knowledge of intellectual property.
• Demonstrate knowledge of cash flows of intellectual property.
• Demonstrate knowledge of historical performance data on visual works of art.
• Demonstrate knowledge of research and development and patents as unbundled
intellectual property.

KEY CONCEPTS
When gaining exposure to various real assets, it is important to determine if the investment
vehicle is a pure play on the underlying real asset, and, if not, how correlated it is or is not
with equity markets. Liquidity and volatility can vary across investment vehicles that appear
to be similarly designed to provide exposure to the same underlying real asset. This is
particularly true when the company or companies comprising a fund are operationally
intensive, as in the case of commodity producers and liquid real assets (MPLs).

Infrastructure investments tend to have stable, high dividends due to several common
characteristics that result in inelastic demand for their goods and services. That is, demand is
insensitive to changes in prices for the goods and services.

Intellectual property (IP) investments are increasingly becoming “unbundled” from

companies that historically have included these intangible assets in their overall valuations.
These intangible real assets are generally “wasting” assets, whereby the cash flows decrease
over time as exclusivity wanes (e.g., patents expire). A variant of the dividend discount
model for stocks can be adapted to value such wasting assets by assuming the growth rate in
future cash flows is negative. In addition, early-stage projects can be considered to have
option-like pay-offs, where they make money if successful or cost a premium if they are not.

Learning Objective: Demonstrate knowledge of commodity producers.1*

COMMODITY PRODUCERS
MAIN POINT: Stock returns of commodity producers are driven by operational issues and
are often not strongly correlated with changes in the prices of the commodities they are
producing or servicing. Their stocks are not a pure play on commodities.

How commodity prices affect operating performance of firms that transform natural
resources into commodities depends on:

1. Price elasticity of demand: %Change in Quantity Demanded/%Change in Price

2. Price elasticity of supply for the commodity: %Change in Quantity Supplied/%
Change in Price
3. How much commodity price risk the producer has hedged

© 2020 Wiley
REAL ASSETS

Demand is relatively inelastic (not sensitive to changes in price) when the good is
necessary and more elastic when there are substitutes for the good. Supply is more elastic
in the long run than the short run. Supply is relatively inelastic when the production
process is long and complicated and more elastic when there are extra inventories and
excess storage capacity.

The general relationship between commodity prices and equity prices of commodity
producing firms is weak.

Example: Gold
Long-term (2002-2012): Gold peaked in 2012, with a six-fold increase in price while the
stocks of gold mining firms only went up 50%.

Short-term (September-November 2008): Gold was slightly up but gold mining firms went
down.

More formally, empirical evidence shows that while commodity price changes are not
highly correlated with equity returns, the stock returns of commodity producers are highly
correlated with overall equity returns, about as much as they are correlated with commodity
prices.

Example: Oil
Oil price changes (USO, an ETF providing access to the price of West Texas intermediate,
light sweet crude oil) are not highly correlated with equity returns (SPY, an ETF mimicking
the S&P 500): .45.

The stock returns of oil producers (XES, an ETF containing stocks of oil and gas equipment
services companies, and XOP, an ETF of oil and gas exploration and production stocks) are
highly correlated with overall equity returns (SPY): .65 and .62, respectively.

The returns on XES and XOP are similarly correlated with USO: .71 and .69, respectively.

The stocks of commodity producers are therefore not a strong diversifier and behave more
like equity than the related commodity.

Learning Objective: Demonstrate knowledge of liquid alternative real assets.

LIQUID ALTERNATIVE REAL ASSETS

MAIN POINT: Master limited partnerships (MLPs) are generally operating companies in
the energy sector structured as publicly traded limited partnerships. Their distributions are
not taxed and this gives rise to controversy surrounding their valuations as either based on
the present valuation of future growth opportunities or perhaps, instead, on distributions
from other investors, rather than earnings.

Master limited partnerships (MLPs) are an increasingly popular way to get liquid exposure
to operationally intensive real assets. Most MLPs are natural resource operating companies
in the energy sector, but there are also some in real estate, timber, and other areas allowed
by regulations. MLPs are simply limited partnerships that are traded publicly: their “units”
are listed on exchanges. Units are like corporate security shares in that they represent
ownership in the company. As in the case of buying corporate shares of natural resource
companies (commodity producers), MLPs are not pure plays on the commodity the
company produces.

266
© 2020 Wiley
 OTHER REAL ASSETS

Upstream operations focus on exploration and production; midstream operations focus on

storing and transporting the oil and gas; and downstream operations focus on refining,
distributing, and marketing the oil and gas.

Midstream operations and midstream MLPs—the largest of the three segments—process,

store, and transport energy and tend to have little or no commodity price risk. They are also
known as a toll road for energy.

Tax Characteristics of MLPs

Unlike C Corporations, MLPs are not subject to double taxation. At the partnership level,
MLPs are not taxed. The earnings flow through to the limited partners who then pay taxes
on the income whether distributed or not, but any distributions are not taxed, as in the case
of other investment companies.

Double taxation is the application of income taxes twice: taxation of profits at the corporate
income tax level and taxation of distributions at the individual income tax level.

The distributions from MLPs lower the tax basis so that sales proceeds tend to be taxed at a
rate higher than the capital gains rate. Thus, the tax-free distributions in the short run
represent a tax deferral in the long run.

Tax benefits must be weighed against three potential drawbacks:

1. MPLs must file a K-l form, which is more complicated than 1099 forms filed by
other investment companies.
2. MLPs may be subject to state taxes. 3. For some pension plans and not-for-profit
corporations, MLPs can cause unrelated business income tax liability if the income
is the result of activities unrelated to the tax-exempt purpose of the organization.

Valuation of MLPs
There is controversy surrounding the valuation of some MLPs due to the way income may
be distributed. Other investment companies like REITs and mutual funds set their
distributions close to their income. However, particularly since for MLPs distributions are
not taxed, they can set distributions as high as the cash flow will allow. Some allege these
high distribution rates are not sustainable. Others believe that high valuations are based on
the present value of growth opportunities.

In corporate finance, present value of growth opportunities (PVGO) describes a high

value assigned to an investment based, on the idea that the underlying assets offer
exceptional future income.

In any event, MLP investing is skill based, requiring knowledge of the company and sector.

Learning Objective: Demonstrate knowledge of infrastructure in the alternative

investment space.

INFRASTRUCTURE AS AN ALTERNATIVE ASSET

MAIN POINT: Investable infrastructure shares many characteristics. For example, they tend
to be monopolistic and can provide services to the public that have inelastic demand, such as
utilities, with stable growing cash flows. Greenfield projects (new) are riskier, offering
upwards of 10% annual returns more than brownfield (mature) projects, offering typically
7% to 10% returns. Investment vehicles include listed and unlisted funds that are either

267
© 2020 Wiley
REAL ASSETS

open-ended or closed-end funds. The most liquid are listed open-ended funds that are
relatively volatile and correlated with equity markets. Least liquid are unlisted closed-end
funds that are less volatile and uncorrelated with equity markets. In terms of an asset class,
infrastructure investments have commonalities with debt, real estate, and private equity.

Not all infrastructure assets are suitable for private investment.

For our purposes, investable infrastructure is typically differentiated from other assets
with seven primary characteristics: (1) public use, (2) monopolistic power, (3) government
related, (4) essential, (5) cash generating, (6) conducive to privatization of control, and
(7) capital intensive with long-term horizons.

An investable infrastructure project may not possess all seven of these characteristics.

A critical property of infrastructure is the nature of the revenues. Investable infrastructure

is distinguished from traditional assets in that stable cash flows that grow with the rate of
inflation are generated because of the monopolistic rather than competitive environment.

The major types are divided into:

1. Economic infrastructure (e.g., transport: airports, seaports, roads, railways; utilities;

water treatment and distribution; specialty sectors such as forests)
2. Social infrastructure (e.g., education facilities, healthcare facilities, and correctional
facilities)

Public-Private Partnerships in Infrastructure Investing

Governments realize that sometimes one monopolistic firm can provide services at a lower
social cost with greater efficiencies than can many competitive firms. Investments in
infrastructure create positive externalities and thus governments will often create a statutory
monopoly.

Some investments may have many of the seven characteristics but not be investable
infrastructure. For example, a municipal bond backed by the revenues from a toll road
remaining full government authority would not qualify because it has not been privatized.

When a governmental entity sells a public asset to a private operator, this is termed
privatization.

A public-private partnership (PPP) occurs when a private sector party is retained to

design, build, operate, or maintain a public building (e.g., a hospital), often for a lease
payment for a prespecified period of time.

In either the case of full privatization or partial privatization, as in a PPP, transactions

are subject to regulatory risk.

Risks and Government Regulation of Infrastructure Investing

Revenues are closely tied to the price of the services offered. Regulated pricing happens
when the service is deemed necessary to the public and price increases have to be approved
by the government. While regulated pricing may limit profits, it generally provides very
stable cash flows.

© 2020 Wiley
 OTHER REAL ASSETS

Regulatory risk can occur in a transaction. Regulatory risk is the economic dispersion to an
investor from uncertainty regarding governmental regulatory actions.

Political infrastructure risk includes both regulatory and non-regulatory risk. The risk of
expropriation is a good example. Because of this type of risk many investors will not invest
in a country that has a poor political infrastructure.

Another risk stems from not being able to pay debt back if the initial price of the project is
too high or cash flow projections too optimistic.

Stages of Infrastructure
Greenfield projects tend to be more risky than brownfield projects.

Investable infrastructure can originate as a new, yet-to-be-constructed project, referred to as

a greenfield project, that was designed to be investable.

Investable infrastructure can also be an existing project, or brownfield project, that has a
history of operations and may have been converted from a government asset into something
privately investable.

As illustrated in the figure, the riskiness of the investment depends on its maturity
(greenfield versus brownfield) and its exit strategy. Common exit strategies include selling
assets to other investors in the secondary market, getting co-investors, floating an initial
public offering, selling to a strategic buyer or securitizing the cash flows.

Risk Profile of Infrastructure Development Stages

Source: CAIA Level I, 4th ed., 2020. Exhibit 11.4. Copyright © 2009, 2012, 2015 by The CAIA Association.

Infrastructure Investment Vehicles

There are several types of infrastructure investment vehicles, which can be in stocks, various
types of funds (as summarized in the table following), or direct investments. In addition,
infrastructure investment vehicles are often global and may carry currency risk.

© 2020 Wiley
REAL ASSETS

Infrastructure stocks tend to have relatively high dividends and low volatility. This stems
from the price inelasticity of goods and services provided by many infrastructure projects
and their monopolistic nature.

The following table compares closed-end and open-end funds, both of which can be either
listed or unlisted.

Listed Funds Unlisted Funds

Closed-End Funds More liquid than unlisted Structured like private
Fixed size funds. Less liquid than equity funds, with a typical
open-end funds due to life of 10 to 15 years, with
prices deviating from NAY. similar management fees
(1-2%) and carried interest
(10-20%) over a preferred
return of 8% paid at the
exit. Lower correlation to
equity markets with lower
volatility, perhaps due to
appraisal-based valuation
and illiquidity.
Open-End Funds More liquid than unlisted Evergreen funds. More
Allow investors to funds and closed-end liquid than unlisted closed-
subscribe to and invest funds. end fund. If demand for
further or redeem and make Greater volatility and redemptions is too great, the
withdrawals on a regular correlation with equity fund may erect gates.
basis markets, relative to unlisted
funds.

Infrastructure Investment Funds

Unlisted open-end funds, also called evergreen funds, allow investors to subscribe to or
redeem from these funds on a regular basis.

Gates are fund restrictions on investor withdrawals.

The next figure presents another classification of infrastructure funds.

Types of Infrastructure Investments

Unlisted Direct
Investment Unlisted Fund Listed Securities
Investment Very high Moderate Low
size
Ease of access Difficult; takes Moderate difficulty; Easy and
considerable time takes moderate time immediate
Length of Long term Long term Flexible
investment
Capacity Limited Moderate High
Liquidity Low Low to medium High

270
© 2020 Wiley
 OTHER REAL ASSETS

Unlisted Direct
Investment Unlisted Fund Listed Securities
Leverage Low but varies High Moderate
Lees/expenses No fees; very high High fees; low Low fees and
expenses expenses expenses
Diversification Concentrated risk; low Medium to high; low High; high
correlation to other correlation to other correlation to
assets assets other assets
Control Maximum control over High level of control Limited control
assets

Source: CAIA Level I, 4th ed., 2020. Exhibit 11.5. Copyright © 2009, 2012, 2015 by The CAIA Association.

Twelve Determinants of Infrastructure

Earlier we listed seven characteristics of infrastructure. Here we list 12, and there is some
overlap. The intent here is to distinguish investable infrastructure from other asset classes.

1. Inelastic demand
2. Monopolistic market positions
3. Regulated entities
4. Capital-intensive setup, low operating costs
5. Low volatility of operating cash flows
6. Resilience to economic downturns
7. Technology risk
8. Long-term horizons
9. Inflation-indexed cash flows
10. Stable yield
11. Low correlation with other asset classes
12. Potentially low total and idiosyncratic risks

Infrastructure versus Other Asset Classes

Operating
Type Financing Costs Return Others
Infrastructure Long-term Medium Medium Long duration and
with leverage inflation protection
Real estate Long-term Medium Medium Long duration and
with leverage inflation protection
Private Medium-term Low High Exposure to equity risks;
equity with some high leverage and interest
leverage rate risk for buyouts
Public equity Highly liquid Very low High Volatile and limited
protection against inflation
Public debt Llexible Very low Low to No protection against
maturity and medium inflation and exposure to
varied interest rates
liquidity

Source: CAIA Level I, 4th ed., 2020. Exhibit 11.4. Copyright © 2009, 2012, 2015 by The CAIA Association.

27,
© 2020 Wiley
REAL ASSETS

Opportunities and Allocations in Infrastructure Investments

Globally, under-investment in infrastructure has resulted in new capacity. Historically,
infrastructure has been under the purview of governments but partnerships with private
investment can help improve the degradation of existing assets in forward-thinking
countries.

Characteristics of Different Asset Classes

Institutional Institutional
Infrastructure Bonds Real Estate Private Equity
Nature of Typically an operating Financial Physical property Operating company
asset company dependent on security
control of large, physical
assets
Asset Asset scarcity; many in Deep volumes Moderate to deep Moderate volumes in
availability unique, monopoly in most markets volumes in most most markets
situations markets
Acquisition Competitive tenders; Efficient, on- Competitive Competitive tenders,
dynamic regulatory, market tenders; management buyout,
environmental, social, purchase environmental negotiated trade sale,
and political issues; and social issues typically medium-term
often held for the long common exit strategy
run
X L i X X

Liquidity Moderate Very high Moderate in most Moderate

sectors
Income Once assets mature, very Fixed coupon; Mixture of fixed Typically dominated by
stable; inflation/GDP sensitive to and variable capital returns
growth relative; interest rates interest rates and
typically higher than sector dependent
bonds and core real
estate
Growth Dependent on asset Low Dependent on Dependent on asset
stage; modest (late asset characteristics; typically
stage) to high (early characteristics; high
stage/development moderate to high
assets)
Volatility Moderate (early stage) Moderate Low/moderate High (early stage) to
to low (late stage) (market factors) moderate (late stage)
depending on industry
sector
Typical Mature portfolio: Approximately Core: ~7%-9%; Diversified portfolio:
return 7%-10%; development 5%-7% value added: >15%
expectation portfolio: >10% ~12%-18%;
per annum opportunistic:
post fees >18%

Source: CAIA Level I, 4th ed., 2020. Exhibit 13.4. Copyright © 2009, 2012, 2015 by The CA1A Association.

As shown in the previous figure, investable infrastructure investments share commonalities

with fixed income, private equity, and real estate investments. Many investors, when they
analyze their asset allocation, classify infrastructure as debt, while others classify it as

© 2020 Wiley
 OTHER REAL ASSETS

private equity, and yet others as real estate or real assets. About 50% surveyed in a CFA
Institute paper called it a unique asset class.

Learning Objective: Demonstrate knowledge of intellectual property.

INTELLECTUAL PROPERTY
MAIN POINT: The value of intellectual property has been included in the value of the
equity of firms that own the intellectual property, but is being increasingly “unbundled” as a
stand-alone asset. A variation of the dividend discount model can be used to value some
intellectual property where the growth rate is negative, because it is a wasting asset that
enjoys diminishing cash flows as time passes.

Intellectual property is an intangible asset and can be viewed as both (1) excludable
creativity and (2) ownership rights to “creations of the human mind.”

Intangible assets are economic resources that do not have a physical form. Intangible assets
are real assets and can include ideas, technologies, reputations, artistic creations, and so
forth.

Intellectual property(IP) is an intangible asset that can be owned, such as copyrighted

artwork.

An excludable good is a good others can be prevented from enjoying. Exclusivity

distinguishes private goods and private property (e.g., houses) from public goods (e.g., air).

In recent years, there has been an increased interest in unbundling IP from corporations and
permitting it to be purchased as a stand-alone investment. Examples of such assets include
patent portfolios, film copyrights, art, music, other media, and brands.

Most IP is a “wasting” asset, although some offer capital accumulation over time (e.g., some
artwork). For wasting assets, most of the benefits occur early on and then decline over time
as, for example, patents expire and exclusivity wanes. Riskiness often depends on the stage
of the IP. Early-stage IP assets have payoffs like options, whereas cash flows from later
stage assets are relatively known and stable: Consider the rights to a film. Before its release,
it is like an option that is either successful with large returns or unsuccessful with no payout.
After its release, 50% of the revenues are realized the first year, and revenues drop 5% each
year thereafter, although the life may be as long as 80 years, according to one study.

A Valuation Model for Wasting Assets

If we denote p as the probability of the film being successful then the value, V, of the film
discussed here can be written in the simplified model for valuing wasting assets following,
which can be rearranged to find the return, r, as in the second equation. This is the familiar
model for valuing a stock by discounting it. Cash flows grow at a rate of g, with two
exceptions: (1) the probability, p, and (2) although the growth rate is usually positive for
stocks, here it is negative.

r = p x (CFi/Vjp,0) + g

© 2020 Wiley
REAL ASSETS

Example 1
If the probability of a film being successful is 40% and the first year’s expected cash
flow is $50 million, with each subsequent year’s cash flow being 5% smaller, what is the
value of the film if the discount rate is 20% ?

Solution

p = .4; CFX = $50,000,000; g = -.05; r = 2\ V = .4(50,000,000)/(0.20 - (-.05)) =

$80 million

Example 2
If the probability of a film being successful is 50% and the first year’s expected cash
flow is $50 million, with each subsequent year’s cash flow being 6% smaller, then what
is the expected return if the estimated value of the film is $100 million?

Solution

p = .4; CFj = $50,000,000; g = -.06; V = $100,000,000; r = .4(50 million/100 million)

+ (-.06) = 14%

Learning Objective: Demonstrate knowledge of cash flows of intellectual

property.

CASH FLOWS OF INTELLECTUAL PROPERTY (FILMS)

MAIN POINTS: Film exhibition venues begin with “theatrical” immediately after release
and end up in “television syndication” an average of 132 months after the initial release.
Nine major types of financing options are available to film studios. The returns on
individual films are difficult to predict but in general are skewed to the right.

Film production and distribution is an IP category of artwork. Several other forms of film
exhibition venues are released in between the initial “theatrical” and final “TV syndication”:
including home video, pay-per-view, and basic cable. Profits are very difficult to estimate
without direct involvement or the assistance of analysts with specialized expertise. The costs
of producing a film are positive costs, including story rights acquisition, pre-production
costs (e.g., crew selection, costume design), principal photography production (paying
actors, set construction), post-production (e.g., film editing), and marketing and advertising.
These can be substantial and are called negative costs.

Negative costs refer not to the sign of the values but to the fact that these are costs required
to produce what was, in the predigital era, the film’s negative image.

There are several types of financing structures available to film studios reviewed in the
curriculum as outlined in the following sections.

Equity Types
Slate equity financing: An outside investor funds a set of films for a studio to produce.
A common motivation is diversification across films.

274
© 2020 Wiley
 OTHER REAL ASSETS

Corporate equity: Regular equity fund raising.

Coproduction: This is where two or more studios produce a film as partners, sharing
revenue and expenses.

Miscellaneous third-party equity: Commonly seen with smaller independent films,

financing may come from a combination of high-net-worth individuals, some institutional
investors, and/or other non-standard sources.

Debt Types
Senior-secured debt: Backing by a bank or other financial institution in the form of debt
can be in the form of collateral such as:

• Negative pickup deal: having an agreement of a distributor prior to film’s

completion
• Foreign presales: distribution rights for specific regions sold in advance
• Tax credits/grants: The producer may be able to receive (saleable) tax credits or
(paid in cash) grants for location specific projects.

Gap financing: Covers the difference between production costs and the senior secured debt
and may be collateralized by sales in unsold territories.

Super gap financing/junior debt: This is often financing by a syndicate to cover a final
gap that senior debt providers do not want to risk covering. It may be supported by royalty
participations which can be transferred to a third-party after the film is completed.

Returns to film investments are skewed to the right. Profits have ranged from over $ 1 billion
to a negative $143.5 million.

Learning Objective: Demonstrate knowledge of historical performance data on

visual works of art.

VISUAL WORKS OF ART AND HISTORICAL PERFORMANCE DATA

MAIN POINT: Visual works of art (paintings) might be appropriate for some high-net-
worth investors but not for institutions. The real rate of return is very low (2.2%) and this
does not account for transaction prices.

A median 2.2% rate of return for paintings—which is consistent across calculation methods
—is based on hammer prices, that is, final auction prices. Therefore, transaction prices,
which can include up 15% in commissions with a typical turnaround cost of 25%, can take
10 years to be covered.

Studies show that Sharpe ratios are very low—due not only to the low real rate of return
(median 2.2%) but also to very high return volatility (median 17%). Part of the explanation
for the low returns is that art also provides an aesthetic benefit—a nonfinancial benefit
arising from the enjoyment of viewing the art. Another is that for high-net-worth investors it
can represent a store of value (capable of being hidden from government confiscation, for
example) and a hedge against inflation.

275
© 2020 Wiley
REAL ASSETS

Learning Objective: Demonstrate knowledge of research and development and

patents as unbundled intellectual property.

R&D AND PATENTS AS UNBUNDLED INTELLECTUAL PROPERTY

MAIN POINT: Investors can access R&D through patents. Patent acquisition and licensing
strategies are generally built around royalty streams. Other patent strategies include patent
sale license back (SLB), patent lending, and patent and pooling. A key factor in patent
enforcement and litigation is the time it takes for resolution, with most cases are settled out
of court. Some risks to investment in patents include illiquidity, technology/operational risk,
obsolescence, and expiration risk, among others.

Accessing R&D through patents

Previously, returns to research and development (R&D) could only be accessed through
equity in the company doing the research. However, there are now several different ways to
access returns to R&D through patents. This is called unbundled IP, and much of the
following discussion can also be applied to other types of unbundled IP, such as music
royalties and other copyrights.

Patent acquisition has been motivated by operational use, as “trading cards,” or for a
strategic use such as defensive protection when negotiating with dealers. Increasingly, there
is a monetary exploitation motivation from an emerging class of IP asset managers.
Oftentimes money is made by licensing the patent to a licensee.

Patent Acquisition and Licensing Strategies

License rates are generally a function of revenues generated from the technology of the
patent.

Key terms between licensor and grantors include:

• Minimum royalty provision—license can be terminated or made non-exclusive if

royalties do not meet the minimum agreed upon.
• Field of use provisions—exclusive use may be granted for a particular market or
location.
• Reservation of rights provision—often for noncommercial research.
• Improvement provisions— since either licensor or licensee could make an
improvement to the patent, this is a difficult aspect of negotiations.
• Audit/reporting/payment due date obligations—licensors may wish to monitor
royalty payments.
• Exclusive responsibilities—generally the licensor must enforce exclusivity and the
licensee must report infringement cases, but these duties vary widely from license to
license.

Patent Enforcement and Litigation Strategies

Ownership of patents may necessitate defending them from patent infringement. Litigation
can be lengthy and expensive so it follows that about 80% of cases are settled out of court.

Stylized facts include:

• Defaults that result in summary judgements that take 5 to 35 months to be resolved.

• Trials can take 35 to 50 months.
• Late dispositions can take more than 50 months.

276
© 2020 Wiley
 OTHER REAL ASSETS

Patent Sale License Back Strategies

In a sale license back (SLB) strategy a patent owner sells the patent and then the buyer
licenses the patent to the original owner, as well as other parties. This helps the owner
monetize some of the intangible asset and can have tax benefits if the buyer is an IP holding
company in a jurisdiction with lower tax rates than the original owner. These SLB strategies
can make it more difficult to prevent or act on patent infringements.

Patent Lending Strategies

Lending backed by patents can be either securitized debt—backed by IP collateral—or
mezzanine financing. The form of lending usually depends on the form of IP. For example,
whether some parties could be excluded from using the IP in the case of a liquidation would
be a consideration.

Patent Sales and Pooling

Under patent pooling, multiple patent owners agree to jointly license a number of patents to
external users and divide royalty income, based on revenue sharing formulas. This is
difficult to do unless there are industry standards. Two standard setting organizations have
recently emerged: Moving Picture Experts Group (MPEG) and DVD patent pools.

Risks to investment in patents include:

• Illiquidity
• Technology/operational risk
• Obsolescence
• Macroeconomic/sector risk
• Regulatory risk
• Legal risk
• Expiration risk

277
© 2020 Wiley
 Re a l E s t a t e A s s e t s a n d D e bt

LESSON MAP
• Demonstrate knowledge of categories of real estate.
• Demonstrate knowledge of advantages, disadvantages, and styles of real estate
investments.
• Demonstrate knowledge of real estate style boxes,
• Demonstrate knowledge of residential mortgages,
• Demonstrate knowledge of commercial mortgages,
• Demonstrate knowledge of mortgage-backed securities.
• Demonstrate knowledge of liquid alternatives: real estate investment trusts (REITs),
• Demonstrate knowledge of historical performance of mortgage REITs.

KEY CONCEPTS
Real estate is an alternative investment that offers attractive returns and some diversification
of risk when combined with traditional portfolio assets such as stocks and bonds.

Mortgages are loans secured by real estate. Mortgages are held by investors and are a major
part of the fixed income market (a traditional asset). Equity investors (owners) of real estate
use mortgages to add leverage to their real estate portfolios.

Most residential mortgages are collected into pools, guaranteed or insured as to default, and
financed with mortgage-backed pass-throughs. Commercial loans are more heterogeneous,
are not insured for default, and are not pooled.

REITs can make equity investments in real estate, investments in mortgages, or a

combination of equity and mortgage investments. The returns on mortgage REITs have been
high, recently exceeding returns on most other assets, but expose the investor to significant
investment risk.

Learning Objective: Demonstrate knowledge of categories of real estate.1*

CATEGORIES OF REAL ESTATE

There are four especially common categories that can be used to differentiate real estate:

1. Equity versus debt

2. Domestic versus international
3. Residential versus commercial
4. Private versus public

Equity versus Debt

A mortgage is a debt instrument collateralized by real estate. In turn, real estate debt is
usually defined as including all mortgages. However, mortgages with substantial credit risk
can behave more like equity, and equity ownership of properties with very long-term leases
can behave like debt. The value of a mortgage is more closely associated with the value of
the real estate than the profitability of the borrower.

Domestic versus International

International real estate investing is regarded as offering substantially improved
diversification. However, investors should be aware that the heterogeneity of real estate
investments and the unique character of many real estate positions cause international real
estate investing to be more problematic than international investing in traditional stocks
and bonds.

© 2020 Wiley
REAL ASSETS

Other challenges faced when investing internationally in real estate include: lack of
relationships with foreign real estate managers, scant knowledge and experience regarding
foreign real estate markets, liquidity concerns, time and expense of travel for due diligence,
political risk, currency risk management, and taxation differences.

Residential versus Commercial

Housing or residential real estate includes many property types, such as single-family
homes, condominiums, town houses, and manufactured housing. The residential real estate
sector is conventionally defined as including owner-occupied housing rather than large
apartment complexes. Within residential real estate, the institutional investor is mainly
concerned with investing in mortgages that are backed by residential real estate.

Commercial real estate properties include the following property sectors: office buildings,
data centers, industrial centers, retail (malls and shopping centers), apartments, self-storage
facilities, health-care facilities and hotels. Collections of numerous smaller properties and
large commercial properties may be managed by a real estate company (e.g., REITs), or
through private equity real estate funds. Within commercial real estate, the institutional
investor can access opportunities through either debt or equity investments.

Residential and commercial real estate require very different methods of financial analysis.
For example, the credit risk of mortgages on residential real estate is normally analyzed
focusing on the creditworthiness of the borrower. Mortgages on commercial real estate are
analyzed based on the net cash flows from the property.

Private versus Public

Private real estate equity investment refers to the direct or indirect acquisition and
management of actual physical properties. Private real estate includes equity investments
(direct ownership of the property) or debt (mortgage claims on the property). The private
real estate market comprises several segments: commercial real estate properties, housing or
residential real estate properties, timberland, and farmland. The advantages of investing in
the private side of real estate equity are that investors can choose specific properties, enjoy
the potential for tax-timing benefits, and exert direct control on their investments.

Public real estate investment (also known as securitized, indirect, financial, or exchange-
traded real estate) consists in the buying of shares of real estate investment companies and
investing in other indirect exchange-traded forms of real estate. Public real estate
investments can take the form of equity, debt, derivative positions, or funds, and may be a
claim on either underlying private real estate positions or underlying public real estate
positions.

REITs are securitized pools of real estate that constitute an important form of public real
estate around the world. Income distributed by a REIT to its shareholders is taxed at the
investor level (and not at the REIT level) after it flows through the REIT. To enjoy this tax
status REITs are subject to two main restrictions (U.S.): (1) 75% of the income received
must be derived from real estate activities, and (2) the REIT has to pay out 90% of its
taxable income in the form of dividends.

Real Estate Categorization by M arket Size

Real estate assets are categorized as trading in the prim ary real estate m arket if the
geographic location of the real estate is in a major metropolitan area of the world (with many
large real estate properties or a strong growth rate in real estate projects). Secondary real
estate markets have easily recognizable names and large institutional investors focus their
investments in these primary markets. Secondary real estate markets include moderately

© 2020 Wiley
 REAL ESTATE ASSETS AND DEBT

sized communities (as well as suburban areas of primary markets). Finally, tertiary real
estate markets have less recognizable names, smaller real estate projects, and smaller
populations.

Learning Objective: Demonstrate knowledge of advantages, disadvantages, and

styles of real estate investments.

ADVANTAGES, DISADVANTAGES, AND STYLES OF REAL ESTATE

INVESTMENTS
MAIN POINT: Real estate is a common alternative investment with many desirable
characteristics as an investment and as a diversifier. Real estate investing provides cash flow
income. Real estate is illiquid.

Five Potential Advantages of Real Estate

1. The potential to offer absolute returns. Real estate, especially a diverse real estate
portfolio, may produce returns less subject to drawdowns.
2. The potential to hedge against unexpected inflation. Real estate valuations tend to
rise in inflationary times.
3. The potential to provide diversification with stocks and bonds. Correlation of real
estate returns to those of stocks and bonds is low enough to reduce portfolio risk.
4. The potential to provide cash inflows. Many types of real estate provide a high
portion of return as lease payments.
5. The potential to provide income tax advantages. The tax code makes many types of
real estate a tax-favored investment.

Disadvantages of Real Estate Investments

1. Heterogeneity. Many types of real estate have unique risks, different life cycles, and
different conditions for success. These differences are diversifiable but make real
estate investment decisions more complicated.
2. Lumpiness. Investors can buy large or small positions in most stocks and bonds by
adjusting the number of shares or the face value. Many real estate investments are
too large to be considered by individual investors. Even institutional investors have
little ability to scale into or out of real estate investments.
3. Illiquidity. Transaction costs are higher for real estate transactions, and the time
required to sell is longer and uncertain.

Differentiating Real Estate Styles with Eight Attributes

The three NCREIF styles (core, value-added, and opportunistic) can be differentiated using
the following eight major real estate attributes:1

1. Property type (purpose of structure: for example, general office versus specialty
retail)
2. Life-cycle phase (e.g., mature/operating versus new/developing)
3. Occupancy (e.g., fully leased versus vacant)
4. Rollover concentration (tendency of assets to trade frequently)
5. Near-term rollover (likelihood that rollover is imminent)
6. Leverage
7. Market recognition (extent that properties are known to institutions)
8. Investment structure/control (extent of control and type of governance)

© 2020 Wiley
281
REAL ASSETS

The styles and their attributes can be used to organize individual properties.

Value-Added Opportunistic
Core Attributes Attributes Attributes
Property Major property types Major property types Nontraditional
type only: office and plus specialty retail, property types,
industrial apartments, low-income housing, including speculative
and retail hospitality, senior/ development for sale
assisted-care housing, or rent and
storage undeveloped land
Life-cycle Fully operating Operating and leasing Development and
phase newly constructed
Occupancy High occupancy Moderate to well- Low economic
leased and/or occupancy
substantially
preleased
development
Rollover Tend to be held for a Moderate rollover High rollover
concentration long period of time, concentration—a concentration risk—
forming the central higher percentage of most of the assets are
component of the real the assets are held for held for appreciation
estate portfolio, a short- to and resale
which is geared intermediate-term
toward generating sale and rollover into
income rather than new assets
sales appreciation
Near-term Low total near-term Moderate total near- High total near-term
rollover rollover term rollover rollover
Leverage Low leverage Moderate leverage High leverage
Market Well-recognized Institutional and Secondary and
recognition institutional emerging real estate tertiary markets and
properties and markets international real
locations estate
Investment Investment structures Investment structures Investment structures
structure/ often have substantial often have moderate often have minimal
control direct control control, but with control, usually in a
security or a limited partnership
preferred liquidation vehicle and with
position unsecured positions

Source: CAIA Level I, 4th ed., 2020. Exhibit 12.1. Copyright © 2009, 2012, 2015 by The CAIA Association.

© 2020 Wiley
 REAL ESTATE ASSETS AND DEBT

THREE PURPOSES OF REAL ESTATE STYLE ANALYSIS

There are three main purposes for introducing styles into real estate portfolio analysis:

1. Performance measurement. To provide a better understanding of an investment’s

or a sector’s objectives and success in achieving those objectives. This includes:
identifying peer groups, return objectives, range of risks, return or performance
attribution, and peer performance.
2. Monitoring style drift. Portfolio managers sporadically drift from their stated risk,
return, or other objectives. Classifying different styles of real estate investments
allows investors to assess the association between a portfolio and its underlying
investment assets as the portfolio changes over time.
3. Style diversification. The ability to compare the risk-return profile of a manager
relative to its style may allow for a better diversification of the portfolio.

Real Estate Styles Overview

The National Council of Real Estate Investment Fiduciaries (NCREIF) classifies real estate
investing as follows:

Core Real Estate

1. Income oriented; not seeking gain in property value.
2. Completed projects such as office, retail, multifamily, industrial, or hotel properties.
3. Little or no leverage or borrowing.
4. Low volatility.
5. Least risky.

Value-Added Real Estate

1. Investors look to income and appreciation.
2. Parcels are not as financially reliable.
3. Includes some hotels, outlet malls, resorts, hospitals, assisted living facilities, and
low-income housing.
4. Could include new properties that are not fully leased.
5. Intermediate risk.

Opportunistic Real Estate

1. Return from appreciation; not looking to income for returns.
2. May involve development of raw property or redevelopment.
3. Short (three- to five-year) horizon.
4. Significant volatility.
5. Most risky.

Learning Objective: Demonstrate knowledge of real estate style boxes.

Real estate style boxes use two categorizations of real estate to generate a box or matrix
that can be used to characterize properties or portfolios. For private commercial equity, the
styles of NCREIF (core, valued-added, and opportunistic) are primary candidates for the
horizontal axis of the box. Primary, secondary, and tertiary real estate markets are
potentially useful for the vertical axis of the box. A real estate style box serves as a method
of better understanding the top-down allocations of a real estate portfolio.

283
© 2020 Wiley
REAL ASSETS

Learning Objective: Demonstrate knowledge of residential mortgages.

RESIDENTIAL MORTGAGES
MAIN POINT: Few investors directly own residential mortgages. Most residential
mortgages are pooled, guaranteed, and transformed into securities that are broadly held by
individual and institutional investors.

Homeowners generally retain the right to prepay loan amounts without penalty, which
exposes investors to more rapid repayment just when reinvestment rates may be lowest.

A mortgage is a loan collateralized by commercial or residential property. If the loan is not

repaid, the lender can seize the collateral before unsecured lenders can claim the property.
The lender pays either a fixed rate or a rate the lender can change from time to time.

The standard fixed-rate loan charges interest each month at the same rate (an annual rate
divided by 12). The borrower makes a fixed monthly payment that includes payment of
interest and repayment of principal. As the loan balance declines or amortizes, the interest
expense declines, so more of the payment goes toward repaying principal. A loan is fully
amortized when the principal has been repaid.

A standard, level-pay mortgage is a monthly annuity. The mortgage principal equals the
value of an annuity as shown in the following formula:

Monthly payment Rate

Mortgage Principal = -N
Rate
1 - 1 +
~Y 2

where Rate is the annual mortgage borrowing rate and N is the number of months in the
loan.

To calculate a mortgage payment that will repay the loan in N periods, rearrange the terms
of the previous equation:

Monthly Payment = Mortgage Principal x Rate/[1 - (1 + Rate/12) - A]

Candidates can also use a calculator to determine the monthly payment required to repay a
mortgage principal over the life of a mortgage. For example, calculate the monthly payment
on a 30-year (360-month) loan with an annual 5% interest rate and principal balance of
$ 100, 000.

Using the HP 12-C Calculator to Find Monthly Mortgage Payment

• Enter {f} {Clear_FIN}—clear the financial registers.
• Enter 100000 {PV}—mortgage principal.
• Enter 5 {g } {12/i}—monthly interest rate.
• Enter {PMT}—calculate payment.
• Display shows -536.82.

284
© 2020 Wiley
 REAL ESTATE ASSETS AND DEBT

Notice that both the HP and the TI instructions suggest that you clear the financial registers
before starting the calculations. If you have been making other time value of money
calculations, the calculator may contain information in the FV register, which will change
the calculation. Notice, too, that both calculators display the PV or mortgage balance with
the opposite sign (minus versus plus) as the PMT value.

To calculate the loan payment on a variable-rate mortgage, follow the same procedure with
the prevailing rate and the number of months until the loan is repaid. Usually the rate
remains fixed for a year. When the new rate is set, the monthly payment is again
recalculated with the updated principal and remaining months.

A similar procedure can be used to calculate the total principal amount. For example, if the
candidate in the previous example can pay $600 per month at a rate of 5% for 30 years, to
calculate the amount the bank would lend, see the following examples.

Using the HP 12-C Calculator to Find Mortgage Loan Amount

• Enter {f } {Clear_FIN}—potentially not necessary.
• Enter 600 {PMT}—enter monthly payment.
• Enter 5 {g } {12/i}—enter monthly interest rate.
• Enter {PV}—calculate payment.
• Display shows -111,768.97.

Using the TI BA II Plus Calculator to Find Mortgage Loan Amount

• Enter {2nd} {CLR TVM}.
• Enter 360 {N}.
• Enter 5/12 = {FY}.
• Enter 600 {PMT}.
• Enter {CPT} {PV}.
• Display shows -111,768.97.

To be consistent with the previous monthly payment calculation, the candidate could have
entered the monthly payment as -600, in which case the calculators would display
111,768.97 (opposite sign).

Commercial loans frequently include penalties for prepaying some or all the loan earlier
than the original repayment schedule. Prepayments are loan repayments that are made
before the scheduled payment date.

285
© 2020 Wiley
REAL ASSETS

Most residential mortgages do not assess penalties for prepaying. In the case of a partial
prepayment, the monthly payment remains the same. The monthly interest cost is lower, so
more of the payment goes toward repaying principal and the loan is repaid sooner.

Prepayment Option
The freedom to repay a fixed-rate loan without penalty creates an option for the borrower. If
rates rise, the borrower can repay the loan on the original schedule, even though prevailing
rates are higher. If rates decline, the borrower can pay more than the required payment to
retire the loan more quickly. The borrower can also refinance the entire loan and repay the
entire balance early. Conditional prepayment describes the pattern of slowing prepayments
when rates rise and accelerating prepayments when rates decline.

While this option works to the benefit of the borrower, it works to the detriment of the
lender. When rates decline, the lender is repaid and must reinvest at the lower prevailing
rates.

Not all prepayments occur because interest rates have declined. A borrower may sell a
house, or a calamity or default may cause early repayment of the loan, when rates are higher.
These repayments are beneficial to the lender.

Burnout occurs because when refinancing mortgages has been cost effective for some time,
the rate of conditional prepayment usually declines. There are several reasons why this
might be the case. It might be that the loan balance is small enough that the savings would
be small as well. Perhaps the value of the house has declined and the home wouldn’t be
appraised high enough to refinance the entire loan. Or perhaps some borrowers don’t follow
market conditions and aren’t aware of the opportunity. In addition, if rates have declined and
risen back to the same levels, investors generally assume that most of the people who are
responsive to the prepayment option will have already refinanced. If rates decline again, it is
likely that far fewer of the remaining borrowers will refinance at the second opportunity.

Interest-Only Mortgages
Some mortgages are designed to repay no principal in the early years that the loan is
outstanding. The borrower usually pays the monthly interest, which can be based on either a
variable rate or a fixed rate. These loans are designed to reduce the initial monthly payments
so the borrower can qualify for a larger loan principal.

After some time, interest-only mortgages establish a monthly payment that will repay the
principal in the remaining period. These payments are larger than a standard level-pay
mortgage because the principal payment is spread over a shorter period.

Interest payments can go up or down with variable-rate loans. Some variable-rate mortgages
put caps on the amount that monthly payments can rise, in which case the lender adds
unpaid monthly interest to the remaining mortgage principal. This increase in principal is
called negative amortization.

Variable-Rate Mortgages
Variable-rate mortgages are also called adjustable-rate mortgages (ARMs). The loan rates
are tied to some market rate of interest, often a short-term U.S. Treasury security. The rate
resets after an interval, frequently annually, at the index rate plus a margin, the spread over
the index rate. The initial rate is set when the mortgage is created and may be below the
index rate plus the margin.

© 2020 Wiley
 REAL ESTATE ASSETS AND DEBT

The amount that the rate can rise upon each reset and the amount that the rate can rise over
the loan may be subject to caps. If the index rate plus the margin calls for a new rate greater
than the cap rate, the rate is set to the cap rate.

Models to value variable-rate mortgages are complex. Future rates must be forecasted in a
way that is consistent with existing interest rates. If caps are included in the terms, then the
model must assign probabilities to many rates each month.

Other Variations of Mortgages

Lenders have created many other mortgage terms. Most of the provisions reduce monthly
payments early in the life of the loan. In return, lenders seek to be compensated for both the
flexibility they offer and the increased risk.

One feature that became common some years ago was a loan that came with a teaser rate.
These variable-rate loans set a below-market initial rate combined with a higher margin
when the loans reset. The borrower benefited from lower initial payments and was better
protected by lifetime caps, because a low starting rate sets a low cap rate. The lender was
exposed to greater risk of default from borrowers who couldn’t afford higher interest
payments.

Another feature that lowered initial monthly payments was a graduated payment mortgage.
These loans set somewhat higher fixed rates but created a schedule of payments in the early
years that may have been smaller than the accrued interest expense. The shortfall was added
to the loan balance and the payments rose to pay more principal in the middle and late years
of the loans. Again, the lender was exposed to additional risk because the rising payments
could be too much for some borrows. The negative amortization also meant that the loan
principal rose relative to the starting value of the collateral.

A third variant that sought to make monthly payments easier to handle was called an option
ARM, an adjustable-rate mortgage that gave the borrower the option each month to either
(1) pay principal and interest much like a regular fixed-rate mortgage, (2) pay interest only,
or (3) pay a predetermined minimum. The minimum acted much like a cap, in that the
increase in payments was constrained in a rising rate environment.

The loan still accrued interest at the ARM rate, so the mortgage could also experience
negative amortization.

Balloon Payment Mortgages

Mortgages with a balloon payment require monthly payment of principal and interest at first,
much like other types of mortgages. Payments are set like mortgages that are amortized or
repaid over a longer period but must repay any unpaid balance at the end of an earlier balloon
period. For example, a mortgage may require cash flows as if it were a 30-year fixed-rate
mortgage but any unpaid principal would need to be repaid at the end of five years.

Balloon payments are commonly used with commercial mortgages but are also created for
home lending. As a practical matter, most borrowers expect to refinance the mortgage before
the balloon payment occurs.

The principal advantage of balloon mortgages to lenders is they are protected from much of
the risk of rising rates. The borrower, in contrast, is at risk that rates may be higher when the
balloon payment is due. The borrower would be expecting to refinance at a lower rate,
because shorter fixed-income instruments usually have lower rates than issues with longer
maturities.

287
© 2020 Wiley
REAL ASSETS

Example

Calculate the monthly payment on a 3.5% $100,000 fixed-rate mortgage with a five-year
maturity compared to a 3.5% $100,000 fixed-rate balloon mortgage that amortizes over
30 years with a balloon in five years.

Solution

The payment on the balloon mortgage on an HP 12-C:

• {f} {Clear_FIN}—clear the financial registers.

• 100000 {PV}—enter mortgage principal.
• 3.5 {g} {12/i}—enter monthly interest rate.
• 360 {N}
• {PMT}—calculate payment.
• Display shows -44-9.04.

The payment on the five-year level-pay mortgage on an HP 12-C:

Hint: you don’t need to enter PV or 12/i in this case because they are still stored and
available for the calculation.

• 60 {N}
• 0 {PMT}—calculate payment.
• Display shows -1,819.17.

The payment on the balloon mortgage on a TI BA II Plus:

• {2nd} {CLR TVM}

• 360 (N)
• 3.5/12 = {I/Y}
• 100000 {PV}
• {CPT} {PMT}
• Display shows -449.04.

The payment on the five-year level-pay mortgage on a TI BA II Plus:

• 60 {N}
• {CPT} {PMT}
• Display shows -1,819.17.

Clearly, the five-year balloon mortgage with a 30-year amortization schedule reduces
payments compared to a five-year level-pay mortgage. The five-year mortgage repays the
entire loan, whereas the balloon mortgage leaves the borrower with a substantial loan
balance after five years (either of the two calculators could show that the balance on the
balloon mortgage would be $89,697.07).

Residential Mortgages and Default Risk

Most residential mortgages are pooled and guaranteed by U.S. agencies or private issuers.
Default on residential mortgages has historically been very low because housing prices
increased steadily until around 2007, meaning it has generally been possible to repay
mortgages by selling the collateral.

288
© 2020 Wiley
 REAL ESTATE ASSETS AND DEBT

In the years leading up to 2009, a greater portion of mortgages were sold to investors
without guarantees.

Many of those loans were categorized as Alt-A or subprime, meaning either that the banks
had lent a high percentage of the appraised value, that the borrower’s income had not been
verified, or both. At the same time, real estate prices declined. Both types of loans produced
very high rates of default.

Government regulation first pressured lenders to stop making risky mortgage loans, but
recently lenders are again encouraged to stretch lending standards. At least for now, though,
most new mortgages are sold with guaranteed principal repayment.

MAIN POINT: Commercial mortgages are backed by many different types of real property,
making risk analysis relatively difficult. Investors are exposed to credit risk, mitigated
significantly because real property backs the loans. Investors are not exposed to significant
prepayment risk, because the loan maturities are fairly short and agreements frequently
contain prepayment penalties.

Learning Objective: Demonstrate knowledge of commercial mortgages

COMMERCIAL MORTGAGES
Commercial mortgages are loans backed by hotels, apartments, and office, retail, and
industrial property.

Most commercial mortgages are balloon loans with relatively short balloon dates. Loans on
completed properties are longer than loans for developing property.

The risk of default is influenced by the credit condition of the borrower as well as the
amount and type of collateral. Many commercial loans are nonrecourse, meaning the lender
looks only to the stream of income from the property and can seize the property but cannot
recover losses from the borrower. Many times real estate loans are structured in subsidiaries
that isolate the parent from responsibility for the loans.

Commercial loan agreements generally include covenants that seek to reduce default risk.
For example, the covenants require the borrower to maintain the property backing the loan
in good repair. These covenants require the borrower to incur expenses that support the lease
revenue. In return for accepting such terms in the loan, the borrower can negotiate a lower
borrowing rate, reflecting the reduced default exposure.

Cross-collateral provisions may also reduce the risk of default. These provisions provide
that two or more properties can serve as collateral for two or more loans. The primary
advantage of cross-collateralizing is the reduced risk if a single property loses value due, for
example, to natural disaster. A cross-collateral provision may restrict the borrower from
selling a property if it is supporting one or more other loans.

Key Financial Ratios for Commercial Mortgages and Default Risk

• Loan-to-value ratio (LTV)—the amount of the loan divided by the value
(either market or appraised) of the property.
• Interest coverage ratio—the property’s net operating income divided by the loan’s
interest payments.
• Debt service coverage ratio (DSCR)—the property’s net operating income divided
by all loan payments, including the amortization of the loan.

289
© 2020 Wiley
REAL ASSETS

• Fixed charges ratio—the property’s net operating income divided by all fixed
charges that the borrower pays annually.

MAIN POINT: Most residential mortgage-backed securities (RMBS) are issued primarily
by U.S. federal agencies and backed by an explicit guarantee of principal repayment.
However, homeowners generally can prepay mortgages without penalty, which creates risk
for investors in RMBS. Commercial mortgage-backed securities (CMBS) are exposed to
default risk.

Mortgage-backed securities are mortgages pooled together to create securities that are much
easier to buy and sell than individual loans. The larger principal amount makes them
attractive to institutional investors even while small investors can buy smaller face values of
the same securities.

Securities backed by residential mortgages are called residential mortgage-backed securities

(RMBS), and securities backed by commercial mortgages are called commercial mortgage-
backed securities (CMBS).

The simplest mortgage securities are called pass-through securities. Interest, principal, and
default payments from all loans in the pool are combined and paid to investors.
Collateralized mortgage obligations (CMOs) can be considerably more complex, splitting
the aggregate cash flows into different securities or tranches. See the lesson “Introduction to
Structuring” for more information on these types of investments.

Prepayments
Prepayments on individual loans are very lumpy. One borrower may never make any
prepayments until a job transfer forces a home sale. Another borrower may prepay a little of
the loan balance when possible.

When assembled into pools, the prepayments become somewhat more predictable. There is
very little prepayment early in the life of a loan. There is no immediate incentive to
refinance if the loan rate is close to the prevailing rate. People don’t sell recently acquired
houses very often. Also, defaults don’t usually occur for some time. But these prepayments
tend to rise over time and level off.

The constant prepayment rate (CPR) model measures how fast a pool of mortgages is
prepaying. Although prepayments may vary month to month, a 5% CPR means that 5% of
the pool’s current loan balance pool is expected to prepay over the next year.

The Public Securities Administration created a prepayment scale for mortgage-backed

securities, such as Residential Mortgage Backed Securities (RMSB), which is presented in
the PSA Prepayment Model table (see Exhibit 12.7 in the CAIA curriculum).

The model assumes that, after a period of lower prepayments, 6% of outstanding loans will
repay in a year. The prepayment rate ramps up from .2% in the first month and rises by .2%
each month for 2Vz years, then settles into 6%.

Not all pools pay at rates consistent with the PSA model. A pool that has been outstanding
for three years or 36 months is expected to prepay at 6%, but if a particular pool prepays at
9%, it is described as paying at 150% of the PSA rate. The CPR assumed by the PSA
model in month 25 is 5%. The PSA-expected CPR = Month x .2% for months up to 30.
A pool that is experiencing a CPR of 4% in month 25 is prepaying at 80% PSA.

© 2020 Wiley
 REAL ESTATE ASSETS AND DEBT

As mentioned earlier, borrowers have an option to strategically prepay a fixed-rate mortgage

when they can refinance into a lower mortgage rate. Pools made up of loans with higher
rates tend to prepay faster than pools made up of loans with lower rates.

A variety of things are associated with prepayment in addition to changing interest rates.
As the PSA model documents, newer loans are less likely to prepay, to a point. The general
level of economic activity can influence prepayment if it affects job transfers and
promotions. Decisions about family size can motivate transactions that create prepayments.
The location of the mortgages can affect prepayment rates if the loans are originated in a
particular geographical area.

The PSA model is frequently used to value mortgage-backed securities. Assuming a

prepayment rate (e.g., 125% PSA) provides enough information to generate cash flows on
the pool for the life of the security.

Standard present value mathematics is used to calculate a value (the discounted present
value of the cash flows) or yield (the internal rate of return consistent with a price and the
generated cash flows).

Learning Objective: Demonstrate knowledge of mortgage-backed securities.

Commercial Mortgage-Backed Securities

Commercial mortgage-backed securities have less prepayment risk than RMBS because the
loan maturities are short. Also, most fixed-rate commercial mortgages include a prepayment
penalty.

Investors must consider default risk on CMBS. Many factors can influence default rates:

1. Type of property
2. Location
3. Credit-worthiness of the borrower
4. Credit-worthiness of the tenant
5. Lease provisions
6. Skill of the property manager
7. Age of the property
8. When the loans were originated

Learning Objective: Demonstrate knowledge of liquid alternatives: real estate

investment trusts (REITs).

LIQUID ALTERNATIVES: REAL ESTATE INVESTMENT TRUSTS

MAIN POINT: REITs represent a liquid real estate alternative investment that provides an
easy way to add real estate to an investment portfolio. They provide management, liquidity,
and tax efficiency. While institutional investors may prefer direct ownership, REITs offer an
opportunity to add real estate to an individual’s investment portfolio.

REITs are operating companies that invest primarily in real estate. Publicly traded REITs are
thus similar to the many corporations whose stocks trade on exchanges. In other ways, they
are more like exchange-traded funds (ETFs), which are also exchange-traded investment
portfolios.

29,
© 2020 Wiley
REAL ASSETS

Equity REITs primarily invest in equity ownership of private real estate parcels. Mortgage
REITs primarily invest in debt. Hybrid REITs are a blend of the two investment styles.

REITs offer investors three important advantages over direct investment in real estate:

1. Professional management of the properties. This includes both property management

services and portfolio management.
2. Liquidity. Investors can buy and sell quickly and at low cost.
3. Tax efficiency. By organizing as tax flow-through entities (such as partnerships),
REITs don’t pay corporate income tax. All net income is taxed on the individual tax
forms of the owners.

Institutional investors, however, may find REITs are not the best way to invest in real estate
because of:

• Management fees: institutional investors can provide property management less

expensively than these for-profit companies.
• Control: REITs are not structured to give investors, even large investors, input to
portfolio or property management decisions.
• Volatility: REITs appears more risky than direct real estate investments because of
volatility; it is not clear if the risk of direct investments is understated or if market
forces create additional risk.

Important rules REITs must observe are:

• At least 75% of income should come from real estate.

• They must pay out at least 90% of taxable income as dividends; retained earnings are
taxed as corporate income.
• There are certain restrictions on ownership by groups of investors.

Learning Objective: Demonstrate knowledge of historical performance

of mortgage REITs.1*

OBSERVATIONS FROM HISTORICAL RETURNS ON MORTGAGE REITS

MAIN POINT: Mortgage REITs are portfolios invested in various types of mortgages.
Historically, mortgage REITs have produced very high but volatile returns.

Historical returns show that mortgage REITs returns (2000-2018):

1. Had historic volatility moderately exceeding that of global equities.

2. Generated a moderate Sharpe ratio.
3. Had a moderate negative skew.
4. Had a markedly positive excess kurtosis.
5. Experienced a massive maximum drawdown (i.e., almost -70%).

292
© 2020 Wiley
 Re a l Est a t e Equit y Inv e st me nt s
LESSON MAP
• Demonstrate knowledge of real estate development.
• Demonstrate knowledge of commercial real estate valuation.
• Demonstrate knowledge of valuation and risks of real estate equity.
• Demonstrate knowledge of the income method of real estate valuation.
• Demonstrate knowledge of alternative real estate investment vehicles.
• Demonstrate knowledge of historical risks and returns of equity real estate
investment trusts (REITs).
• Demonstrate knowledge of equity REIT returns.

KEY CONCEPTS
Real estate development projects are completed in stages. At each stage, there may be an
option to continue or abandon the project. Therefore, they can be viewed as a series of real
options, and can be valued more accurately using backward induction than by ignoring the
real options. A common method for valuing completed projects that generate cash flows is
the income approach, which discounts future net operating income to find the present value.

When no income is generated, a comparable sale prices approach looks for transaction data
on similar properties. Private equity real estate investment vehicles are highly illiquid and
include commingled real estate funds (CREFs), syndications, and joint ventures. All of them
are increasingly organized as limited partnerships that use gearing (leverage). Public equity
real estate investment vehicles are more liquid, and include open-end real estate mutual
funds, options and futures on real estate indices, exchange-traded funds (ETFs), closed-end
real estate mutual funds, and real estate investment trusts (REITs). Since properties are
infrequently traded, stale pricing is an issue in valuing real estate and for gaining full
exposure to the true values. Public funds vary with respect to how closely their returns
reflect the returns of the underlying real estate investments.

Real estate indices come in three main varieties:

1. Appraisal based (which results in problematic smoothing).

2. Adjusted privately traded prices (attempts to address the problems of stale pricing
and smoothing).
3. Price based (using REITs).

REITs tend to be highly correlated with equity prices and may not reflect the true value of
the underlying investments. Nevertheless, this chapter uses a REIT-based index to review
statistical properties of the historical performance.

Whereas real estate debt investments and mortgages are discussed elsewhere, this lesson
focuses on real estate equity investments. The equity or residual claim is equal to the value of
the property minus any mortgages on the property. Valuation is the central focus of this lesson.

Learning Objective: Demonstrate knowledge of real estate development.

REAL ESTATE DEVELOPMENT

Real Estate Development as Real Options

MAIN POINT: Because real estate development involves several stages, it can be valued as
a string of real options using backward induction and decision trees.

293
©2020 Wiley
REAL ASSETS

Real estate development can be valued as a string of real options. Real estate
development projects can include one or more stages of creating or improving a real
estate project, including the acquisition of raw land, the construction of improvements,
and the renovation of existing facilities.

At each stage of development, there is a real option. A real option is the complement option
type to financial options.

A real option is an option on a real asset rather than a financial security. A string of
real options can be represented by a decision tree.

A decision tree shows the various pathways that a decision maker can select as well as
the points at which uncertainty is resolved.

There are two types of nodes in a decision tree: the decision node and the information node.

A decision node is a point in a decision tree at which the holder of the option must
make a decision.

An information node denotes a point in a decision tree at which new information

arrives.

A valuation for a multistaged development project can be found by using backward

induction. Backward induction can be used for the valuation of financial derivatives as well.

Backward induction is the process of solving a decision tree by working from the final
nodes toward the first node, based on valuation analysis at each node.

Decision Tree Example

This example has a simplifying assumption that the discount rate is zero.

Other assumptions: This is a three-year sports hotel development project where the
magnitude of its success is dependent on obtaining a franchise from the sports league:
The hotel will be worth $80 million if the franchise is obtained and only $20 million if not.
The probability of getting the franchise is 50%. The expected value, ignoring real options, is
.5($80 million) + .5($20 million) = $50 million. With costs at $50 million, it is a zero net
present value project, ignoring the value of the real options.

Costs are $10 million in year 1, $20 million in year 2, and $20 million in year 3, for a total
of $50 million. The Decision Tree figure has one information node at point B and three
decision nodes. Starting with the case where the franchise is granted, the completed hotel is
worth $80 million - $50 million in costs = $30 million. If the franchise is not granted,
the third-year expenses are not incurred if the project is abandoned, so the value is
$20 million - $30 million = -$10 million. The preferred option is the decision to complete
the hotel for $30 million.

294
© 2020 Wiley
 REAL ESTATE EQUITY INVESTMENTS

Decision Tree

Complete hotel

Franchise is granted

Abandon

Invest — ►

Complete hotel

Franchise is denied

' Abandon
Abandon

Source: CAIA Level I, 4th ed., 2020. Exhibit 13.1. Copyright © 2009, 2012, 2015 by
The CAIA Association.

At decision point D, the preferred option is to abandon the hotel to lose only $10 million,
instead of $20 million value minus $50 million costs or a loss of $30 million.

Using this real option analysis, we see that the value at the beginning of the project is
positive: ($30 million)(.5) + (-$10 million)(.5) = $10 million.

Learning Objective: Demonstrate knowledge of commercial real estate

valuation.1*

COMMERCIAL REAL ESTATE VALUATION

MAIN POINT: The discounted cash flow (DCF) approach (i.e., income approach) to
valuing real estate involves the estimation of future net operating income and a discount
rate. When no cash flows are generated from the real estate property, the comparable sale
prices approach is more appropriate.

Real estate valuation is the process of estimating the market value of a property and
should be reflective of the price at which informed investors would be willing to both
buy and sell that property.

There are several methods of valuing real estate that should be matched to the type of real
estate being valued. Candidates should be familiar with the calculations required for the
income approach, and with the issues related to the comparable sale prices approach.

Three Reasons for the Emphasis on Commercial Real Estate Equity

1. Most commercial real estate throughout the world is privately held rather than
publicly traded.
2. Most of the equity of residential real estate is held by the occupier of the property
(rather than by an institutional investor).
3. The valuation of equity claims to private commercial real estate drives the pricing of
the credit risk in the valuation of commercial mortgages.

The Comparable Sales Approach as a M ajor Valuation Approach

When a property does not generate cash flows, such as a house used as the owner’s primary
residence, the income approach cannot be used and the comparable sale prices approach is
more appropriate.

295
©2020 Wiley
REAL ASSETS

The comparable sale prices approach values real estate based on transaction values of
similar real estate, with adjustments made for differences in characteristics.

The comparable sale prices method works best when there are many transactions in the same
area for homogeneous properties. For highly specialized or unique properties, an alternative
method can be used that sums up the estimated replacement construction costs and the value
of the land.

The Profit and Cost Approaches

Approaches other than the comparable sale prices method and income approach also exist,
such as the profit approach.

The profit approach to real estate valuation is typically used for properties with a
value driven by the actual business use of the premises; it is effectively a valuation of
the business rather than a valuation of the property itself. The profit approach can be
considered as a special case of the income approach, which values real estate by
projecting expected income or cash flows, discounting for time and risk, and summing
them to form the total value.

The cost approach to real estate valuation is based on the assumption that a buyer will
not pay more for a property than it would cost to build an equivalent one. This approach
is often used to value newer structures and in markets with substantial new
construction.

Cap Rates and the Perpetuity Valuation Approach

The capitalization (or cap) rate is a somewhat crude but widespread metric in real estate
valuation. The cap rate of a real estate investment is the net operating income (NOI)
provided by an investment divided by a measure of the real estate’s total value (e.g., as
purchase price or appraised value):

Cap Rate = NOI/Value

Example 1

Assume that a current real estate project has a current market value of $76 million and
expected annual cash flows from rent, net of operating expenses, of $6 million. What is
its cap rate?

Solution

The answer is found as: Cap Rate = ($6 million/$76 million) = 7.9%

Specifications of the inputs to the cap rate formula vary between users and purposes. For
example, NOI can be: recent, current, or forecasted. Value can be: beginning of period
versus end of period, transaction price versus appraised price.

Cap rates can be regarded as direct estimates or forecasts of required returns or expected
returns.

296
© 2020 Wiley
 REAL ESTATE EQUITY INVESTMENTS

Transaction-Based Methods (Repeat Sales and Hedonic)

MAIN POINTS: Transaction-based real estate valuation methods are estimated based on
actual contemporaneous property sales of large data sets of sample properties that trade in
each period.

A repeat sale occurs when a specific property is sold at least two times during the sample
period that is being used.

The two main methods used to estimate transaction-based price indices are the repeat-sales
method and the hedonic pricing method (HPM), which are discussed in Level II.

Two Advantages of Appraisal-Based Models over Transaction-Based Models

1. They do not suffer from a small sample size problem (in general).
2. Properties can be appraised frequently (and by many experts). However, this is
costly.

Four Disadvantages of Appraisal-Based Models over Transaction-Based Models

1. Appraisals are subjective and backward looking and this creates potential errors in
valuations.
2. For real estate price indices based on appraisals, not all properties are reappraised as
frequently as the index is reported and this may cause a stale appraisal effect (i.e.,
errors from the use of dated appraisals).
3. Appraisal-based indices are smoothed (compared with actual changes in real estate
market values). Thus, measures of volatility based on appraisal-based models are
underestimated. Smoothing techniques (to be studied in Level II) help mitigate this
issue.
4. Appraisal-based methods rely on data from comparable properties and, therefore, the
quality of the appraisal depends critically on the quality of available data.

The NCREIF Property Index as an Appraisal-Based Index

The National Council of Real Estate Investment Fiduciaries (NCREIF) is a U.S. not-for-
profit institutional real estate investment industry association. NCREIF collects real estate
income and pricing data from its members (mostly, institutional real estate investment
managers), and computes major real estate index and sub-indices of commercial properties
(as well as several other indices, such as a farmland index and a timberland index).

The NCREIF Property Index (NPI) is a value-weighted index published quarterly and is
based on unleveraged commercial-property appraisals (or leveraged data adjusted to an
unleveraged basis). The illiquid nature of real estate explains the fact that, to compute the
NPI, most valuations are appraisal-based.

The change in value of each property in the NPI is calculated quarterly, assuming that the
property was purchased at the beginning of the quarter (at its appraised value), held for
income during that quarter, and sold at the end of the quarter (at its end-of-quarter appraised
value). The total return on the NPI is calculated as the sum of an income return and a capital
value return.

297
©2020 Wiley
REAL ASSETS

Learning Objective: Demonstrate knowledge of valuation and risks of real estate

equity.

The Income Approach as a M ajor Valuation Approach

There are two major items to estimate when using the income approach: future net operating
income and the appropriate discount rate.

The income approach is also called the discounted cash flow (DCF) method when
cash flows are discounted rather than accounting estimates of income.

The investment value (IV) of a property can be found by discounting cash flows (CF)
received until the property is sold for its net sales proceeds.

Where NSP are the net sale proceeds, calculated as the expected selling price of the
property minus any expected selling expenses arising from the sale of the property at time T.

More accurately, we should define these cash flows as net operating income (NOI).

Net operating income (NOI) is a measure of periodic earnings that is calculated as the
property’s rental income minus all expenses associated with maintaining and operating the
property.

Cash Flow (NOI) Estimates

Here we illustrate the estimation of future NOI for an office building.

The potential gross income is the gross income that could potentially be received if all
offices in the building were occupied.

Let the potential gross income for the first year of a commercial property be $300,000, as
shown in the Net Operating Income Estimates table.

The vacancy loss rate is the observed or anticipated rate at which potential gross
income is reduced for space that is not generating rental income.

Assume a vacancy loss rate of 10%. This implies a vacancy loss of $30,000.

The effective gross income is the potential gross income reduced for the vacancy loss
rate. The effective gross income is then $270,000.

Operating expenses are non-capital outlays that support rental of the property and can
be classified as fixed or variable. Operating expenses for the first year are assumed to
include fixed expenses of $42,000, and variable expenses of $75,000, for a total of
$117,000.

298
© 2020 Wiley
 REAL ESTATE EQUITY INVESTMENTS

Fixed expenses, examples of which are property taxes and property insurance, do not
change directly with the level of occupancy of the property.

The fixed expenses are $42,000.

Variable expenses, examples of which are maintenance, repairs, utilities, garbage

removal, and supplies, change as the level of occupancy of the property varies. The
variable expenses are $75,000.

Net Operating Income = $270,000 —$117,000 = $153,000

Given the first-year estimate, some additional assumptions allow us to generate future-year
NOI estimates. These include:

Rent will increase at 4% per year.

Vacancy rate remains constant.

Net sale proceeds in year 7 are $1,840,000.

Net Operating Income Estimates

Year 1 Year 2 Year 4 Year 5 Year 6 Year 7

Potential Gross Income $300,000 $312,000 $324,480 $337,459 $350,958 $364,996 $379,596
Vacancy Loss -$30,000 -$31,200 -$32,448 -$33,746 -$35,096 -$36,500 -$37,960
Effective Gross Income $270,000 $280,800 $292,032 $303,713 $315,862 $328,496 $341,636
Operating Expenses -$117,000 -$121,680 -$126,547 -$131,609 -$136,873 -$142,348 -$148,042
Net Operating Income $153,000 $159,120 $165,485 $172,104 $178,988 $186,148 $193,594

Source: CAIA Level I, 4th ed., 2020. Exhibit 13.3. Copyright © 2009, 2012, 2015 by The CAIA Association.

Discount Rate Estimation

A discount rate is required to get the investment value (IV). A common method uses the risk
premium approach.

The risk premium approach to estimation of a discount rate for an investment uses the
sum of a riskless interest rate and one or more expected rewards—expressed as rates—
for bearing the risks of the investment.

The following two equations provide estimates of an appropriate discount rate based on the
risk-free rate (Rf) plus a premium for liquidity (RLP) and a premium for the riskiness of the
property/project (RPP). The first equation is “exact” in the sense that it is mathematically
accurate (though estimated), and the second is an approximation because cross-terms in the
multiplication of the first equation are generally so small they can be ignored.

299
©2020 Wiley
REAL ASSETS

Example 2

Assume a risk-free rate (with a seven-year maturity) of 5.8%, a liquidity premium of 1%,
and a risk premium for the systematic risk of the project of 2.2%.

What is the estimated “mathematically exact” discount rate? What is the approximate
discount rate?

Solution

The mathematically exact discount rate is (1.058)( 1.01)(1.02) - 1 = 9.21%. The

approximate discount rate is 5.8% + 1% + 2.2% = 9%.

For most institutions, the approximate rate is acceptable.

Additional Issues
Our simplified example ignored several additional issues that must be considered in practice.
For example, the lease terms are important in determining future NOIs.

In a net lease, the tenant is responsible for almost all of the operating expenses.

In addition, depreciation can impact the NOI. This is additionally discussed as a separate
learning objective.

Depreciation is a noncash expense that is deducted from revenues in computing

accounting income to indicate the decline of an asset’s value.

After-Tax and Pre-Tax Approaches

The example assumed a pre-tax discounting approach, which is appropriate for institutional
investors not subject to income taxes.

The pre-tax discounting approach is commonly used in finance, where pre-tax cash
flows are used in the numerator of the present value analysis (as the cash flows to be
received), and the pre-tax discount rate is used in the denominator.

For investors subject to income taxes, the after-tax discounting approach should be used.

In an after-tax discounting approach, the estimated after-tax cash flows (e.g., after-tax
bond payments) are discounted using a rate that has been reduced to reflect the net rate
received by an investor with a specified marginal tax rate.

Note that both approaches yield the same valuation if tax rates are consistent through time
and applicable to all cash flows. Consider the following example, and then consider its flaws
in a more realistic scenario.

300
© 2020 Wiley
 REAL ESTATE EQUITY INVESTMENTS

Example 3: Pre-Tax versus After-Tax

Assumptions for sample investment opportunity:

Cash flows: $80 per year in taxable income with final taxable cash flow of $1,000 in five
years.

Required rate of return: 8% before tax, and 4.8% after tax (since investor is in 40% tax
bracket).

Value of investment on pre-tax basis and after-tax basis: $1,000.

Value of investment on a pre-tax basis is $1,000 because the cash flows of $80 per year
plus the final $1,000 are being discounted at 8%.

Value of investment on an after-tax basis is $1,000 because of discount cash flows: $80
(1 - .4) = $48, by 8%(1 - .4) = 4.8%.

Note: The (1 - .4) cancels out in the numerator and denominators of the DCF equation.

Flaws: The coupons are subject to a different rate of taxation than the principal, not the
same as assumed in the example. In practice, different cash flows may have different tax
rates.

Learning Objective: Demonstrate knowledge of the income method of real

estate valuation.

Returning to our previous example, and given the 9% discount rate that was calculated, the
investment value of the office building example is $1,863,772.

If there is a mortgage on the property (office building example), then the investment value
(i.e., equity residual) can be viewed as $1,863,772 minus the balance on the mortgage.

An alternative approach, often termed the equity residual approach, focuses on the
perspective of the equity investor by subtracting the interest expense and other cash
outflows due to mortgage holders (in the numerator) and by discounting the remaining
cash flows using an interest rate reflective of the required rate of return on the equity of
a leveraged real estate investment (in the denominator).

The accuracy of the DCF approach is dependent on the accuracy of the NOI and discount
rate estimates.

Learning Objective: Demonstrate knowledge of alternative real estate

investment vehicles.

ALTERNATIVE REAL ESTATE INVESTMENT VEHICLES

MAIN POINT: Alternative real estate investment vehicles can be categorized as either
private or public. Increasingly, private equity real estate funds are being organized as limited
partnerships that use gearing. Public investment vehicles are more liquid than private
vehicles.

3 .,
©2020 Wiley
REAL ASSETS

Private Equity Real Estate Investment Vehicles

Private equity real estate funds are privately organized funds that are similar to other
alternative investment funds, such as private equity funds and hedge funds, yet have real
estate as their underlying asset.

Three types of private equity real estate funds collect money from investors and invest in the
debt or equity of real estate projects. They allow investors access to large or specialized
properties, but investors lack control and often lack liquidity and a sufficient exit route,
and must “hold to liquidation.”

Valuations of the underlying properties in the portfolios are uncertain. The three types are
described next.

Commingled real estate funds (CREFs) are a type of private equity real estate fund that is
a pool of investment capital raised from private placements that are commingled to purchase
commercial properties.

Syndications are private equity real estate funds formed by a group of investors who retain
a real estate expert with the intention of undertaking a particular real estate project.

Real estate joint ventures are private equity real estate funds that consist of the
combination of two or more parties, typically represented by a small number of individual or
institutional investors, embarking on a business enterprise such as the development of real
estate properties.

These three types of private equity real estate funds are increasingly being organized as
limited partnerships that use gearing (leverage). As with other limited partnership structures,
sponsors in a private real estate equity fund act as the general partner and raise capital from
institutional investors who serve as limited partners.

Public Equity Real Estate Investment Vehicles

The following five types of public equity real estate vehicles are discussed here: open-end
real estate mutual funds, options and futures on real estate indices, exchange-traded funds
(ETFs), closed-end mutual funds, and equity real estate investment trusts (REITs).

Open-end real estate mutual funds are public investments that offer a non-exchange-
traded means of obtaining access to the private real estate market.

These open-end funds provide liquidity to investors, allowing them to freely redeem their
shares at the shares’ net asset value (NAV). However, due to stale pricing, the NAV may not
reflect the true value.

The use of prices that lag changes in true market prices is known as stale pricing.

In a rising market, wealth is transferred from existing investors to new investors because the
stated NAVs are lower than their true values, and the converse is true in declining markets.
There may be redemption problems in declining markets, as illiquid assets must be sold at
deep discounts to provide liquidity. On account of this liquidity mismatch, some funds
reserve the right to defer redemption.

The second type of public equity real estate vehicle is options and futures on real estate
indices. By linking the payoff of a derivative to the performance of a real estate index,
exposure is obtained without direct investment. To the extent that the indices are not

© 2020 Wiley
 REAL ESTATE EQUITY INVESTMENTS

correlated with the underlying investments due to the difficulty in valuing heterogeneous,
illiquid assets, there is some basis risk, but increased transparency and liquidity.

Exchange-traded funds (ETFs) represent a tradable investment vehicle that tracks a

particular index or portfolio by holding its constituent assets or a subsample of them.

Exchange-traded funds can be cost-effective and tax-efficient, and offer benefits of stocks
such as liquidity, dividends, and short and leveraged positions.

Arbitrage activity helps keep the prices of ETFs close to the underlying NAVs.

A closed-end real estate mutual fund is an investment pool that has real estate as its
underlying asset and a relatively fixed number of outstanding shares.

Shares in closed-end funds cannot be redeemed at their NAV but rather trade on exchanges
and their prices may deviate from their NAV. The closed-end fund has a life (generally
15 years) that is stated at its inception. At the end of the fund’s life the portfolio is liquidated
and capital is returned to the shareholders. This structure is suitable for investments in
illiquid assets and for the use of leverage.

The fifth type of public equity real estate vehicle is equity real estate investment trusts
(REITs). The focus here is on equity REITs rather than mortgage REITs. Equity REITs
invest directly in real estate as equity investments and trade on exchanges.

They are highly correlated with equity markets, particularly small-capitalization stocks.
Theoretically, REIT returns should be driven by their operating profits, which should
increase as rents increase with inflation (providing an inflation hedge), and not by their
capitalization or because they trade on exchanges.

Learning Objective: Demonstrate knowledge of historical risks and returns of

equity real estate investment trusts (REITs).

HISTORICAL RISKS AND RETURNS OF EQUITY REITS

The following are five key observations on equity REIT returns (2000-2018). Equity REITs
returns:

1. Had historic volatility substantially exceeding that of global equities.

2. Generated a moderate Sharpe ratio.
3. Had a moderate negative skew.
4. Had a markedly positive excess kurtosis.
5. Experienced a massive maximum drawdown (i.e., almost -70%).

Learning Objective: Demonstrate knowledge of equity REIT returns.

EQUITY REIT RETURNS AND TWO MAJOR UNRESOLVED ISSUES

Private versus Public REITs

Throughout this lesson on REITs, the focus has been on traded-REITs. Public equity REITs
are REITs with a majority of their underlying real estate holdings representing equity claims
on real estate (rather than mortgage claims). Private REITs are offered to investors through
private structures that are exempt from SEC registration in the United States. Many investors

303
©2020 Wiley
REAL ASSETS

prefer public REITs given their liquidity, because of the potential safety from the regulatory
oversight, and also because of the price revelation available from public trading.

Do Public REITs Offer an Illiquidity Premium?

There are two competing forces here. On the one hand the underlying properties of a REIT
are illiquid. On the other hand, competition by investors to receive a positive illiquidity
premium (while holding a liquid REIT) would appear to drive property values up to the
point that they no longer offer a risk premium for illiquidity.

Real Estate Indices Based on Financial Market Prices

The reported returns of REITs are calculated based on observations of frequent market
prices (unlike private commercial real estate). Publicly traded real estate (especially REITs
in the United States), provides regular market prices with which to observe, measure,
and report returns on real estate investments.

The FTSE NAREIT US Real Estate Index Series is a group of REIT-based performance
indices that considers the different sectors of the U.S. commercial real estate arena.

© 2020 Wiley
 H e d g e Fu n d s

© 2020 Wiley
 St r uc t ur e o f t he He dg e Fund Indust r y
This is an introductory lesson to hedge funds in general and covers issues common to
various specific hedge fund strategies. A brief overview of types of strategies grouped
according to systematic risk emphasizes that a hedge fund program should diversify across
hedge fund strategies.

LESSON MAP
• Demonstrate knowledge of the distinguishing features of hedge funds and their
growth and concentration over time.
• Demonstrate knowledge of hedge fund fees.
• Demonstrate knowledge of various types of hedge funds.
• Demonstrate knowledge of hedge fund returns and asset allocation.
• Demonstrate knowledge of the process of evaluating a hedge fund investment
program.
• Demonstrate knowledge of research studies on whether hedge funds adversely affect
the financial markets.
• Demonstrate knowledge of hedge fund indices.

KEY CONCEPTS
Hedge funds are private, charge performance-based fees, and have investment flexibility.
Typical hedge fund fee arrangements are “2 and 20” with the 20% incentive fee feature
exhibiting option-like payouts to managers. Funds of funds (FoFs) invest across various
types of strategies and have a double layer of fees. Hedge fund programs should diversify
across various strategies, such as equity strategies with a lot of market risk, those with short
volatility exposure, and absolute return strategies, as well as diversified strategies like global
macro strategies. While some institutions have stayed away from hedge funds to avoid
headline risk, academic studies find little evidence that hedge funds negatively impact
markets. Hedge fund indices are useful for describing hedge funds as an asset class, but
there are many index providers with unique construction methods, so investors should be
aware of the many biases that indices may contain.

Learning Objective: Demonstrate knowledge of the distinguishing features of

hedge funds and their growth and concentration over time.

MAIN POINT: Hedge funds are private, charge performance-based fees, and have
investment flexibility. The flexibility allows them to trade multiple asset classes, use
leverage, and take concentrated positions and short positions. Low correlation to traditional
asset returns led to industry growth, and the financial crisis of 2007-8 led to industry
consolidation because larger funds are perceived as being less risky than smaller funds.

Three primary elements of hedge funds are: (1) they are privately organized, (2) managers
generally earn performance-based fees (thus attracting talent), and (3) they offer much
greater investment flexibility than traditional investment vehicles (e.g., mutual funds).

Six investment flexibilities offered by hedge funds are: (1) trading strategies (use of
leverage and concentrated positions), (2) private securities, (3) real assets, (4) derivatives,
(5) short positions, and (6) structured products and other esoteric investments. Note: Hedge
funds may invest in assets that are also available to traditional managers, but to the extent
their trading strategies are less restricted and may include concentrated positions, short
positions, and more, they are classified as alternative investment vehicles. Again, this is
more because of their trading structure than because of the assets they hold.

© 2020 Wiley
HEDGE FUNDS

Mutual funds’ offering method and disclosure requirements are prescribed and detailed,
whereas hedge funds are flexible and voluntary. Concerning investment strategies available,
concentration limits, and use of leverage and derivatives, mutual funds are restricted
whereas hedge funds are unrestricted. However, mutual funds are unrestricted in terms of
allowable investors whereas hedge funds are restricted to accredited investors.

Reasons for hedge fund industry growth include investors increasingly recognizing hedge
funds’ investment flexibility so that they often have a low correlation with traditional assets
and (can serve as diversifiers), and can also offer higher returns (can serve as a return
enhancers). Assets under management (AUM) grew from less than $500 billion in 2000 to
more than $2.8 trillion in 2014. (They lost 25% AUM during the financial crisis, but growth
picked up again in 2009.)

The financial crisis of 2007-8 led to the trend of consolidation within the hedge fund
industry. Larger funds now dominate the industry. They are perceived as being less risky
(e.g., more stable with better risk management systems), and they have resources available
to get through the strict due diligence processes performed by investors.

• Consolidation is an increase in the proportion of a market represented by a relatively

small number of participants (i.e., the industry concentration).

Learning Objective: Demonstrate knowledge of hedge fund fees.

MAIN POINT: Typical hedge fund fee arrangements are “2 and 20” and have attracted
talented managers to the hedge fund industry away from traditional mutual funds, but
incentive fees have drawn scrutiny from regulators due to their asymmetric nature and
potential to provide perverse incentives. Incentive fees can potentially impact hedge fund
manager behavior. Hedge fund fees can viewed as an annuity, illustrating incentives for
managers to keep hedge funds open as long as they can, yet the option-like payout of
incentive fees can incentivize managers to increase the volatility of the fund’s assets.
Empirical evidence regarding hedge fund fees and managerial behavior shows managers
may take fewer risks after periods of high returns and more risks after periods of negative
returns, and they also have incentives to modify the time series of returns to enhance
reported performance.

Typical hedge fund fee arrangements are “2 and 20,” where the first number (2), which can
range from about 1 to 3, represents the management fee and is calculated as a percentage of
the net asset value (NAV) of the fund, and the second number (20) represents the incentive
fee, calculated as a percentage of profit, if positive (or in some cases greater than a hurdle
rate). Mutual funds lack an incentive fee, so the traditional fund industry witnessed an
exodus of talent to join hedge funds. Yet competition in recent years has put pressure on
hedge funds to lower fees. There are often other conditions included in the contract
describing manager compensation, including hurdle rates and clawbacks. Management fees
may be charged more frequently than annually, but incentive fees are generally charged on
an annual basis.

Annual Fee = Management Fee

+ {max [0, Incentive Fee
x (Gross Return above HWM —Management Fee —Hurdle Rate)]}

where HWM represents the high-water mark.

308
© 2020 Wiley
 STRUCTURE OF THE HEDGE FUND INDUSTRY

• The high-water mark (HWM) is the highest NAV of the fund on which an incentive
fee has been paid.

It is unlikely that on any annual date when an incentive fee has been paid the fund will be at
its highest overall NAV. The purpose of HWMs is too avoid managers collecting incentive
fees when the NAV is not higher than the previous year’s NAV that incentive fees were
already collected on. An exception would be if there were a clawback arrangement and the
incentive fee was returned due to a decline in the NAV, in which case an incentive fee could
be applied to the recouped losses since doing so would not constitute doubling the fee.

Example 1: Determining Fees and the Ending After-Fees NAV

Here we are assuming no hurdle rate, subscriptions, or redemptions. In addition, we

assume that management fees are calculated using the beginning-of-year NAV (NAV0),
which is $200 million. Then if the ending (one-year-later) before-fee NAV is
$250 million, what is the annual management fee and incentive fee in dollars for a 2 and
20 arrangement? What is the ending NAV after fees?

Solution
We apply the formula:

Annual Fee = Management Fee

+ {max [0, Incentive Fee
x (Gross Return above HWM —Management Fee —Hurdle Rate)]}

Management fee is 2%($200 million) = $4 million.

Notice that the management fee is subtracted from the gross profit before the incentive
fee is calculated.

Incentive fee is 20%($250 million - $200 million - $4 million) = $9.2 million

Ending after-fees NAV is $250 million - $4 million - $9.2 million = $236.8 million.

Since NAV went up and there is no hurdle rate, we can ignore the instance when the
incentive fee ( / ) is zero and the simplified version of equation relating NAV0, and ending
after-fees NAVs can be written as follows:

NAVW = NAVW - NAV0 x f m - (N A V W - NAV0 - NAV0 x / J / , -

This says the ending-period NAV after fees (NAVijfl/) is found by taking the ending-period
NAV before fees and subtracting two dollar amounts:

1. The management fee (NAV0 multiplied by the percentage/,,).

2. The incentive fees (the incentive fee percentage,/, multiplied by the profit, where
the profit is the difference in ending and beginning NAVs and after taking out the
management fee).

Candidates should also be able to find the NAV before fees. This solution finds the
incentive fee directly as a percentage of the profits after fees:

309
© 2020 Wiley
HEDGE FUNDS

Incentive Fee = (NAVW - NAV0)[/•/(! -/•)]

Example 2: Determining Fees and the Ending, Before-Fees NAV

Here we are again assuming no hurdle rate, subscriptions, or redemptions. In addition,

we assume that management fees are calculated using the beginning-of-year NAV
(NAV0), which is $200,000,000. Then if the ending (one-year-later) after-fee NAV is
$270,000,000, what is the annual management fee and incentive fee in dollars for a 1.5%
and 20% arrangement? What is the ending NAV before fees?

Solution
We can calculate the incentive fee first as a portion of the total profits after fees://(l -/•).

($270 million - $200 million)[.2/(1 - .2)] = $70 million(.2/.8) = $17.5 million

We know the management fee is $3 million. Therefore, the before-fees ending NAV =
the after-fees NAV + the management fee + the incentive fee = $270 million +
$3 million + $17.5 million = $290.5 million.

The potential effects of incentive fees on hedge fund manager behavior may be perverse:
while management fees are common throughout the traditional asset management industry,
hedge fund incentive fees have drawn criticism from the public and from regulators. The
incentive fees are designed to align the interests of the manager and the investor. However,
they are asymmetric.

• Asymmetric incentive fees, in which managers earn a portion of investment gains

without compensating investors for investment losses, are generally prohibited for
stock and bond funds offered as '40 Act mutual funds in the United States.

Perfect alignment of manager and investor interests may not be possible.

• Optimal contracting between investors and hedge fund managers attempts to align
the interests of both parties to the extent that the interests can be aligned cost-
effectively, with marginal benefits that exceed marginal costs.

Coinvesting by the hedge fund manager and investors may provide enhanced alignment.

• Managerial coinvesting in this context is an agreement between fund managers and

fund investors that the managers will invest their own money in the fund.

Yet coinvesting may lead to excess conservatism by the manager, who would likely be less
diversified than the investors.

• Excessive conservatism is inappropriately high risk aversion by the manager, since

the manager’s total income and total wealth may be highly sensitive to fund
performance.

It has been suggested that managers with a 30% personal stake (30% of their own personal
net worth invested) will minimize any perverse incentives.

i,0
© 2020 Wiley
 STRUCTURE OF THE HEDGE FUND INDUSTRY

• A perverse incentive is an incentive that motivates the receiver of the incentive to

work in opposition to the interests of the provider of the incentive.

By taking an annuity view of hedge fund fees, several manager incentives are highlighted:
there is a very strong incentive to avoid poor returns, but when there are poor returns, there
is a very strong incentive to take excessive risks.

• The annuity view of hedge fund fees represents the prospective stream of cash flows
from fees available to a hedge fund manager.

A simplified example of an annuity view of hedge fund fees that assumes a constant rate of
return on the fund that is the same rate used as a discount rate for determining the present
value of the constant stream of fund fees. It shows that the longer the fund is open, the
higher is the percentage of the NAV earned that is distributed to managers. This provides a
strong incentive to keep the fund open. The assumption that investor returns are reinvested
while the manager’s distributions are not is a key factor driving the results. If the fund is
performing well, the investors also do quite well.

Option View of Incentive Fees and Its Implications for M anager Behavior
Options increase in value with the volatility of the underlying asset.

• The option view of incentive fees uses option theory to demonstrate the ability of
managers to increase the present value of their fees by increasing the volatility of the
fund’s assets.

Payout on Incentive Fee Option = max[i(ENAV —BNAV),0]

In this single-period analysis, i in the equation is the incentive fee, ENAV is the ending
NAV, and BNAV is the strike price, which is the beginning NAV, or the high-water mark.
This view emphasizes the asymmetric nature of the incentive fee.

• The incentive fee option value is the risk-adjusted present value of the incentive fees
to a manager that have been adjusted for its optionality.

The value of the incentive fee option can be found using the Black-Scholes model that
requires five inputs. An approximation can be used if it is assumed that the incentive fee
option is at-the-money and interest rates are very low.

• The at-the-money incentive fee approximation expresses the value of a managerial

incentive fee as the product of 40%, the fund’s NAV, the incentive fee percentage,
and the volatility of the assets ((Ji) over the option’s life.

Incentive Fee Call Option Value- / x 40% x NAV x o\

Example 3: At-the-Money Option Value of Incentive Fees

For a 20% incentive fee, the approximate value of the incentive fee option is given by:

Incentive Fee Call Option Value - 8% x $1 billion x o\

For a $1 billion hedge fund, the value of the incentive fee when volatility is 20% is
$16 million. What is the value of the incentive fee when annual asset volatility is 30%?

© 2020 Wiley
ii.
HEDGE FUNDS

Solution
Incentive Fee Call Option V alu e-8% x $1 billion x .3 = $ 2 4 million

Note that while the manager has a motivation to increase the value of the incentive fee by
increasing volatility, there is a second implication of this view. If the option is far out-of-
the-money (the NAV is far below the strike price), then the manager has reason to consider
closing the fund and perhaps opening a new one.

These potential conflicts of interest should be investigated and mitigated, but also need to be
balanced against the benefits of incentive fees. Without incentive fees, managers may
become asset gatherers or closet indexers.

• A pure asset gatherer is a manager focused primarily on increasing the AUM of the
fund.

• A closet indexer is a manager who attempts to generate returns that mimic an index
while claiming to be an active manager.

Empirical Evidence Regarding Hedge Fund Fees and M anagerial Behavior

Two main points emerge from the literature.

First, managers may take fewer risks after periods of high returns, and more risks after
periods of negative returns.

For example, Hodder and Jackwerth’s “Incentive Contracts and Hedge Fund Management” 1
find a lock-in effect after periods of high returns.

• The lock-in effect in this context refers to the pressure exerted on managers to
avoid further risks once high profitability and a high incentive fee have been
achieved.

Second, managers may modify the time series of returns to enhance performance results (on
a risk-adjusted basis, and/or by number of profitable months reported).

• The terms managing returns and massaging returns refer to efforts by managers to
alter reported investment returns toward preferred targets through accounting
decisions or investment changes.

Learning Objective: Demonstrate knowledge of various types of hedge funds•*

MAIN POINT: Single-manager hedge funds and multistrategy funds have one layer of fees,
whereas funds of funds (FoFs) have two layers of fees. FoFs are compensated primarily for
the due diligence they perform when selecting single-manager hedge funds.

There are different ways to classify hedge fund strategies—various index providers do so
similarly, but there are usually variations.

• A classification of hedge fund strategies is an organized grouping and labeling of

hedge fund strategies.

312
© 2020 Wiley
 STRUCTURE OF THE HEDGE FUND INDUSTRY

In the CAIA curriculum, strategies are classified into five main groups with a chapter
devoted to each:

1. Macro and managed futures funds

2. Event-driven hedge funds
3. Relative value hedge funds
4. Equity hedge funds
5. Funds of funds

In the next learning objective, strategies are grouped by systematic risk into four groupings
that have similarities with this scheme, but it is not a one-to-one mapping.

Here, a distinction between single-manager funds and FoFs is emphasized.

A fund of funds is a hedge fund with underlying investments that are predominantly
investments in other hedge funds.

• A fund of funds (FoF) charges a fee for the due diligence it performs, and the funds
within the FoF also charge fees. Therefore, there is a double layer of fees.

• A single-manager hedge fund, or single hedge fund, has underlying investments

that are not allocations to other hedge funds.
Single-manager funds and multistrategy funds charge a single layer of fees.
• A multistrategy fund deploys its underlying investments with a variety of strategies
and submanagers, much as a corporation would use its divisions.
Fund mortality is also an important issue. Of all funds alive in 2010, approximately half
survived into 2015. The average fund life is four and a half years. Longer-lived funds tend
to be larger and have lower volatility. Fund mortality is an important issue and related to
survivorship bias, discussed later.

• Fund mortality, the liquidation or cessation of operations of funds, illustrates the

risk of individual hedge funds and is an important issue in hedge fund analysis.

Learning Objective: Demonstrate knowledge of hedge fund returns and asset

allocation.21*

MAIN POINT: Diversify across hedge fund strategies; that is, don’t put all your eggs in one
basket. Hedge fund strategies are grouped by their systematic risk as (1) equity strategies,
(2) event-driven and relative value strategies, (3) absolute return strategies, and
(4) diversified strategies.

Hedge fund programs should diversify across hedge fund strategies.

• A hedge fund program refers to the processes and procedures for the construction,
monitoring, and maintenance of a portfolio of hedge funds.

In view of asset allocation, there are generally four groupings of hedge fund strategies
according to their systematic risk exposures:

1. Equity strategies, which exhibit substantial market risk.

2. Event-driven strategies, which seek to earn returns by taking on event risk, such as
failed mergers, that other investors are not willing or prepared to take, and relative

in
© 2020 Wiley
HEDGE FUNDS

value strategies, which seek to earn returns by taking risks regarding the
convergence of values between securities.
3. Absolute return strategies, which seek to minimize market risk and total risk.
4. Diversified strategies, which seek to diversify across a number of different
investment themes.

Each group is discussed briefly in the following paragraphs, and then an entire
lesson is devoted to each of the five CAIA classifications presented in the last
learning objective.

Equity strategies include equity hedge and short bias funds. Long/short funds may have low
net beta exposure but significant exposure to stock picking skills. Short bias funds are the
worst-performing strategy over full market cycles, with negative betas, but may have
significant alpha such that on a risk-adjusted basis they outperform the market.

Event-driven and relative value strategies have low standard deviations and large negative
skewness and excess kurtosis. They can be viewed as insurance companies or option
writers: regularly collecting “nickels” (i.e., premiums) but suffering when there is a bad
event. Since option values increase with volatility, and these strategies are like writing
options, they may be said to have short volatility exposure.

• Short volatility exposure is any risk exposure that causes losses when underlying
asset return volatilities increase.

These strategies are typically hedged. An example is the merger arbitrage strategy that holds
offsetting positions in the companies involved in a merger. Three-quarters of the time these
funds earn positive monthly returns of up to about 2%, leading to low volatility. But they
are exposed to event risk where they can have large losses and therefore exhibit negative
skewness.

Investors need to understand the risks of these types of strategies because they are off-
balance-sheet risks.

• Event risk is effectively an off-balance-sheet risk—that is, a risk exposure that is not
explicitly reflected in the statement of financial positions. Another way to understand
the risk/retum profile of event-driven strategies is as an insurance contract. The
strategy’s risk/retum profile is like that of an insurance company that collects many
relatively small premiums but is exposed to the large risk of a claim. This can also be
viewed as writing an option: collecting premiums but having to pay if a claim arises.
The claim (e.g., damage to a house) is the face value of the insurance contract, which
can be viewed as the strike price.

Relative value strategies hold a short position in a security that is expected to fall relative to
a similar but lower-priced security that is expected to rise and is held long. They are also
called convergent strategies.

• Convergent strategies profit when relative value spreads move tighter, meaning that
two securities move toward relative values that are perceived to be more appropriate.

The disastrous Long-Term Capital Management demise depended on consistent relative

values (a convergence-arbitrage strategy) to earn money, but collapsed when the
relationships no longer held as a result of the Russian government defaulting on its bonds in

© 2020 Wiley
 STRUCTURE OF THE HEDGE FUND INDUSTRY

1998. The fund had previously been very successful collecting option-like premiums on a
regular and consistent basis.
Like credit-risky investments such as high-yield bonds exposed to event risk such as credit
downgrades, these event-driven and relative value hedge fund strategies have fat-tailed
distributions (leptokurtosis).

Absolute return strategies are measured against an index of zero—they strive to have
positive returns in all markets. This contrasts with the relative value benchmark that is
expected to have negative returns when the overall market/benchmark is negative.

• A relative return product is an investment with returns that are substantially driven
by broad market returns and that should therefore be evaluated on the basis of how
the investment’s return compares with broad market returns.

Since many hedge fund strategies can take short positions when the market is falling, their
benchmark is zero: they should be able to make money in both bull and bear markets. Two
such strategies are equity market neutral and market defensive hedge funds. They are
characterized by low standard deviations, excess kurtosis, and excess skewness. They also
have low drawdowns and correlations with equity markets.

Diversified strategies include funds of funds, multistrategy funds, global macro funds, and
managed futures funds. These exhibit normal, symmetrical distributions and can offer
attractive returns with low drawdowns.

Learning Objective: Demonstrate knowledge of the process of evaluating a

hedge fund investment program.

MAIN POINT: Hedge fund investment programs set risk and return targets and other
parameters such as desired liquidity and minimum length of track record. Performance must
be evaluated in light of these constraints. While most studies conclude that the addition of a
hedge fund program to a portfolio of traditional assets improves the risk-return
characteristics of the portfolio, there are some caveats. Some reasons that benefits of hedge
funds may be overstated include the high correlation of hedge fund strategy returns during
shocks and biases in hedge fund databases.

Investors should set risk and return parameters that may be used in a hedge fund investment
program at two levels: for the individual fund managers and for the overall program.
Acceptable individual fund parameter ranges may be set wider than those for the program as
a whole. In addition to target return and standard deviation, parameters may include
liquidity, drawdown, leverage, length of track record, minimum investment, and assets
under management, among others.

But should hedge funds be included at all? Hedge funds have been shown to expand the
investment opportunity set and provide positive return with reduced risk when included in a
portfolio of traditional assets. There are, however, three caveats that relate to the
documented hedge fund investment performance and diversification benefits:

1. Shocks to one hedge fund strategy can spread quickly to other strategies.
2. Future results can differ from past results.
3. Empirical studies often suffer biases in data such as survivorship bias or selection
bias.
These three facts can mean that the benefits of hedge fund programs may be overstated.

il!
© 2020 Wiley
HEDGE FUNDS

Yet opportunistic hedge fund strategies offer several advantages with the aim of
complementing the risk-return profile of a fund rather than simply reducing risk.

• An investment strategy is referred to as opportunistic when a major goal is to seek

attractive returns through locating superior underlying investments.

These strategies take advantage of many opportunities that are not available to traditional
mutual funds such as taking concentrated (e.g., specializing in an industry or sector),
leveraged, and/or short positions alongside long positions, with potentially more frequent
trading. This ability maximizes the manager’s information set and is consistent with the
fundamental law of active management: the long-only constraint is the most expensive
constraint (lost alpha) relevant to active management. Opportunistic strategies are generally
evaluated relative to a benchmark. (Few are absolute return strategies).

Learning Objective: Demonstrate knowledge of research studies on whether

hedge funds adversely affect the financial markets.

MAIN POINT: A series of academic studies have concluded that hedge funds do not
directly impact markets. However, headline risk may be a deterrent to institutional
investment because hedge funds have been linked to market crises in the press.

• Headline risk is dispersion in economic value from events so important, unexpected,

or controversial that they are the center of major news stories.

Empirical evidence regarding the market impact of hedge funds finds that hedge funds did
not impact the Malaysian ringgit, nor the slide in a basket
)
of Asian currencies that occurred
in 1997, according to Brown, Goetzmann, and Park.

Empirical evidence from another study (Fung and Hsieh) finds that hedge funds do
sometimes impact markets, most notably the devaluation of the pound sterling in 1992.
Yet George Soros, betting against the pound sterling, did not trigger the devaluation
even though he exacerbated its decline. Hedge funds do not change the course of a
market driven by economic fundamentals.

Empirical evidence regarding the market impact of hedge funds during the financial crisis of
2007-8 includes the Khandandi and Lo study of quantitative equity market-neutral hedge
funds rapidly unwinding positions that caused a liquidity crisis. But despite this, it has been
argued that short-selling activity can reduce risk and that the hedge fund industry was
beneficial by providing liquidity.

Empirical evidence is consistent with the theoretical arguments that speculators, buying low
and selling high—pushing prices toward their mean—stabilize financial markets, although
there are mixed, alternative arguments.

Learning Objective: Demonstrate knowledge of hedge fund indices.

MAIN POINT: There are several hedge fund index providers with little overlap in the
managers in each database and unique approaches to index construction. Therefore, there

316 © 2020 Wiley

 STRUCTURE OF THE HEDGE FUND INDUSTRY

are several issues to be aware of when using any particular index. These include fee bias;
recognizing what constituents are include (some include managed futures whereas others do
not); the impacts of different weighting schemes; database biases (e.g., survivorship,
selection, instant history, liquidation); understanding the challenges involved in defining
hedge fund strategies; the effect of style drift; and the trade-off between investability of
hedge funds and the representativeness of noninvestable indices.

There are more than 15 hedge fund index providers, and each constructs its indices
uniquely. They may obtain hedge fund returns from the hedge funds or let managers enter
their returns to a database directly. Databases are then averaged to compute an index.
While hedge funds are largely alpha driven and hard to benchmark, benchmarking is one
use of the hedge fund indices. The other main use is as a proxy for hedge fund returns as
an asset class, for asset allocation considerations.

Fees
There are at least two reasons that reported net-of-fee returns in hedge fund indices will
contain fee bias:

1. Incentive fees are calculated monthly, but in reality fees are paid annually so
monthly calculations are only estimates.
2. As private investments, different investors will have different fee arrangements as
the fund can change fee terms over time.

Fee bias is when index returns overstate what a new investor can obtain in the hedge fund
marketplace because th e fees used to estimate index returns are lower than the typical fees
that new investors would pay.

Managed Futures
Hedge fund index returns may vary across providers depending on whether they include
managed futures. Some view managed futures programs that invest across a spectrum of
commodity and financial futures as hedge funds, whereas others view them as too different
from most hedge fund strategies and exclude them. Although they often invest in financial
futures, managed futures are also called commodity trading advisers (CTAs).

Asset-Weighted and Equally Weighted Hedge Fund Indices

HFR estimates that 17% of the largest hedge fund managers control 90% of the AUM. If
hedge fund indices were as set-weighted, they would largely exclude 83% of the managers.
For that reason, most indices equally weight returns across managers.

In addition, some large hedge funds do not report to databases, so an asset-weighted index
might be difficult to interpret. Asset-weighted indices are influenced by fund flows to large
funds as well as popular strategies such as global macro. But in an asset allocation program,
other capitalization-weighted indexes are used, such as the S&P 500, so there is an
argument for using cap-weighted hedge fund indices. But correlations with equity and
fixed-income indices are very similar whether using equally weighted of cap-weighted
hedge fund indices.

Size of the Hedge Fund Universe

The size of the hedge fund universe is unknown. Most hedge funds do not report to multiple
databases. There are large differences in the funds across databases and indices, with little
overlap in funds and reported returns. Hedge fund mortality is also an issue. New
regulations requiring registration are, however, increasing transparency in the industry.

317
© 2020 Wiley
HEDGE FUNDS

Representativeness and Data Biases

Representativeness can vary due to data biases (e.g., survivorship, selection, instant history,
liquidation) impacting hedge fund returns reported by databases.

• The representativeness of a sample is the extent to which the characteristics of that

sample are similar to the characteristics of the universe.

These biases are upward in nature, potentially overstating average returns by as much as
10% when added together. Databases usually contain one or more of the following four
biases.

Survivorship Bias
• Survivorship bias arises when an index is constructed that disproportionately
includes past returns of those investments that remain in operation, meaning they
have survived, while excluding return histories of those investments that have not
survived.

Survivorship bias equals the average a of surviving funds minus the average a of all funds,
both alive and dead (where a is the risk-adjusted return over the S&P 500) ~2.6% to 5%
per year.

This bias is common in mutual funds and other non-hedge fund indices as well. However,
this bias does not usually impact indices. An index averages returns of the fund and, unless
a dead fund’s returns are dropped from the past calculations, its past performance is
reflected in the index. Survivorship bias occurs in a database when the dead fund is dropped
from the data base.

Selection Bias
• Selection bias occurs when an index disproportionately reflects characteristics of
managers who chose to report their returns.

It is difficult to measure selection bias because the managers’ self-selection to report to a

database impacts past as well as future returns.

Instant History Bias

• Instant history bias or backfill bias occurs when an index contains histories of
returns that predate the entry date of the corresponding funds into a database and
thereby cause the index to disproportionately reflect the characteristics of funds that
are added to a database.

When managers are performing well they are more likely to choose to report to a database
than if they are in a period of bad returns. When a fund’s past relatively high performance is
backfilled to a database instantly after choosing to report, the backfilled returns will be
upwardly biased. This can create a bias estimated between 1% and 5% per year.

Liquidation Bias
• Liquidation bias occurs when an index disproportionately reflects the characteristics
of funds that are not near liquidation.

Liquidation bias is like survivorship bias. The difference is that before liquidation, the fund
is likely experiencing poor returns and is too busy and not interested in reporting those poor
returns.

© 2020 Wiley
 STRUCTURE OF THE HEDGE FUND INDUSTRY

The flip side of liquidation bias and instant history bias is participation bias.

• Participation bias may occur for a successful hedge fund manager who closes a
fund to new investors and stops reporting results because the fund no longer needs to
attract new capital.

Hedge Fund Strategy Definitions and Style Drift

There are several challenges involved in defining hedge fund strategies.

• Strategy definitions, the method of grouping similar funds, raise two problems:
(1) definitions of strategies can be very difficult for index providers to establish and
specify, and (2) some funds can be difficult to classify in the process of applying the
definition.

Once a hedge fund is classified in a database and potentially included in a strategy-specific

index, it is possible for it to change its style but remain in the database as originally
classified.

• Style drift (or strategy drift) is the change through time of a fund’s investment
strategy based on purposeful decisions by the fund manager in an attempt to improve
risk-adjusted performance in light of changing market conditions.

Further confounding classification is the introduction of synthetic hedge funds.

• Synthetic hedge funds attempt to mimic hedge fund returns using listed securities
and mathematical models.

Investability of Hedge Fund Indices

Investable hedge fund indices underperform noninvestable hedge fund indices, yet have
somewhat similar distributions.

• The investability of an index is the extent to which market participants can invest to
actually achieve the returns of the index.

The main reason that investable and noninvestable hedge fund indices differ is that
noninvestable indices include hedge funds that are closed to investment because they are at
capacity.

• Capacity is the limit on the quantity of capital that can be deployed without
substantially diminished performance.

Many hedge funds reach capacity due to competition within their strategies. Noninvestable
hedge fund indices are more representative of the hedge fund universe because many hedge
funds are closed to new investment. Thus, there is a trade-off between broad
representativeness and investability.

© 2020 Wiley
ii.
 M a c r o a n d M a n a g ed F u t u r es F unds

This lesson introduces two hedge fund strategies that are similar in many ways but also
distinctly different in their approaches: managed futures are systematic trading strategies
whereas macro funds are use manager discretion. Both trade broadly across several markets,
but managed futures are distinct from other hedge fund strategies and regulated by the
Commodity Exchange Act, which requires that they register with the Commodity Futures
Trading Commission (CFTC). Despite their differences, the risk and return characteristics
are similar, with bot] i providing ample downside risk protection.

LESSON MAP
• Demonstrate knowledge of macro and managed futures strategies,
• Demonstrate knowledge of global macro,
• Demonstrate knowledge of managed futures,
• Demonstrate knowledge of systematic trading.
• Demonstrate knowledge of the core dimensions of managed futures investment
strategies.
• Demonstrate knowledge of systemic futures portfolio construction,
• Demonstrate knowledge of various core benefits of managed futures for investors,
• Demonstrate knowledge of evidence on managed futures returns,
• Demonstrate knowledge of benefits of managed futures funds.

KEY CONCEPTS
Managed futures are organized as commodity pools with a commodity pool operator (CPO)
registering with the Commodity Futures Trading Commission (CFTC) and hiring one or
more commodity trading advisers (CTAs). Macro funds are organized as hedge funds. Both
charge similar management and incentive fees. Macro funds are discretionary and rely
primarily on fundamental analysis. They make large sector- or country-level bets. Managed
futures are systematic (sometimes called “black-box”) strategies that rely primarily on
technical analysis. It is important to backtest and validate rules-based strategies. Most of
these are trend-following strategies. Three examples are provided: simple moving averages,
weighted and exponential moving averages, and breakout strategies. Some non-trend-
following strategies include the relative strength index and relative value strategies. Apart
from empirical evidence that finds managed futures earn alpha, a conceptual reason for this
to be true is that they fill the gap between supply and demand for futures from natural
hedgers.

Learning Objective: Demonstrate knowledge of macro and managed futures

strategies.

MAIN POINT: Relative to other hedge fund strategies, macro and managed futures funds
have greater liquidity, greater capacity, and less counterparty risk. They both look for trades
at the sector and country levels. Managed futures tend to be more systematic using technical
analysis than global macro strategies that use fundamental analysis in discretionary trading.

Before discussing differences between macro and managed futures funds, we note some
similarities and why they are grouped together in this topic.

Similarities
Both macro and managed futures funds make large sector bets or exploit inefficiencies at the
sector and country levels. Other similarities relative to other strategies include greater
liquidity, greater capacity, and less counterparty risk.

© 2020 Wiley 5
HEDGE FUNDS

• Counterparty risk is the uncertainty associated with the economic outcomes of

one party to a contract as a result of potential failure of the other side of the contract to
fulfill its obligations, presumably due to insolvency or illiquidity.

Owing to the greater capacity of these funds, together they make up about 20% of the hedge
fund universe.

Differences
Both strategies are discussed in more depth throughout this topic, but here we note two
characteristics:

1. Global macro funds tend to be more discretionary, and managed futures funds tend
to be more systematic.
2. Global macro funds tend to use fundamental analysis, and managed tend to use
technical analysis.

Discretionary fund trading and systematic fund trading are terms that apply to other
strategies as well, but the distinction is particularly relevant for these two strategies.

• Discretionary fund trading occurs when the decisions of the investment process are
made according to the judgment of human traders.
• Systematic fund trading, often referred to as black-box model trading because the
details are hidden in complex software, occurs when the ongoing trading decisions of
the investment process are automatically generated by computer programs.

Global macro strategies tend to use fundamental analysis primarily at a macro level.

• Fundamental analysis uses underlying financial and economic information to

ascertain intrinsic values based on economic modeling.

Managed futures funds primarily use technical analysis based on the belief that there are
some weak form market inefficiencies.

• Technical analysis relies on data from trading activity, including past prices and
volume data.

While there are exceptions to these characterizations, the remainder of the lesson is
organized around describing and contrasting the two strategies in these terms: global macro
as discretionary using fundamental analysis and managed futures as systematic using
technical analysis.

Learning Objective: Demonstrate knowledge of global macro.

MAIN POINT: Global macro funds are characterized by a high-level top-down

macroeconomic approach to investing. Examples that illustrate the foundation of global
macro trading strategies include taking advantage of faults inherent in fixed or managed
exchange rates, betting on sovereign bonds, applying an expert understanding of central
bank intervention impacts, and thematic investing. The main risks of macro investing are
market, event, and leverage risk.

322
© 2020 Wiley
 MACRO AND MANAGED FUTURES FUNDS

Global macro funds take a macroeconomic approach on a global basis and use several
financial instruments to take long and short positions that may be concentrated and
leveraged.

• Global macro funds have the broadest investment universe: They are not limited by
market segment, industry sector, geographic region, financial market, or currency,
and therefore tend to offer high diversification.

Illustrations
Focuses of global macro strategies are, for example, exchange rates, sovereign bonds,
central bank intervention, and thematic investing.

1. Fixed or managed exchange rates experiencing pressure to adjust as a result of

market forces often eventually must adjust, and in a big way. For example, George
Soros bet against the British pound in 1992 at a time when it was managed to remain
within 6% of its target rate relative to the German deutsche mark. To maintain the
value, the British government had to keep purchasing pounds. It finally gave up and
moved to a floating rate, which lost 25% of its value relative to the U.S. dollar in
three months.
2. Sovereign bonds are often the focus of macro strategies. For example, from 1994 to
1998 bullish bets were made on the sovereign bonds of new entrants to the euro
currency. Portugal, Italy, Greece, and Spain (PIGS) were required to lower their
deficits, national debt, and inflation.
3. A strong understanding of central bank intervention impacts is illustrated by bets on
Japan’s new prime minister’s 2012 campaign message of economic reform
(“Abenomics”) to deliver on promises. He increased the monetary supply, and the
Nikkei index increased by 50% while the yen declined 20%, rewarding macro bets
that were long Japanese stocks and short the yen.
4. Thematic investing is illustrated by bets on long-term economic growth in China.
Thematic investing is a trading strategy that is not based on a particular instrument
or market; rather, it is based on secular and long-term changes in some fundamental
economic variables or relationships—for example, trends in population, the need for
alternative sources of energy, or changes in a particular region of the world
economy.

Other strategies, for example arbitrage-based strategies, are based on understanding market
microstructure.•

• Market microstructure is the study of how transactions take place, including the
costs involved and the behavior of bid and ask prices.

In contrast, macro strategies take a broad view.

Primary Global Macro Risks

Macro strategies have low standard deviations, but are exposed to the following risks more
than many other strategies.

They may make very concentrated bets and take on a large amount of market risk.

• Market risk refers to exposure to directional moves in general market price levels.

Macro strategies bet on events such as market dislocations due to, for example, government
policies, and are subject to event risk.

323
© 2020 Wiley
HEDGE FUNDS

• Event risk refers to sudden and unexpected changes in market conditions resulting
from a specific event (e.g., Lehman Brothers’ bankruptcy).

Macro strategies may also use substantial amounts of leverage and be exposed to leverage
risk.

• Leverage refers to the use of financing to acquire and maintain market positions
larger than the assets under management (AUM) of the fund.

Learning Objective: Demonstrate knowledge of managed futures.•

MAIN POINT: Managed futures are organized as commodity pools with a CPO registering
with the CFTC and hiring one or more CTAs. Pools may be either public (like mutual
funds) or private (like hedge funds), with the same relative advantages and disadvantages as
other public and private investment pools. For large-enough accounts, individually managed
accounts placed directly with CTAs offer benefits similar to other separately managed
accounts.

Managed futures funds take long and short positions in a variety of futures markets. It is a
systematic, skill-based investing style. While commodity futures have existed for centuries,
originally to hedge agricultural price risk, the first financial futures were introduced in the
1970s. Before that, managed futures were largely unregulated.

• The term managed futures refers to the active trading of futures and forward
contracts on physical commodities, financial assets, and exchange rates.

The use of forward and futures contracts are a low-cost means (avoiding transactions,
financing, and storage costs) to gain exposure to a variety of spot or cash markets with clear
pricing and the ability to go short.

Congress enacted the Commodity Exchange Act (CEA) in 1974 and created the Commodity
Futures Trading Commission (CFTC), defining the terms commodity pool operator (CPO)
and commodity trading adviser (CTA). CPOs and CTAs are required to have periodic
training through the National Futures Association (NFA), a self-regulatory body.

Three main avenues for accessing returns to managed futures funds are public commodity
pools, private commodity pools, and managed accounts.

• Commodity pools are investment funds that combine the money of several investors
for the purpose of investing in the futures markets.

They are managed by general partners who usually must register with the CTFC and the
NFA as a CPO.

• Public commodity pools are open to the general public for investing in much the
same way that a mutual fund sells its shares to the public.

Liquidity and low minimum investments are advantages to public CPOs. They are
organized like mutual funds and must register with the Securities and Exchange
Commission (SEC).

• Private commodity pools are funds that invest in the futures markets and are sold
privately to high-net-worth investors and institutional investors.

324
© 2020 Wiley
 MACRO AND MANAGED FUTURES FUNDS

Private CPOs are organized like hedge funds.

• Commodity trading advisers (CTAs) are professional money managers who

specialize in the futures markets.

Typically, both private and public CPOs hire one or more CTAs.

• A managed account (or separately managed account) is created when money is

placed directly with a CTA in an individual account rather than being pooled with
other investors’ money.

Advantages of separately managed accounts include the ability of having the strategy
specifically tailored for the investor, and the investor retaining custody of the assets
(allowing the CTA authority to trade), which provides transparency. The account needs
to be large enough to be cost-effective, however.

Similar to hedge funds, managed futures charge a management fee and an incentive fee,
with ranges of about 0% to 3% and 10% to 35%, respectively.

Learning Objective: Demonstrate knowledge of systematic trading.•

MAIN POINT: Backtesting is used to derive systematic trading rules. It is important to

incorporate reasonable transaction costs estimates. When evaluating individual trading
strategies, one should understand what the rules are and how they were developed, when the
rules work and may not work, and how the strategy is implemented. To validate the trading
system, out-of-sample data should be used to ensure robustness, and techniques to monitor
potential degradation should be applied.

Deriving Systematic Trading Rules

Systematic trading rules are generally derived from backtesting and therefore assume
that past price or return patterns identified will continue to do so in the future, which is a
very big assumption that often turns out to be faulty. Issues regarding the derivation of rules
are related to the assumptions made when using backtests such as overfitting and data
dredging. Traders do not rely on the same or a single rule but generally use multiple rules
and update them over time. Another issue in developing trading rules is to make reasonable
assumptions about transaction costs and to minimize the occurrence of slippage.

• Slippage is the unfavorable difference between assumed entry and exit prices and the
entry and exit prices experienced in practice.

Evaluating Systematic Trading Rules

Three questions to ask when evaluating trading rules are:

1. What are the rules and how were they developed? Is the concept sound? Are the
research methods solid (e.g., to avoid overfitting)?
2. Why and when does a rule work and not work? For example, understanding what
market conditions impact the rule’s success leads to a better grasp of the risks
involved.
3. How is a rule implemented? Operational factors that may undermine the strategy’s
success can be uncovered.

325
© 2020 Wiley
HEDGE FUNDS

Validating Systematic Trading Rules

Quantitative research methods using historical data include validating the rule to make sure
that it is robust (reliable) using out-of-sample data.

• Validation of a trading rule refers to the use of new data or new methodologies to test
a trading rule developed on another set of data or with another methodology.
• Robustness refers to the reliability with which a model or system developed for a
particular application or with a particular data set can be successfully extended into
other applications or data sets.
• Out-of-sample data are observations that were not directly used to develop a trading
rule or even indirectly used as a basis for knowledge in the research.
• In-sample data are those observations directly used in the backtesting process.
Out-of-sample data consist of more recent data than were used in the backtest.

Over time, trading systems degrade. A highly successful system will eventually be
discovered by others and, as with arbitrage opportunities that quickly disappear due to
forces of supply and demand, profits from a systematic trading system will diminish.

• Degradation is the tendency and process through time by which a trading rule or
trading system declines in effectiveness.

Discerning whether a system’s poor performance is due to degradation or to bad luck or

other factors requires careful statistical analysis.

Learning Objective: Demonstrate knowledge of systematic trading.•

MAIN POINT: Trend-following strategies covered here include simple moving averages,
weighted and exponential moving averages, and breakout strategies. Non-trend-following
strategies covered include the relative strength index or indicator and relative value
strategies.

Most systematic trading strategies are trend-following strategies.

Trend-Following Strategies
In this section, we illustrate a systematic trend-following strategy based on a simple moving
average.

• Trend-following strategies are designed to identify and take advantage of

momentum in price direction (i.e., trends in prices).
• Momentum is the extent to which a movement in a security price tends to be
followed by subsequent movements of the same security price in the same direction.

Trend-following strategies are the opposite of those that assume mean reversion.

• Mean-reverting refers to the situation in which returns show negative

autocorrelation—the opposite tendency of momentum or trending.

Theoretically in efficient markets, price series are not mean-reverting, nor do they exhibit
momentum, but rather are a random walk. Systematic trading strategies are difficult, if not
impossible, to implement in efficient markets where prices follow a random walk.

• A price series with changes in its prices that are independent from current and past
prices is a random walk.

326
© 2020 Wiley
 MACRO AND MANAGED FUTURES FUNDS

Assuming an asset’s price is trending and exhibits momentum, a strategy based on a simple
moving average can be profitable.

• A moving average is a series of averages that is recalculated through time based on a

window of observations.
• A simple moving average is a simple arithmetic average of previous prices.

An n-day moving average of prices is defined as follows:

Rule: Enter long if current price is > SMA(n) and short if current price is < SMA(n).

The idea is that a trend is developing: if the current price is above the moving average, it
will continue to move that way, so you should be long; if the price is below the moving
average, you should be short.

Example 1: Simple Moving Average

A stock price experiences the following 10 consecutive daily prices (t = -10 to t = -1):
100, 99, 98, 102, 97, 100, 99, 101, 100, and 103. What are the simple moving average
prices on day 0 using three-day and 10-day moving averages, as well as three-day
moving averages for days -2 and -1?

Solution

The three-day moving average on day 0 is 101.33, and it is 100 for both days -2 and -1.
The 10-day moving average for day 0 is 99.9. Because the price on day -1 has moved
above the recent three-day moving averages, a classic interpretation of a simple moving
average trading system would be that a long position should be established.

For further intuition, see the Simple Moving Average figure.

Adapted from CAIA Level I, 4th ed., 2020. Application 17.6.1 A. Copyright © 2009,
2012, 2015 by The CAIA Association.

327
© 2020 Wiley
HEDGE FUNDS

Simple Moving Average

A A B
1 t P
2 -10 100
3 -9 99
4 -8 98
-7 102
6 -6 97
-5 100
8 -4 99
9 -3 101 3-DaySM As
10 -2 100 100 =AVERAGE(B7:B9) Conclusion/Rule:
11 -1 103 100 =AVERAGE(B8:B10) 103>100 go long
12
13
0 ♦n 101.33 -|
!=AVERAGE(B9:B11)

14 0 10-daySMA: 99.9 =AVERAGE(B2:B11)

Notice that in our example, where we chose to calculate the average of the past three days’
prices (i.e., n = 3), we could have chosen any number for n. Thus, there are many possible
rules associated with this simple example, and it highlights the potential problem of data
dredging. Furthermore, there are several variations on this simple rule, as the next examples
illustrate.

Weighted and Exponential Moving Averages

Variations of the simple moving average, which weights past prices equally, include the
weighted moving average and exponential moving average, which both place more
importance on recent prices by weighting them more heavily than prices in the relatively
distant past.

• A weighted moving average is usually formed as an unequal average, with weights

arithmetically declining from most recent to most distant prices.

328
© 2020 Wiley
 MACRO AND MANAGED FUTURES FUNDS

We divide by 15 because 5 + 4 + 3 + 2 + 1 = 15.

On day -1, the weighted moving average is:

[97(5) + 100(4) + 99(3) + 101(2) + 100(1)]/15 = $99.87

Adapted from CAIA Level I, 4th ed., 2020. Application 17.6.2A. Copyright © 2009,
2012, 2015 by The CAIA Association.

• The exponential moving average is a geometrically declining moving average

based on a weighted parameter, 2, with 0 < 2 < 1.

The following equation represents the exponential moving average. The last three dots in
the equation indicate that it continues forever, so is hard to implement in practice. We
provide intuition in the example that follows, but this form of the equation does not need to
be memorized because it is on the CAIA equations exception list.

Equivalently, the reduced form is as follows. This is not on the equations exception list, so
you are required to memorize it.

EMA,(2) = (2 x P,_i) + [(1 - 2) x EMA,_i(2)]

Example 3: Exponential Moving Average

A stock price experiences the following five consecutive daily prices (t = -5 to t = -1):
100, 99, 101, 100, and 103. What are the exponential moving average prices on days -1
and 0 using 2 = .25? Assume that the exponential moving average up to and including
the price on day -2 was 100.

Solution

For day -1, EMA = .25(100) + (1 - .25)(100) = 100.00

For day 0, EMA = .25(103) + (1 - .25)(100) = 100.75

Adapted from CAIA Level I, 4th ed., 2020. Application 17.6.2B. Copyright © 2009,
2012, 2015 by The CAIA Association.

Illustration: System with Two Moving Averages

The 10-Day and 45-Day SMA with Price Data figure illustrates a strategy whereby when a
short-term (10-day) SMA (represented by the dark line) crosses above a long-term (45-day)
SMA, it signals a buy. Similarly, when the short-term (10-day) SMA crosses below the 45-
day SMA, it signals a sell.

329
© 2020 Wiley
HEDGE FUNDS

10-Day and 45-Day SMA with Price Data

Source: CAIA Level I, 4th ed., 2020. Exhibit 17.3. Copyright © 2009, 2012, 2015 by The CAIA Association.

While the illustration indicates a successful strategy, it is dependent on market conditions

that trend upward or downward smoothly for extended periods of time so that the trader
does not get whipsawed and incur trading losses and excessive costs of bid-ask spreads and
commissions.

• Whipsawing is when a trader alternates between establishing long positions

immediately before price declines and establishing short positions immediately
before price increases and, in so doing, experiences a sequence of losses. In trend-
following strategies, whipsawing results from a sideways market.
• A sideways market exhibits volatility without a persistent direction.

There are spots in the figure that exhibit a sideways market. For example, about halfway
between the beginning of the series and the first sell signal the two SMAs come very close
to each other. There is academic debate about the viability of this type of strategy and about
trend-following strategies in general.

Breakout Strategies
The best way to understand breakout strategies is through examples.

• Breakout strategies focus on identifying the commencement of a new trend by

observing the range of recent market prices (e.g., looking back at the range of prices
over a specific time period).

Example 4: Channel Breakout Strategy—Long Position

A stock price experiences the following 10 consecutive daily high prices (f = -10 to t =
-1): 100, 99, 98, 102, 97, 100, 99, 101, 100, and 103. What is the day 0 price level that
would signal a breakout and possibly a long position, using these 10 days as
representative of a trading range?

330
© 2020 Wiley
 MACRO AND MANAGED FUTURES FUNDS

Solution

The maximum price is 103; therefore, above 103 would signal a breakout and indicate a
long position.

Adapted from CAIA Level I, 4th ed., 2020. Application 17.6.4A. Copyright © 2009,
2012, 2015 by The CAIA Association.

Example 5: Channel Breakout Strategy—Sell Signal

A stock price experiences the following 10 consecutive daily low prices (t = -10 to
t = —1): 100, 99, 98, 102, 97, 100, 99, 101, 100, and 103. What is the day 0 price level
that would signal a breakout and possibly a sell position, using these 10 days as
representative of a trading range?

Solution

The minimum price is 97; therefore, below 97 would indicate a breakout and signal a
sell.

Adapted from CAIA Level I, 4th ed., 2020. Application 17.6.4A. Copyright © 2009,
2012, 2015 by The CAIA Association.1*

Analysis of Trend-Following Strategies

This is a short synopsis of some academic studies on managed futures. Empirical
analysis confirms that trend following is the dominant strategy followed by CTAs.
One study finds two drawbacks of trend-following strategies and another centers on the
strategy’s volatility exposure.

Two Drawbacks
1. Systems are slow to identify trends—a trend may have been in existence for some
time before the trend is identified.
2. Systems are designed to identify something that shouldn’t exist in competitive
markets.

Volatility Exposure
Trend-following strategies are often thought of as long volatility strategies. The reason is
that they make money in markets that have large unidirectional price movements, which by
some measures can indicate high volatility. The flaw in this reasoning is that, as described
earlier, trending-following strategies make money in smoothly trending (low-volatility)
markets (upward or downward) and lose money in volatile sideways markets. Describing
trend-following strategies as long volatility is accurate only in the context of how volatility
is measured (e.g., over longer terms rather than over short time frames).

One view is that describing trend-following strategies as taking long gamma positions is
more accurate. Here, gamma risk refers to exposure from increasing long positions in rising
markets and from increasing short positions in declining markets.

331
© 2020 Wiley
HEDGE FUNDS

Non-Trend-Following Strategies
Not all systematic strategies are trend-following: some are countertrend strategies.

• Countertrend strategies use various statistical measures, such as price oscillation or

a relative strength index, to identify range-trading opportunities rather than price-
trending opportunities.
• The relative strength index (RSI), sometimes called the relative strength indicator,
is a signal that examines average up and down price changes and is designed to
identify trading signals such as the price level at which a trend reverses.

where U = the average of all positive price changes over a particular period, and D = the
absolute value of the average of all negative price changes over the same period.

Price changes can be calculated with any frequency: weekly, daily, hourly, and so on. Most
non-trend managers trade much more frequently (5,000 or more contracts per $1 million
AUM annually) than do trend-following managers (between 1,000 and 2,000 contracts per
$1 million AUM annually).

The RSI is a type of pattern recognition system, illustrated in the Relative Strength
Index (or Indicator) figure.

• A pattern recognition system looks to capture non-trend-based predictable

abnormal market behavior in prices or volatilities.

Relative Strength Index (or Indicator)

8
• MM

(f)
cc
x
0

O
c
)
0
00
a>
>
• «^M

J5
0
CC

Sell when RSI reenters the top of the range.

Buy when RSI reenters the bottom of the range

Source: CAIA Level I, 4th ed., 2020. Exhibit 17.6. Copyright © 2009, 2012, 2015 by The CAIA Association.

Relative Value Strategies

The relative value strategy does not depend on trends or mean reversion but rather on
divergence and convergence in prices between two similar assets such as gas and oil.

332
© 2020 Wiley
 MACRO AND MANAGED FUTURES FUNDS

Generally a very short-term trading strategy, it identifies highly correlated assets and signals
trades when the relationships diverge. The expectation is that the divergence is temporary
due to, for example, a liquidity imbalance. A pair of trades involves selling one asset (A) if
it has increased in price more than the similar asset (B), which is bought. Eventually A is
expected to drop in price (earning money on the short position) more than B will. This is
illustrated in the second and third sets of trades in the Relative Value Strategy figure.

Relative Value Strategy

(1>
O

Contract A

Contract B

oc
CD

CD
O®
CL Q

Trade the spread when the relationship of the instruments is unbalanced.

Source: CAIA Level I, 4th ed., 2020. Exhibit 17.7. Copyright © 2009, 2012, 2015 by The CA1A Association.

The types of strategies presented in this section are all much simpler than those used in
practice, which can combine many rules, position sizings, filters, and types of risk
management.

Learning Objective: Dem onstrate knowledge o f core dim ensions of m anaged

futures investm ent strategies. 1*

MAIN POINT: Managed futures strategies can be defined across four core dimensions:
(1) data sources, (2) implementation styles, (3) strategy focus, and (4) time horizons.

Four Core Dimensions of Managed Futures Investment Strategies

1. Entry: When to enter a position
2. Position sizing: How large a position to take on
3. Exit: When to get out of a position
4. Market allocation: How much risk or capital to allocate to different sectors and markets

Given these four core decisions, a systematic futures trading system is a dynamic system
that processes price data inputs, generates trading signals, and outputs automated executable
trading decisions.

1. Data sources
Managed futures strategies are often denoted as either fundamental or technical.

333
© 2020 Wiley
HEDGE FUNDS

2. Implementation Style
Systematic programs are more broadly diversified than discretionary traders (both in the
types of strategies employed and in the number of markets analyzed).

3. Strategy Focus

Momentum Strategies
Time series momentum is a trading strategy that takes long positions in outperforming
assets and short positions in underperforming assets.

A moving average crossover strategy uses moving averages across different windows
coupled with crossover rules to determine when a trend signals that it is time to take a long
or short position.

Breakout strategies rely on resistance and support levels to generate trading signals.

Resistance level refers to a price at the top of a trading range. When a market moves above
the resistance level, a breakout strategy creates a positive trend signal.

Support level refers to a price at the bottom of a trading range. When a market moves below
the support level, a breakout strategy creates a negative trend signal.

Trading signals based on breakout strategies call for an exit when either an opposite signal
is generated by hitting the resistance or support levels, or a trailing stop is hit.

A trailing stop is a stopping rule that exits a position depending on the recent path of the
price such that the stop price “trails” the current price.

Global Macro Strategies

Global macro hedge fund strategies are treated in another lesson with hedge funds. Here
we simply recall that these strategies use fundamental analysis to go long or short a broad
array of global markets. Since they use fundamental analysis, they have different data inputs
to generate trading signals than most managed futures strategies, which use technical
analysis.

Relative Value Strategies

Relative value strategies consist of short and long positions in futures markets (spreads) of
various types (calendar, crack, and crush spreads), as well as cross-asset value spreads.

Other Strategies: Contrarian, Carry Trading, and Multistrategy

Managed futures strategies other than the more common momentum strategies include
contrarian, carry trading, and multi strategy.

Contrarian (aka mean-reverting) strategies trade against the prevalent trend. Carry trading
profits from differences in “carry” among commodities and financial assets. Multistrategy
CTAs combine a variety of strategy focuses to provide a diversified set of potential return
sources and risk-reward profiles.

4. Time Horizon Dimensions

Managed futures strategies are also differentiated by the core dimension of time horizons,
that is, the average holding period for the strategy, also known as the trading speed. CTA
time horizons generally do not include high-frequency intraday horizons but rather range
from short-term (up to one month, with an average of 10 days) to medium-term (one to six
months) to long-term (longer than six months) horizons. Time-sensitive issues in managed

334
© 2020 Wiley
 MACRO AND MANAGED FUTURES FUNDS

futures include (1) transaction costs (particularly for those with short-term horizons);
(2) trading capacity (which impacts trades that are large and quick such that they may move
the market against the strategy if capacity is insufficient); and (3) slippage, whereby
performance slips away from what is expected due to, for example, the time it takes to trade
multiple accounts for multiple clients.

Learning Objective: Demonstrate knowledge of systemic futures portfolio

construction.

Given the four core decisions discussed before, a systematic futures trading system is a
dynamic system that processes price data inputs, generates trading signals, and outputs
automated executable trading decisions.

The following are the four components that are integrated into portfolio construction: (1)
data processing (Data inputs for futures trading systems can include both fundamental and
technical data), (2) position sizing, (3) market allocation, and (4) trading execution.

Position Sizing in Futures Portfolio Construction

Futures trading systems systematically allocate capital to positions across many different
asset classes. Position sizing must take into account the volatility of a particular market.

One approach to this is volatility targeting, where the size of the position is determined by
the trader’s conviction in the signal, the volatility of the particular futures market, and a
volatility target that is determined by the trader. In particular,

Risk Loading x Equity RVOLj

Number o f Futures Contracts = Sizing Function x ---------------------------- x ---------
J 6 Notional Value RVOL r

... (15.5)

An alternative approach would be to determine the position size based on a range of factors
other than a volatility target. This approach can be expressed as follows:

Risk Loading x Capital

Number of Contracts = Sizing Function x ------------------------------
PVOL r x Contract Size

Market Allocation in Futures Portfolio Construction

Equal dollar risk allocation is a strategy that allocates the same amount of dollar risk to each
market. This approach does not consider the correlation between markets and is similar to
the UN approach.

Equal risk contribution is a strategy that allocates risk based on the risk contribution of each
market, taking correlation into account. This approach is similar to risk parity.

Market capacity weighting is an approach in which capital is allocated as a function of

individual market capacity. In futures markets, a market capacity weighting will depend on
the market size, as measured by both daily volume and price volatility.

Alpha decay is the speed with which performance degrades as execution is delayed.

A systematic futures trading system is a dynamic system that processes price data inputs,
generates trading signals, and outputs automated executable trading decisions.

335
© 2020 Wiley
HEDGE FUNDS

Learning Objective: Demonstrate knowledge of various core benefits of

managed futures for investors.

Managed futures provide the following eight benefits in terms of risk-return trade-offs to
investors:

1. Diversification
2. Performance
3. To multiple markets
4. Transparency
5. Liquidity
6. Size
7. No witholding taxes
8. Very low foreign exchange risk

Learning Objective: Demonstrate knowledge of evidence on managed

futures returns.•*

An empirical study showed that CTAs demonstrate significant market timing abilities by
going long in rising markets and short in falling markets. A simulation-based approach
found that 13 of 31 simulated momentum strategies were profitable. The second layer of
fees charged by CPOs, however, eliminates the profitability available when CTAs are
accessed through a pool operator. Macro and managed futures funds emerged relatively
unscathed from the turbulence of the financial crisis that began in 2007.

Downside Risk Protection

Evidence shows that managed futures are very good at providing downside risk protection
due to managers’ skill in taking short positions during declining markets.

Oher research indicates that only in limited situations will a CTA product outperform a
passive commodity index. The Mount Lucas Management Index is different from other
managed futures indices. It mechanically trades futures contracts and exhibits lower
volatility than other managed futures indexes and has a remarkably symmetric bell-shaped
distribution of returns (with somewhat fatter tails).

• The M ount Lucas Management (MLM) Index is a passive, transparent, and

investable index designed to capture the returns to active futures investing.

The passive (systematic) simple price-trend-following strategy takes long and short
positions in a basket of 22 markets divided into three equally weighted sub-baskets.

Reasons Managed Futures Can Provide Superior Returns

Rather than simply accepting empirical evidence, here we seek conceptual reasons why
managed futures can provide superior returns. They are trading futures contracts across a
broad spectrum of commodities and financial futures, but futures are a zero-sum game.
When one trader makes money, another loses money, so in the aggregate it is difficult to see
how any one group can consistently make money in such a zero-sum game. Yet commodity
producers, farmers, multinational firms, and other natural hedgers have reasons to use
futures for hedging purposes rather than trading profits.

• A natural hedger is a market participant who seeks to hedge a risk that springs from
its fundamental business activities.

336
© 2020 Wiley
 MACRO AND MANAGED FUTURES FUNDS

Supply and demand from natural hedgers are often equal. For example, com farmers will short
futures because they are long com, while cattle owners are short com feed so would take a long
position in com. When supply does not equal demand, traders can fill the gap. For example, if
natural hedging demand for short positions is strong, prices may fall to a point that traders
perceive as attractive and they will take long positions. If natural hedging demand for long
positions is strong, prices may rise to a point that traders will find short positions attractive.
CTAs will take risks that hedgers do not want. Natural hedgers with different time horizons can
also explain why trends may persist. CTAs are more active in markets with more natural
hedgers such as currencies, agricultural products, and industrial metals, and less active in equity
futures.

A noted earlier, central bank intervention is another reason that futures prices in currencies
and sovereign bond markets may trend.

Risks to managed futures investment include (1) transparency risk, (2) model risk,
(3) capacity risk, (4) liquidity risk, (5) regulatory risk, and (6) lack of trends risk.

Transparency risk arises because of the black-box nature of the systematic trading strategies.
Transparency is the ability to understand the detail within an investment strategy or
portfolio. Transparency risk is dispersion in economic outcomes caused by the lack of
detailed information regarding an investment portfolio or strategy.

Model risk arises because systematic strategies rely on models. Model risk is economic
dispersion caused by the failure of models to perform as intended.

Capacity risk can occur when a manager who has expertise in a thinly traded market increases
allocations to the fund or strategy, as this can move prices in ways that diminish the
profitability of the strategy. This is like arbitrage activity eliminating an arbitrage opportunity.

• Capacity risk arises when a managed futures trader concentrates trades in a market
that lacks sufficient depth (i.e., liquidity).
• A fourth risk, liquidity risk, is somewhat related to capacity risk in that it refers to
how a large fund that is trading in a thinly traded market will affect the price should it
decide to increase or decrease its allocation.

Yet liquidity risk can arise in both thinly traded and high-volume markets when competition
increases, as it can make it difficult to execute trades at desired prices; that is, slippage is
more likely.

Regulatory risk is present because changes in margin requirements or government actions

that restrict or tax futures trading are possible.

Lack of trends risk arises because most managed futures strategies are trend following.
Lack of trends risk comes into play when the trader continues allocating capital to
trendless markets, leading to substantial losses.

Investors making an allocation to managed futures must tackle the problem of how to
structure the investment. Generally, the single-managed futures funds route exposes
investors to a greater amount of risk. If the investors are sufficiently large, they must decide
how to create a diversified portfolio of managed futures funds.

The primary benefits of a multi-managed futures fund structure are accessing the expertise
that the fund manager has in choosing the managers, structuring the portfolio, reporting

337
© 2020 Wiley
HEDGE FUNDS

performance, monitoring risk, performing both investment and operational due diligence,
and accounting.

A managed account is a brokerage account, held by a brokerage firm that is also registered
as a futures commission merchant, and in which investment discretion has been assigned to
the managed futures fund manager.

A managed futures funds investment can also be structured through a platform. This is a
relatively new product that operates almost like a multi-managed futures fund (except that
investors can select their own leverage).

Learning Objective: Demonstrate knowledge of benefits of managed futures

funds.1*

The following are key observations on the returns to systematic diversified funds:

1. The historic return distribution resembled that of a normal distribution with no

indication of a pronounced skew or fat tails (excess kurtosis).
2. Volatility of returns was moderately low relative to world equities.
3. Returns showed little or no autocorrelation.
4. Maximum drawdown was much better than observed for global equities.

The following are key observations on the returns to macro funds:

1. The historic return distribution resembled that of a normal distribution with no

indication of a marked skew or fat tails (excess kurtosis).
2. Volatility of returns was low compared to world equities.
3. Returns showed little or no autocorrelation.
4. Maximum drawdown was very much better than observed for global equities.

Kazemi and Li use the direct examination of actual managers and show that systematic
CTAs have demonstrated statistically significant, positive market-timing ability. Kazemi
and Li conclude that CTAs have demonstrated skill in differentiating between upward- and
downward-trending markets.

Simulation-based is a second approach in studying whether CTAs have produced consistent

alpha. Following this approach, Miffre and Rallis simulated well-known momentum
strategies, such as trend following, and found that 13 momentum strategies studied were
profitable, for the period of their analysis.

The greatest concern for investors is generally downside risk. In 2008, the downside risk of
the market crisis was severe. Empirical evidence indicates that macro and managed futures
funds emerged relatively unscathed from the turmoil of the financial crisis that began in 2007.

338
© 2020 Wiley
 E v en t -D r iv e n H ed g e F unds

Most event-driven strategies can be viewed as selling insurance to others unwilling to accept
corporate event risk. Three main types of strategies are covered. First, activist event-driven
strategies are alpha-driven strategies that seek to minimize conflicts of interest between
shareholders and managers. Second, merger arbitrage strategies do well when the equity
market is healthy and many deals go through. Third, distressed securities funds do well
when the equity market is not strong and there are more underpriced distressed securities
available. A fourth type of event-driven fund, the multistrategy fund, can do well in both
healthy and weak equity markets by shifting among different event-driven strategies in
different equity markets.

LESSON MAP
• Demonstrate knowledge of the sources of most event-driven strategy returns.
• Demonstrate knowledge of activist investing.
• Demonstrate knowledge of merger arbitrage.
• Demonstrate knowledge of distressed securities hedge funds.
• Demonstrate knowledge of event-driven multistrategy funds.

KEY CONCEPTS
A common event-driven strategy involves buying the stock of a firm that is the target of a
cash takeover since if the takeover is successful the target’s stock will have generally
increased in price. This strategy can be shown to have the payoff of a long bond and binary
put option, with a payoff similar to that of selling insurance, generating negatively skewed
returns. When there is a stock-for-stock merger, a common merger arbitrage strategy is to
short the stock of the acquirer and use the proceeds to buy the stock of the target company.
A common distressed securities strategy is capital structure arbitrage where the fund
manager generally purchases senior claims that are expected to be recovered and shorts
junior claims that may not be fully recovered. Activist strategies involve minimizing
conflicts of interest through corporate governance changes.

Learning Objective: Demonstrate knowledge of the sources of most event-

driven strategy returns.•*

MAIN POINT: Event-driven strategies can be viewed as selling insurance because a fund
can regularly collect relatively small “premiums” but occasionally will experience large
losses. The distribution of returns is negatively skewed, as in writing a put option. This
section shows how the payoffs to positions in a long bond with face value equal to the strike
price of a binary option are equivalent in two cases: (1) when combined with a call option
with a strike equal to the potential lower ending price of the target firm (if the deal fails) and
(2) when combined with a put option with a strike equal to the potential upper ending price
of the target firm (assuming the merger is successful).

Sources of event-driven strategy returns can be viewed as selling insurance against

corporate event risk.

• Corporate event risk is the dispersion in economic outcomes due to uncertainty

regarding corporate events.

For example, a common event-driven strategy involves buying the stock of a firm that is the
target for a takeover. Generally, after a takeover announcement the target firm’s stock price
(e.g., $70) will rise (e.g., to $90) toward the offered price (e.g., $100), but there is a chance

© 2020 Wiley
HEDGE FUNDS

that the deal will fall through and the stock price will drop back to its pre-announcement
level (e.g., $70) or lower. Many shareholders would prefer to sell their shares at a discount
from the offered price to avoid the risk of the deal failing. The discount ($100 - $90 = $10)
can be thought of as an insurance premium.

• Selling insurance in this context refers to the economic process of earning relatively
small returns for providing protection against risks, not the literal process of offering
traditional insurance policies.

Continuing with this example, the position in the target company can be viewed as a long
position in a riskless bond plus a binary call option. The face value of the bond is the lower
potential price of $70, which is also the strike price of the option. The payout is therefore
$30 if the merger is successful ($100 - $70) or zero if not. The price of the call option must
be $20 ($90 equivalent stock position - $70 in the riskless bond).

• A long binary call option makes one payout when the referenced price exceeds the
strike price at expiration and a lower payout or no payout in all other cases.

This view of the target position as a long bond plus a call option emphasizes the magnified
equity risk inherent in the position and suggests that the equity risk premium is relatively
high. Call options have higher betas than the underlying stock. Inherent systematic risk is
also indicated by the tendency of mergers to go through during healthy, normal market
conditions.

Equivalently, the $90 position in the target firm can be viewed as long the potential upper
price of $100 in a riskless bond plus a short position in a binary put option with a strike
price equal to $100. The payoff to the long put position is again $30 (as it was in the call
option view) if the merger is unsuccessful, and zero otherwise. The price of the put option is
$10: $100 - $90 = $10.

• A long binary put option makes one payout when the referenced price is lower than
the strike price at expiration and a lower payout or no payout in all other cases.

This view illustrates the position in the target stock as having an asymmetric payoff like a
short put—collecting many small insurance-like premiums when the put is out-of-the-
money and experiencing large losses when it is in-the-money.

Not all event-driven strategies can be viewed as a short put option. Some event-driven
managers may instead take a short position in the target if their superior information and
analysis suggests they do so. In addition to deriving returns from systematic risk, event-
driven strategies may be derived from alpha.

Example 1: Binary Option View of an Event-Driven Position

AQU Corp. has offered to purchase TARG Corp. for $15 per share. Immediately before
the merger proposal announcement, TARG was trading at $11 per share. Immediately
after the announcement, TARG is trading at $13.50 per share. Assuming that the share
price of TARG would fall to $10 if the deal fails and that the riskless interest rate is 0%,
describe a long position in TARG taken by an event-driven hedge fund both as a
combination of positions in a risk-free bond and a binary call option and as a
combination of positions including a binary put option.

340
© 2020 Wiley
 EVENT-DRIVEN HEDGE FUNDS

Solution

The hedge fund’s position may be viewed as a long position in a riskless bond with a
face value of $10 and a long position in a binary call option with a potential payout of $5
in case the merger is successful and shares of TARG rise to $15 per share. The hedge
fund may also be viewed as a long position in a riskless bond with a face value of $15
and a short position in a binary put option with a potential payout of $5 in case the
merger is not successful and shares of TARG decline to $10 per share.

Adapted from CAIA Level I, 4th ed., 2020. Application 18.1.2A. Copyright © 2009,
2012, 2015 by The CAIA Association.

Learning Objective: Demonstrate knowledge of activist investing.•*

MAIN POINTS: Activist investing involves identifying companies that have potential but
are inefficiently managed, buying shares in the company, and getting proxies to vote to
effect change in management or in management decisions. Agendas include addressing
excessive executive compensation, adjusting capital structure or dividend policy, and
potential merger or divestiture activities. This is an alpha-driven strategy that seeks to
improve contracting to minimize conflicts of interest as described in agency theory.

Activist Investment Strategy Overview

The first of four event-driven strategy styles covered, activist investing is involvement in
corporate governance and is alpha driven.

• Corporate governance describes the processes and people that control the decisions
of a corporation.

The basic steps are (1) identify a poorly managed company with potential, if managed
properly, (2) establish a position in the company equity, and (3) get involved and effect
positive changes.

• The activist investment strategy involves efforts by shareholders to use their rights,
such as voting power or the threat of such power, to influence corporate governance
to their financial benefit as shareholders.

In the CAIA curriculum, an activist investment strategy has the objective of earning superior
rates of return. Positive changes are brought about through shareholder activism.

• Shareholder activism refers to efforts by one or more shareholders to influence the

decisions of a firm in a direction contrary to the initial recommendations of the firm’s
senior management.

The shareholders’ vote for the board of directors is one of the most important events of
shareholder activism: the outcome depends on the proxy battle.

• A proxy battle is a fight between the firm’s current management and one or more
shareholder activists to obtain proxies (i.e., favorable votes) from shareholders.

These battles between activists and the current board of directors, both soliciting
shareholders for proxies that allow them to cast votes on their behalf, can be very expensive.

i<.
© 2020 Wiley
HEDGE FUNDS

Since the board will use corporate assets to wage the war, the activists pay for both sides of
the battle.

Activist Player Dimensions

Shareholder activists and the key players in financial activism differ across five dimensions.
First, the objective can be either financial or social. The CAIA curriculum is concerned only
with financial activism. Second, activists oppose current management whereas pacifists
oppose the activists. Third, initiators take the steps to effect change and bear the expenses of
doing so, while followers support activists and may be viewed as free riders.

• A free rider is a person or entity that allows others to pay initial costs and then
benefits from those expenditures.

Fourth, the degree of confrontation with management can range from friendly and quiet to
hostile and public. Public confrontations can attract the support of other activists and hedge
funds. Fifth, active initiators are distinguished from passive activists by motive. Passive
activists may happen to already hold the company stock whereas active investors purchase
the stock with the express purpose of engaging in activism. As proxy battles are waged,
activists need to be careful not to violate securities rules by working in packs, particularly
without filing regulatory disclosures.

Agency Costs and the Conflicts of Interest

Activist investors assume that current managers are not maximizing shareholder wealth.
Agency theory helps explain why that may be true.

• Agency theory studies the relationship between principals and agents.

In this context, the principals are the shareholders and the agents are the managers. The
managers are expected to maximize the shareholders’ wealth or utility, but managers may
have their own interests in mind.

• A principal-agent relationship is any relationship in which one person or group, the

principal(s), hires another person or group, the agent(s), to perform decision-making
tasks.

At the heart of agency theory is the concept of “optimal contracting,” which is designed to
align interests and reduce conflicts of interest. In the shareholder-manager relationship,
optimal contracting can be attempted with an agent compensation scheme.

• An agent compensation scheme is all agreements and procedures specifying

payments to an agent for services, or any other treatment of an agent with regard to
employment.

The goal in reducing conflicts of interest is also to minimize agency costs.

• Agency costs are any costs, explicit (e.g., monitoring and auditing costs) or implicit
(e.g., excessive corporate perks), resulting from inherent conflicts of interest between
shareholders as principals and managers as agents.

In reality, optimal contracting is difficult, and only imperfect schemes are available. As a
result, managers may (1) be overly risk averse, (2) receive excessive compensation,
(3) make decisions (at a cost to shareholders) to protect their own jobs, (4) make decisions
that increase risk since they have limited downside exposure, (5) avoid hard work or reject

342
© 2020 Wiley
 EVENT-DRIVEN HEDGE FUNDS

optimal change, or (6) avoid sharp conflicts that may be necessary such as with labor
unions.

Corporate Governance Battles

Activist investing is intensive, so typical portfolios consist of only five to 15 companies. As
it involves equity investing, some classify the strategy as traditional rather than hedge fund
investing. But the few positions are very concentrated, typically constituting 1% to 15% of
the outstanding equity of the target firm. The activists may wish to keep their plans private
as they accumulate positions, and can do so if they have less than 5% of the outstanding
equity. Otherwise they need to file Form 13D.

Form 13D is required to be filed with the Securities and Exchange Commission
(SEC) within 10 days publicizing an activist’s stake in a firm once the activist owns
more than 5% of the firm and has a strategic plan.

Many establish a toehold by investing 4.9%, just under the 5% threshold.

• A toehold is a stake in a potential merger target that is accumulated by a potential

acquirer prior to the news of the merger attempt becoming widely known.

Activist agendas include a wide range of corporate governance issues. The composition of
the board of directors, proposed mergers, capital structure, and executive compensation are
just a few. Other investors can follow the progress of potential activist activity with Form
13D, the less restrictive Form 13G for passive investors, and Form 13F (which requires
reporting of long but not short positions).

• In the United States, Form 13G is required of passive shareholders who buy a 5%
stake in a firm, but this filing may be delayed until 45 days after year-end.

• Form 13F is a required quarterly filing of all long positions by all U.S. asset
managers with more than $100 million in assets under management, including hedge
funds and mutual funds, among other investors.

Activists may have followings, wolf packs, that can help to make managers more receptive
to changes. However, they must be careful to not violate securities regulations and to make
required disclosures about working together.

• A wolf pack is a group of investors who may take similar positions to benefit from an
activist’s engagement with corporate management.

Staggered board seats make it more difficult to accomplish goals by voting in new board
members.

• Staggered board seats exist when, instead of having all members of a board elected
at a single point in time, portions of the board are elected at regular intervals.

Activist Agendas
Activist Agenda 1: One type of activist agenda is concerned with CEOs, compensation, and
boards of directors. For example, interlocking boards can lead to excessive manager
compensation, which is a conflict of interest that activists often look to resolve.

343
© 2020 Wiley
HEDGE FUNDS

• Interlocking boards occur when board members from multiple firms—especially

managers—simultaneously serve on each other’s boards and may lead to a reduced
responsiveness to the interests of shareholders.

Activist Agenda 2: A second type of activist agenda is concerned with capital structure and
dividend policy. Unless the firm has growth opportunities to invest in, it should distribute
cash as dividends rather than retain it. Company managers who are improperly incentivized
can be inclined to retain more cash than they should. Activists often favor increased
dividends or share repurchases that are taxed at a lower capital gains rate than taxes on
dividends. Companies are sometimes criticized for not having enough debt in their capital
structures. Debt can help to discipline managers and lower the weighted average cost of
capital.

Activist Agenda 3: A third type of activist agenda involves mergers or divestitures, which
can be viewed as a battle for control of assets. Activists look for operational inefficiencies
within segments of large corporations and encourage selling or spinning off such segments
or businesses. Similarly, activists sometimes encourage separation of hard assets (e.g., real
estate holdings) from intellectual property (e.g., retail operations).

• A spin-off occurs when a publicly traded firm splits into two publicly traded firms,
with shareholders in the original firm becoming shareholders in both firms.

• A split-off occurs when investors have a choice to own Company A or B, as they are
required to exchange their shares in the parent firm if they would like to own shares
in the newly created firm.

Why such reorganizations might add value is explained by agency theory (reducing
conflicts of interest) and market imperfections or inefficiencies.

Activist Historical Risk and Return Characteristics

Activist historical risk and return characteristics are summarized as follows:

• Average return—high relative to broader event-driven category

• Volatility—moderately high relative to broader event-driven category
• Skew—negative
• Kurtosis—leptokurtotic
• Correlation with global equities, high-yield bonds, and commodities—positive
• Correlation with changes in credit spreads and equity volatility—negative

Learning Objective: Demonstrate knowledge of merger arbitrage.

MAIN POINTS: Since in a stock-for-stock merger the stock of the target company will
generally rise through negotiations, a typical strategy is to buy the target company stock
using proceeds from shorting the acquirer’s stock. In a cash offer, one would just buy the
target company stock. Third-party bidders can push the target price up higher, increasing
potential profits if the deal goes through, but also potentially increasing risk. The two main
risks are regulatory risk (e.g., antitrust reviews may block the merger) and financing risks
(does the acquirer have access to financing in a cash offer?).

Characteristics of M erger Arbitrage

• M erger arbitrage attempts to benefit from merger activity with minimal risk and is
perhaps the best-known event-driven strategy.

344
© 2020 Wiley
 EVENT-DRIVEN HEDGE FUNDS

This section focuses on an offer to exchange shares. For example, Big company offers to
exchange one share for 3.5 shares of Small company in a stock-for-stock merger.

• Stock-for-stock mergers acquire stock in the target firm using the stock of the
acquirer and typically generate large initial increases in the share price of the target
firm.

Prior to the announcement, Small is trading at $20 and Big is trading at $102. After the
announcement, Small jumps to $25 and Big drops to $100.

The merger arbitrage strategy is to short one share of Big and use the proceeds to buy 3.5
shares of Small. If the merger goes through, there will be a profit. If the merger fails, it is
assumed that the prices will drop back to the pre-announcement levels and there will be a
loss.

• Traditional merger arbitrage generally uses leverage to buy the stock of the firm
that is to be acquired and to sell short the stock of the firm that is the acquirer.

It is difficult to use a traditional merger arbitrage strategy with small companies that may be
too illiquid to short.

Example 2: Stock-for-Stock Merger Arbitrage

Pre-Announcement Post-Announcement Strategy

Big $102 $100 Short 1
Small $20 $25 Buy 3.5

The arbitrageur receives $100 for shorting Big and pays $25(3.5) = $87.50 for the
position in Small.

If the merger goes through, the arbitrageur pockets $100 - $87.50 = $12.50, and
delivers Big to close out the short.

If the merger fails, it is assumed that the prices drop to the pre-announcement levels.
Sell Small for $20(3.5) = $70 and buy back Big at $102. Payoff is ($70 - $87.50) +
($100 - $102)—that is, a loss of $19.50.

Adapted from CAIA Level I, 4th ed., 2020. Application 18.3.1 A. Copyright © 2009,
2012, 2015 by The CAIA Association.

Bidding Contests
Bidding contests can benefit a traditional merger arbitrage strategy as the target firm’s price
continues to rise. It can be very risky, however, if the deal eventually fails.

• A bidding contest or bidding war is when two or more firms compete to acquire the
same target.

The chances of failure increase when there is an antitrust review or other government
decision likely to block the merger. For example, cross-border deals may be blocked for
nationalistic or security reasons.

345
© 2020 Wiley
HEDGE FUNDS

• An antitrust review is a government analysis of whether a corporate merger or some

other action is in violation of regulations through its potential to reduce competition.

M erger Arbitrage Risks

Regulatory risk is one of two major merger arbitrage strategy risks, and merger arb
managers are skilled at predicting the outcomes of potential antitrust reviews. The other
major risk is financing risk.

• Financing risk is the economic dispersion caused by failure or potential failure of an

entity, such as an acquiring firm, to secure the funding necessary to consummate a
plan.

Financing risk exists in deals that contain a cash component (not stock swaps), and
leveraged buyouts are particularly susceptible to financing risk. The key question is whether
the acquiring firm has access to the cash necessary to complete the deal as proposed.

M erger Arbitrage Historical Risk and Return Characteristics

Characteristics of merger arbitrage returns (2000-2018) can be summarized as follows:

1. Returns recorded much lower volatility than world equities.

2. Returns exhibited similar skew and kurtosis to world equities.
3. Returns had a very favorable maximum drawdown.
4. Returns had moderate positive autocorrelation.

Learning Objective: Demonstrate knowledge of distressed securities hedge

funds.•*

MAIN POINT: Distressed securities hedge funds generally seek to buy undervalued
securities that they expect to recover after resolution with creditors in a reorganization,
although they may pursue other strategies such as shorting securities and capital structure
arbitrage. In contrast, private equity funds invest in distressed securities to gain control and
have longer investment horizons than hedge funds, yet there can be some overlap with
similar strategies pursued by both private equity and activist hedge funds. The strategy of
short selling distressed securities is like writing naked call options, and generates negatively
skewed distributions. Estimating the time to recovery and the recovery value of assets is a
major determinant of the returns to distressed investing. A typical capital structure arbitrage
strategy buys the more senior claim and shorts the junior claim. The expected outcome is
that the senior claim is recovered and the junior claim is not.

Distressed Debt Strategies: Hedge Funds versus Private Equity

Both private equity firms and hedge funds invest in distressed debt. Private equity funds
have long lockup periods. Hedge funds are interested in shorter-term returns.

• Distressed debt hedge funds invest in the securities of a corporation that is in

bankruptcy or is likely to fall into bankruptcy.

Bankruptcy Process Basics

Creditors to the firm are paid according to seniority as determined in the bankruptcy
process.

The bankruptcy process is the series of actions taken from the filing for bankruptcy
through its resolution.

346
© 2020 Wiley
 EVENT-DRIVEN HEDGE FUNDS

Senior debt holders are paid before junior or subordinated debt holders, with equity holders
retaining some value only if anything is left after creditors have been paid. In Europe, firms
are almost always liquidated.

• In a liquidation process (Chapter 7 in U.S. bankruptcy laws), all of the assets of the
firm are sold, and the cash proceeds are distributed to creditors.

In the United States, firms are either liquidated or reorganized. Some firms that have
liquidity issues but are otherwise still viable businesses may be reorganized.

• In a reorganization process (Chapter 11 in U.S. bankruptcy laws), the firm’s

activities are preserved.

Most distressed securities transactions are unique, one-off transactions with large
information asymmetries offering the potential for alpha.

• A one-off transaction has one or more unique characteristics that cause the
transaction to require specialized skill, knowledge, or effort.

In the case of distressed securities, alpha is not necessarily a zero-sum game. There are
many reasons that distressed securities will trade at prices low enough to permit generous
alphas. Many institutions are not interested in holding distressed securities, regardless of the
price. They do not want to be holding “inappropriate” or embarrassing securities, are not
interested in monitoring the bankruptcy process, and will sell, pushing prices down further.

Short Sales of Equity as W riting Naked Call Option Positions

When an analyst determines that a company will most likely liquidate (prior to the
announcement of a bankruptcy), the simplest trade is to short sell the stock. Shares in highly
leveraged firms resemble call options, and therefore a short sale is akin to writing a naked
call option. Any naked option is a position in an option without an accompanying position
in the underlying asset. Writing a naked call option generates a negatively skewed
distribution.

After bankruptcy filing, most stocks are delisted and their value falls to the point of being
considered worthless, but sometimes they still trade at prices reflecting a higher than
realistic probability of payouts to shareholders, and therefore short sales may still appear
desirable. These stocks can also rally while in bankruptcy. For example, during the
bankruptcy process it may be determined that the value of real estate holdings far exceeds
the value of outstanding debt.

Recovery Values, Holding Periods, and Annualized Holding Period Returns

Before and during the bankruptcy process, distressed securities often trade at values far below
their recovery values because many institutional investors sell distressed securities to avoid
complications associated with holding inappropriate securities. Therefore, a distressed investor
needs to estimate the value of the security when the firm emerges from bankruptcy—based on
the firm’s recovery value—to estimate potential return.•

• The recovery value of the firm and its securities is the value of each security in the
firm and is based on the time it will take the firm to emerge from the bankruptcy
process and the condition in which it will emerge.

© 2020 Wiley
HEDGE FUNDS

For example, if a bond is purchased at 40% of its face value and after bankruptcy 30% of
the bond’s face value is recovered (a 25% loss), then the annualized return also depends on
the time between the purchase and the emergence from bankruptcy.

Example 3: Recovery Values and Holding Period Returns

A bond is purchased at 40% of face value. After bankruptcy, 30% of the bond’s face
value is ultimately recovered. CAIAA asks the candidate to express the rate of return as a
nonannualized rate and as an annualized rate based on two different holding periods:
four months and four years.

Nonannualized rate: 30%/40% - 1 = -25%

Annualized four-month rate: -25% x (12/4) = -75%

Annualized four-year rate: -25%/4 = -6.25%

Adapted from CAIA Level I, 4th ed., 2020. Application 18.4.3A. Copyright © 2009,
2012, 2015 by The CAIA Association.

The time element of returns is further illustrated by the following possible strategy. If
investors believe a bankruptcy will not occur for two years and are correct, they can profit
by buying debt with a maturity of less than two years (receiving full face value prior to
bankruptcy declaration) and shorting debt with a longer maturity (buying back at less than
the recovery value).

Distressed Activists
Most distressed hedge funds are not activists. They invest and wait without trying to
influence outcomes. However, given that returns are magnified when bankruptcy is resolved
earlier rather than later, some may take an activist approach to speed up the resolution of the
process or influence a more favorable payout relative to other claims.

Capital Structure Arbitrage

The previous discussion of investing in distressed securities was largely focused on
unhedged positions. Capital structure arbitrage, in contrast, involves offsetting (i.e., hedged)
positions.

• Capital structure arbitrage involves offsetting positions within a company’s

capital structure with the goal of being long relatively underpriced securities, being
short overpriced securities, and being hedged against risk.

A typical capital structure arbitrage trade will buy a more senior claim and short a
subordinated, junior claim. Examples include (1) buy senior debt and short junior debt and
(2) buy preferred stock and short common stock. Recall that priority in payments is senior
debt first, junior debt second, preferred equity third, and common equity last. (There may be
more levels in between, but common equity is always last.)

348
© 2020 Wiley
 EVENT-DRIVEN HEDGE FUNDS

Capital Structure Arbitrage Potential Cases—One-to-One Hedge Ratio: $10,000

Short Junior Debt, $10,000 Long Senior Debt
Assume junior debt is trading at a discount to senior debt.

1. Bearish extreme—no recovery.

Hedge breaks even.
The gain on the short position in the junior claim equals the loss on the long
position in the senior claim.

2. Bullish extreme—full recovery.

Loses money.
The loss on the short position in the discounted junior position exceeds the
gain on the senior position.

3. Recovery on senior debt, no recovery on junior debt.

Large profit.
Both legs, the short and the long positions, generate profits.

4. Recovery is equal in both cases.

Net loss.
The junior, discounted bond gains more (but is a short position) than the senior
position gains.

Senior claims tend to offer small upside potential and large downside risks relative to junior
claims. This is evident in case 2, where the senior debt has a relatively small gain with full
recovery. It is also evident in case 4, where the junior debt gains more than the senior debt
when recovery rates are equal.

To the extent that the market overprices junior debt and underprices senior debt, profits are
available. Overpricing and underpricing can occur due to market segmentation. The stock
market participants and bond market participants can be seen as different clienteles using
different valuation methods.

• Financial m arket segmentation occurs when two or more markets use different
valuations for similar assets due to a lack of participants who trade in both markets or
perform arbitrage between the markets.

Many different hedge ratios may be used, and the use of derivatives can expand the types of
potential capital arbitrage strategies. For example, a manager may buy put options on stock
to hedge long positions in bonds. Credit default swaps can also be used in capital arbitrage
strategies.

Buying Firms Using Distressed Securities

Generally, event-driven hedge funds buy distressed securities shortly before the
announcement of a reorganization with hopes for a positive resolution with creditors. If
instead the fund buys the distressed securities for control purposes, it is behaving more like
a private equity fund.

349
© 2020 Wiley
HEDGE FUNDS

Distressed Debt Historical Return and Risk Characteristics

Summary based on years 2000-2018:

1. Event-driven distressed returns showed substantially lower volatility than world

equities.
2. Event-driven distressed returns had somewhat fat tails and, like world equities, a
negative skew.
3. Event-driven distressed returns exhibited a moderate maximum drawdown, much
less than world equities.
4. Event-driven distressed returns had substantial positive first order autocorrelation.

Learning Objective: Demonstrate knowledge of event-driven multistrategy

funds.•*

The fourth style of event-driven strategies is event-driven multistrategy funds. They can
invest in merger strategies that do well when equity markets are doing well, and also do
well investing in securities that tend to become distressed when equity markets are not
performing well.

• Event-driven multistrategy funds diversify across a wide variety of event-driven

strategies, participating in opportunities in both corporate debt and equity securities.

Multistrategy funds have more capacity for assets and smoother returns over the business
cycle.

• Special situation funds invest in a number of event styles and are typically focused
on equity securities, especially those with a spin-off or recent emergence from
bankruptcy.

Historical Risk and Return Summary for Event-Driven Multistrategy Funds

Summary based on years 2000-2018:

1. Event-driven multistrategy returns had substantially lower volatility than world

equities.
2. Event-driven multistrategy returns exhibited somewhat fat tails and, like world
equities, a negative skew.
3. Event-driven multistrategy returns showed a moderate maximum drawdown, much
less than world equities.
4. Event-driven multistrategy returns had some positive first-, second- and third- order
autocorrelation.

350
© 2020 Wiley
 Re l a t iv e V a l u e H e d g e F u n d s : Re l a t iv e V a l u e St r a t e g ie s a n d
Co n v e r t ibl e B o n d A r bit r a g e

NOTE FROM THE AUTHOR

This CAIA topic is divided into two lessons for the candidate’s use in preparing for the
exam. This lesson focuses on relative value strategies and convertible bond arbitrage.
The next lesson will focus on volatility arbitrage, fixed-income arbitrage, and relative
value multistrategy hedge funds.

LESSON MAP
1. Demonstrate knowledge of relative value strategies.
2. Demonstrate knowledge of convertible bond arbitrage.

KEY CONCEPTS
Relative value hedge funds seek returns by owning undervalued assets and selling short
overvalued assets. The strategies generally use leverage and produce an intermediate level
of returns with significantly lower volatility of returns than many other strategies.

This topic (in two lessons) will explore several popular strategies: relative value strategies,
convertible bond arbitrage, volatility arbitrage, fixed-income arbitrage, and relative value
multistrategy funds. The last category involves a hedge fund that combines several relative
value strategies in one portfolio.

Learning Objective: Demonstrate knowledge of relative value strategies.

MAIN POINT: Relative value strategies seek returns by concentrating on portfolio positions
that don’t depend on the aggregate level of stock or bond prices. Instead, they rely on the
performance of individual securities that the managers believe are mispriced.

While there are many strategies employed by hedge funds to produce returns, a large portion
of funds are significantly exposed to the general level of stock prices, commodity prices,
interest rates, or other major factors that influence returns. The relative value strategies
described here primarily seek returns that should not be driven primarily by market returns.
Usually, relative value hedge funds carry long and short positions in securities that should
produce offsetting gains and losses in response to a change in market levels.

Individual funds may be more or less successful in hedging that macro exposure, and many
of these funds are exposed to other risks, such as the level of volatility, the spread between
high-yield and sovereign interest rates, or the spread between rates of bonds with different
maturities.

Many of these funds rely on convergence. These funds identify relationships that appear to
be persistent. Traders buy and sell individual securities that deviate from the expected
relationship to profit if the relationship returns to the predicted levels. Specifically, they will
buy the securities that appear to be “cheap” or undervalued and sell short the securities that
appear to be “rich” or overpriced.

Learning Objective: Demonstrate knowledge of convertible bond arbitrage.

MAIN POINT: Convertible bond arbitrage seeks to produce returns by buying undervalued
convertible bonds and hedging with common stock.

!5.
© 2020 Wiley
HEDGE FUNDS

Introduction to Convertible Bonds

A convertible bond is a bond that grants to the owner the option to exchange the bond for a
specific number of shares of stock. The conversion ratio documents the terms of the
potential exchange. For example, a $1,000 face value bond may be exchanged for 10 shares
of stock, in which case the conversion price would be $100 (face value/conversion ratio).

_ . . Face Value of Bond

Conversion Price = ------------:------- :—
Conversion Ratio

Conversion Value = Current Stock Price x Conversion Ratio

_ _ Convertible Bond Price —Conversion Value

Conversion Premium = -------------------------------------------------------
Conversion Value

Generally, a company would issue the bond when the value of common stock is well below
the conversion price. The bond buyer accepts a somewhat lower coupon rate on the bond
because of the profit potential if the price of the stock rises above the conversion price.

The embedded option is called an “exchange option” because the profitability of the
conversion is affected by both the price of stock that can be potentially acquired and the
price of the bond. Because convertible bonds are often sold by young companies, success
and growth could lead to gains in both the stock price (because of generally favorable
prospects) and the bond price (because of lower risk of default).

The classic arbitrage would involve buying the convertible bond and selling short the
common stock. This combination can be profitable in both rising and declining markets if
the bond is cheap.

Valuation
Valuing convertible bonds usually involves several steps. First, value the bond as if the
convertible feature is not present, reflecting the general level of rates, the risk of default,
liquidity, and other factors. To this value, add the value of an option to exchange this bond
for the stock. This technique of unbundling works because the two simpler securities
together replicate the more complicated convertible bond.

In practice, valuation often must account for call features (the issuing company may have
the right to redeem the bonds at a call price after some deferred date) or put features (the
convertible bond buyer may have the right to force the company to redeem the bonds before
the scheduled maturity).

Moneyness
A call option can be described as at-the-money, in-the-money, or out-of-the-money if the
asset’s price is at, above, or below the strike price. The concept applies to the conversion
option. If the stock price is well above the conversion price, then the bond price will
primarily reflect the value of the bond if converted to stock. Changes in the price of the
stock feed directly and proportionately into the value of the bond. Equity-like convertibles
are bonds that are deep-in-the-money with respect to the conversion price.

When the stock is trading well below the conversion price, there is little chance that the
stock will rise enough to motivate conversion. In this case, the value of the bond will
depend primarily on the coupon rate, the general level of interest rates, and the default risk,
with little value attributed to the value of conversion. Busted convertible bonds are bonds
that trade primarily as bonds, with little value attributed to the embedded option.

© 2020 Wiley
 RELATIVE VALUE HEDGE FUNDS: RELATIVE VALUE STRATEGIES AND CONVERTIBLE BOND ARBITRAGE

• Hybrid convertible bonds sit between these two scenarios, having some optional
value (and hence, some sensitivity to changes in the value of the common stock), but
conversion is not so likely that the bonds trade in lockstep with the stock.

The “Greeks”
1
Several Greek letters are traditionally used to represent the sensitivity of option prices to
9

inputs used to price the options.

In the previous example, the sensitivity of convertible bond price to the company’s common
stock ranges from low (insensitive) to high (closely tied). For example, the value of the
bond may be only half (.50) as sensitive to changes in the stock. If the stock rises 10% and
the bond rises 5%, it has a delta of .50. Delta is the predicted change in bond price divided
by a potential change in the stock price. The delta is used to determine how many shares of
stock to sell as a hedge against holding the bond.

Change in Convertible Bond Price

Delta = A
Change in Common Stock Price

Example 1

Suppose that each $1,000 face value of bonds can be converted into eight shares of
common stock and the delta is .60. A market-neutral trade would be long $5 million
bonds and short 24,000 shares of stock (5,000 x 8 x .60).

As the transition from busted to hybrid to equity-like demonstrates, the delta of a

convertible bond changes along with the price of the common stock. Gamma measures the
change in delta as the common price goes up or down.

Change in Delta
Gamma = F =
Change in Common Stock Price

Gamma is generally regarded as a favorable trait—the more a stock rises, the more closely
the convertible bond tracks the common stock so the profit potential of the bond increases
as the stock rises. Also, the more the stock declines, the less the convertible bond tracks the
share price, so the convertible bond becomes more defensive when the stock declines.

Gamma measures the opportunity to profit from changes in the price of the company stock.
Suppose the delta of a convertible bond is .50. The trader will buy the bond and sell short half
the amount of stock suggested by the conversion ratio. At that point, the gains (or losses) on
the bond position should match the losses (or gains) on the short stock position. However, if
the share price moves up, the position begins to act like a long position in the stock. If the
share price moves down, the position begins to act like a short position in the stock.

Theta measures the change in the convertible bond price as time passes and other market
conditions are held constant (primarily interest rates, default risk, volatility, and the price of the

1
One of the “Greeks,” the vega, is not a Greek letter but gets included in the list of measures called the “Greeks.”
2
These sensitivities can be described as partial derivatives. Candidates don’t need to understand the mathematical origins of these
measures, but those familiar with calculus may find it easier to understand them this way. Delta, theta, and vega are first derivatives
with respect to the stock price, time to expiration, and volatility. Gamma is the second partial derivative with respect to the stock
price. Candidates will not likely be asked about an additional measure, rho, which measures the sensitivity of the convertible bond
price to changes in the interest rate used in the option pricing model.

353
© 2020 Wiley
HEDGE FUNDS

common stock). Convertible bonds are sold with a lower coupon than investors would demand
on a straight bond (that is, a bond not having an option to convert to common stock). Investors
are willing to accept a lower coupon in return for the time available for the stock to rise. As
time passes, the option loses value as the probability of favorable market moves declines.

Change in Convertible Bond Price

Theta = 9 =
Change in Time Left to Convert

Vega measures the change in the convertible bond price as volatility rises or declines.
Realize that volatility is defined as the standard deviation of returns on the stock and
volatility calibrates the normal distribution. The normal distribution assigns probabilities to
all possible gains and losses in the stock price. The option to convert is more valuable if the
level of volatility is higher because the probability of profitable conversion is higher.

Change in Convertible Bond Price

Vega = v =
Change in Volatility

The value of the conversion option rises when volatility rises and declines when volatility
declines. For this reason, the fair value of a convertible bond portfolio, which usually holds
long positions in the conversion option, is likewise sensitive to changes in the level of
volatility. Unless a hedge fund creates hedging positions in other options, convertible arb
strategies get marked-to-market gains when volatility rises and losses when volatility declines.

Sustainable Disequilibrium?
If convertible bond prices are efficiently priced, hedge funds should not be able to earn
excess returns using them. Likewise, it would be expected that mispriced bonds would be
overvalued about as often as they are undervalued. Typically, hedge funds buy cheap
convertible bonds and only infrequently sell short overpriced convertible bonds. Convertible
bond prices often trade below theoretical value because they are both illiquid and complex.
Hedge funds are compensated for accepting this illiquidity and complexity.

Convertible arbitrage is a well-documented strategy that has produced returns for many
years. There are some possible explanations for why these profits have not disappeared:

• Perhaps the issuers are not aware that they are selling bonds below theoretical value.
• Selling convertible bonds that offer some preference over equity in default may be
the best way for young companies to access the capital markets.
• Holders of straight bonds may also demand a concession comparable to or greater
than the discount in the convertible bond price. The defense of this premise from
CAIA starts with the observation that, all other things equal, equity holders want
more debt in the capital structure than do lenders. The point is that shareholders have
an option-like position, keeping the upside potential and leaving the downside risk
with the bondholders. This asymmetry may allow the buyers of bonds (both straight
debt and convertible) to demand a concession.
• Finally, the firm may consider the convertible bond as a backdoor way to issue stock.

Sources of Return
• Sources of revenue and gains:
o Bond coupon income
o Gain on long bond and/or short stock positions
o Interest received on stock loan collateral

354
© 2020 Wiley
 RELATIVE VALUE HEDGE FUNDS: RELATIVE VALUE STRATEGIES AND CONVERTIBLE BOND ARBITRAGE

• Sources of expense and losses:

o Dividend income expense
o Loss on long bond and/or short stock positions
o Repo interest expense on loans to finance bond positions

Risk and Return Drivers

The primary source of return in convertible bond arbitrage is the mispricing of the option to
convert. Of course, not all convertible bonds are mispriced, so the trader needs to value
potential investments to focus on profitable opportunities. The terms of each bond differ but
one example of mispricing presented by CAIA assumed that a particular issue should be
priced at a volatility of 27%, rather than 25%. This difference created a 1% change in the
value of the bond, which required the trader to hold the position for three years. The trader
likely borrowed money to finance a large part of the investment in the position. This
leveraged the expected return and diversified the return across a portfolio.

Leverage, of course, amplifies both the gains and the losses of market forces that affect the
strategy—such as interest rates, default risk, and volatility. The investor certainly prefers
leverage if it increases the return over time and the investor is comfortable with the level of
risk. The hedge fund benefits from higher returns and is not especially bothered by the
increased risk because most of the risk is borne by the investor.

Historical Return of Convertible Bond Arbitrage Funds

The Statistical Summary of Returns (HFRI) table reproduces returns presented by CAIA
using data from Hedge Fund Research for the period 2000-2019. The return on stocks was
low, reflecting the starting level of stock prices at a market top. The average return looks
attractive for the period with modest levels of risk.

Statistical Summary of Returns (HFRI)

Convertible Bond Index MSCI World Equity
Annualized Arithmetic Mean 5.7% 4.5%
Annualized Standard Deviation 7.0% 15.0%
Annualized Semivolatility 7.2% 11.6%
Annualized Median 7.7% 11.6%
Skewness -2.8 -0.7
Excess Kurtosis 26.0 1.6
Sharpe Ratio 0.45 0.1
Sortino Ratio 0.44 0.2
Annualized Geometric Mean 5.5% 3.4%
First-Order Autocorrelation 57.1% 13.5%
Annualized Standard Deviation* 13.5% 17.1%
Maximum 9.7% 11.2%
Minimum -16.0% -19.0%
Max Drawdown -35.3% -54.0%
*Adjusted for autocorrelation.
Source: CAIA Level I, 4th ed., 2020. Exhibit 17.7. Copyright © 2009, 2012, 2015 by The CAIA Association.

355
© 2020 Wiley
HEDGE FUNDS

The skewness is negative (skewed left) and kurtosis is high (fat tails) for both the
convertible arb strategy funds and the relative value hedge funds, as a group. This m
eans that there is a higher probability of loss than would be expected from assets
with the observed standard deviation of return.

The convertible bond returns show significant autocorrelation. Autocorrelation often

shows up when valuations don’t immediately reflect new market information. When
adjusted, convertible arb strategies look much more volatile. At least part of this result
may have been caused by valuations in 2008-2009, when a significant decline in market
liquidity led to large markdowns to the prices of both convertible bonds and high-yield
bonds.

356
© 2020 Wiley
 Re l a t iv e Va l u e H e d g e Fu n d s : V o l a t il it y A r bit r a g e ,
F i x e d -I n c o m e A r b i t r a g e , a n d R e l a t i v e V a l u e
M u l t is t r a t e g y He d g e Fu n d s

NOTE FROM THE AUTHOR

This CAIA topic is divided into two lessons for the candidate’s use in preparing for the
exam. This lesson focuses on volatility arbitrage, fixed-income arbitrage, and relative value
multistrategy (RVMS) hedge funds. A previous lesson focused on relative value strategies
and convertible bond arbitrage.

LESSON MAP
• Demonstrate knowledge of volatility arbitrage.
• Demonstrate knowledge of fixed-income arbitrage.
• Demonstrate knowledge of relative value multistrategy funds.

KEY CONCEPTS
Arbitrage originally meant the simultaneous purchase and sale of an asset in two different
markets to create a risk-free profit. The convertible bond, volatility, and fixed-income
strategies employed by hedge funds are generally not arbitrages in this narrow sense.
Instead, the term has come to mean a combination of long and short positions that usually
seek to hedge exposure to the level of stocks, interest rates, or other market factors and are
more accurately described as relative value trades than as arbitrage trades.

Volatility arbitrage and fixed-income arbitrage are two strategies that seek returns without
significant exposure to stock and bond returns. These hedge funds rely on considerable
leverage to produce modest returns and low risk. However, the leverage has led to
infrequent but significant losses.

Learning Objective: Demonstrate knowledge of volatility arbitrage.

MAIN POINT: This relative value strategy of volatility arbitrage seeks to profit from
forecasts of volatility or by identifying options and optionlike securities that are mispriced
relative to each other.

The value of an individual option is sensitive to all of the inputs used to value the option
(time to expiration, volatility, the price of the underlying asset, and the risk-free rate of
interest). Volatility arbitrage is a strategy the seeks to profit from forecasts of future
volatility.

INSTRUMENTS USED FOR VOLATILITY ARBITRAGE

The standard deviation of return (volatility) is used by many option pricing models to assign
probabilities to possible market movements. A higher volatility associates higher
probabilities to movements away from the starting level. In general, higher volatility leads
to higher valuation. The Impact of Volatility on Call Price chart shows the value of a call at
different levels of volatility.

© 2020 Wiley
HEDGE FUNDS

Impact of Volatility on Call Price

0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10
0.00
2.00% 3.00% 4.00% 5.00% 6.00% 7.00% 8.00% 9.00% 10.00%

Three Measures of Volatility

• Implied volatility is the volatility required as an input in an option pricing model to
produce a particular price. Option pricing models rely on the several inputs listed
earlier. There is a straightforward calculation from volatility to a price. Implied
volatility, in contrast, begins with an option price and determines the volatility
input consistent with that price.
• Anticipated volatility is the level of volatility forecasted to occur over a stated
time interval in the future. The anticipated volatility is forward-looking, based on
recent and longer-term price behavior.
• Realized volatility is the level of volatility measured from historical prices.

The three concepts of volatility are related. Implied volatility can be thought of as the
market’s anticipated volatility, although other factors such as supply/demand imbalances,
margin, and taxes may affect the prices that options clear and hence affect implied volatility.
A trader’s anticipated volatility can differ from the implied forecast of volatility and serve as
an opportunity to trade profitably. If realized volatility turns out to be higher than the
implied volatility, this difference contributes to profits to the investors. Whether the
difference contributes to net profits relies heavily on how or if the position was hedged.

Instruments Used for Volatility Arbitrage

The standard deviation of return (volatility) is used by many option pricing models to
assign probabilities to possible market movements. A higher volatility associates higher
probabilities to movements away from the starting level. In general, higher volatility leads
to higher valuation.

Puts show the same upward response to higher volatility. Options with longer times to
expiration are more sensitive to changes in volatility. Hedge funds may include exchange-
traded or over-the-counter (OTC) options on stocks, bonds, currencies, or commodities.
Other instruments include warrants, callable or putable bonds, and convertible bonds.
Two direct ways to trade volatility, OTC variance swaps and volatility futures and
options, are described next.

A variance swap establishes a one-time payment from one party to another based on the
realized volatility of a particular instrument. One trader receives a payment from the
counterparty if the realized variance is above a specified level, but the trader pays the
counterparty if the realized variance is below that level.

358
© 2020 Wiley
 RELATIVE VALUE HEDGE FUNDS: VOLATILITY ARBITRAGE, FIXED-INCOME ARBITRAGE, AND RELATIVE VALUE MULTISTRATEGY HEDGE FUNDS

Example 1: Variance Swap Example

The variance notional equals $10 million. The variance strike is 1% (consistent with a
standard deviation or volatility of 10%). Suppose the realized variance is 1.5%
(a standard deviation of 12.25%). The calculation of the cash payment varies somewhat
in individual contracts but generally resembles the calculation in the following equation:

Variance Swap Payoff = Variance Notional Value x

(Realized Variance — Strike Variance)
= $10 million x (1.5 — 1.0) = $5 million

A volatility swap works similarly:

Volatility Swap Payoff = Vega Notional Value x

(Realized Volatility — Strike Volatility)
= $2 million x (12.50 — 10.00) = $5 million

In the volatility swap, the example relies on a vega amount of $2 million and is not directly
comparable to the variance swap contract. Note, too, that the payoffs are not proportional.
See the comparison in the Variance and Volatility table.

Variance Volatility
Strike Notional 1.00% 1.00%
10,000,000 2,000,000
Realized Payoff Realized Payoff
0.49% -5,100,000 7.00% -6,000,000
0.64% -3,600,000 8.00% -4,000,000
0.81% -1.900,000 9.00% -2,000,000
1.00% 0 10.00% 0
1.21% 2,100,000 11.00% 2,000,000
1.44% 4,400,000 12.00% 4,000,000
1.69% 6,900,000 13.00% 6,000,000

Volatility futures are cash-settled futures contracts based on the level of at-the-money or
near-the-money options. Like the OTC variance swap and the volatility swap, the futures
contract pays an amount proportional to the level of volatility. Two popular volatility futures
are the CBOE Volatility Index (VIX), which is linked to stock option volatility, and the
TYVIX, which is linked to options on the CME 10-year note futures contract. Calls and puts
grant the right but not the obligation to buy or sell these futures contracts at a specified level.

Exchange-Traded versus OTC Volatility Derivatives

• Exchange-traded contracts present less counterparty risk.
• Exchange-traded contracts have more price transparency.
• Exchange-traded contracts have more liquidity.

359
© 2020 Wiley
HEDGE FUNDS

Volatility Arbitrage Strategies

• Buy underpriced options and sell overpriced options:
o May be vega-neutral overall.
o May be long vega (set to profit if volatility is higher than implied) or short
vega (set to profit if volatility is lower than implied),
o General portfolios are hedged against changes in stock, bond, and currency
prices.
• May be exposed to correlation risk—the dispersion trade. For example, a fund may
sell options on the S&P 500 Index and buy options on individual stocks that make up
the index. The volatility of the index is less than the average of the individual stock
volatilities because the index gets a diversification effect from imperfect correlation
between the individual stocks.
o The portfolio will lose money if correlation is higher (the index behaves
more like the individual stocks) than anticipated and will make money if
correlation is lower than anticipated by market participants collectively.

Challenges with Estimating and Forecasting Dispersion

• Traders should focus on the many conventions used to calculate payoffs on
derivatives.
• Position managers should be conscious of the nonlinear relationship between
variance swaps and volatility swaps.

Managing Tail Risk

Some hedge funds focus on extreme price movements (so-called black swan events). Many
other hedge funds remain unhedged to similar outlier events. In these extreme market
events, prices on holdings seem to move adversely, as if to inflict the largest loss on the
portfolio. This is often described as “correlations going to one,” which means seemingly
unrelated trades all seem to produce losses at the same time.

These funds seek to manage the tail risk by:

• Dynamically hedging throughout the movements (called delta hedging or portfolio

insurance).
• Buying out-of-the-money options.
o These options can be very expensive—high volatilities.
The goal of tail risk funds is to produce returns when other assets are losing to
equity price declines, widening credit spreads, and so on. They:
■ Serve as diversifiers for hedge fund investors.
■ Seek to help investors cope with rising correlation, which happens
when markets decline.

HFRX Relative Value:

Index (Jan. 2005-Dec. 2018) Volatility Index MS Cl World Equity
Annualized Arithmetic Mean 3.3% 6.6%
Annualized Standard Deviation 5.3% 14.7%
Annualized Semi volatility 6.2% 12.1%
Annualized Median 2.5% 4.7%
Skewness -2.4 -0.9
Excess Kurtosis 8.7 2.7

360
© 2020 Wiley
 RELATIVE VALUE HEDGE FUNDS: VOLATILITY ARBITRAGE, FIXED-INCOME ARBITRAGE, AND RELATIVE VALUE MULTISTRATEGY HEDGE FUNDS

HFRX Relative Value:

Index (Jan. 2005-Dec. 2018) Volatility Index MSCI World Equity
Sharpe Ratio 0.1 0.3
Sortino Ratio 0.1 0.30%
Annualized Geometric Mean 3.1% 5.5%
First-Order Autocorrelation 9.0% 15.3%
Annualized Standard Deviation* 8.2% 17.2%
Maximum 2.8% 11.2%
Minimum -7.7% -19.0%
Max Drawdown -15.4% -54.0%

*Adjusted for autocorrelation.

Source: CA1A Level I, 4th ed., 2020. Exhibit 17.7. Copyright © 2009, 2012, 2015 by The CA1A Association.

Learning Objective: Dem onstrate knowledge o f fixed-incom e arbitrage.

MAIN POINT: Fixed-income arbitrage is a relative value strategy that buys and sells
specific securities or sectors to make nondirectional returns.

Duration-Based Trade Weighting

Most fixed-income arbitrage trading is considered market-neutral or duration-neutral, which
in this case means the hedge fund seeks to hedge against gains or losses caused by the
general movement of rates up or down.

Modified duration is usually defined as the time-value-weighted average life of a bond.

Modified duration also equals the percentage change in price for a 1% (or 100 basis point)
change in yield. This leads to a weighting scheme described in the following equation:

Modified Duration#™*^
V a lu V a lu X
Modified Duration#™^ #
Q B o n d B = Z B o n d A

Note that this equation applies to the market value of the bonds, not the face value, and
includes the value of accrued interest. This weighting will produce an equal change in value
in a parallel yield curve shift, when if the yields on bonds of different maturities move by
the same amount.

Example 2

A trader wants to hedge $50 million1 worth of two-year Treasury notes with a modified
duration of 1.975 with 10-year Treasury notes with a modified duration of 8.904. The
proper trade weighting is $4,508 million worth of two-year notes for each $1 million
worth of 10-year notes (8.904/1.975), or $221,817 worth of 10-year notes for every
$1 million worth of two-year notes (1.975/8.904). Therefore, 11.09 million worth of
10-year notes hedge $50 million worth of two-year notes.

If a trader buys one issue and sells short a weighted value of the other issue, the gain on one
side should match the loss on the other position if the yields of the two bonds change by the

1This assumed market value includes the value of accrued interest and any discount or premium above the face value.

© 2020 Wiley
HEDGE FUNDS

same amount. Changing the yields on the bonds changes their durations, so this weighting
will change as yields move away from the starting level. Also, if the yield on an instrument
can be expected to move more than the yield on the other issue, the trader may underweight
the amount of the more volatile security.

• Effective duration seeks to measure the sensitivity of bond price relative to interest
rates incorporating the impact of optionlike provisions. Positions that include
callable or putable bonds or many types of mortgage-backed securities (MBS) need
to keep up-to-date estimates of effective duration of those securities.

Creating Leverage with Fixed-Income Securities

Suppose the hedge fund borrowed money in the repo market to buy $50 million worth of two-
year notes. The hedge fund uses the notes as collateral so is able to borrow 99% or more of the
market value (in this case $49.5 million). The leverage on this position is 100 to 1 or perhaps
higher, although the hedge fund’s leverage overall would be considerably lower.

Suppose also that the hedge fund borrows $11 million of the 10-year note in the reverse repo
market. The hedge fund borrows the security by giving the owner cash collateral as security.
The hedge fund may need to collateralize the loan of securities with 101% of the value of the
bonds (in this case $11.11 million). Of course, most of that $11.11 million comes from the short
sale of the securities for $11 million. The leverage on this position is also 100 to 1 or higher.

Leverage contributes to the return on fixed-income arbitrage funds because the profit
potential on individual trades is small without leverage.

Liquidity
The example discussed so far involves highly liquid U.S. Treasury securities. Many hedge
funds invest much of their capital in very illiquid securities. Liquidity can decline during
some market conditions. Fixed-income funds faced significantly lower liquidity during
2008-9.

Types of Trades
The yield curve can be defined visually as the yields on similar securities (usually U.S.
Treasuries or swap rates) plotted against time to maturity. A related relationship between
zero-coupon yields and years to maturity is called the term structure of interest rates. Over
long periods of time, there is an orderly relationship where the shortest maturities have the
lowest yields and successively longer maturities have progressively higher yields.

Curve Trades
The spread between the yield on a longer maturity and the yield on a shorter maturity (that
is, YieldLonger - YieldShorter) has generally been positive over the past several decades.
Buying the curve means to buy the shorter issue and sell short a duration-weighted amount
of the longer issue. The trade is profitable if the spread widens (also described as the curve
getting steeper) and loses money if the spread narrows (also described as the curve getting
flatter). Likewise, selling the curve means to buy the longer issue and sell short a duration-
weighted amount of the shorter issue. The trade is profitable if the curve flattens and loses
money if the curve steepens.

Butterfly trades buy or sell a bond and take opposite positions in an issue that is longer and
an issue that is shorter. Generally, each of the outer issues is hedged with a duration-neutral
amount of the issue in the middle. This type of trade seeks to profit from that issue or sector
being overvalued or undervalued without creating overall exposure to the steepness of the
yield curve.

© 2020 Wiley
 RELATIVE VALUE HEDGE FUNDS: VOLATILITY ARBITRAGE, FIXED-INCOME ARBITRAGE, AND RELATIVE VALUE MULTISTRATEGY HEDGE FUNDS

Other Types of Trades

Fixed-income arbitrage funds frequently invest in a carry trade, where bonds are purchased
with borrowed money to earn a coupon rate above the financing rate. Sometimes, these
positions mismatch maturities to produce a return and are not duration-neutral. Other times,
funds carry issues with limited liquidity or default risk, hoping that the carry return is not
offset by mark-to-market losses.

Many trades favored by fixed-income arbitrage funds are called convergence trades. The
hedge fund identifies a relationship between two or more bonds where the value of the
securities differs from the expected relationship. Convergence trades are long and short
positions taken by the hedge fund that will realize net gains if the prices of the securities
held move toward the expected relationship.

Risks and Returns of Sovereign Debt

Sovereign debt can differ significantly from corporate debt. Investors may believe that there
is practically no risk of default on debt of some countries. Governments can simply print the
money to repay debt. In addition, the debt of many governments is rated very highly,
indicating very little risk of default.

However, some countries have defaulted on debt more than once. Some countries have high
levels of debt that will be a challenge to service. In fact, a country can default on principal
or interest payments without declaring bankruptcy.

Sovereign debt funds that seek to profit from a flatter or steeper yield curve are exposed to
changes in the other direction. Some hedge funds do not hedge the general level of interest
rates.

These funds may be duration-neutral but funds can experience losses to large, rapid changes
in rates because duration weightings change as rates change. Convexity measures the
change. A portfolio of bonds that starts out being duration-neutral can become net long or
net short because the convexity of individual issues differs.

Sovereign funds may have currency exposure. These funds generally hedge the currency
exposure in several ways. First, they carry both long and short positions in a particular
currency. Second, they finance the positions in the same currency. Finally, they may create
forward or futures currency trades. Changes to the value of positions and changes in options
deltas make it difficult to completely remove all currency exposure.

Asset-Backed Securities and Mortgage-Backed Securities in Fixed-Income Hedge Funds

Hedge funds own asset-backed securities (ABS) and mortgage-backed securities (MBS) to
earn the spread return over risk-free fixed-income instruments. These securities earn a
spread because the cash flows are uncertain. Homeowners may time mortgage prepayments
in a way so that they accelerate when rates decline and slow when rates rise. Many of these
issues pose default risk. The funds use more leverage than almost every other hedge fund
strategy to amplify the return.

Funds that invest in MBS rely on sophisticated computer models to forecast prepayments, to
value the securities, and to hedge the positions. These models evaluate the prepayment
option and calculate the return on the MBS in excess of the value of the option. This
residual spread is called the option-adjusted spread (OAS) and is the primary source of
return in this sector. Funds might own a long portfolio of MBS or ABS earning a spread and
hedge the positions with securities that do not have prepayment risk. Other funds will be

363
© 2020 Wiley
HEDGE FUNDS

long and short options with different prepayment risks, essentially going long and short
different prepayment options.

Risks in MBS and ABS Fixed-Income Arbitrage

The options are complex and may be affected by economic factors, changes in rates, the
value of the underlying collateral (houses, credit card loans, and more), and other factors.
Funds hedge with a variety of securities and options that may not track the portfolio. In
particular, these funds tend to own MBS and ABS and are short U.S. Treasury securities, an
exposure that generally performs badly during market stress. Some positions create
counterparty risk.

Historical Return of Fixed-Income Arbitrage Funds

The Statistical Summary of Returns table reproduces returns presented by CAIA using data
from Hedge Fund Research. The average return looks attractive for the period (2000-2018)
with modest levels of risk.

MS C l World
Index (Jan. 2000-Dec. 2018) Incom e-Corporate Index Equity
Annualized Arithmetic Mean 5.1% 4.5%
Annualized Standard Deviation 5.3% 15.0%
Annualized Semi volatility 5.2% 11.6%
Annualized Median 8.0% 11.6%
Skewness -2.1 -0.7
Excess Kurtosis 13.0 1.6
Sharpe Ratio 0.49 0.1
Sortino Ratio 0.50 0.2
Annualized Geometric Mean 5.0% 3.4%
First-Order Autocorrelation 50.5% 13.5%
Annualized Standard Deviation* 9.2% 17.1%
Maximum 4.5% 11.2%
Minimum -10.6% -19.0%
Max Drawdown -28.2% -54.0%

*Adjusted for autocorrelation.

Source: CAIA Level I, 4th ed., 2020. Exhibit 17.11a. Copyright © 2009, 2012, 2015 by The CAIA
Association.

Like most other relative value strategies, fixed-income arbitrage returns are skewed left and
show significantly leptokurtotic returns (fat tails). Together, they document the trouble that
fixed-income arbitrage underwent in 2008-9, where loss of liquidity and distressed pricing
led to poor performance. If this probability distribution is typical of future returns, the
strategy has a higher probability of large losses than would be expected by the standard
deviation.

364
© 2020 Wiley
 RELATIVE VALUE HEDGE FUNDS: VOLATILITY ARBITRAGE, FIXED-INCOME ARBITRAGE, AND RELATIVE VALUE MULTISTRATEGY HEDGE FUNDS

Learning Objective: Dem onstrate knowledge o f relative value m ultistrategy

funds.

MAIN POINT: Relative value multistrategy (RVMS) funds are hedge funds that employ two
or more relative value strategies, such as convertible arbitrage, volatility arbitrage, and fixed-
income arbitrage. These multistrategy funds exist for several reasons. First, some of the largest
hedge funds in existence are relative value funds, and following more strategies may be
helpful in earning a return on a larger pool of investments. Second, the profitability of different
relative value strategies varies over time, so funds like to have more than one strategy in place.
Finally, combining multiple strategies creates some diversification of returns.

The Statistical Summary of Returns: Relative Multistrategy Funds table reproduces

performance data presented by CAIA on relative value multistrategy funds.

Index (Jan. 2000-Dec. 2018) Multi-Strategy Index MSCI World Equity

Annualized Arithmetic Mean 5.0% 4.5%
Annualized Standard Deviation 4.1% 15.0%
Annualized Semivolatility 4.2% 11.6%
Annualized Median 6.2% 11.6%
Skewness -2.6 -0.7
Excess Kurtosis 17.2 1.6
Sharpe Ratio 0.59 0.1
Sortino Ratio 0.59 0.2
Annualized Geometric Mean 4.9% 3.4%
First-Order Autocorrelation 48.3% 13.5%
Annualized Standard Deviation* 7.0% 17.1%
Maximum 3.9% 11.2%
Minimum -8.4% -19.0%
Max Drawdown -21.5% -54.0%

*Adjusted for autocorrelation.

Source: CAIA Level I, 4th ed., 2020. Exhibit 17.12. Copyright © 2009, 2012, 2015 by The CAIA
Association.

Returns on relative value multistrategy funds are higher than on global bond returns with
less risk as measured by standard deviation but appear more risky using the minimum return
or the drawdown. Returns are lower than relative value funds committed to just convertible
arbitrage or fixed-income arbitrage, but the multistrategy funds appear to get some risk
reduction from diversification, because the standard deviation of return is lower on the
multistrategy sector.

The returns on these multistrategy relative value funds are skewed and leptokurtotic
(fat tails), as are the returns from convertible bond and fixed-income strategies. This
combination means that the probability of significant losses was considerably greater than
would be expected from a distribution with a standard deviation of 5.10%. At least over the
period 2005-2014 (reflecting notably the losses in 2008-9), diversification offered fairly
little protection compared to individual relative value strategies.

365
© 2020 Wiley
 E q u it y H ed g e F u n d s

Equity hedge funds are the most popular hedge fund strategies in terms of the number of
funds and by assets under management (AUM). As of 2014, the largest of the three
strategies discussed here is equity long/short ($734 billion AUM), followed by market-
neutral ($48 billion) and short-bias ($5.7 billion).

LESSON MAP
• Demonstrate knowledge of commonalities between equity hedge funds.
• Demonstrate knowledge of sources of return for equity hedge funds.
• Demonstrate knowledge of market anomalies.
• Demonstrate knowledge of approaches to implementing anomaly strategies.
• Demonstrate knowledge of various (three) equity strategies.

KEY CONCEPTS

Learning Objective: Dem onstrate knowledge o f com m onalities between equity

hedge funds.

The three major equity hedge strategies are short-bias (with net short positions and a
negative beta), equity long/short (which tends to be net long with a positive beta), and
equity market-neutral (which maintains a beta of zero with offsetting long and short
positions). The returns of these strategies therefore need to be considered relative to their
systematic exposures, not in absolute terms.

Learning Objective: Dem onstrate knowledge o f sources o f return for equity

hedge funds.*•

MAIN POINTS: Equity hedge strategies may earn alpha even if the absolute return is
negative. That is, the strategies should be evaluated relative to systematic risk, which may
be negative if net short. Sources of return to these strategies include providing liquidity,
providing informational efficiency, and using factor analysis.

There are three main types of strategies. The primary difference among the three is their net
exposures.

• Equity long/short funds tend to have net positive systematic risk exposure from
taking a net long position, with the long positions being larger than the short
positions.
• Equity market-neutral funds attempt to balance short and long positions, ideally
matching the beta exposure of the long and short positions and leaving the fund
relatively insensitive to changes in the underlying stock market index.
• Short-bias funds have larger short positions than long positions, leaving a persistent
net short position relative to the market index that allows these funds to profit during
times of declining equity prices.

In general, equity hedge strategies may be expected to earn excess returns by exploiting
several market inefficiencies. Sources of returns include providing liquidity, providing
informational efficiency, and using factor analysis. These return sources are summarized in
the Sources of Returns to Equity Hedge Funds table and the following more detailed
discussion of market anomalies.

© 2020 Wiley
HEDGE FUNDS

Sources of Returns to Equity Hedge Funds

Providing Liquidity Often market participants are more concerned with executing a
trade in a timely manner than getting the best price and will
take liquidity in order to attain desired long-term positions.
In such cases, the equity hedge fund manager may be able to
purchase stock at a discount or sell at a premium, acting
as a market maker that earns a spread by placing buy orders
on the bid side and sell orders on the ask side (e.g., by using
limit orders).
Providing Informational Equity hedge fund managers may be able to earn a complexity
Efficiency premium through superior ability to identify informational
inefficiencies in the form of mispriced securities. Since fewer
market participants can engage in short selling, theoretically
there is less competition for finding overvalued securities than
undervalued securities. Stocks with high short interest do tend
to underperform, lending support to the notion that short sellers
are skilled. Note: Two examples of market inefficiencies
mentioned in this section are asynchronous trading and over/
underreacting. See definitions.
Using Factor Analysis Bottom-up analysis focusing on firm-specific factors such as
market capitalization or book value to price (in contrast to
macroeconomic variables) may also provide a source of
returns. This is based on past findings such as small-cap and
value stocks outperforming large-cap and growth stocks, but it
is debatable as to whether these return differentials will
continue in the future.•

KEY TERMS
Often market participants are more concerned with executing a trade in a timely manner
than getting the best price and will take liquidity to do so.

• Liquidity in this context is the extent to which transactions can be executed with
minimal disruption to prices.

An institution may take liquidity in order to make portfolio adjustments.

• Taking liquidity refers to the execution of market orders by a market participant to

meet portfolio preferences that cause a decrease in the supply of limit orders
immediately near the current best bid and offer prices.

An equity hedge fund manager may provide liquidity at a cost to the institution.

• Providing liquidity refers to the placement of limit orders or other actions that
increase the number of shares available to be bought or sold near the current best bid
and offer prices.

When providing liquidity, an equity hedge fund manager is acting as a market maker.

• A market maker is a market participant that offers liquidity, typically both on the
buy side by placing bid orders and on the sell side by placing offer orders.

368
© 2020 Wiley
 EQUITY HEDGE FUNDS

Sources of returns to equity hedge funds also include providing informational efficiency.

• Markets are said to be informationally efficient when security prices reflect

available information (i.e., there is no reliable, consistent way to outperform the
market assuming a risk level that is similar to the market).

Stocks with high short interest tend to underperform, lending support to the notion that short
sellers are skilled.

• Short interest is the percentage of outstanding shares that are currently held short.

Two examples of market inefficiencies:

1. Asynchronous trading is an example of market inefficiency in which news

affecting more than one stock may be assimilated into the prices of the stocks at
different speeds.
2. Overreacting/underreacting is an example of market inefficiency in which short-
term price changes are too large or too small, respectively, relative to the value
changes that should occur in a market with perfect informational efficiency.

ABNORMAL RISKS
Providing liquidity and informational efficiency are both forms of speculation: bearing
abnormal risks in the hope of abnormal returns. The goal is to buy low and sell high, which
tends to stabilize markets. Therefore, speculation can be argued to provide a valuable
market role despite debate regarding whether speculators increase or reduce volatility.

• In this context, speculation is defined as bearing abnormal risk in anticipation of

abnormally high expected returns.

Learning Objective: Dem onstrate knowledge o f m arket anom alies. •

MAIN POINT: Anomalies are violations of market efficiency, but it must be remembered
that market efficiency tests are tests of joint hypotheses for both market efficiency and for
the model used for the test. Research has identified several market anomalies reviewed in
this section: accounting accruals, price momentum, earnings momentum, net stock issuance,
and insider trading. Each plays a potential role in generating ex ante alpha.

This section provides an overview of several market anomalies that may be exploited by
equity hedge fund managers.

• Investment strategies that can be identified based on available information and that
offer higher expected returns after adjustment for risk are known as market
anomalies, and they are violations of informational market efficiency.

We must keep in mind that any anomaly may be the result of using a misspecified model.

• An empirical test of market efficiency is a test of joint hypotheses, because the test
assumes the validity of a model of the risk-return relationship to test whether a given
trading strategy earns consistent risk-adjusted profits.

In fact, the many issues with statistical tests that were discussed in the Alpha, Beta, and
Hypothesis Testing chapter should be kept in mind when evaluating any results of tests that
find market anomalies.

369
© 2020 Wiley
HEDGE FUNDS

One anomaly indicates that investors seem too interested in net income, which can be
impacted by accounting conventions, when they should be focused on cash flow.
Specifically, firms with high accounting accruals (non-cash-flow items that increase current
reported net income) tend to have negative future earnings surprises. This means that stocks
with high accounting accruals and consequent high reported net income relative to cash
flows should be sold, and stocks with low accounting accruals and consequent low reported
net income relative to cash flows should be bought.

• An accounting accrual is the recognition of a value based on anticipation of a

transaction.

Total Accruals = A C A — ACL — A Cash + A ST DEBT — D&A

An increase in noncash current assets such as inventory (i.e., an increase in the change in
current assets relative to current liabilities and cash, A C A — AC L — A C ash) can indicate
lower future earnings if, for example, inventory becomes obsolete or accounts receivable are
not collected. An increase in short-term debt, A ST DEBT, may increase current earnings but
be simply deferring liabilities. Similarly, a decrease in depreciation and amortization, D&A,
will increase the current period’s net income but will need to be paid at a later date.

Another anomaly finds that equity prices predictably follow trends in approximately
six-month intervals to the extent that momentum-based trend-following strategies can be
profitable. (Reversals occur during shorter intervals and in the longer run.) Because
momentum is strongest in small-cap stocks, it lends support for the explanation whereby
funds that identify undervalued stocks build their positions gradually to minimize price
impacts. When others learn of the trades, then the prices are further pushed up, building
momentum.

• Price momentum is trending in prices such that an upward price movement indicates
a higher expected price and a downward price movement indicates a lower expected
price.

Momentum also exists in earnings and is related to another anomaly: post-eamings-

announcement drift.

• Earnings momentum is the tendency of earnings changes to be positively

correlated.

Earnings per share (EPS) cannot react to news quickly as prices can, yet they are the main
drivers of idiosyncratic stock returns. A positive earnings surprise is when the actual
earnings announcement is higher than the expected earnings (e.g., consensus analyst EPS
forecast).•

• An earnings surprise is the concept and measure of the unexpectedness of an

earnings announcement.

To discern if a surprise is material, it can be standardized.

• Standardized unexpected earnings (SUE) is a measure of earnings surprise.

Although exact definitions of the SUE measure vary, the following is a general
representation.

370
© 2020 Wiley
 EQUITY HEDGE FUNDS

EPS —Analyst Consensus EPS Estimate

SUE =
Standard Deviation of Earning Surprises

One method of calculating the standard deviation might be to calculate the standard
deviation of the quantity in the numerator that occurred over the past eight quarters.

• A post-earnings-announcement drift anomaly has been documented, in which

investors can profit from positive surprises by buying immediately after the earnings
announcement or selling short immediately after a negative earnings surprise.

Net stock issuance is yet another anomaly. Positive net stock issuance can signal a sell
whereas negative net stock issuance can signal a buy.

Net stock issuance is issuance of new stock minus share repurchases.

The intuition for a buy signal (based on negative net issuance) is as follows.

• When a company chooses to reduce its shares outstanding, a share buyback

program is initiated, and the company purchases its own shares from investors in the
open market or through a tender offer.

The reduction in number of shares outstanding automatically increases the earnings per
share (EPS) as well as reducing the supply of stock and increasing the demand. Reduced
dividends payable help to increase EPS growth. This pushes prices upward, all else equal.
(Share repurchase activity could also signal that the firm has no growth opportunities in
which it can invest its excess cash, which would be an opposite signal.)

The intuition for a sell signal (based on positive net issuance) is as follows.

• Issuance of new stock is a firm’s creation of new shares of common stock in that
firm and may occur as a result of a stock-for-stock merger transaction or through a
secondary offering.

Firms issuing shares are looking for cash and diluting EPS.

The last two anomalies covered in this section concern insider trading.

• Illegal insider trading varies by jurisdiction but may involve using material
nonpublic information, such as an impending merger, for trading without required
disclosure.

Legal insider trading by executives can be informative on a company-specific level as well

as for the market as a whole. Insider executives tend to buy shares when the market is at a
bottom and individual shares are undervalued.

Trading by insiders can be legal insider trading when it is performed subject to legal
restrictions.

ANOMALY SECTION SUMMARY

Important issues involved in predicting persistence of market anomalies include identifying
the sources from which the abnormal (risk-adjusted excess) returns are being obtained and

m
© 2020 Wiley
HEDGE FUNDS

why they are willing to pay the abnormal return (transact at relatively harmful prices).
(See Summary of Anomalies table.)

Summary of Anomalies

Potential Role in Generating Ex

Anomaly Defmition/Comment Ante Alpha (How to Profit)
Accounting accruals Although returns are driven by Buy stocks with negative accruals
Changes in noncash items (e.g., free cash flow, investors often (high ratio of free cash flow to net
sales on credit) impact accruals focus too much on net income. income).
and net income, but not They overreact to accruals (which Short stocks with positive
necessarily cash flow. impact reported earnings) and accruals (low ratio of free cash
underreact to reliable cash flow flow to net income).
indicators.
Price momentum is trending in Momentum is observed at six- A trend-following strategy may be
prices such that an upward price month intervals; however, short- profitable, particularly in small-
movement indicates a higher term and very long-term intervals cap stocks whereby large
expected price and a downward experience reversals. investors are prevented from
price movement indicates a lower taking large positions at once so
expected price. they do not leak out information
to the market.
Post-earnings-announcement Standardized unexpected earnings Post-earnings-announcement drift
drift is based on earnings (SUE) is a measure of earnings anomaly: An investor can profit
momentum (the tendency of surprise. Stock prices drift in the from positive (or negative)
earnings changes to be positively same direction as SUE after an earnings surprises by buying (or
correlated) and on earnings earnings announcement instead of selling) immediately after the
surprise (the concept and measure reverting to a random walk. earnings announcement.
of the unexpectedness of an
earnings announcement).
Net stock issuance is issuance of This is one the most profitable Share repurchase programs
new stock minus share anomalies. There are caveats to (negative net issuance) can signal
repurchases. the general signals, of course; for a buy, whereas issuance of new
example, a share buyback could stock can signal a sell.
signal that the firm has few
investment opportunities instead
of creating EPS growth.
Insider trading (of the legal It is important to determine Senior executives’ insider trading
typea) is done by the company whether company insiders are can provide buy and sell signals in
executives within legal selling due to personal financial the same direction that a majority
restrictions. reasons or due to perceived of them trade.
weakness in the stock value.
a
It is illegal to trade on inside information, which is defined as information that is both material and nonpublic. (Recall the Standards of Practice—Standard
11(A): “Members and Candidates who possess material nonpublic information that could affect the value of an investment must not act or cause others to act on
the information.”)

Learning Objective: Demonstrate knowledge of approaches to implementing

anomaly strategies.

MAIN POINT: Most equity hedge managers do not rely on a single anomaly but
incorporate several into a multiple-factor scoring model. Another equity hedge strategy for
seeking alpha is pairs trading, which involves identifying two highly correlated stocks,

372
© 2020 Wiley
 EQUITY HEDGE FUNDS

taking opposite positions when the spread between them widens, and unwinding the
positions when the spread narrows to its usual size. The ability to sell short increases
breadth relative to strategies constrained to be long only. This can help increase risk-
adjusted return as measured by the information ratio. A reason that market anomalies are not
arbitraged away is that there are limits to arbitrage, including the avoidance of risk of ruin
due to the potential need to hold a mispriced security for longer than is feasible.

In practice, equity hedge managers rely on several market anomalies to develop trading
signals. They will rank a stock on each of the anomalies they are considering and incorporate
them into a multiple-factor scoring model. This provides diversification across signals.

• Multiple-factor scoring models combine the factor scores of a number of

independent anomaly signals into a single trading signal.

Another approach to equity hedge strategies involves pairs trading, which is another version
of a relative value strategy followed by other types of hedge funds (e.g., relative value funds
following a convertible arbitrage strategy, or managed futures funds following a black-box
relative value [non-trend-following] strategy).

• Pairs trading is a strategy of constructing a portfolio with matching stocks in terms

of systematic risks but with a long position in the stock perceived to be relatively
underpriced and a short position in the stock perceived to be relatively overpriced.

An example is Coca-Cola and PepsiCo. Their stock prices move together with a spread.
When the spread widens, a short position is take in the stock whose price has diverged
upward, and a long position is take in the other. Eventually the spread will narrow to normal
so that a profit is made on the short when the price declines and on the long when its price
rises. Note that the absolute value of the change in either stock is irrelevant: they might both
decline with the trader still profiting. It is rather the rise and fall of the prices in the pair
relative to each other that matters.

Short Selling Increases Breadth

The ability to short sell increases breadth, as discussed earlier in the context of FLOAM.
Greater breadth allows for a higher alpha at any given level of tracking error. Recall that the
information ratio increases with the square root of breadth, holding the information coefficient
(correlation between forecasted returns and actual returns) constant. Relative to a long-only
constraint with less breadth, short selling therefore increases the information ratio (strategy
return in excess of the benchmark, relative to tracking error), all else equal. In summary, short
selling increases breadth and therefore the risk-adjusted return (information ratio) and alpha,
all else equal (holding the information coefficient and tracking error constant).

Limits to Arbitrage
If we are to explain the profits to equity hedge strategies as those due to exploiting
mispricing in market anomalies, we must be able to explain why the anomalies are not
arbitraged away. The answer is that some are, but also there are limits to arbitrage.

The limits to arbitrage refer to the potential inability or unwillingness of speculators, such
as equity hedge fund managers, to hold their positions without time constraints or to
increase their positions without size constraints.

This means that even if an anomaly exists and hedge fund managers are exploiting it, they
will not take positions large enough to eliminate it. The reasons for the inability or
unwillingness to eliminate the opportunity include running the risk of ruin. For example, a

373
© 2020 Wiley
HEDGE FUNDS

mispricing may exist for very long periods of time before correction. Managers may
experience large losses before finally being proved correct, and that may be too late.
Another reason that arbitrage may not be eliminated has to do with market structures. For
example, institutional investors can be too large to participate in micro-cap stock markets
that may exhibit inefficiencies: the market impact would be too large.

• M arket impact is the degree of the short-term effect of trades on the sizes and levels
of bid prices and offer prices.

Micro-cap stocks are often very illiquid, and the bid-ask spreads are therefore relatively
wide. Coupled with thin volume, large trades would move prices substantially. Thus, market
anomaly studies need to consider the impact of transaction costs, including bid-ask spreads,
in relation to liquidity.

Learning Objective: Demonstrate knowledge of various (three) equity

strategies.

MAIN POINTS: All three equity hedge strategies use short selling to some extent. The
returns to short selling differ from returns to long positions in a few different ways. Short
sellers sell stock that they borrow from a lender and therefore must post collateral in the
form of cash or a long position in a stock. When posting cash, the short seller earns interest
in the form of a rebate. Short sellers need to pay any dividends to the lender of the stock.
Short-bias funds maintain a net short exposure and often have a negative expected return,
but relative to the systematic risk can still have alpha. Historically, short-bias funds have
had a negative correlation with equity and a mean annual return of zero. Equity long/short
funds tend to have a net long exposure. Historically, their annualized mean return has been
higher than the overall equity hedge category and world equity with similar risks. Equity
long/short funds are positively correlated with equity markets and other equity hedge fund
indices and negatively correlated to equity volatility and credit spreads. Finally, equity
market-neutral funds, which try to maintain a beta of zero, have extremely low volatility,
muted correlations, and betas with mean returns lower than major indices.

Mechanics and Risks of Short Selling

All three equity hedge strategies may use short sales. The mechanics and risks of short
selling differ from those of taking long positions in a few ways. First, the theoretical losses to
short positions are unlimited, and the potential gain is equal to the price at which the position
is sold short. Conversely, the profits to long positions are theoretically unlimited, and the
potential maximum loss is limited to the price at which the position was purchased. Second,
short selling can raise liquidity problems because collateral is required. Typically, a long/
short manager can post long positions as collateral. However, consider the Scenario table.

Scenario

Initial position
Long A 100 Posted as collateral for B
Short B 100
Next day both move 10% against manger
Long A 90
Short B 110

374
© 2020 Wiley
 EQUITY HEDGE FUNDS

After the adverse price movements, the manager does not have enough collateral posted and
may need to liquidate at poor prices.

Third, the lender of the short security has the right to demand it back. Usually the broker
will simply find another lender. Yet in a short squeeze (upward pressure on prices of short
positions), it may be difficult to find others willing to loan shares if the original lender
demands the short position be returned. In this case the manager would need to close out the
short at an unattractive price.

Return to Short Position

When managers post cash as collateral for borrowing shares, they generally receive a rebate
of, for example, 1% of the initial short position as interest on the collateral. This is one
component of the total return on a short position. However, short sellers do not receive
dividends, but rather must pay them to the lender of the security.

Short-Bias Funds

Short-bias funds generally maintain a net short exposure and may often have negative
returns. They may still, however, be valuable additions to a portfolio. Specifically, they
should be evaluated based on their returns relative to systematic risk, not their absolute
returns. Consider an example of short selling in a capital asset pricing model (CAPM)
context.

375
© 2020 Wiley
HEDGE FUNDS

There are regulatory and reputational risks to short selling.

• Regulations may also have or institute an uptick rule that permits short sellers to
enter a short sale only at a price that is equal to or higher than the previous transaction
price of the stock.

Historical Returns to Short-Bias Funds (2000-2018)

• Returns for equity short-bias funds averaged -4%. This was expected, considering
that the average returns of world equities were +6.5%.
• Short bias exhibited somewhat less volatility than world equities.
• Returns had the reverse skew as world equities and similar excess kurtosis.
• Maximum drawdown for short-bias funds was slightly higher than that of world
equities.
• Returns had very small but consistently positive first- through fourth-order partial
autocorrelations.

376
© 2020 Wiley
 EQUITY HEDGE FUNDS

Equity Long/Short Hedge Funds

The equity long/short (ELS) strategy builds a core portfolio of long stock or exchange-
traded funds (ETFs) positions combined with short positions either through short sales of
stocks or by selling equity futures or options contracts. The ELS manager tends to hold
more long than short positions, so the net market exposure (long minus short positions) is
positive.

Consider a simple (extreme) example where on July 10, 2016, an equity long-short manager
has a 150% investment in the iShares XLK (ETF passively investing in the S&P 500
technology sector) and a 50% short position in XLU (the utilities sector). The beta of XLK
is 1.02, and the beta for XLU is .27 so that the weighted beta of the portfolio is 1.4. Then,
given a return on the S&P 500 of 1.12% and a risk-free rate of return of .075% for the same
three-month period, the CAPM predicts this strategy would return .075% + 1.4(1.12% -
.075%) = 1.533%. However, the actual returns for XLK and XLU are much different than
the overall S&P over the three months: 9.6% and -9.38%, respectively. The manager is then
able to earn 19.1% in this three-month period with this simple strategy, which is much
higher than predicted by the CAPM.

CAPM Return Prediction

Weighted Weighted
Beta Weight Beta Return Return
XLK 1.02 1.5 1.53 0.096 0.144
XLU 0.27 -0.5 -0.135 -0.0938 0.0469
1.395
CAPM return prediction: 1.533% Actual: 19.1%

We should acknowledge that while the beta of this simple ELS strategy is high (over 1, due to
leverage), the risk inherent in the strategy is still understated by this measure. The manager
has made two idiosyncratic bets: one on the technology sector outperforming and one on the
utilities sector underperforming. While the overall exposure to the market is only slightly
elevated, these two concentrated bets can create substantial risk. Managers need to strike a
balance between concentration (where correct bets can provide substantial returns) and
breadth (diversification to reduce risk). Two basic approaches to choosing the correct bets
include fundamental analysis and quantitative or technical analysis. ELS managers may
invest across sectors and countries or may be more narrowly focused on a particular segment.

Historical Returns to ELS Strategies (2000-2018)

• ELS returns had approximately half the volatility of world equities.
• Long-short returns were symmetrical (but with substantially higher excess kurtosis
than world equities).
• Maximum drawdown was less than 50% that of world equities.
• Returns recorded slightly positive first-order partial autocorrelations.

Equity Market-Neutral Funds

Equity market-neutral (EMN) funds strive for a market beta of zero and also aim for market
neutrality across sectors. Unlike other equity hedge funds, they do not try to time the
market. Statistically, in addition to EMN strategies, many types of hedge fund strategies
appear to be market-neutral: merger arbitrage, convertible arbitrage, and relative value
arbitrage. Directional funds, in contrast, have statistically significant market exposures.
Mean neutrality is the standard definition of market neutrality.

377
© 2020 Wiley
HEDGE FUNDS

• Mean neutrality is when a fund is shown to have zero beta exposure or correlation to
the underlying market index.

Mean neutrality implies that the fund returns are equally likely to go up or down when the
market moves in one direction. Market neutrality can also be defined in terms of variance,
and other risk measures such as value at risk and tail risk.

• Variance neutrality is when fund returns are uncorrelated to changes in market risk,
including extreme risks in crisis market scenarios.

Research shows that fewer funds meet the variance neutrality criteria. In fact, a zero beta does
not imply zero risk. An example is when a fund is not sector or industry neutral, even if the
overall market beta is zero. During the Internet bubble, many funds experienced large losses
from short positions in Internet stocks that were not balanced out by gains in retail stocks.

A three-step procedure to EMN strategies involves (1) screening stocks by liquidity and
other criteria, (2) identifying which are underpriced and which are overpriced, and
(3) constructing a portfolio that is market and sector neutral. Because computer models
assist in the process, to the extent that EMN managers identify similar trades they may
become crowded and represent a potential risk.

Historical Returns to Equity M arket-Neutral Strategies (2000-2018)

• Equity market neutral recorded only a fifth of the volatility of world equities.
• EMN returns were symmetrical but had slightly higher excess kurtosis than world
equities.
• Maximum drawdown was only around a fifth the size of that of world equities.
• Returns had small, but consistently positive first- through fourth-order partial
autocorrelations.

378
© 2020 Wiley
 F u n d s o f H ed g e F u n d s

LEARNING OBJECTIVES
The risk in investing in hedge funds can usually be lowered by splitting the investment into
many different funds. There is diminishing impact from adding more funds, especially after
adding 15 or 20 funds that are thoughtfully selected to provide diversification. Investors
with enough money (a pension fund, for example) can buy several funds and create this
diversification. Hedge funds that invest in other hedge funds pool money from many
investors and can provide a diversified return with a smaller investment minimum. Hedge
funds that pursue multiple strategies also can provide some diversification.

Funds of hedge funds charge additional management and incentive fees. In return, they
provide professional management, including portfolio strategies, due diligence, and
performance monitoring. Investors should compare the incremental cost of hedge fund
selection, due diligence, and monitoring to the cost of professional management.

LESSON MAP
• Demonstrate knowledge of the benefits and costs of diversification in hedge fund
investing.
• Demonstrate knowledge of investing in multistrategy funds.
• Demonstrate knowledge of the process of investing in funds of hedge funds.
• Demonstrate knowledge of building a portfolio of single hedge funds.
• Demonstrate knowledge of multialtematives and other hedge fund liquid
alternatives.
• Demonstrate knowledge of observations regarding historical performance of funds of
hedge funds.

Learning Objective: Demonstrate knowledge of the benefits and costs of

diversification in hedge fund investing.

MAIN POINT: As with most investment products, diversification reduces risk without
necessarily lowering returns. This lesson compares three ways to diversify hedge fund
returns: (1) directly invest in a portfolio of hedge funds, (2) invest in a hedge fund that holds
a portfolio of hedge funds, or (3) invest in a hedge fund that follows several strategies.
Funds of hedge funds also offer professional management and manager selection, but these
advantages come with another layer of fees.

Diversifying Hedge Fund Returns

Funds of hedge funds (FoFs) are hedge funds that invest in other hedge funds. FoFs are
popular with individuals and some pensions and endowments that value the many services
that the FoF manager provides.

Realize that both of these indices get some diversification by including a large number of
hedge funds or funds of funds in the average. The lower correlation on fund of funds returns
occurs significantly because the FoF managers choose investments to lower the correlation.

Using both theoretical and empirical methodologies, FoFs should invest in at least 15 or 20
separate funds. The theoretical argument begins by assuming a level of correlation between
all possible funds while the empirical methodology relies on actual performance. In both
cases, benefits of diversification are large for the first several funds added to a portfolio. But
each additional fund contributes less risk reduction. In contrast, each additional fund
imposes similar costs to conduct due diligence and monitor the investment.

© 2020 Wiley
HEDGE FUNDS

Carefully picking individual managers and strategies can reduce the risk of an FoF
investment. It is possible to narrowly focus an FoF in a single strategy. For example, an FoF
may invest in tech stocks in Latin America. This concentration limits the impact of
diversification.

Funds of Hedge Funds

MAIN POINT: Funds of hedge funds provide diversification, fund selection, due diligence,
and portfolio management in return for higher fees than investors would pay for a direct
hedge fund investment.

Objectives of Fund of Fund Management

To justify a second layer of fees, managers must offer something of value to investors. The
most important functions of management are:

• Establish a strategy and select managers o f individual hedge funds. Allocation to

specific strategies is primarily driven by historical performance of the strategy and
individual managers. A major part of manager selection involves due diligence and
performance analysis to reduce the chance of fraud, to identify managers with
superior risk management, and to find managers that can be expected to produce
attractive returns. Existing investors can sometimes invest new money in funds that
are otherwise not available to new investors because the closed fund may agree to
accept additional investments from that FoF.
• Build a portfolio. The portfolio should match the allocation to the targeted strategies.
That allocation may reflect short-term strategic overweighting or underweighting of
some strategies. The FoF will also establish the maximum that it will invest with any
manager to diversify fund-specific risks. Usually the limit is expressed as a
percentage of the assets in the FoF.
• Design the FoF portfolio to provide the highest possible return fo r an amount o f risk.
One approach is mean-variance optimization (also called a Markowitz portfolio).
Some managers may create heuristics with similar goals. Still other managers may
actively change the style weighting and individual managers to increase performance
relative to other FoFs.
• Risk management. The FoF manager carefully reviews performance to detect
possible changes in a fund’s risk posture and adherence to a stated strategy. For
example, if a convertible arbitrage fund’s performance does not track the level of
volatility, the FoF manager might question whether the fund has adopted a different
strategy or is not accurately reporting performance. Many FoFs invest in separate
accounts run by fund managers similar to commingled accounts. The FoFs may
therefore have custody of the securities and a full account of the specific investments
(transparency).
• Due diligence. Investors should conduct significant review of a hedge fund before
investing and continue reviewing during the holding period. Due diligence can
significantly reduce certain risks such as fraud and should thereby increase the
expected return. This analysis may not be justified for individuals considering a
single hedge fund investment, but an FoF enjoys economy of scale by sharing the
cost over many investors.

Advantages of Investing in an FoF

• Diversification. Because of investment minimums, individual and small institutional
investors can’t own enough different funds to get the potential risk reduction possible
in an FoF. Some portfolios, however, are large enough to create nearly as much
diversification as an FoF offers.

© 2020 Wiley
 FUNDS OF HEDGE FUNDS

• Accessibility. FoFs generally allow much smaller minimum investments ($100,000)

than hedge funds, which may require $500,000 (median) or more.
• Economies o f scale. Individuals and small institutions can avoid FoF fees by making
direct hedge fund investments. However, FoF management and incentive fees will be
less than the cost of management and due diligence.
• Information advantage. FoFs are committed full-time to following hedge fund
performance, meeting many different managers, and often sharing insights with other
FoF managers. They have access to data that is not available to smaller direct
investors.
• Liquidity. Investors can generally redeem direct hedge fund investments only at
month-end or quarter-end. They may be subject to a lockup period when a new or
incremental investment cannot be redeemed. In contrast, investors have daily
liquidity in an FoF listed on an exchange. Privately negotiated over-the-counter
(OTC) transactions are also possible. Some FoFs maintain lines of credit to offer
greater liquidity to their investors than the hedge funds would provide to them.
• Access. FoFs may have access to closed funds or funds with high minimum
investments.
• Negotiated fees. The size of an FoF may give it power to lower fees on its hedge fund
investments.

Disadvantages to Investing in FoFs

• A second layer o f fees. An FoF typically charges a 1% management fee and 10%
incentive fee on top of direct fees (which are typically 2/20). Losses in one fund
aren’t netted with gains in other funds in applying 2/20 fees.

Example 1

Suppose an FoF had funds that averaged 10% gains and other funds that averaged 10%
losses, netting to 0% before direct incentive fees. However, the profitable funds would
still charge an incentive fee.

• Less transparency. Hedge funds are generally very secretive. While large investors
may demand more information, typically hedge funds will disclose only summary
information such as the percentage of the fund in technology stocks or the highest
percentage invested in a single issue. An FoF might disclose the percentage of the
fund invested in relative value hedge funds or the largest investment in any single
fund. Therefore, an FoF investor has less information about factors that could
influence the risk.
• Most FoFs are registered offshore. This can create tax disadvantages for some
investors. While many individual hedge funds are also registered offshore, some are not.
• Impact of other investors. Flows into and out of an FoF may require the manager to
make transactions that affect trading costs and cause dilution.
• Lack o f control. The investor may prefer a different allocation to strategies and
individual managers than the allocations made by the FoF manager.

Learning Objective: Demonstrate knowledge of investing in multistrategy

funds.

MAIN POINT: A multistrategy fund is a hedge fund that runs several distinct strategies
within the same fund. The multistrategy fund is not organized differently than a

© 2020 Wiley
381
HEDGE FUNDS

single-strategy hedge fund. However, the fund’s capital is allocated to different types of
positions and produces a return that is a blend of the strategies employed. The risk on a
multistrategy fund can be somewhat lower because it blends several returns.

As mentioned earlier, an FoF will charge both an incentive fee and a management fee. The
FoF will pay both incentive and management fees to individual hedge funds, which are not
netted. If one hedge fund makes money and another hedge fund loses money, the first hedge
fund collects an incentive fee even if the returns net to zero or a loss. In contrast, a
multistrategy hedge fund charges just one management fee and one incentive fee. The
incentive fee is calculated off the net return, not the returns to individual strategies.

Multistrategy funds are generally less flexible than FoFs. An FoF manager can quickly add
new managers and even new strategies just by making a new allocation. The FoF can also
reduce exposure to certain strategies without needing to fire employees devoted to that
strategy. Especially if the assets in the strategy are illiquid, it may be much easier to reduce
a hedge fund investment than to scale back a sector of the multistrategy fund. However,
FoFs can generally exit hedge funds only at the end of a month or quarter, and FoFs may
have lockups that restrict their ability to reduce exposure to particular funds and strategies.
In contrast, a multistrategy fund can scale back positions at any time.

Multistrategy hedge funds may provide more transparency to investors than do FoFs. Many
hedge funds provide minimal disclosures of positions (percentage allocations to equity
business sectors or the amount invested in particular foreign countries, for example). But
FoFs will disclose considerably less. They may list some or all of the hedge funds in the
FoF but not provide even minimal descriptions of their positions or risk exposure. The FoF
will usually not even provide the names of the hedge funds in its portfolio.

FoFs have several advantages over multistrategy funds. First, they can choose the hedge
fund that they believe is the best fund to implement a particular strategy. It is unlikely that a
multistrategy fund will have the best team in place to implement each of its strategies. The
second advantage FoFs have relative to multistrategy hedge funds involves operational risk
management. FoFs spread out their investments, reducing the impact of several types of
fraud. Also, part of the management that FoFs provide is to take steps to minimize
operational risk. FoFs are more likely to get access to trading practices and accounting
records. An FoF may demand a separate account, so that it gets complete transparency and
safekeeping in accounts owned by the FoF.

Learning Objective: Demonstrate knowledge of the process of investing in funds

of hedge funds.

MAIN POINT: FoFs invest in a diverse portfolio of funds to target an investment style and
level of risk. Investors can select from FoFs that seek to provide an alternative to stock and
bond returns that will contribute risk reduction through diversification. Other FoFs target
high return and are less concerned with risk. Still other hedge funds narrowly target returns
to a specific geographical region, asset, or other specialization.

It is possible for some large investors to make direct investments in several separate hedge
funds. These investors avoid the second layer of fees. This portfolio of hedge funds still
calculates incentive fees based on individual fund returns, not the net return. FoFs may have
a cost advantage over a portfolio of hedge fund returns. The additional fees paid to an FoF
manager may be less than the cost of hiring a staff to research and monitor hedge fund
investments. In addition, FoFs may have access to funds that are closed to new investment.

382
© 2020 Wiley
 FUNDS OF HEDGE FUNDS

FoFs may have the ability to increase their investment in a fund that is otherwise closed to
new or additional investment.

Hedge fund indices generally show higher returns than averages of hedge fund returns.
Indices are subject to several biases. Hedge funds that experience losses may not report
performance in the months before they close. New hedge funds will back-fill performance
for months before they began reporting. Such selective reporting includes positive returns
and omits losses.

Because FoFs report actual performance, their returns reflect losses that precede a fund
closing. The FoF cannot back-fill performance data before investment in a new successful
fund. For this reason, FoF performance is less subject to common biases present in index
returns.

Types of Funds of Funds

HFR separates FoFs into five groups:

1. Composite index includes funds that invest in macro, equity, event-driven, and
relative value strategies. This index is similar to an index of all hedge funds, such as
the HFRI Fund Weighted Composite Index, an average of single hedge funds.
2. Conservative index includes FoFs invested in equity market-neutral, relative value,
and event-driven strategies. The underlying funds tend to pursue low-volatility
strategies.
3. Diversified index is similar to the composite index.
4. Market-defensive index focuses on strategies not correlated to stock and bond
returns, and avoids event-driven and relative value strategies.
5. Strategic index focuses on strategies expected to produce higher returns, including
directional strategies, such as equity hedge or emerging markets funds.

Funds of Funds as Venture Capitalists

FoFs are often created by people who are good at raising money and not experienced at
managing the funds. Individual hedge funds are often started by people who are good at
managing money but not necessarily good at marketing the fund. The existing FoF is in a
good position to provide the seed capital needed by new hedge fund operators. The hedge
fund manager benefits because the manager can focus on returns in a new hedge fund. The
FoF that funds a young hedge fund will get favorable terms—perhaps ownership of a
portion of the management company or the FoF may get lower fees or guaranteed access to
the fund even if it otherwise closes to new investment.

Learning Objective: Demonstrate knowledge of building a portfolio of single

hedge funds.

MAIN POINT: The process of building a portfolio begins with a bird’s-eye view of
scanning and filtering from a large universe of hedge fund candidates. As the focus narrows,
managers spend more time analyzing finer details, and ultimately build a portfolio to match
expected return and risk they want to target.

Selecting Hedge Funds for a Portfolio

The process of narrowing the range of choices is similar for an FoF or an institution seeking
to create a portfolio. First, consider only funds for which performance data can be obtained
and that are not closed to new investment. Most hedge funds provide monthly and historical
performance data to one or more organizations such as HFR, Barclays, Momingstar, Credit

383
© 2020 Wiley
HEDGE FUNDS

Suisse, or Hennessee. The first cut reduces the 8,000-plus universe down to some 4,000
possible funds.

Next, review average returns and volatilities of return. Reduce the number of possible
investments by filtering out the ones with lower returns and/or higher volatilities. This
selection process lowers the number of candidate funds down to between 500 and 1,000.
More funds left at this point makes the next step more expensive.

During the next step, conduct a due diligence review. This analysis will eliminate all but
about 100 to 200 candidate funds. The FoF manager will continue to update due diligence
files for the funds not previously eliminated.

Finally, choose a portfolio of 10 to 50 funds to include in the portfolio. A variety of factors

will determine whether a fund is included: capacity of the hedge fund to accept a desirable
amount from the FoF, how the performance of a hedge fund lines up with the performance
of other funds, and whether the investment by the FoF would constitute a high percentage of
that hedge fund’s capital.

Learning Objective: Demonstrate knowledge of multialternatives and other

hedge fund liquid alternatives.

MAIN POINT: Multialtematives are hedge funds that pursue several investment strategies
and can provide some of the diversification provided by FoFs. Liquid alternatives are
registered investment products that provide some of the investment characteristics of hedge
funds and FoFs.

A multistrategy fund is an alternative to an FoF. The hedge fund runs several investment
strategies. This may be a large hedge fund where there isn’t sufficient capacity to commit all
of the capital to fewer strategies, or the fund manager may want to diversify its performance
to make it more appealing to potential investors.

A multistrategy fund has a couple of advantages over an FoF. First, the hedge fund charges
only one layer of fees, eliminating the FoF fees (1/10). The multistrategy fund charges an
incentive fee on the net return of the hedge fund, so if some strategies are profitable and
others are losses, the incentive fee will match the net return. In addition, a multistrategy
fund can easily increase or decrease its commitment to a strategy without limitations from
lockup provisions. Finally, a direct investment in a multistrategy fund offers more
transparency to the investor than an FoF would.

There are some disadvantages of multistrategy funds. An FoF manager has much greater
freedom to pick individual managers for a strategy. It seems unlikely that the multi strategy
fund that is excellent at convertible bond arbitrage is also the best at implementing a macro
strategy. Second, although a multistrategy fund can diversify across investment strategies, it
does nothing to hedge operational risk.

Liquid Alternatives
Liquid alternatives follow investment strategies similar to hedge fund strategies but are
structured more like mutual funds. They are U.S.-regulated securities that are not exempt
from the Investment Company Act of 1940. They offer significant transparency, low fees,
typically no incentive fees, the liquidity of exchange trading, and low minimum investment
requirements. Borrowings are limited to 33% of fund assets.

384
© 2020 Wiley
 FUNDS OF HEDGE FUNDS

Similar structures in Europe are Undertakings for Collective Investment in Transferable

Securities (UCITS). These funds do not permit real estate, private equity, or commodities.
These regulated funds significantly limit leverage and concentration (no more than 20% in
one name). No more than 10% of the fund can be illiquid.

Regulations discourage use of some hedge fund strategies:

• Macro strategies typically rely on futures and forwards that are very liquid. Macro
strategies are common in liquid alternatives.
• Managed futures strategies are also commonly offered as liquid alternatives.
• Event-driven strategies should be possible to implement within liquid alternative
structures but are not common so far.
• Distressed strategies are hampered by the liquidity rules since these securities are
generally illiquid.
• Private equity investments are not commonly included in liquid alternatives because
they are illiquid and likely cannot be resold quickly.
• Relative value strategies such as convertible arb and fixed income can be found in
liquid alternatives. Regulations don’t permit typical leverage, but these highly
leveraged strategies are combined with other unleveraged strategies.
• Long/short equity strategies are commonly found in liquid alternatives.
• Equity market-neutral strategies are commonly employed in liquid alternatives.

Liquid alternatives frequently adopt multialtemative strategies. The funds comply with
restrictions on liquidity, leverage, and other rules in aggregate even though positions within
a strategy would not be permitted.

Since liquid alternatives are fairly new products, data on performance relies on recent data.
One study compared liquid alternatives to exempt hedge funds run by the same manager.
The liquid alternatives had lower risk and lower return net of fees. Another study limited to
equity long/short strategies found that returns on liquid alternatives matched the returns of
long/short equity hedge funds.

Learning Objective: Demonstrate knowledge of observations regarding

historical performance of funds of hedge funds.1*

MAIN POINT: Funds of hedge funds provide lower return than direct hedge fund investing
and are less risky.

Types of FoFs
HFR provides four sectors of FoF performance plus a composite. The Statistical Summary
of Returns table reproduces the data provided by CAIA. Those sectors are:

1. Market defensive: This category seeks to produce returns that are not correlated with
stock or bond returns and also have limited downside risk. This group of FoFs
avoids event-driven and relative value strategies and emphasizes investments in
macro, systematic diversified, and short-selling funds. This group nevertheless
produced the highest return of the HFR strategies and was about as risky as FoFs
generally. It is, in addition, the only FoF strategy that is not negatively skewed and
does not suffer from fat tails caused by outsized losses.
2. Conservative: This category includes funds with lower standard deviations and
primarily equity market-neutral, relative value, and event-driven strategies. Returns

385
© 2020 Wiley
HEDGE FUNDS

and risk are both relatively low, although outcomes are significantly negatively
skewed and subject to fat tails.
3. Strategic: This group focuses primarily on return, not risk or diversification, and
includes directional strategies such as equity hedge and emerging markets funds.
This group’s deemphasis on risk shows up in the risk number for the group, which is
the highest of all the FoF strategies and higher than hedge funds generally. Returns
are modest, with fat, mostly symmetric tails.
4. Diversified: This broad category includes macro, equity, event-driven, and relative
value strategies and matches most closely the HFR composite of all single-strategy
hedge funds, with modest risk and moderately low returns. The returns are skewed
left and subject to fat tails, making outlier losses somewhat more likely than would
be expected from the level of standard deviation.

Statistical Summary of Returns (January 2000-December 2018)

HFRI Fund of Funds Indexes

Market
Index (Jan. 2000-Dec. 2018) Defensive Conservative Strategic Diversified Composite
Annualized Arithmetic Mean 4.2% 3.0% 3.2% 3.2% 3.2%
Annualized Standard Deviation 4.9% 3.6% 6.8% 4.8% 4.9%
Annualized Semistandard 2.8% 3.6% 5.4% 4.0% 4.1%
Deviation
Skewness 0.22 -2.24 -0.63 -1.00 -1.04
Kurtosis 0.30 10.17 3.06 4.09 3.94
Sharpe Ratio 0.34 0.13 0.09 0.13 0.14
Sortino Ratio 4.12 0.13 0.12 0.16 0.16
Annualized Geometric Mean 4.10% 2.96% 2.95% 3.07% 3.11%
Annualized Standard Deviation 4.9% 5.8% 8.5% 6.5% 6.6%
Maximum 4.9% 2.4% 8.7% 5.4% 5.2%
Minimum -3.2% -5.9% -7.7% -6.5% -6.5%
Autocorrelation 0.6% 45.2% 24.5% 30.4% 30.5%
Max Drawdown -10.9% -20.4% -26.8% -21.8% -22.2%
*Adjusted for autocorrelation.
Source: CAIA Level I, 4th ed., 2020. Exhibit 19.5. Copyright © 2009, 2012, 2015 by The CA1A Association.

386
© 2020 Wiley
Pr iv a t e Eq u it y
 P r iv a t e E q u it y A sset s

LEARNING OBJECTIVES
This lesson introduces basic information about venture capital investing and leveraged
buyouts and serves as an introduction to several, more specialized topics.

LESSON MAP
• Demonstrate knowledge of the terms and background of private equity.
• Demonstrate knowledge of pre-IPO private equity investing.
• Demonstrate knowledge of venture capital.
• Demonstrate knowledge of venture capital as a compound option.
• Demonstrate knowledge of growth equity.
• Demonstrate knowledge of buyouts and leveraged buyouts.
• Demonstrate knowledge of buyouts of private companies.
• Demonstrate knowledge of leveraged buyouts (LBOs).
• Demonstrate knowledge of merchant banking.
• Demonstrate knowledge of the dynamics of private equity opportunities.

KEY CONCEPTS
Venture capital investing offers the prospect of high returns but high risks to some investors.
Leveraged buyouts offer somewhat lower returns and lower risks.

Learning Objective: Demonstrate knowledge of the terms and background of

private equity.

PRIVATE EQUITY TERMS AND BACKGROUND

MAIN POINT: This lesson focuses on private equity assets, especially venture capital,
growth equity, and buyouts.

Private Equity Securities

Private equity first existed when the first business was created. Usually private equity refers
to third-party investors making long-term investments in someone else’s business. The
payoffs resemble out-of-the-money calls. The investments include venture capital (funding
new companies), growth equity (revitalizing existing companies), and buyouts (usually
established and mature companies). The category includes mezzanine debt and distressed
debt that are legally classified as debt but carry equity risk and produce equity-like returns.

Introduction to Mezzanine Debt

Mezzanine debt is junior to all other debt and is ahead of equity in the capital structure. It
often includes an equity kicker, such as warrants or other equity payouts. It is, therefore, a
hybrid security.

Introduction to Distressed Debt

Distressed debt is either in or near default. The security is distressed in price because the
assets are not likely to cover repayment of the debt. The name carries a legal connotation as
well because a reorganization is likely where the debt holders become the owners.
Bankruptcy is used to eliminate more junior owners, including equity, to improve the
financial position of the company and the position of the distressed investor.

© 2020 Wiley
PRIVATE EQUITY

Hedge funds invest in distressed debt with a short to medium horizon. They are likely to sell
when legal proceedings streamline the capital structure. Private equity funds are long-term
investors and may seek to take control of the equity.

Introduction to Leveraged Loans

Leveraged loans are more senior than mezzanine debt. The loans may have been created
after a bankruptcy event or are created to finance a restructuring. The name refers to
leverage found on the borrowers’ balance sheets. Investors do not use borrowing to leverage
their investments.

Learning Objective: Demonstrate knowledge of pre-IPO private equity

investing.

THREE FORMS OF PRE-IPO PRIVATE EQUITY INVESTING

MAIN POINT: Venture capital, growth equity, and buyout investors often seek an initial
public offering (IPO) as an exit strategy.

Venture Capital to IPO

Venture capital technically includes new business self-financed by the owners. CAIA
focuses on institutional investments in startups. These new companies lack the track record
required by traditional public market equity investors and lenders.

These investments are small ($5 million invested in a company worth $10-100 million) and
risky at least in part because the new company may be producing little or no revenue.
Because of the risk, the investors seek to make 10 to 20 times their investment.

Growth Equity to IPO

A growth equity investment is equity infusion into a company with an established business
plan and existing revenues. The company may not be cash flow positive and cannot
generate the cash needed to accommodate growth. Investors face less risk and seek to make
less than 10 times their investment.

Buyout to IPO
The private equity investor buys a controlling interest in a mature company. Plans generally
involve streamlining and cost cutting with the intent to exit via an IPO.

Contrasting VC, Growth Equity, and Buyouts

Venture Capital Growth Equity Buyouts

Asset size $10 million+ $100 million+ $100 million+
Annual revenue $0-10 million $25 million+ $25 million+
Control by investor Team approach No control change Buyer in control
Use of capital Establish product Revenue expansion Earnings growth
Time horizon 5-10 years 3-7 years 3-5 years
Potential upside 5-20 fold 3-8 fold 2-5 fold
Target IRR 30%-60% 25%^t0% 20%-50%
Investment risk Very high Moderately high Moderate

© 2020 Wiley
 PRIVATE EQUITY ASSETS

Learning Objective: Demonstrate knowledge of venture capital.

VENTURE CAPITAL
MAIN POINT: Venture capital funds entrepreneurs. They are active investors. They can get
involved at different stages of the new company’s life. Frequently, the VC investor will be
involved in important hiring decisions, suggest professional business partners (accountants,
legal, etc.), and may have a seat on the board of directors.

Target companies generally have negative cash flow. The cash burn rate is the size of the
cash shortfall, including the funds needed for capital investment. The size of a company’s
liquid assets divided by the bum rate predicts when an additional round of financing will be
necessary.

Risks are high and expected returns are set to compensate. Generally, banks are unwilling to
provide financing because the companies don’t have fixed assets to secure traditional
financing.

Securities and Goals Used in Venture Capital

VC investors may hold private equity, preferred stock, or an equity-linked fixed income
security. These investments are generally fairly small but include a commitment to fund
later stages. Straight debt is not commonly used. Time horizon mns 5-10 years, during
which time the investors are often actively involved. The goal is a public offering, sale, or
leveraged recapitalization.

Companies are hard to value and may be concentrated in risky tech strategies. Many or most
of their investments will not succeed but they hope to earn high returns on a few
investments. There may be several rounds of funding called A, B, or C or, or clinical trials,
phases I, II, or III.

The most common security is a convertible preferred stock but other securities might be
convertible notes or debentures. The investors may also get warrants to buy additional
shares. The preferred stock has higher priority than common stock and the conversion
option provides upside. Note or bond investments may trigger conversion on a particular
event, such as an IPO, merger or, other sale.

The Option-Like Payout of Venture Capital

The payout of a VC investment resembles a call: an upfront payment with limited downside
and upside participation. Even more than with calls, the VC investment has a high
probability of loss, often total loss. A 20-bagger is an investment that returns 20 times the
original investment.

History of Venture Capital

The prudent man or prudent person rule demands that investment managers treat
investments for their clients as if they were executing for their own self-interest. This rule
prevents institutional VC investments because of their illiquidity and risks. The rule has
been reinterpreted to apply to the total portfolio, some of which could possibly be illiquid
and risky. The standard is to be applied ex ante, rather than after the results are in. This
allows pension plans to invest in the sector.

© 2020 Wiley 2
PRIVATE EQUITY

Angel and Other Very Early Stages of Venture Capital

Angel investments often come from friends and family (F&F) and possibly fools
(another F). It also includes high net worth individuals. Investments are frequently
structured as private placements but may be informally recorded on shared notes.

During the angel stage, the company develops a business plan and a prototype product.
The alpha stage tests the product or service in laboratory conditions.

The amount of angel funding is typically $50,000 to $500,000, based in part on the limits
of the F&F investors.

The second round of financing is called seed capital, which might include institutional
money and ranges from $1 to $5 million. The business plan is complete but the product is
untested. Some management will be in place and the company should have completed a
market analysis. This capital permits the company to complete product development and test
marketing of prototypes. In beta testing, free samples are sent to potential customers.

Due diligence focuses on management, an independent market analysis including

competitors, estimates for later rounds of financing, and prediction of a time line.

First Stage, Start-Up, and Early Stage Venture Capital

During the first stage, also called the start-up or early stage, the company test markets a
revised prototype at the anticipated price. Although some revenue is produced, at this stage,
the company probably needs another $2 million. The company will be creating full scale
manufacturing. The management team will be complete. Business and marketing plans will
have been revised. The company will seek to penetrate an existing market or create a new
market with the goal of producing a breaking-even level of sales.

Second and Later Stages of Venture Capital

The second stage or late stage begins when the company has produced a profit or is close
to breakeven. Later stages might be a third stage or formative stage. These stages are
sometimes put in the equity growth stage rather than as a VC stage.

The working capital is tight and the company is probably not cash flow positive. The
company may be slow in collecting receivables but is producing profits. For these reasons,
the company will seek one or two more rounds of funding.

The last stage before IPO or other sale is called mezzanine venture capital or pre-IPO
financing. This hybrid security is debt with equity-like features. It is used to fund growth,
offset negative cashflows, or buy out some equity investors.

The J-Curve for Private Equity Projects

During early stages, little or no revenue offsets development costs. As this reverses, the net
resembles a J or J-curve (previously discussed). In practice, these accounting “expenditures”
could be seen as “investments”—but only if the company succeeds, which is hard to predict.

The figure represents typical interim IRRs that account for frontloaded expenses and
backloaded revenues.

392
© 2020 Wiley
 PRIVATE EQUITY ASSETS

J-Curve of Interim IRRs

Source: CAIA Level I, 4th ed., 2020. Exhibit 8.2. Copyright © 2009, 2012, 2015 by The CAIA Association.

The Valuation of a VC Company Based on Operating Income

Enterprise value equals the value of the assets, ignoring cash (and ignoring debt). Making
a valuation based on future cashflows is unrealistic for most VC assets because they are
hard to predict. Valuations may be based on a multiple of EBITDA, the pre-tax cashflow:

EBITDA x Multiple
Enterprise Value = ------------------ ~-----
(1 + IRR)r

T is the anticipated number of years required to hold the investment and the IRR is high,
reflecting both the portfolio required return plus the low probability of success.

Venture Capital Business Plans

The business plan is the most important document reviewed by the VC investor. It should
include the company strategy, its niche, and resources required (assets, expenses,
personnel). It should be complete, thorough, and internally consistent. The plan serves both
as a tool to attract investment and as a guiding document for the company.

The plan usually includes an executive summary, plans for the market, plans for the
product/service, discussion of intellectual property rights, the management team, description
of operations (including prior operating history), and projections of financial results and
financing requirements.

The business plan should also include an exit plan: how the investors plan to cash out of
this investment.

393
© 2020 Wiley
PRIVATE EQUITY

Learning Objective: Demonstrate knowledge of venture capital as a compound

option.

VENTURE CAPITAL AS A COMPOUND OPTION

MAIN POINT: VC investors are frequently required to participate in later stage funding
rounds or lose their investment. The investor can, alternatively, abandon that investment to
avoid making additional investments in a project that no longer seems viable. Each round of
financing is a kind of option on an option or compound option. A milestone refers to the
things that must be accomplished before preceeding to the next funding stage. This includes
revenue targets, patents, EBITDA goals. The purpose of milestones is to reduce risk to the
next round of investors.

In option lingo, the time to the next milestone is an expiration of part of the compound
option; funding or abandoning corresponds to the decision to exercise; the investment is the
option premium. Each milestone represents an out-of-the-money strike. The VC investor
seeks underpriced options (investments that are likely to produce profits).

Learning Objective: Demonstrate knowledge of growth equity.

GROWTH EQUITY
MAIN POINT: The last round of financing before IPO can alternatively be called second
and third stage, borrowing stage, late stage, or mezzanine stage: in this case, the equity
growth stage, growth capital, or expansion capital. If the VC investor still has some control,
it is viewed as a VC stage. If management has taken over all aspects of running the
company, it would be deemed to be in the growth equity stage.

Describing Growth Equity Investments

The securities used to raise growth equity have a fairly high priority in the capital structure
but nevertheless do not offer the investor a control position. The new cash is used to
increase revenues and improve profitability, and thereby increase the likelihood of success.
Like a VC company, a company in the growth equity stage still has no interest expense but
has little free cashflow.

Protective Provisions as a Key Deal Characteristic

During this stage, the company creates protective provisions requiring investor consent to
complete key transactions, make changes to the capital structure, accounting and tax
changes, key employees, and operating activities. Investors should get notice and provide
consent to changes in budgets and the business plan.

Redemption Rights as a Key Deal Characteristic

Redemptive rights allow investors to redeem their investments if certain events or triggers
occur. Three common triggers are time (60-66 months), performance (generally revenues or
profitability), and violation of covenants.

The redemption value will be spelled out and might be the original investment plus a
specified return, or some multiple of the original investment, or fair value.

The provisions also specify whether the company can fund triggered redemptions by issuing
a note, whether they are required to apply all available cash, or whether they are required to
sell off assets to fund the redemption.

394
© 2020 Wiley
 PRIVATE EQUITY ASSETS

Growth equity securities may include default remedies such as a springing board remedy
by which the investors can name a majority of directors to the board. Another possibility is
a forced sale remedy, in which investors can compel the owners to make sales to generate
cash to make triggered redemptions.

The Valuation of Growth Equity Based on Revenue

Like VC companies, traditional discounted cashflows are not helpful in valuing growth
equity companies. One alternative is to apply a multiple to revenues, called the times
revenue method.

Annual Revenues * EV/R

Enterprise Value = ---------------------- ~----------
(1 + IRR)r

The revenue multiple appears as EV/R in the equation.

Learning Objective: Demonstrate knowledge of buyouts and leveraged buyouts.

BUYOUTS AND LEVERAGED BUYOUTS

MAIN POINT: An acquisition occurs when a company buys another and merges their
operations. A buyout occurs when investors use debt and equity to buy a company but run it
as a separate enterprise.

Overview of Buyout Types

Buyouts are a type of private equity. Investors look for companies where profitability can be
improved with IPO as a typical exit strategy.

Overview of Leveraged Buyouts

A leveraged buyout (LBO) differs from a traditional investment because:

• The investor gains control.

• The company becomes private. P2P means public to private.
• The investor uses significant debt to acquire the company.

Unlike a merger or acquisition, the target company is not combined with the operations of
the buyer. The object might be to monetize hidden value, take advantage of unused
borrowing power, use more tax-favored debt, or to fund corporate opportunities.

Types of Private Equity Buyouts and Resulting Management

A management buy in (MB I) involves an outside manager buying the company and
replacing the existing team. A management buyout (MBO) involves the existing
management team taking a company private. A buy-in management buyout retains some
existing managers and introduces some new members to the team. A secondary buyout
involves a sale of a private company to a buyout first (usually sold by another buyout team).

Private Equity Strategies Based on Their Purpose

Other transactions don’t match the preceding rationale. Rescue capital or turnaround capital
is a cash infusion after the company has experienced some kind of difficulty with the intent
to return to profitability. With replacement capital or secondary purchase capital, a private
equity investor buys private shares from another private equity investor.

395
© 2020 Wiley
PRIVATE EQUITY

Learning Objective: Demonstrate knowledge of buyouts of private companies.

BUYOUTS OF PRIVATE COMPANIES

MAIN POINT: These private to private transactions usually involve all of the equity and
control of the target company.

Buyout Objectives
The return objective of buyout investors is high but lower than VC investors because the
risk is significantly lower. The transaction could be an alternative to an IPO. The new buyer
focuses on improving the profitability of the company. New capital goes primarily toward
strategies to improve company efficiency.

Buyouts and Capital Structure Optimization

LBO investors make fewer, larger investments than VC investors. They invest equity but
also increase debt, secured by company assets. Company cashflow is used to pay down
debt. The new owners seek a more optimal capital structure.

The capital structure after acquisition may include several layers of debt (generally secured
bank debt), mezzanine financing (subordinated with conversion rights or warrants), and
equity.

Buyouts and Operational Efficiency Optimization

Buyout firms divest operations or increase vertical integration through acquisition.
Successful buyouts occur when the team can also improve operating efficiency.

Learning Objective: Demonstrate knowledge of leveraged buyouts (LBOs).

LEVERAGED BUYOUTS
MAIN POINT: A buyout becomes a leveraged buyout when the debt to equity ratio goes up
significantly after the transaction. Typically debt to equity ratios end up around 9:1 or 90%
debt and 10% equity.

History of Leveraged Buyouts

Leveraged buyouts occurred as early as the 1940s but the industry started to grow with the
development of the high yield or junk bond market. The activity peaked around 1989 then
subsided because of the recession in 1990-1991 and the Russian bond default. Lenders that
would permit capital structures up to 95% debt began capping the debt load at 75%.
Activity rose eventually through 2007. The subsequent credit crunch all but shut down the
market for low-grade debt. Activity has not yet recovered to peak (2007) levels.

Three Key Economic and Agency Issues of Buyouts

The buyout market raises several interesting questions. First, are the markets where buyouts
occur segmented and are they informationally inefficient? Segmentation refers to a market
where separate groups of investors buy different, non-overlapping assets and may not be
fairly priced relative to each other. If markets are informationally inefficient, trading occurs
at prices that differ from fair value (probably caused by segmentation). As buyout activity
has increased, markets are less segmented and are more informationally efficient.

The second question is whether managers are violating their fiduciary duties to the pre-
buyout shareholders. Day-to-day management of the company introduces some conflicts of
interest. Those conflicts increase in a buyout. On the one hand, managers have an
informational advantage over investors and it seems unfair to identify hidden values and

396
© 2020 Wiley
 PRIVATE EQUITY ASSETS

buy shares from investors to reap the narrow rewards. On the other hand, if management
pays a premium to shareholders, they benefit—compared to having no buyout at all.

Third, do management buyouts create perverse incentives? Management is biased to resist

outside offers that would cause them to lose their jobs. However, if the buyer negotiates
generous severance for the managers, they might be incented to favor a deal that is not in
the best interest of shareholders.

Five General Categories of LBOs That Can Create Value

The strategies include:

1. Efficiency buyout—Management may not own enough of the company to care

about maximizing shareholder value. Sometimes, incentive plans cause the
management to maximize other metrics such as revenue. A buyout concentrates
ownership and motivates the new owners to pare down assets and optimize sales.
High leverage makes it hard to pursue suboptimal capital investments.
2. Entrepreneurship stimulation—A new structure can accomplish many different
things. For example, pulling out a subsidiary in a conglomerate may both permit and
motivate managers to make changes to improve those operations.
3. Overstuffed corporation—Many buyouts involve conglomerates that perform better
when separated.
4. Buy and build—This strategy, also called a rollup or buildup, assembles companies
or divisions of separate operations to gain efficiencies through integration or other
synergies.
5. Turnaround—This strategy dates back only to 2007 and involves taking over
troubled public or private companies (which might be owned by other private equity
investors). The companies may already have too much leverage. The buyer infuses
capital, culls unprofitable lines, and optimizes workforce utilization.

The Appeal and Four Benefits of a Leveraged Buyout to Targets

Shareholders like leveraged buyouts because they sell shares at a premium to the otherwise
prevailing price. Managers that are retained see benefits as well:

1. Tax deduction of interest in a more debt-heavy capital structure.

2. Less pressure from public shareholders and regulators.
3. Freedom from corporate parent.
4. Can own a significant stake in the company and benefit by good performance.

The acquiring company also benefits. If the investment goes well, the new investors should
earn an attractive return.

Valuation of an LBO
The payoff on an LBO investment resembles a call option in that it has limited downside
and outsized upside potential.

Five LBO Exit Strategies

Getting out is important because that is the return of capital. Typically, LBO investors
look to:1

1. Sale to strategic buyer. The most common way for private equity investors to exit an
LBO is to sell to a competitor or other interested buyer.
2. IPO. If the company has been streamlined and revitalized, the public market is a
viable exit strategy.

© 2020 Wiley
PRIVATE EQUITY

3. Another LBO. After using generous cashflow to pay down debt, the LBO investor
could take out substantial money by leveraging the company again.
4. Straight refinancing. This is similar to creating another LBO but relies on a more
traditional capital structure to free up equity cash.
5. Buyout to buyout. About a third of LB Os are buyout-to-buyout deals or secondary
buyouts where one private equity investor sells to another.

Four Spillovers of Corporate Governance to the Public M arket

The benefits include:

1. The good governance created by the LBO investor will probably remain in place
post-IPO.
2. The threat of an LBO may cause managers of other public companies to make
needed changes.
3. Public companies can imitate the incentive and monitoring systems used by LBO
investors.
4. Breaking up inefficient conglomerates should make those businesses run better and
discourage other unwise consolidation.

Learning Objective: Demonstrate knowledge of merchant banking.

MERCHANT BANKING
MAIN POINT: M erchant banking involves financial institutions buying operating
companies. The practice is very similar to LBP investing by private equity funds. The intent
of merchant banking within investment banks and money center banks is primarily profits
but they can also cross sell services to their portfolio companies.

Learning Objective: Demonstrate knowledge of the dynamics of private equity

opportunities.

THE DYNAMICS OF PRIVATE EQUITY OPPORTUNITIES

MAIN POINT: Several consequences have followed the development of VC and LBO
investing. First, fairly many companies have quickly become dominant in their industries.
This has implications for risk, diversification, and antitrust. LBO investing has
demonstrated the advantages of sound corporate governance and should have implications
for public companies as well. While there are advantages to being public and other
advantages of being private, there are fewer public companies than in the past, with wide
ranging implications.

Implications of Winner-Take-All M arkets

A winner-take-all m arket is a line of business where one company comes to dominate the
segment. Many young companies are dominant in their field, leading to antitrust questions.
This has created a new environment where some of the largest companies in the world are
controlled by youthful entrepreneurs.

A unicorn is a VC startup that becomes worth more than $1 billion in a short period of
time.

With fewer big winners come more losers. We might see investors making lots of smaller
VC investments to diversify risk. They may channel their investments to the most successful
private equity managers.

398
© 2020 Wiley
 PRIVATE EQUITY ASSETS

Implications of Longer Time Horizons to Exits

The average time to exit has risen from 4.7 years pre-2007 to 5.8 years now. The longer
time frame affects yearly returns and means the sector is now less liquid than before.
Companies are more likely to rely on growth equity to get to the point of exit.

Three Potential Reasons for the Declining Number of Public Firms in the United States
The number of listed (public) companies has declined from 7,000 in the mid-1990s to 4,000
in 2018. This trend may follow from increased pressure from regulators (to the extent that
private companies face less regulation). Second, private companies avoid the pressure at
public companies for short-term results. Finally, the number of IPOs per year has declined
from 300 per year around the year 2000 to only 100 recently.

Public companies also disappear through merger and bankruptcies. For the reasons given
earlier, public companies are also choosing to go private to avoid fees, disclosure
requirements, and shareholder litigation spurred by share price movements.

Competition between Private and Public Ownership Structures

Start-up companies have no choice but to be private. Larger, well-established companies
need to look at the advantages of private and public registration. The advantages of each are
explored in the next topic.

© 2020 Wiley
 P r iv a t e E q u it y F u n d s : VC F u n d s , R e l a t io n s h ip s , a nd L if e C y c l es

LESSON MAP
• Demonstrate knowledge of private equity (PE) funds.
• Demonstrate knowledge of PE funds as intermediaries.
• Demonstrate knowledge of the limited partner (LP) and general partner (GP)
relationship life cycle in private equity.
• Demonstrate knowledge of PE fund fees and terms.
• Demonstrate knowledge of key determinants of VC fund risks and returns.

KEY CONCEPTS
This lesson covers private equity from a fund perspective, with a focus on venture capital.

Learning Objective: Demonstrate knowledge of private equity (PE) funds.

OVERVIEW OF PE FUNDS
MAIN POINT: Private equity funds are organized as limited partnerships where the fund
manager is the general partner who invests in portfolio companies and the limited partners
are investors with limited liability.

PE funds are investment pools that provide private equity exposure for investors.

The Organizational Structure of PE Funds

There are three layers of investment in private equity: (1) PE firms and investors, (2) PE
funds, and (3) underlying enterprises. Firms, funds, and the underlying enterprises are often
referred to as “private equity,” but the structure and distinction between each should be clear
to CAIA candidates.

PE funds which have a life of about 7 to 10 years, invest in claims on the equity of the
underlying business enterprises. Private equity funds are investment pools created to hold
portfolios of private equity securities.

PE Firms
Private equity firms invest in private equity and serve as managers to private equity funds.
Private equity firms, as the general managers of PE funds, usually invest their own money
along with institutional investors into PE funds. Institutional investors are usually limited
partners with limited liability. That is, their liability is limited to invested capital. PE firms
serve dual roles: (1) as a general partner in the limited partnership that receives an incentive
fee, and (2) as an investment adviser that receives a management fee. These roles may be
performed by different or the same personnel.

PE Portfolio Companies
Underlying business enterprises in VC private equity are the unlisted, typically small
businesses seeking to grow through investment from private equity funds or private equity
firms. PE limited partnerships usually invest in 10 to 30 portfolio companies over the first
three to five years of the fund’s life.

PE Investment by Institutional Investors

Institutional investors may choose to diversify their investments in private equity funds
across time, or to concentrate on funds formed during business conditions perceived to be
favorable to underlying business enterprises. They commit to investments in the fund that
are drawn as needed. The amount of commitments that are not yet drawn is known as dry
powder or undrawn commitment.

«
© 2020 Wiley
PRIVATE EQUITY

Private equity funds of funds manage primary investments in newly formed limited
partnerships, manage co-investments alongside primary investments, and manage
secondaries. Co-investments are discussed in the CAIA Level II program.

Oftentimes an institutional PE fund investment program buys units of a PE fund o f funds,

which in turn buys units of PE funds, which make investments in portfolio companies. This
involves a second layer of fees but is often worthwhile, particularly for institutions just
beginning a PE investment program. The cost of private equity funds of funds is the double
layer of management fees and the carried interest that could be avoided if an in-house PE
program were used. As the institution becomes more knowledgeable about PE investing,
they may invest in single funds, make co-investments, and eventually they may make direct
investments.

Blind pool is the nature of LP investments, in which investors don’t know the underlying
portfolio companies before committing capital.

Because of the blind-pool nature of PE investing, the evaluation of manager skills is

particularly important for primary investing in newly formed LPs, and funds of funds can
provide this skill. Similarly, co-investing requires direct investment experience and skills.
Not all funds of funds are blind pools. Most are marketed as either partially blind pools (that
identify some of the intended partnerships) or fully informed pools (that identify all intended
partnership groups).

PE investing requires resources and information including a network of contacts, liquidity

management skills, and access to high quality PE funds. Funds of funds provide the
selection skills, expertise, access, and resources that are not available to new, inexperienced
PE investors. Furthermore, institutional investors usually cannot adequately compensate in-
house managers to oversee a successful PE investment program. Funds of funds managers
are better incentivized and equipped to oversee PE investments.

Learning Objective: Demonstrate knowledge of PE funds as intermediaries.

PE FUNDS AS INTERMEDIARIES
MAIN POINTS: Stages of the life cycle of venture capital funds start with fundraising and
end with either an IPO or other successful exit, or a liquidation if unsuccessful. Different VC
investments correspond to different stages of development in the underlying portfolio
companies. For example, angel investors are friends and family and correspond to the very
earliest stage start-ups that cannot attract the interest of VC funds because unproven. At later
stages, VC funds will supply seed capital, first-stage or second-stage venture capital, and even
mezzanine venture capital just prior to an IPO. Importantly, earlier stages are associated with
negative returns and later stages with very high returns: This is the J-curve effect.

PE Fund Intermediation and Risk

Private equity funds typically enter the funding process when traditional lenders are not
willing to do so. The advantages of private equity investors taking on risk that traditional
lenders will not is that PE investors are able to participate in the upside.

PE Fund Intermediation and Efficient Incentives

Private equity funds benefit from inefficiencies in traditional corporate structures by more
closely aligning the interests of shareholders and managers.

PE Funds Serve the Following Five Prim ary Functions

PE funds serve five basic functions:

402
© 2020 Wiley
 PRIVATE EQUITY FUNDS: VC FUNDS, RELATIONSHIPS, AND LIFE CYCLES

1. Pooling capital to invest in private companies.

2. Selecting companies for investment (after screening and evaluating).
3. Financing (for growth and development or buyouts).
4. Controlling (coaching and monitoring) portfolio companies.
5. Exiting (sourcing exit opportunities). The PE fund manager’s goal is to successfully
exit all investments before the end of the fund’s life.

Forms of PE Funds Intermediation

There are four basic forms of private equity fund intermediation, that is, routes to PE
investing.

1. Fund of funds.
2. PE fund.
3. Co-investing. Co-investment refers to the practice of investors being invited by GPs
to make direct investments in portfolio companies.
4. Direct investment. Direct investment in private equity eschews PE funds altogether,
as the PE investment program makes investments straight into a portfolio company
(without intermediation), similar to a co-investment but without the input of a PE
fund manager.

The dominant form of PE investing is through PE funds, usually structured as a limited

partnership.

The Life Cycle of a VC Fund

There are five stages in the life cycle of venture capital funds and portfolio companies.

The five VC fund life cycle stages include:

1. Fundraising
2. Sourcing investments
3. Investment of capital
4. Operation and management of companies in the portfolio
5. Windup and liquidation

The fundraising stage typically takes from 6 to 12 months, with investors committing capital
by signing a subscription agreement but the capital is not yet collected.

The second stage is sourcing investments, the process of locating possible investments
(i.e., generating deal flow), reading business plans, preparing intense due diligence on
start-up companies, and determining the attractiveness of each start-up company.

During the third stage of investing capital, the type of financing is determined
(e.g., preferred stock or convertible debt) and IRR drops because accounting losses are
incurred due to immediate operating expenses and fees. In an economic sense, the value
of the start-up firms is increasing because valuable assets are acquired including some
that may not be recognized in an accounting sense, such as management fees. Furthermore,
during the first three to five years, some companies in the portfolio will fail. The accounting
interim IRRs (based on estimated NAVs) are plotted against time in the J-curve.

Research suggests that businesses attract funds during cyclical expansions which leads to
competition and higher prices and subsequent poor returns. Therefore, the vintage years of
private equity funds are often analyzed in comparison.

403
© 2020 Wiley
PRIVATE EQUITY

The year a particular private equity fund commences operations is known as its vintage
year.

During the fourth stage, operation and management of the portfolio companies, the fund
begins to offset initial losses as the company prepares for an IPO.

During the fifth stage three outcomes are possible: an IPO, a bankruptcy liquidation, or a
sale to a strategic buyer. The profits are distributed and incentive fees collected. Most
returns come during the second half of the fund’s lifetime, when portfolio companies are
sold and profits realized. Whereas most of the time profits are distributed as soon as is
feasible, some funds have a reinvestment provision, often subject to a reinvestment cap,
where proceeds of realizations maybe reinvested and not distributed to investors. When
distributions are made in the form of securities of the portfolio company they are called
in-kind distributions.

The Fund J-Curve

The J-curve was discussed in earlier lessons. Recall that early losses may be only in
accounting terms and that needing more funds than revenues can cover may well represent
economic growth. Note that there are different types of J-curves.

The J-curve is the classic illustration of the early losses and later likely profitability of
venture capital.

The classic PE J-curve plots IRRs over time. It illustrates low and negative IRRs in the early
stages, turning to high positive IRRs as the start-up company approaches the ultimate goal
of an IPO. The fund J-curve plots interim IRRs and follows the same shape as do the NAV
J-curve and cash flow J-curve. The NAV J-curve plots NAV versus the NPI (net paid in)
over time and the cash flow J-curve plots net accumulated cash flows from investors over
time. The J or U shape of the cash flow J-curve is due to commitments being drawn as
needed as distributions, occurring as soon as practical.

Undrawn Capital Commitments

Commitment risk refers to the possibility that an LP could become a defaulting investor
and is one of the four substantial risks of private equity.

Four Substantial Risks of PE

1. Market risk—Uncertainty regarding valuation.
2. Liquidity risk—The secondary market for PE fund shares is very small.
3. Commitment or funding risk—Commitments are contractually binding so that if an
LP can’t meet a capital call the investor stands to lose a portion or even the entire
share in the partnership.
4. Realization risk—The risk of not recovering invested capital depends on (a) the
manager’s skill in creating value, and (b) the level of equity markets when the IPO is
occurring.

Learning Objective: Demonstrate knowledge of the limited partner (LP) and

general partner (GP) relationship life cycle in private equity.

THE LP AND GP RELATIONSHIP LIFE CYCLE

MAIN POINT: There is a symbiotic relationship between LPs and GPs, offering advantages
for both. The three stages of the relationship life cycle of the GP-LP relationship are entry

404
© 2020 Wiley
 PRIVATE EQUITY FUNDS: VC FUNDS, RELATIONSHIPS, AND LIFE CYCLES

and establish, build and harvest, and thirdly, decline or exit. The GP-LP relationship
changes throughout the life cycle from “courting” to “marriage” and finally “divorce.”

The Relationship between LPs and GPs in PE

For a long-term relationship with successive follow on funds (about every three to five
years), GPs prefer experienced, knowledgeable, and financially strong LP investors who
understand benchmarks and valuations. Poorer performing funds will court less suitable
investors and eventually both will fail: There is adverse selection in the PE market.

The symbiotic, long-term relationship between LPs and GPs offers several advantages
to both:

1. Familiarity with fund managers reduces due diligence costs for LPs.
2. There is access to co-investment opportunities.
3. Fund raising costs are lower for funds with an established loyal investor base.
4. Predictable fund closings and follow-on fund intentions provide for better planning
and efficient use of money.

The Three Phases in the Relationship Between LPs and GPs

The life cycle of the GP-LP relationship focuses on the long-term pattern of GPs as they
create multiple funds through time.

The first stage of the GP-LP relationship life cycle is entry and establish.

Entry and establish is a phase in the life cycle of the GP-LP relationship involving the
initial funds.

The second stage is build and harvest.

Build and harvest, or grow and compete, is a phase in the life cycle of the GP-LP
relationship in which the funds thrive and grow.

The third stage ends the fund through a decline, exit, or spinout.

Decline is a phase in the life cycle of the GP-LP relationship when competition is lost.

Exit is a phase in the life cycle of the GP-LP relationship when they gave up, made it, or
transitioned to new managers.

Spinouts are a phase in the life cycle of the GP-LP relationship when there is a transition to
new managers.

Characteristics of these stages are given in the following figure.

405
© 2020 Wiley
PRIVATE EQUITY

GP-LP Relationship Life Cycle Model

Fund Entry and

Characteristic Establish Build aud Harvest Decline or Exit
Investment Differentiation Star brand Unexciting
strategy
Fundraising Difficult Loyal LP base LPs leave and are
fundraising replaced by other types
of investors (secondary
plays, new entrants in
market)
Performance Unknown: either Likely top Not top but consistent
top or out performer performer
Size Fund is too small Fund size is right Fund size too large/too
many funds
Economies of Fund is too small to Best alignment of Senior managers
scale get rich interests made it
Management Management team Management team Succession issues,
team forming performing spinouts
Source: CAIA Level I, 4th ed., 2020. Exhibit 7.4. Copyright © 2009, 2012, 2015 by The CA1A Association.

In the first stage (first fund) there significant barriers to entry for both GPs (fund raising and
lack of track record) and LPs (lack of experience and information). The relationship is most
stable when there are successive follow-on funds during the build and harvest stage. LPs will
forgive some mistakes and subpar performance, preferring to stay with a known manager
rather than starting a new GP-LP relationship. Eventually, the “marriage” relationship ends in
“divorce”: decline, exit, or spinout, and the end can be due to success or failure.

Learning Objective: Demonstrate knowledge of PE fund fees and terms.

PE FUND FEES AND TERMS

MAIN POINT: After investors receive profits that yield their preferred return, the manager
begins to collect carried interest and investors do not receive any profits. This is called the
“catch up zone.” After the manager collects carried interest (e.g., 20%), both the manager
and investors share profits in the proportion stipulated by the carried interest (e.g., 20%/
80%). In addition to management fees and carried interest, there are a host of other terms in
the agreement.

PE Management Fees and Carried Interest

Carried interest is the portion of profits, usually 20%, that the manager receives as an
incentive for performance. It is payable only when the internal rate of return exceeds the
preferred rate of return, also called the hurdle rate, and is usually set at 8%: below that of
small cap stocks but substantially higher than the risk-free rate.

Committed capital is the cash investment the investor promises to pay. A capital call is a
demand for investors to contribute additional capital as agreed upon. Recognize that
management fees will increase as more capital calls are made, so there is a perverse
incentive to identify a portfolio company that requires a capital call even if it is not of the
highest quality.

406
© 2020 Wiley
 PRIVATE EQUITY FUNDS: VC FUNDS, RELATIONSHIPS, AND LIFE CYCLES

Carried interest can be calculated on either a deal-by-deal basis or on the fund as a whole.
Since the Great Recession, almost all LPs are demanding the carried interest be determined
based on the fund as a whole since it more closely aligns interests.

PE and Clawback Provisions

Most PE funds have a clawback provision whereby, if at the end of the fund"s life the LPs
have not received the preferred return previously paid, incentive fees are returned. It is not
uncommon to have a clawback escrow agreement.
PE Carried Interest and Hurdle Rate
The distribution waterfall shows how proceeds from an exit are split between the LP and GP
and the timing of the split. This figure shows how all proceeds are first returned to the LP in
the hurdle zone and nothing is given to the limited partner in the catch-up zone. Once the
GP is made whole, profits are split between the GP and LP in the third zone.

Impact of Catch-Up on NAV Attributed to LPs

Source: Adapted from CAIA Level I, 4th ed., 2020. Exhibit 7.6. Copyright © 2009, 2012, 2015 by The CA1A
Association.

The table following further illustrates the split in profits. Notice the LP first received the
committed capital, then the preferred return of 8%. After that, the GP receives two million
euros to “catch up” and according to the 80/20 split in profits, finally, corresponding to the
third zone, the residual amount is split 80/20.

Example of W aterfall Using a Hurdle Rate

LPs GP Total
Original contribution -€100 million -€100 million
Sale of investment for €200 million
Return of capital €100 million €100 million
Preferred return for limited partners €8 million €8 million
Catch-up for GP €2 million €2 million
80/20 split of residual amount €72 million €18 million €90 million
Closing balance €80 million €20 million €100 million

Source: Adapted from CAIA Level I, 4th ed., 2020. Exhibit 7.7. Copyright © 2009, 2012, 2015 by The CAIA
Association.

© 2020 Wiley
PRIVATE EQUITY

The simplified waterfall distribution example ignores any clawback. Oftentimes managers
are required to put 20% to 30% of the carried interest in escrow. A clawback is triggered if
the LP hasn’t received all the committed capital plus a predetermined return. This could
happen if early investments perform better than later investments. Clawbacks can run the
other way, too, whereby the GP claws back profits from the LP if they haven’t received their
fair share of profits.

PE Perverse Incentive from Fees

In addition to the perverse incentive to invest in an inferior portfolio company to make a
capital call that will result in higher management fees, there are two perverse incentives
stemming from hurdle rates:

1. High hurdle rates that can encourage excessive risk taking.

2. Hurdle rates measured by IRRs which are not correlated with multiples over
different time periods. This can encourage GPs to realize an investment sooner than
the LP would prefer. For example, a 50% IRR over three months yields a multiple in
invested capital of 1.11, whereas a 10% IRR for three years yields a multiple of 1.33.

Additionally, the increasing use of subscription lines (lines of credit) by GPs can delay the
need for capital calls, which in turn reduces the time LPs are invested in the fund—so that
the IRR is higher than it would be otherwise, increasing incentive fees.

G P’s Contribution to Initial PE Fund Investment

Importantly, the fee structure rewards outperformance handsomely, and can encourage
excessive risk taking, but does not punish underperformance. For that reason, the GP’s
capital contributions, known as hurt money, are particularly important. Whereas a capital
commitment of 1% of total committed capital is often an acceptable amount of hurt money,
it may be too low in the case of wealthy managers. It really depends on the percent of the
manager’s personal wealth more than the percent of committed capital. The goal is to
prevent excessive risk taking.

H urt money is a capital contribution made by GPs to a PE fund, usually 1%, and should be
made in cash rather than through the waiver of fees.

Key-Person Provision
As a people business, key person provisions are important in PE limited partnership
agreements (LPAs.) LPs generally have rights to terminate a fund or adjust terms as needed
if a key manager retires, leaves, or underperforms, in the sense that he can no longer devote
the required time to the fund investment management. A key person clause allows limited
partners to suspend or divest investment or even terminate the fund if key management
persons depart.

Termination and Divorce

If a GP is terminated, whether for cause or without cause, the manager will likely have a
very hard time raising funds again since the PE community is tightly knit and reputation is
so important. LPs will try to avoid such extreme results. Nevertheless, they are often able to
exercise “leaver” clauses if necessary.

Bad-leaver clause may trigger a for-cause removal of the GP and investments to be

suspended until a new fund manager is elected or, in the extreme, the fund is liquidated.

Good-leaver clause enables investors to cease additional funding of the partnership with a
vote requiring a qualified majority, generally more than 75% of LPs.

408 © 2020 Wiley

 PRIVATE EQUITY FUNDS: VC FUNDS, RELATIONSHIPS, AND LIFE CYCLES

Other Covenants
Terms of partnership agreements for VC funds contain several other details such as the
following:

1. Size of investment in any one portfolio company is limited so that the fund remains
diversified.
2. Gearing (use of leverage) is limited.
3. Limits are placed on the various manager’s activities to keep the manager focused on
increasing the value of the funds.

Learning Objective: Demonstrate knowledge of key determinants of VC fund

risks and returns.1*

KEY DETERMINANTS OF VC FUND RISKS AND RETURNS

MAIN POINTS: The main risks of venture capital investments include business risk,
liquidity risk, and idiosyncratic risk. Return persistence is exhibited by top-tier VC firms,
so accessing those firms and obtaining vintage-year diversification are keys to successful
venture capital investment.

Access as a Key to Enhanced Returns

Unlike other more efficient asset classes, there is strong evidence of return persistence in the
VC market, which is tied to the expertise of VC firms. Institutional investors can become
more successful VC investors if they can access top tier venture capital firms.

Three Dimensions to Diversifying VC Risk

Institutional investors can be more successful VC investors if they can (1) access the top tier
venture capital firms, and (2) diversify risks.

Returns of VC firms also follow boom and bust cycles so that diversification across vintage
years is important to reduce risk.

Three dimensions to diversifying risk are (1) vintage years, (2) industry, and (3) geography.

Three Main Risks and the Required Risk Premiums for VC

Three major risks of venture investing are (1) business risk, (2) liquidity risk, and
(3) idiosyncratic risk. Accessing top tier VC firms (which exhibit return persistence) and
diversifying across vintage years are important for successful institutional investing in VC.

1. Business risk. Companies receiving VC funding have more business risk than
publicly traded companies that have been able to fully implement their business
plans.
2. Liquidity risk. The secondary market for VC investments is small and fragmented
and sales in the secondary market usually result in a large discount.
3. Idiosyncratic risk. VC investing requires specialized knowledge, yet there is a
tradeoff between specialization and diversification. A portfolio of companies that are
businesses which a VC firm can claim to be highly specialized in may result in
concentration such that idiosyncratic risks are not diversified away.

Compensation for these three risks is a premium of 400 to 800 basis points over the returns
of the public stock market, depending on the stage of financing.

409
© 2020 Wiley
 P r i v a t e E q u i t y F u n d s : L B O F u n d s a n d P r i v a t e In v e s t m e n t s
in Pu bl ic E q u it y

LESSON MAP
• Demonstrate knowledge of roles and three key distinctions of VC and buyout
managers.
• Demonstrate knowledge of leveraged buyout (LBO) funds.
• Demonstrate knowledge of liquid alternatives in the private equity sector.
• Demonstrate knowledge of funds-of-funds in the private equity sector.
• Demonstrate knowledge of private investments in public equity (PIPEs).
• Demonstrate knowledge of secondary markets and structures within the private
equity sector.

KEY CONCEPTS
This lesson covers private equity from a fund perspective, with a focus on leveraged
buyouts.

Learning Objective: Demonstrate knowledge of roles and three key distinctions

of VC and buyout managers.

ROLES AND THREE KEY DISTINCTIONS OF VC AND BUYOUT MANAGERS

PE fund managers play very different roles depending on the PE strategy goals. Distinctions
between VC funds and LBO funds are as follows:

• Venture capitalists help start-ups while buyout managers leverage established

companies’ assets.
• Venture capitalists assist entrepreneurs while buyout managers work with
experienced management teams.
• Venture capitalists are more actively involved in the portfolio companies than are
buyout managers.

Learning Objective: Demonstrate knowledge of leveraged buyout (LBO) funds.

LBO FUNDS
MAIN POINT: A leveraged buyout is the dominant form of buyout. There are categories of
LBO funds: small cap (companies they take private have less than $1 billion in sales
revenue), mid-cap and large cap (companies with more than $5 billion in revenue). This
section discusses LBO structures, their fees, and agency relationships. It also covers auction
markets and club deals. It concludes by comparing the risks of LBO funds with the risks of
VC funds.

LBO Fund Structures

LBOS are structured as limited partnerships, similar to the structure of VC funds. There may
be only a few LP investors or more than 50, but typically between 20 and 50. The life of a
buyout fund is contractually set at 10 years, typically, and there may be provisions to extend
the life for a few years. The first half of the life is spent sourcing and reviewing deals and
investing capital. Portfolio companies are taken private and distributions to investors are
made when they are when sold, taken public, or recapitalized.

Total Number, Size, and Implications of Buyout Fund Fees

Number of fees: Buyout managers earn a management fee and an incentive fee (carried
interest) like most funds structured as limited partnerships, but also additional fees:

© 2020 Wiley
PRIVATE EQUITY

• 1% of selling price to the corporation it is taking private. Sometimes the LBO firm
shares this with limited partner investors but not always.
• A divestiture fee for managing the sale of a division or corporation.

Size of fees: Management fees of 1.25% to 3% for small LBO firms—when the industry
was young—were necessary to cover operational expenses. Now, however, $10 billion
funds are common, and it is increasingly difficult to justify the size of the management fees
charged.

Implications: Since LBO managers are receiving such large management fees, they may not
have the incentive to screen companies to the extent necessary to earn incentive fees (20%
to 30%)!

Note that it is common for LBO firms to offer an 8% hurdle rate, but this is not so common
with VC firms. The most likely reason is that a hurdle rate provides an incentive for LBO
managers to take risks in order to earn the investor’s target return, but all VC investments
are risky.

Agency Relationship and Costs

When companies become very large, the potential conflicts of interest between shareholders
and the managers, as their agent, may increase because the shareholder base is so large and
diverse. When a company is taken private in an LBO transaction the interests become more
aligned. Ownership is far more concentrated among limited partners, company management,
and LBO firms. As majority equity owners, LBO firms are very active in the management
of the firm.

There are two forms of agency cost that LBOs reduce:

1. The cost of better aligning interests including monitoring costs and compensation
schemes as examples.
2. The cost that results from misaligned interests and the consequence of management
not acting in the best interest of the shareholders.

LBO Auction M arkets

In the past, private equity deals were offered by a single PE firm without competition from
other firms. Money has flowed into the LBO market, however, making it now more
competitive. For example, alternatives to the single-sourced approach to funding LBO
transactions include auction markets and club deals.

Now, when a parent company wants to sell a subsidiary in an LBO format, it will contact an
investment banker that facilitates an auction process.

An auction process involves bidding among several private equity firms, with the deal
going to the highest bidder.

LBOs, Club Deals, Benefits, and Concerns

In a club deal, two or more LBO firms work together to share costs, present a business plan,
and contribute capital to the deal.

It is debatable whether club deals create value. The impact of clubs (fewer bids could
depress prices) versus individual firms bidding on acquisition prices is uncertain, but clubs
can spread the initial costs of due diligence. In any case, the private equity market is far
more competitive than in the old days of single-sourced deals.

© 2020 Wiley
 PRIVATE EQUITY FUNDS: LBO FUNDS AND PRIVATE INVESTMENTS IN PUBLIC EQUITY

Three Factors Driving Buyout Risk Relative to VC Risks

VC funds are riskier than LB Os for three main reasons:

1. LBOs invest in established mature public companies.

2. The exit strategy if an IPO is more likely for LBOs than VC funds.
3. LBOs are more diversified than VC funds which usually specialize in a particular
industry.

Venture capitalists make several small investments, and these often fail, but the few wins
are big. Buyout firms make fewer investments, experience few failures, and look for
consistent, rather than outsized, returns.

Venture capitalists grow companies, offering expertise, and make a series of equity
investments without the use of any leverage. It is necessary to secure follow-on financing
for a successful VC exit. In contrast, buyout transactions typically use both debt (leverage)
and equity, with the assets of the target firm being used as collateral for the debt and its
cashflows to pay off the debt. Buyouts sometimes use financial engineering to optimize the
structure of the balance sheet.

The roles of the private equity manager in venture capital and buyout investments differ
because they have different objectives. The VC manager actively assists the management of
an emerging company, coaching teams from the ground up, whereas the buyout fund
manager adjusts the business model, or optimizes the balance sheet, and guides a seasoned
management team.

Learning Objective: Demonstrate knowledge of liquid alternatives in the private

equity sector.

PE LIQUID ALTERNATIVES
MAIN POINT: Business development companies (BDCs) provide liquid access to private
equity. Yet their returns are highly correlated with public equity and so are not portfolio
diversifiers. Furthermore, the closed end fund structure means that they may trade at a
premium (or discount) to the NAVs. Because of the illiquidity of the underlying
investments, NAVs may be inaccurate and therefore premiums and discounts are not good
indicators of the relative attractiveness of the BDCs.

Business Development Companies

BDCs are liquid alternatives to more direct private equity investment. As most liquid
alternatives, BDCs are publicly traded. They became popular as recently as 2012. A key
benefit is the avoidance of corporate income taxes on distributed profits (so retained
earnings, which are taxed, are generally minimal with most earnings being fully distributed),
but this requires that BDCs provide significant managerial assistance to the companies in
their pool and that at least 40% of the assets in the pool are “eligible,” as defined by the
SEC. The distributed profits are taxed only at the investor level.

Business development companies (BDCs) are publicly traded funds with underlying assets
typically consisting of equity or equity-like positions in small, private companies.

Business Development Companies as Closed-End Funds

BDCs use a closed-end structure, trading on major stock exchanges such as the NASDAQ.

© 2020 Wiley
.1!
PRIVATE EQUITY

The main problem with open-end funds (that regularly create new and redeem old shares)
when comprised of illiquid securities (e.g., private equity and real assets) concerns the
creation and redemption based on inaccurate NAV estimations.

The main problem with closed-end funds (which do not create or redeem new shares) is that
supply and demand determine share prices and these may deviate from the true NAV.

Premium (or Discount) = (Market Price/Net Asset Value) — 1

Example 1: Closed-End Fund Discounts and Premiums

Suppose fund XYZ is trading at $20 and its NAV is $22. Next period XYZ is trading at $18
and its NAV is $19.50. What is premium or discount in the first period and in the second
period? What is the return to the investor and what was the percent change in the NAV?

Solution

Initially, XYZ is trading at a premium of 10%: $22/$20 - 1 = 10%. At the end of the
period, it is trading at a discount of 7.7%: $ 18/$ 19.50 - 1 = -7.69%. The return to the
investor is -18.8% = $18/$22 - 1, and the change in the NAV is only 2.5% = $19.50/
$20 - 1.

This example illustrates that the returns to BDCs are driven by the performance of the
underlying assets (as measured by the NAV) as well as the supply and demand for the fund
shares. The share prices can deviate from the NAVs. Particularly when shares are illiquid,
for example, during a crisis—these funds may trade at a deep discount from the NAV.
Furthermore, BDCs and REITs use subjective approaches to measure the NAV rather than
market prices. Appraisals and valuation methods may be imprecise so that premiums and
discounts are less accurate indicators of the attractiveness of the fund relative to closed-end
funds of listed securities that use market prices to determine NAVs. The principal of selling
at a discount to NAV can be extended to illiquid alternatives even if they are not in a closed-
end fund structure. For example, a limited partner that must exit a private equity investment
is likely to suffer a loss, stemming from the fact that it is likely they will receive less than
the true value of their investment when leaving the fund prior to the end of the fund’s life,
that is, the illiquid investment is sold at a discount.

Extending Closed-End Fund Pricing to Illiquid Alternatives

Just as closed-end funds trade at premium or discount to their NAV, many illiquid assets
will be bought or sold at a value that differs from their true value. Most often private equity
sold in the secondary market will be sold at a discount.

Are Liquid PE Pools Diversifiers?

BDCs are not diversifiers and there is little evidence that they are return enhancers.
Specifically, they are highly correlated with listed stocks of the same capitalization range,
and the historical return is similar. Additionally, investors in BDCs face two layers of fees:
at the ETF level and from fees charges by the underlying portfolio companies. Furthermore,
the ETF level fees are much higher than those charged by passively managed ETFs such as
SPY and IWM, tracking the S&P 500 and IWM Russell 2000, respectively.

Other liquid investments in private equity include investing in private equity firms that are
listed publicly, such as Carlyle and Blackstone, but most liquid PE investments are in the
closed-end fund model.

4,4 © 2020 Wiley

 PRIVATE EQUITY FUNDS: LBO FUNDS AND PRIVATE INVESTMENTS IN PUBLIC EQUITY

Learning Objective: Demonstrate knowledge of funds-of-funds in the private

equity sector.

PE FUNDS OF FUNDS
MAIN POINT: Fund of funds can be a first step in starting an institutional PE investment
program.

PE Funds of Funds and Fees

The double layer of fees involved with a fund of funds structure is considered its main
disadvantage. However, for smaller institutions the second layer of fees is less expensive
than the cost of setting up an in-house program to select PE funds.

PE Funds of Funds and the Value of Information and Control

For an inexperienced institution that desires an allocation to PE, the first step in the learning
curve is to work with a fund of funds. During this beginning stage of learning, the investing
institution yields control and information access to the fund of funds. The fund of funds is
expected to have the necessary requirements for successful PE investing: (1) a wide network
and access to top-quality PE funds, (2) well-trained investment judgment, and (3) the ability
to assemble balanced portfolios.

PE Funds of Funds, Diversification, and Intermediation

It is important that funds of funds (FoF) diversify across vintage years, GPs, industry stage
of investment, and geography. Intermediation affords access to PE investments that would
often be too small compared to administrative expenses. This size issue is then addressed in
a FoF format be sharing administrative expenses. In addition, investment can be scaled up
with more diversification by pooling commitments.

PE Funds of Funds, Access, Selection Skills, and Expertise

Fund of fund managers have an advantage over institutional investors in terms of access to
top quality funds, selection skills, and expertise.

Learning Objective: Demonstrate knowledge of private investments in public

equity (PIPEs).•*

PRIVATE INVESTMENTS IN PUBLIC EQUITY (PIPEs)

MAIN POINT: In recent years, there has been increased activity in private investment in
public equity (PIPE).

Private investments in public equity (PIPE) transactions are privately issued equity or
equity-linked securities that are placed outside of a public offering and are exempt from
registration.

Characteristics of and Types of Securities Issued through PIPEs

One of the main advantages of PIPEs is that the issuing firm can offer a variety of securities:

• Privately placed common stock (illiquidity can result in a discount on the PIPE’S
issue price)
• Registered common stock (which investors may also be able to acquire at a discount
to the public market price)
• Convertible preferred shares or convertible debt (where conversion prices tend to be
lower than that of publicly traded instruments)

415
© 2020 Wiley
PRIVATE EQUITY

• Equity line of credit: a contractual agreement between an issuer and an investor that
enables the issuer to sell a formula-based quantity of stock at set intervals of time

Buyer and Seller Motivations of PIPEs

PIPEs are attractive to sellers because they can raise finds quickly and cheaply. They are
attractive to buying PE firms because they allow them to get a substantial stake in the
company at a discount instead of the more regular premium.

Traditional PIPEs and Structured PIPEs

The large majority of PIPE transactions are traditional PIPEs, in which investors can buy
common stock at a fixed price.

The conversion price is the price per share at which the convertible security can be
exchanged into shares of common stock, expressed in terms of the principal value of the
convertible security.

The conversion ratio is the number of shares of common stock into which each convertible
security can be exchanged.

Consider a traditional PIPE with fixed conversion terms.

Example 2: Conversion Price and Ratio

A preferred share has a face value or par value of $50 and is convertible to 5 shares of
common stock. What is the conversion price and conversion ratio?

Solution

The conversion price is $50/5 shares = $10. The conversion ratio is 5 to 1.

Structured PIPEs include more exotic securities, like floating-rate convertible preferred
stock, convertible resets, and common stock resets.

Toxic PIPEs
Firms have become more sophisticated with respect to toxic PIPEs (i.e., avoiding adjustable
conversion terms).

A toxic PIPE is a PIPE with adjustable conversion terms that can generate high levels of
shareholder dilution in the event of deteriorating prices in the firm’s common stock.

A serious consequence of toxic PIPEs is shareholder dilution resulting from adjustable

conversion terms, as the stock price is declining.

A floating conversion rate can lead to a toxic PIPE whereby PIPE investors can exercise
their conversion rights at greatly depressed conversion prices. This occurs following of
sequence of events, usually staring with a decline in the stock price, and leads to a death
spiral due to declining conversion prices and shareholder dilution. After conversion rights
are exercised, PIPE investors can either sell their converted shares or take control of the
company since they have so many new shares.

© 2020 Wiley
 PRIVATE EQUITY FUNDS: LBO FUNDS AND PRIVATE INVESTMENTS IN PUBLIC EQUITY

Learning Objective: Demonstrate knowledge of secondary markets and

structures within the private equity sector.

PE SECONDARY MARKETS AND STRUCTURES

MAIN POINT: The secondary market for shares of private equity funds is very small. Yet it
is sometimes possible for an LP to exit the investment before the fund has reached the end
of its life.

In recent years, there has been increased activity in the secondary market for private equity.
Most private equity investments are as a limited partner in a fund that has a lock up of
typically 10 years. Sometimes limited partners need to exit within the lockup period and
then they need to access the secondary market. Reasons for exiting early are generally
unrelated to performance but rather may be due to (1) a need to raise cash, for example, for
pension distributions, (2) risk management necessitates a change in allocation, for example,
after the crisis, or (3) for strategic rebalancing.

The secondary market enables PE investors to meet these types of liquidity needs, but there
are disadvantages. GPs may need to give permission to the LPs. General partners do not like
seeing their limited partners leave before the lock-up period is over and may not invite them
back to participate in other funds in the future.

There are several advantages for PE investors (buyers) in the secondary market. It can
enable them to diversify across vintage years; the fund is generally closer to the end of the
lock-up period when gains are to be realized; it can provide the investor access to the
general partner’s future funds; and the cash flows may be relatively attractive, particularly
when the investment is offered at a large discount to the NAV.

PE, Hedge Funds, and Six Fee Differences

Increasingly, hedge funds are involved in private equity investments. They have a
competitive advantage in terms of fee structure relative to private equity managers. The
table following summarizes the six major differences.

Fees: Hedge Funds versus Private Equity Funds

Hedge Funds Private Equity Funds

Front loaded Collected at deal termination
Based on changes in NAV Based on realized values
Collected on a regular basis Collected upon exit
Collect before returning investor capital Collect only after returning investor capital
Typically, no clawback Clawback provisions require return of fees
when losses occur
Typically, no hurdle rate Most have a hurdle rate

Publicly Traded PE Firms and their Governance

There are few methods of accessing liquid exposure to PE. The most common is through
business development companies that use a closed-end fund format. But there are others.
For example, there are some open-ended mutual funds that invest in private companies. The
discussion here is about PE firms like Blackstone, Carlyle, and Apollo that are publicly
traded. But these publicly traded PE firms tend not to be structured like corporations:

4,7
© 2020 Wiley
PRIVATE EQUITY

• They tend to be organized as LLCs rather than corporations.

• Managers control the firm rather than shareholders.
• Structures and jurisdictions used tend to reduce or even waive fiduciary duties.
• They opt out of governance rules promulgated by stock exchanges.

The Battle between PE Governance Structures

Governance structures in PE firms range from purely private PE firms to publicly listed
ETFs that invest in PE firms, and forms in between. There are advantages and disadvantages
to each, the private structure and the public structure, along three main dimensions (double-
edged swords):

1. Diversification. Well-diversified investors can require lower rates of return so that

being listed can reduce the cost of capital for a PE firm. However, the reason that the
private PE structure is successful is that the managers are compensated for their
concentration and focus on their portfolio companies.
2. Liquidity in terms of being listed or not. The value of shares will be more accurate
because of the presence of short sellers and there is no need for capital calls, but
listing is expensive and can cause the stock to fluctuate with the market.
3. Regulation. This offers investor protections but can be burdensome.

.,s
© 2020 Wiley
 P r iv a t e C r e d it a n d D is t r e s s e d D ebt

LEARNING OBJECTIVES
This chapter describes investments in leveraged loans, direct lending, mezzanine debt, and
distressed debt. Leveraged loans and direct loans are considered private credit while
mezzanine and distressed debt are private equity, reflecting the difference in risk and
priority in the credit structure.

Use of these instruments has tripled since 2008, perhaps because of Dodd-Frank and Basel 3
that discourage banks from making more risky loans. At the time of publication, alternative
lenders held $200 billion in dry powder, which is capital invested in hedge funds or other
organizations that either has not been lent or the borrower has not drawn down committed
amounts.

LESSON MAP
• Demonstrate knowledge of the types of fund private credit vehicles.
• Demonstrate knowledge of fixed income analysis.
• Demonstrate knowledge of credit risk analysis and the bankruptcy process.
• Demonstrate knowledge of leveraged loans.
• Demonstrate knowledge of direct lending.
• Demonstrate knowledge of mezzanine debt.
• Demonstrate knowledge of distressed debt.
• Demonstrate knowledge of private credit performance and diversification.

KEY CONCEPTS
This chapter describes many types of investments in defaultable debt. Some of the assets
and the strategies that go with them are bond-like and others are equity-like. Returns are
highest for illiquid assets and for complex instruments and strategies.

Learning Objective: Demonstrate knowledge of the types of fund private

credit vehicles.

TYPES OF FUND PRIVATE CREDIT VEHICLES

MAIN POINT: Private funds that invest in defaultable securities range from fairly liquid
interval funds to funds that are both extremely illiquid and are oriented more to producing
equity returns.

Interval Funds
Interval funds are closed-end private funds with a five to seven year stated life. They invest
in illiquid loan assets. The funds allow investors to enter or exit from time to time at net
asset value (NAV), offering up to daily liquidity. The manager commits to redeem a certain
percent of assets under management (for example, 5%) each period. If more investors seek
redemption, partial redemption is allocated and some withdrawal requests are rolled over.

Drawdown Funds
Drawdown funds are private partnerships that accept commitments from investors, then
draw down those commitments as needed. The funds may have a stated life of three to five
years or may run indefinitely. They may buy bank loans or bonds or make direct loans.

© 2020 Wiley
PRIVATE EQUITY

Funds with Loan-to-Own Objective

Some funds make loans to distressed companies or buy existing distressed debt with a goal
of becoming the owners of a company or certain assets. The managers focus on the value of
the assets, not the borrower’s ability to repay principal and interest.

Fulcrum Securities and Reorganization

The fulcrum security is the senior-most security that is not fully repaid in a bankruptcy.
More senior debt is repaid and more junior debt is extinguished without compensation. The
fulcrum security generally receives the highest returns of any credit-investing strategy.
Private credit investors tend to have a long horizon while hedge funds often look for short-
term profits.

Learning Objective: Demonstrate knowledge of fixed income analysis.1*

FIXED INCOME ANALYSIS

MAIN POINT: Loans are higher in priority in bankruptcy and generally have floating-rate
coupons to minimize rate risk but are illiquid. Bonds are lower in priority, usually have
fixed coupons, but have greater liquidity than loan products.

Three Key Differences between Bonds and Loans

1. Liquidity. Bonds trade in a public market and are more liquid than loans. Loans
should earn a liquidity premium over bond rates.
2. Default risk. Loans are generally the most senior debt in the capital structure and
are often secured by assets. Bonds are more junior and more exposed to credit
losses.
3. Interest rate risk. Loans typically have floating rates while bonds generally have
fixed coupons. Loans are generally callable (can be repaid early without penalty)
while bonds are either non-callable or callable after a period.

Implications of Floating Rates vs. Fixed Rates on Interest Rate Risk

The value of a fixed-rate bond rises (declines) when rates decline (rise). Duration is a
measure of this sensitivity (see “Foundations of Financial Economics” and “Relative Value
Hedge Funds”). Floating rate instruments retain a small amount of this risk, reflecting the
short period their rates are fixed until the next reset date.

Implications of Floating Rates vs. Fixed Rates on Duration

Floating rate debt has a duration equal to the time to reset (see “Foundations of Financial
Economics”). A bond that resets daily has no interest rate risk (but would still have default
risk). The value of the bond should return to par on the reset. This is true even for floating
rate debt with longer maturities. Fixed rate debt, however, has durations that increase as the
maturity increases.

Implications of Compounding Conventions on Modified Duration

Modified duration adjusts duration as a measure of risk to account for the differing effects
of compounding frequency.

Duration
Modified Duration =
YTM
1+
M

420
© 2020 Wiley
 PRIVATE CREDIT AND DISTRESSED DEBT

In the equation above, M is the compounding frequency. M = 1 for annual compounding.

M = 2 for semi-annual compounding. So, if the yield to maturity is 4%, divide by 1.04 for
annual bonds and 1.02 for semiannual bonds. Notice that M = °° for continuous
compounding so the second term in the denominator vanishes and Modified Duration =
Duration.

Floating rate debt often involves borrowers with greater credit risk, so lenders avoid most
interest rate risk but often take greater default risk.

Learning Objective: Demonstrate knowledge of credit risk analysis and the

bankruptcy process.

CREDIT RISK ANALYSIS AND BANKRUPTCY PROCESS

MAIN POINT: Rating agencies rely on financial ratios to predict whether a company will
produce cash flow to service debt. Some of the strategies in this chapter rely primarily on
collateral to mitigate credit risk. Other equity-oriented strategies pay little attention to
company financials or collateral value.

Credit Ratings, Yields, and Financial Ratios

Investors rely on ratings by S&P, Moody’s, Fitch, and other organizations to rate bonds and
loans. These ratings help to determine the fair rate for a bond or loan. A borrower rated
investment grade is rated Baa or higher by Moody’s and BBB or higher by S&P and may
borrow at a spread of 1 percent or 100 basis points over a default-free sovereign borrower.
Borrowers below investment grade may borrow at a spread of 3%. If the default-free rate is
4%, the first company may pay 5% interest while the riskier company pays 7%.

Most private debt is not rated. The borrower may have other rated debt. More often, the
lender needs to assess the default risk and decide the fair spread. Private borrowers typically
would be rated B, below investment grade.

These lenders and the credit rating agencies rely on financial ratios such as profit margin,
value of assets, amount of debt, the amount of interest expense, volatility of revenue, and
profits. Two ratios are EBITA/Interest Expense (higher is better) and Debt/EBITA (lower is
better).

Credit Spreads and Credit Risk

The credit spread observed in the market is a measure of the credit risk perceived by the
market. Note that other things can affect the spread, too, such as call provisions and the
liquidity of a security. Still, after accounting for these impacts, spreads will be wider on
securities with greater default risk. That spread can be significant for non-investment grade
borrowers, also called high-yield, speculative, or junk bonds, reflecting a higher probability
of default. In 2018, the spread on high-yield debt was about 3.5%. Maturities tend to be
fairly short, as lenders hesitate to make long loan commitments to these borrowers.

Credit Risk and the Probability of Default

Default rates on investment grade borrowers are generally below 1% per year even in weak
economic times. Spreads on these loans have also been around 1%, as compensation for that
credit exposure.

Default rates on high-yield debt are sensitive to economic conditions. Annual default has
reached 9% three times since 1990. The spread of 3.5% is not enough to compensate for this
risk but lenders earn excess spread during other phases of the business cycle.

© 2020 Wiley s
PRIVATE EQUITY

Covenants
Covenants were described in Chapter 12, “Real Estate Assets and Debt.” Covenants place
restrictions on borrowers to reduce default risk and, as a result, may result in a lower borrowing
spread. Loans with relatively few restrictions are called covenant-lite loans. An indenture is a
loan contract which can contain covenants. Affirmative covenants are actions required by the
borrower or conditions that must be maintained, such as a coverage ratio. Negative covenants
are prohibited actions, such as issuing more senior debt. Incurrence covenants require the
borrower to take specified actions if a specified event occurs. Maintenance covenants require
continuing compliance even in the absence of specified events. Maintenance provisions are
generally more restrictive than incurrence covenants.

Violating covenants produces a technical default. Lenders may force repayment,

restructuring, may seize assets, or may force a bankruptcy filing.

Five Ways Covenants Can Control Risk

1. Preserve capital. Restrictions such as limits on loan-to-value and limits on how much
of the borrower’s assets can be pledged as security seek to reduce the risk of default.
2. Appropriate excess cash flow. Covenants may require that revenues or proceeds
from asset sales should be paid to lenders rather than equity stakeholders.
3. Control business risk. Shareholders keep the upside and lenders have the downside.
Covenants compensate for this bias toward taking more business risk.
4. Require performance. Negative covenants may restrict capital investments to reduce
leverage or increase interest coverage.
5. Require reporting. These affirmative covenants include financial reporting,
disclosure of material information, and company forecasts.

Capital Structure and Priority

A company may have several types of debt and equity. In bankruptcy, priority determines
the order in which stakeholders are paid. Stakeholders with lower priority face increased
chance of loss. The priority from highest (first to be paid) to lowest follows:

• Senior Secured First Lien Debt

• Senior Secured Second Lien Debt
• Senior Unsecured Debt
• Junior, Mezzanine, or Subordinated Debt
• Preferred Stock
• Common Stock

The stated rates or spreads on the debt are lower for the first lien debt then investor risk and
the required returns rises progressively for assets listed later. Common stock doesn’t have a
stated rate but the expected return is higher than the assets listed above it. They, however,
have a claim on the residual left after all of the stakeholders above are repaid.

Capital structures can change over time. Paying dividends, buying back stock, and issuing
more debt all increase leverage. Historically, established companies relied primarily on
senior debt. More commonly now, companies issue multiple classes of debt, often
simultaneously. In the unitrache debt market, companies issue large amounts of debt with
both senior and junior tranches.

Recovery Rates
The recovery rate is the portion of principal the lender expects to receive in the event of
bankruptcy. In a liquidation, proceeds of asset sales are paid to stakeholders following the

422
© 2020 Wiley
 PRIVATE CREDIT AND DISTRESSED DEBT

rules of priority above. In a reorganization, companies may negotiate down some liabilities
such as union contracts, pensions, leases, and debt. A haircut is a negotiated reduction of
principal in a reorganization, usually applied to senior debt.

Historical Recovery Rates

First Lien Loans 76%

Secured Bonds 56%
Senior Unsecured Bonds 44%
Subordinated Debt Typically converted to equity
Equity 0% (100% loss)

Distressed Debt and the Bankruptcy Process

Investors may buy debt that is already in bankruptcy or non-investment grade debt prior to a
bankruptcy filing. As noted earlier, some investors seek to get control of the company
(equity) by buying debt. The following is a summary of U.S. bankruptcy laws. Note that
laws differ in other countries. In particular, some countries do not provide for
reorganization.

Chapter 11 bankruptcy is a reorganization. This filing holds off forced liquidation. The
borrower proposes a reorganization plan, a business plan to transition into a viable
concern, including how different classes of creditors are treated. The plan must be with the
approval of creditors, and, if approved, provides the basis for a court-ordered exit from
bankruptcy. Approval requires half of the creditors and two-thirds of the value of creditors
in each class to approve the plan.

Chapter 11 Calendar

File for bankruptcy.

Court stays (suspends) default notices.
Borrower develops reorganization within 120 days.
Borrower has 60 days to get approval from creditors.
Confirmation hearing if approved.•*

Failing to get approval in the 180 days, any creditor can propose a reorganization plan and
the litigation begins.

Additional Bankruptcy Concepts

• Classification of claims. Claims with the same priority are grouped into a class.
• Prepackaged bankruptcy filing. Both debtor and creditor reach agreement prior to
bankruptcy filing and present an approved plan to the court at the filing.
• Blocking position. If a creditor has or acquires more than one-third of the value of
any class, it can block a reorganization plan and force negotiation.
• Cramdown. If creditors approve the plan, it is imposed on the creditors that oppose
the plan as long as the plan does not discriminate and is fair and equitable.
• Absolute priority. The bankruptcy plan must strictly adhere to the priority of
stakeholders in the capital structure. First priority includes obligations to employees,
taxes, and accounts payable, followed by secured lenders, senior lenders, junior
lenders, subordinated lenders, preferred stock holders, then common stock.
• Debtor-in-possession financing. This is financing provided by secured lenders after a
bankruptcy filing. These creditors see advantages in keeping operations going during

423
© 2020 Wiley
PRIVATE EQUITY

reorganization. These additional obligations have priority over all debt in existence at
the time of the bankruptcy filing.

Learning Objective: Demonstrate knowledge of leveraged loans.

LEVERAGED LOANS
MAIN POINT: Leveraged loans are non-investment grade loans. As a secondary market for
leveraged loans has developed, banks have transitioned from lending and retaining loans to
middle market companies to originating and selling loans to institutional investors to earn
fees.

Leveraged Loan Basics

Leveraged loans are non-investment-grade bank loans issued by a bank syndicate. They are
similar to high-yield bonds. The word “leveraged” implies that the borrower has a lot of
debt (non-investment grade) and does not mean the lender uses leverage. Syndicated loans
to investment grade borrowers are not called leveraged loans. Definition of a leveraged loan
may vary but is generally a synonym for second lien loans. These loans are also identified
as loans with rates greater than 125-200 basis points over LIBOR. Unrated loans tend to
trade at the same spreads as loans rated Ba or BB.

Growth in Leveraged Loans

Rating agencies began rating loans in 1995 and led to the development of a secondary
market with banks selling to institutional investors. Most banks originate and sell leveraged
loans for the fees rather than retaining the loans.

Liquidity and the Demand for Leveraged Loans

Davies (2018)1 is concerned about the future impact of our greater reliance on this
unregulated lending market regarding credit availability and liquidity at other points in the
business cycle. Loan maturities range from 4 to 7 years and, at this point, 40% of new
leveraged loans are rollovers. Companies rely on leveraged loans as a permanent source of
funds. Further, 80% of leveraged loans go into collateralized loan obligations and mutual
funds. Borrowers probably have few alternatives if investors exit the market.

Learning Objective: Demonstrate knowledge of direct lending.

DIRECT LENDING
MAIN POINT: Direct lending involves investment companies lending directly to middle
market non-investment grade borrowers without involvement from banks. These loans are
generally secured by assets and lenders focus very little on traditional underwriting methods
that base underwriting on predicted future cash flows.

Direct lending is also called shadow banking, non-bank lending, and market-based ending
and involves loans originated by private equity funds, private credit funds, and hedge funds.
Rates are higher than bank loans so this includes borrowers who cannot get bank loans.
Direct loans can offer more flexible terms and can often be arranged quicker than bank
loans.

Banks generally lend based upon forecasts that show the borrower is likely to generate cash
flows sufficient to service the loan. Some direct loans are unsecured but many are secured

Paul J. Davies, “The Unseen Risk in the Booming Loan Market,” Wall Street Journal, August 6, 2018.

424
© 2020 Wiley
 PRIVATE CREDIT AND DISTRESSED DEBT

by assets. Revolving loans are secured by inventory or accounts receivable and term loans
are secured by fixed assets (plant, property, and equipment).

Because the loans are not investment grade, direct lending requires knowledge and
experience with bankruptcy to establish proper priority and to keep borrowers on track.

Direct loans involve lower fees and higher rates than bank loans. As a result, private equity
funds don’t experience the J-curve on lending that is typical of their equity investments.

The target market is a middle market corporation with revenues up to $100 million and
EBITDA of up to $10 million. Loan principals range from $20 million to $50 million,
generally as first lien or senior secured debt. This priority puts them first in line to control
the company if the borrower cannot meet future obligations.

Another form of direct lending is peer-to-peer lending, where institutional and retail
investors often make consumer loans via online underwriting apps. Retail lenders were early
participants but have mostly been replaced by institutional lenders. These loans might
refinance credit card debt or student loans and lend primarily to very credit-worthy
borrowers.

Learning Objective: Demonstrate knowledge of mezzanine debt.

MEZZANINE DEBT
MAIN POINT: Mezzanine debt is a diverse category that includes loans supported by
consistent cashflows (favored by insurance companies) and loans that are more like equity
(favored by limited partnership, LBO firms, and commercial banks).

Mezzanine Debt Structures

Equity-like mezzanine loans usually include a w arrant, a call option a company issues to
buy its shares. The value of the call allows the lender to lower the loan rate. More warrants
lower the rate progressively more. The lender can potentially become a major shareholder in
the borrower’s company by exercising the warrants.

Traditional debt can be viewed as a long position in company assets less a call on those
assets. This theory of capital structure is described in more detail in Chapter 24, “Credit
Risk and Credit Derivatives.” Adding the warrant to this debt offsets the short in the upside
of the borrower’s company, making the mezzanine loan much like a long position in the
borrower’s assets.

Mezzanine loans generally don’t involve control of the borrowing company. Mezzanine
debt is subordinated to secured and senior debt, involving greater credit exposure and, with
the warrants, equity risk. Still, both risk and returns are lower on mezzanine loans than
LB Os and venture capital.

Mezzanine loans are generally repaid at an IPO, during a subsequent financing round, if the
borrower is acquired, or if the borrower refinances. This may trigger exercise of the warrant.
Profits on mezzanine loans do not resemble the J-curve because the lender receives semi-
annual coupon payments.

Stylized Example of Mezzanine Debt Advantage

Borrowers may use mezzanine debt in lieu of or to replace traditional equity in order to
lower their weighted average cost of capital.

425
© 2020 Wiley
PRIVATE EQUITY

Capital Structure without Mezzanine Debt

Loan 60% 8.00%

Equity 40% 30.00%
WACC 16.80%

Capital Structure with Mezzanine Debt

Weight
Loan 60% 8.00%
Mezzanine 20% 15.00%
Equity 20% 32.00%
WACC 14.20%

Source: CAIA Level I, 4th ed., 2020. Exhibit 22.4. Copyright © 2009, 2012, 2015 by The CAIA Association.

The company has relatively cheap capital from a bank loan but the loan won’t finance more
than 60% of the balance sheet. The weighted average cost of capital is 16.80%. If the
company replaces half of the equity with mezzanine debt (which is equity-like), the
weighted average cost of capital declines to 14.20%.

Mezzanine Financing Compared with O ther Forms of Financing

Mezzanine financing is common for the largest of the small-cap market, companies with
issues under $400 million. These companies do not have access to the high-yield bond
market or the direct loan market.

Mezzanine debt can be custom engineered to suit the borrower. The uniqueness of the loans
makes them illiquid. Companies might be able to buy loans in the secondary market. More
likely, the borrower will need to negotiate early redemption or other changes with the owner
of the loan.

Mezzanine debt is junior unsecured debt with maturities ranging from 5 to 7 years. Principal
is due upon maturity. Interest is payable during the loan life but borrowers may have a pay-
in-kind (PIK) option to add interest expense to the loan balance. Lenders typically permit a
loan to EBITDA of 2 to 2.5.

Leveraged High-Yield
Loans Bonds Mezzanine Debt
Seniority Most senior Subordinated Lowest priority
Type of First lien Unsecured Unsecured
security
Credit rating Usually Required Not required
required
Loan covenants Extensive Fewer Minimal
Term 5 years 7-10 years 4-6 years
Amortization Installments Bullet Bullet
Coupon type Cash, floating Cash, fixed Cash or PIK fixed

426
© 2020 Wiley
 PRIVATE CREDIT AND DISTRESSED DEBT

Leveraged High-Yield
Loans Bonds Mezzanine Debt
Coupon rate LIBOR + 5%-8% 8%—11 %
Spread
Prepayment Usually none High (call Moderate (may force equity
penalty premium) conversion)
Equity kicker None Sometimes Usually
Recovery rate 60%-100% 40%-50% 20%-30%
Liquidity High Low Very low

Source: CAIA Level I, 4th ed., 2020. Exhibit 22.6. Copyright © 2009, 2012, 2015 by The CA1A Association.

An additional distinction would be whether the debt is sponsored lending, where the loan is
to a company owned by a private equity fund. These funds will typically inject additional
financing, if needed, in a fund’s company to protect its investment.

Seven Basic Examples of Mezzanine Financing

Although the mezzanine loan terms may be infinitely variable, the uses of the money fall
into seven categories:

1. Management buyouts. Gap financing for management-led buyouts.

2. Growth and expansion. Capital investment for companies that can’t get bank loans
or public debt.
3. Acquisition. Middle market companies, who also don’t have access to banks or bond
markets, borrow to finance a merger.
4. Recapitalization. Mezzanine loan may be part of an effort to reengineer a company’s
capital structure.
5. Commercial real estate. First mortgages will finance 40%-70%. Equity runs 10% to
15%. Mezzanine financing can fill the gap.
6. Leveraged buyout. Mezzanine debt is commonly used for LBOs because of limits on
the amount of senior debt.
7. Bridge financing, which is temporary financing used until permanent financing is
secured. Often mezzanine financing provides the initial loans for an LBO.

Investors in Mezzanine Debt

There are four primary investors in mezzanine debt:1

1. Mezzanine funds. These are private investment pools structured like hedge funds,
VC funds, and buyout funds that pool money from pension funds, endowments, and
foundations that do not have the experience or resources to invest in individual
mezzanine loans. Management fees run l%-2% with incentive fees of 20%.
Mezzanine funds seek returns of 15%-20%, compared to 20%-30% for LBO funds,
and 30%-50% for VC funds. Mezzanine staff are experts at financial engineering
(for loan and warrant terms) versus VC funds that are staffed with industry
(especially tech) expertise.
2. Insurance companies. They are not much interested in equity kickers and lean
toward taking less credit risk.
3. Traditional senior lenders. When banks and other senior lenders lend more than the
value of business assets, it is called stretch financing. Terms often include an equity
kicker.

427
© 2020 Wiley
PRIVATE EQUITY

4. Traditional venture capital firms. VC firms provide earlier stage funding as their
core business. Late stage funding is often bridge financing and VCs first make these
loans to their portfolio companies. There is no clear line for them that separates VC
funding from mezzanine funding.

Eight Characteristics of Mezzanine Debt

The following characteristics distinguish mezzanine financing from other types of financing:

1. Board representation. Mezzanine lenders will frequently expect board observation

rights (non-voting) or a full board position.
2. Restrictions on borrower. The borrower may not be able create more debt senior to
the mezzanine lender. The borrower may need approval for acquisitions, changes in
management, or payment of dividends.
3. Flexibility. The flexibility is a defining characteristic.
4. Negotiations with senior creditors. An intercredit agreement includes provisions
affecting senior creditors and the mezzanine lender.
5. Subordination. Blanket subordination prevents any payment to mezzanine lenders
until all more senior obligations have been repaid. Springing subordination allows
payment to mezzanine lenders as long as the borrower is not in default.
6. Acceleration. Acceleration is a provision to repay a loan sooner than scheduled,
usually triggered by a default.
7. Assignment. Senior lenders generally prohibit mezzanine lenders from selling or
otherwise transferring their rights to others without permission. Assignment is
usually permitted if the acquirer signs a new intercreditor agreement.
8. Takeout provisions. Takeout provisions allow the mezzanine lender to repay the
senior lenders, thereby becoming the senior lenders. This can allow the mezzanine
lenders to control the company and convert to equity.

Learning Objective: Demonstrate knowledge of distressed debt.

DISTRESSED DEBT
MAIN POINT: Investing in distressed debt primarily involves equity-oriented strategies and
considerable skill in navigating the bankruptcy process.

Describing Distressed Debt

Distressed debt is debt that is in or near default. The issuer generally has deteriorated since
the debt was created and is worth less than half of the face value, has a yield 1000 or more
basis points above default-free debt, or has a credit rating of Caa/CCC or lower.

Distressed debt is much like equity. Buyers are not concerned that they might not receive
principal or interest payments.

Distressed companies may have a poorly implemented business plan, an outdated or

ineffective plan, too much leverage, or poor cash management. Often, these problems will
be difficult to fix.

Consider the Merton paradigm that debt is ownership of the company’s assets and a short
call to the shareholders. That option is in-the-money for investment grade companies but at
or out-of-the-money for distressed companies. This explains why investment grade debt
does not resemble equity but distressed debt does.

428
© 2020 Wiley
 PRIVATE CREDIT AND DISTRESSED DEBT

The Supply of Distressed Debt

Frequently, companies become distressed gradually, over time. Management may fail to
respond to new challenges or challenges become too large to overcome.

Debt used to create LB Os frequently becomes distressed. Failed LB Os are leveraged

fallouts.

The Demand for Distressed Debt

Turning around a distressed company presents unique challenges. It generally begins by
identifying issues that are priced well (cheaply) to compensate for credit risk. The market
for this debt is not efficiently priced because of illiquidity, limited transparency, and an
excess of traditional investment managers who feel they must sell issues that have become
distressed. Pricing attracts value investors and contrarian buyers. Other buyers of distressed
debt see it as a way to cheaply buy equity control of a company.

Expected Default Losses on Distressed Debt

The default rate is the probability of default by the borrower. This default might involve
failure to make a required interest or principal payment. A technical default occurs when
the borrower cannot comply with certain covenants but has not failed to make required
principal or interest payments.

Loan Loss Rate = Default Rate x Loss Given Default = Default Ratex (1 —Recovery Rate)

The loan loss rate is the expected annual loss as a percent of the investment. Losses are
expected. The investment goal is to invest in companies and manage those companies so
that they earn a spread after losses, income, and recoveries.

Credit spread > Loan Loss Rate + Risk Premium

Note, because losses are cyclical, it is necessary to earn more than the risk premium much
of the time to compensate for larger losses at a point in the business cycle.

Three Distressed Debt Investment Strategies

1. Actively seek control of the company, including board positions and possibly chair
of the board. Convert debt into equity. This often involves buying blocking
positions.
2. Active involvement in the bankruptcy process without seeking a control position.
May convert debt to equity.
3. Passive investing at attractive prices without seeking to convert to equity.

Risks of Distressed Debt Investing

The largest risk is business risk. Although securities are purchased at steep discounts, prices
can go lower (to zero). Even if the investor converts the debt position to equity, it must alter
the business plan to reverse the fortunes of the company.

Commonly used metrics of default risk are not helpful. It is not important to consider the
risk that the debt becomes if the debt is already distressed. Instead, investors must think like
equity investors.

429
© 2020 Wiley
PRIVATE EQUITY

Five Observations on Vulture Investing

1. Just like vultures, vulture investors are beneficial, cleaning up the unpleasant
remains of failed companies.
2. Governments trying to create countercyclical policies are often procyclical, creating
more distressed opportunities at cyclical lows and better than expected recoveries.
3. The most important key to success is to identify the fulcrum security.
4. Fulcrum securities have historically been subordinated debt but are now more likely
to be senior secured bank loans.
5. The negative impression of vulture investors stems from their orientation towards
loan-to-own strategies that place little emphasis on traditional credit analysis.

Learning Objective: Demonstrate knowledge of private credit performance and

diversification.•*

PRIVATE CREDIT PERFORMANCE AND DIVERSIFICATION

MAIN POINT: Data issues complicate the analysis of returns on private credit investing.
Returns are highly correlated within the group and not very volatile.

• Investing in mezzanine, distressed debt, and other direct lending strategies produce a
low volatility of returns, even after adjusting for smoothing effects of low liquidity.
• There is a high correlation between returns on distressed debt, BDCs, high-yield
bonds, and leveraged loans.
• Within the group, direct lending returned 11.8%, followed by distressed at 8.9, high
yield at 8.2%, mezzanine at 7.7%, and leveraged loans at 5.5%.
• It is likely misleading to compare volatilities and correlations on smoothed returns on
mezzanine, direct lending, and distressed to high yield, BCD, and leveraged loan
returns.
• More complex strategies and more illiquid strategies appear to outperform simpler
and more liquid strategies.

430
© 2020 Wiley
St r u c t u r e d P r o d u c t s
 In t r o d u c t io n t o St r u c t u r in g

LESSON MAP
• Demonstrate knowledge of the overview of financial structuring.
• Demonstrate knowledge of the major types of structuring.
• Demonstrate knowledge of the primary economic role of structuring.
• Demonstrate knowledge of collateralized mortgage obligations (CMOs).
• Demonstrate knowledge of the structural approach to credit risk modeling.
• Demonstrate knowledge of interest rate options.
• Demonstrate knowledge of collateralized debt obligations.

KEY CONCEPTS
Financial structuring can create new combinations of risk and reward related to specific
economic factors. The goal of structuring is to transfer risk and return from investors
seeking to reduce risk at the expense of expected reward to other investors that will accept
the risk in return for a higher expected return. Two important structures—collateralized
mortgage obligations (CMOs) and collateralized debt obligations (CDOs)—are introduced
in this lesson and described more completely in other lessons.

Learning Objective: Demonstrate knowledge of the overview of financial

structuring.

MAIN POINT: Structuring is the process of creating a new pattern of return from existing
assets. A put option on a common stock creates a pattern of return tied to the company with
upside potential and limited risk. Many times, structuring combines these known structures.
For example, a collar is built from a long position in an asset, a long position in an out-of-
the-money put, and a short position in an out-of-the-money call. In some of the examples
that follow, cash flows are split to create two or more securities with different risk and
return characteristics. Structuring can also accommodate other preferences, such as taxation
(e.g., highly taxed cash flows can be distributed to tax-exempt investors) or lliquidity
(e.g., structuring an asset intro short-term claims for investors concerned about liquidity).

Learning Objective: Demonstrate knowledge of the major types of structuring.

MAIN POINT: A familiar form of structuring is illustrated by the capital structure of a

corporation. A simple structure would include only common stock, with all shareholders
having identical rights. The company may add debt, adding leverage and fixed interest costs
that may increase both the return and the risk to equity holders by offering the lenders a
more certain stream of coupon income and more favorable treatment in the event of
bankruptcy. Adding preferred stock, secured debt, and subordinated debt further divides the
earnings of the company and creates different prospects for return and risk. However, the
return on all these securities equals the return on assets in the company.

Structuring can be used to allocate other considerations. One class of investor may receive
taxed-favored cash flows and others (probably owners that are not taxed) would receive
cash flows that are otherwise more highly taxed. Structuring may create one asset with a
more liquid claim and another with long-term claims.

Two types of structured products will be discussed: credit derivatives and CDOs.

© 2020 Wiley
STRUCTURED PRODUCTS

Introduction to Credit Derivatives

There are many different forms of credit derivatives. These instruments will be discussed in
detail in another lesson. One of the earliest and simplest credit derivatives is a credit default
swap (CDS). Begin with a bond that creates a loan from the bondholder to the borrower,
periodic coupon payments, and repayment, or, in the event of default, a truncated string of
coupons and repayment or recovery of less than the loan amount. Credit structuring could
split that bond into a loan with certainty of repayment associated with a risk-free lending
rate plus an insurance policy requiring regular insurance premiums and a possible claim
amount equal to the shortfall in the event of bankruptcy.

An investor could buy a defaultable bond and buy protection using a CDS. The combination
should produce returns much like a default-free bond. The buyer of protection creates a
hedge against default. Or an investor could buy a default-free bond and sell insurance
protection. This second combination should behave much like a straight bond issued by the
company. In each case, a CDS is used to transfer credit risk from one party to another.

Introduction to Collateralized Debt Obligations (CDOs)

CDOs create tranches to allocate coupon income, principal payment, and credit losses
among different classes of investors. The CDO owns a portfolio of bonds that might default.
Tranches are actually senior1 and junior bonds and equity much like an operating
corporation’s capital structure. Together, the tranches own the portfolio of bonds.

Objectives of Structured Products

Structured products allocate risk so that investors that want to invest in less risky securities
have that opportunity. The risk is taken by investors that are willing to accept the risk in
return for higher expected returns.

Learning Objective: Demonstrate knowledge of the primary economic role of

structuring.

MAIN POINT: Market participants have many individual motives for being involved with
structured products. Investors may seek higher returns or tax-favored returns, issuers may
seek to raise money more cheaply, and investment bankers are happy to earn some
underwriting fees. Economists point to the benefits of creating an investment product that is
new and different from all other alternatives available to investors and issuers. According to
this argument, investors and issuers are best off when everyone is given more choice about
how to trade off risk and reward. An operating corporation may fund its operations more
efficiently with a capital structure with senior and junior debt along with equity if the range
of investment choices better matches the preferences of investors. Similarly, a bond
portfolio may be more valuable if the risks are allocated into tranches.

In investing, there is a range of future outcomes. The state of the world defines particulars at
one of those outcomes. For a pool of mortgage-backed securities, that might be defined as
the rate of default, rate of repayment, levels of market rates, and a variety of other vital
statistics. The state of the world has implications for the performance of individual
securities. Having more completeness in a securities market allows investors to have greater
control of the outcome in particular states of the world.

State of the world defines a very specific outcome in detail.

Completing the m arket means offering investors unique investment opportunities.

CDOs with more tranches will be discussed in another section.

434
© 2020 Wiley
 INTRODUCTION TO STRUCTURING

Learning Objective: Demonstrate knowledge of collateralized mortgage

obligations (CMOs).

MAIN POINT: CMOs divide principal and interest payments into two or more securities in
order to divide the risks and adjust the expected return on portfolios of mortgage-backed
securities.

Collateralized mortgage obligations were created beginning in the 1980s to divide

investment pools into structured securities with a range of risk and return characteristics. An
example of an investment pool is a mutual fund that holds many mortgage-backed
securities. All of the owners receive the same return and are exposed to the same risks. In
contrast, a CMO might divide a subset of the cash flows into short-term, low-risk bonds and
the balance of the cash flows into one or more risky issues.

The simplest form of a CMO is a sequential-pay bond, where all principal repayments are
applied to individual tranches in succession. A tranche is a well defined claim on assets that
is substantially different from other claims regarding risk, seniority, and maturity. The
senior tranche receives a fixed coupon paid as long as the portfolio receives enough income
to make the payment. The senior tranche receives the principal repayments received on the
portfolio. The junior tranche receives a fixed coupon if the portfolio produces enough
income after paying the senior coupons. The junior tranche begins receiving principal
payments when the senior tranche is paid off.

Many CMOs are created from portfolios of Freddie Mac, Fannie Mae, and Ginnie Mae
pass-through securities. These securities have generally been regarded as default-free and
the agencies had pledged to fully repay all defaulted loans. Congress explicitly guaranteed
the repayment of these loans when the federal government took over the operation of these
quasi-govemmental agencies. However, CMOs could be built from bonds that are subject to
credit loss. Losses are applied first to the junior tranche and then, if necessary, to the senior
tranche.

CMOs backed by agency MBSs should not experience credit losses. Credit losses, when
they occur, are allocated first to the junior tranche and then, if necessary, to the senior
tranche. The equity holder keeps any cash after the senior and junior tranches are retired.

Maturity Risks with CMOs

Most 15- and 30-year loans are repaid many years before the final maturity date. People
move to another community, families outgrow a small house, or parents become empty
nesters. Importantly, most homeowners refinance their loan if rates go lower. As a result,
MBSs behave like securities with final maturities of 5 to 10 years.

The timing of principal repayment is one of the biggest risks with MBSs, especially agency
MBSs with a fixed coupon, whose principal is guaranteed. The homeowner can be thought
of as the “issuer” of the underlying mortgage. The terms of the loan remain the same for the
life of the loan. If rates go up after the loan is made, the lender can’t raise the coupon rate.
However, if rates decline, the borrower can generally repay the loan at face value without
prepayment penalty. The right to refinance without penalty is often described as a call
option, meaning that the borrower can repurchase the loan at par (at 100% of face value)
even if prevailing rates are lower.

Because of the prepayment option granted to these homeowners, these fixed-rate MBSs
behave like long securities when rates rise (and decline in price at an accelerating rate) and

435
© 2020 Wiley
STRUCTURED PRODUCTS

behave like short securities when rates decline (and rise in price at a decelerating rate).
Extension risk is the potential for loss in value if prepayment rates slow. Contraction risk
is the potential for loss in value if prepayment rates speed up.

The sequential CMO allocates most of this contraction/extension risk to the tranches that
receive the deferred repayments. Because the tranches receiving the first cash flows are less
sensitive to rising rates (because they have a shorter duration), these bonds decline less in
value than later tranches. These tranches are affected by the cumulative impact of this
repayment speed.

Planned amortization class CMOs (PAC bonds) provide additional protection against
both contraction and extension. The PAC tranche receives a prespecified repayment (as a
percentage of the remaining face) each month as long as prepayments on the entire pool are
within a prescribed range. As long as prepayments don’t exceed the range, principal
payments follow the planned amount. Another tranche called a companion or support
tranche absorbs the difference between the PAC repayment schedule and actual repayments.

If the prepayment speed of the underlying collateral veers outside the PAC bands, the PAC
bonds could begin to get an overallocation or an underallocation of principal repayments,
based on complex formulas and specific scenarios. Busted PACs are PAC bonds that have
experienced prepayments outside the PAC bands and no longer set prepayments at the
PAC rate.

Targeted amortization class CMOs (TAC bonds) are similar to PAC bonds except they
are repaid at the targeted rate only if the portfolio experiences repayments within the target
prepayment band, with is narrower than the PAC band. The allocation of prepayments
outside the range is more complex than PAC rules.

A common structure separates the cash flows into an interest-only (IO) security and a
principal-only (PO) security. A PO is similar to a Treasury bill that is bought at a discount
to face value, which creates the return. The PO receives the same cash flows regardless of
the prepayment speeds experienced on the underlying collateral, a portfolio of bonds
supporting the securities issued. However, if the collateral experiences rapid principal
payments, the PO owner gets the built-in gain over a shorter period. Conversely, if the
collateral experiences slower prepayments, the IO holder receives more coupon income than
if the prepayment is rapid.

CMOs backed by floating-rate mortgages may create floating-rate tranches to track the
income on the collateral. CMOs backed by fixed-rate collateral may contain a floating-rate
tranche (or “floater”). This tranche receives income tied to a market rate such as LIBOR. An
inverse floater tranche receives income tied to the fixed rate less the floating rate. The
floater receives more income if short rates rise, and an inverse floater receives more income
if short rates decline. Since the face amount of the inverse tranche is usually smaller than
that of the tranche of the floater, the inverse floater is more sensitive to changes in rates than
the floater is. The coupon on the floater may have an upper limit (“cap”) or lower limit
(“floor”), which can affect the rate on another tranche.

Motivations for Structured Mortgage Products

The CMOs divide the cash flows into shorter and longer bonds to match the preferences of
investors. The structure also divides the risk of prepayments accelerating or decelerating.
The principal is not at risk if the collateral is made up of agency MBSs whose principal is
guaranteed. Structured MBS products allow investors to take more or less of these risks.

© 2020 Wiley
 INTRODUCTION TO STRUCTURING

Those investors seeking to minimize risk accept a lower expected return. Other investors
accept additional risk in return for owning a security with a higher expected return.

Im pact of Interest Rates and Prepayments Im pact the Valuation of a CMO

Any fixed-income security is sensitive to changes in interest rates. When rates rise, present
value factors adjust and the value of individual cash flows goes down; when rates decline,
cash flow value goes up. But rising rates generally lead to slower prepayments (and
declining rates to faster prepayments). These changing prepayment speeds alter the timing
and sometimes the total size of the cash flows that a mortgage security will receive.

• Pass-throughs increase in value by a decreasing amount as rates decline.

• Pass-throughs decrease in value by an increasing amount as rates rise.
• IOs may gain value as rates rise because the collateral can be expected to be
outstanding longer.
• IOs may lose value (contraction risk) as rates decline because prepayments can be
expected to accelerate and the IO holder will expect to receive fewer or smaller cash
flows.
• POs gain value as rates decline both because present value factors rise and because
principal repayments can be expected to be received sooner.
• POs lose value (extension risk) as rates rise both because present value factors
decline and because principal repayments can be expected to be received later.

CMOs under Stress

Interest rates rose significantly in 1994, leading to significantly slower prepayments. This
led to lower prices on most CMO tranches. The impact on some tranches was severe. For
example, TAC bonds supported by high-coupon collateral began above par, based on a
likely redemption in a few months. However, the sharp drop in prepayments caused the
bonds to transition from senior to junior and extended the maturity to several years in the
face of rising rates. The coupons on inverse floaters went from very high positive rates to
zero. The impact on these two sectors caused loss of value of 80% or more. The loss was
large enough to close significant financial institutions.

The more recent events beginning in 2007 were associated with sharply lower interest rates.
No doubt investors felt the impact of the rate changes and the follow-on impact on
prepayments. However, the larger impact in the 2007-2010 period was credit loss.

Commercial CMOs
CMOs built from commercial mortgages are significantly different from CMOs built from
residential mortgages for several reasons. First, commercial mortgages generally contain
prepayment penalties that significantly reduce the incentive to refinance when rates decline.
Second, the underlying loans are generally shorter than residential loans, typically with five-
year maturities. For each of these reasons, commercial mortgages (and CMOs backed by
commercial mortgages) have much less interest rate risk than many fixed-income securities.

However, commercial loans are not pooled into securities guaranteed by Freddie Mac,
Fannie Mae, or Ginnie Mae. In addition, many commercial loans are nonrecourse loans—
that is, loans where the borrower looks only to the property for repayment. Income from the
property is intended to be sufficient for regular principal and income payments. And in the
event of default, the lender can seize the property but cannot look to the borrower to
guarantee against a shortfall.

The most important impact of tranches in a CMO backed by commercial mortgages is to

allocate credit risk. The senior tranches receive the first income and principal payments.

© 2020 Wiley
STRUCTURED PRODUCTS

The junior tranches receive the first losses and will receive income only after more senior
tranches are paid.

Analysts forecast overall default rates on the collateral to determine both the risk and the
expected return to each tranche. Analysts also study the correlation of default, because
losses on a particular tranche depend on experiencing multiple losses in the collateral.
Research focuses on understanding the probabilities of various levels of default, not just the
mostly likely outcome.

Learning Objective: Demonstrate knowledge of the structural approach to

credit risk modeling.

MAIN POINT: Calls and puts closely resemble the situation where a company has an
economic incentive to default.

Robert Merton recognized that the Black-Scholes option pricing model could be used to
understand and value a company’s common stock and debt. Suppose an operating company
contained assets that were financed with stock and zero-coupon bonds. Looking forward to
the maturity date of the bonds, the company would revalue the assets and repay the debt if
and only if the value of the assets exceeded the value of the debt. Otherwise, the
shareholders would default, leading the bondholders to take the assets to recover part of the
principal. Seen this way, the value of common stock today closely resembles a European
call option, a contract giving the right but not the obligation to buy the underlying assets on
the expiration date. This is known as the call option view of capital structure.

Equity of Levered Firm = Call Option on Firm’s Assets

The same company can view the structure as a put option. In this case, the shareholders own
the assets purchased in part with cash financed with equity and in part with cash financed
with debt. This is known as the put option view of capital structure. In this scenario, the
value of the assets is subject to going up or down. If the assets’ value goes up or they at
least remain more valuable than the debt, the shareholders will repay the debt on maturity. If
the assets’ value has declined to less than the face value of the debt, the shareholders “put”
the assets to the debt holders. In this way, the equity holders lose no more than their paid-in
capital.

Debt of Levered Firm = Riskless Bond - Put Option on Firm’s Assets

Viewing the capital structure as an option helps to explain an inherent conflict of interest
that exists between stockholders and bondholders. Stockholders are motivated to increase
the amount of debt, all other things being equal, because their loss in limited to their paid-in
amount. Reducing their capital and substituting more debt leaves them with most of the
upside (i.e., the value of the increase in the firm) and less of the downside. Increasing the
debt-to-equity ratio is analogous to using a put with a strike price very close to the current
price instead of a lower strike. In contrast, the debtholders prefer that the assets are financed
more with equity, because shareholders absorb the first losses.

The option vantage also illustrates that shareholders are motivated to increase the volatility
of returns on the assets. For example, they may be content to make a business decision that
could either increase the value of the company by 50% or decrease the value by 50%. The
probabilities for these two outcomes are of interest to the shareholders, but bondholders

438
© 2020 Wiley
 INTRODUCTION TO STRUCTURING

would object to any business decision that had a meaningful chance of ending in bankruptcy
and a loss of all or part of their principal. Stated in options terms, the equity holders prefer
more volatility in the return on assets because it makes the option they own more valuable.
Bondholders prefer less volatility of return because it makes the option they are short more
valuable.

Reconciling the Call-Oriented View to the Put-Oriented View

Put-call parity explains how the value of a call option defines the value of a put. Suppose
that a hedge fund buys a call option and sells a put option, both with the strike of $60. The
position is sometimes called a synthetic long because, if the price of the stock is above $60,
the hedge fund will exercise the call and buy the stock at $60. If the stock price is below
$60, the counterparty will exercise the put and make the hedge fund buy the stock at $60.
Put-call parity says that the value of a call with a particular strike must equal the value of the
stock financed with debt plus a put with the same strike.

In the same way, the value of the stock and bond of the company can be valued either as a
call or as the total assets less the value of a put. There exists a conflict between equity
holders and bondholders regarding the optimal level of risk for a firm’s assets. Stockholders
prefer higher levels of risk, as a consequence of having a long position in a call option.
However, bondholders prefer projects that are safer and have reduced asset volatility, since
they have a short position in a put option.

Using the Black-Scholes Option Pricing Model to Estimate the Value of Debt That
Contains Credit Risk
The Black-Scholes model calculates the present value of the expected value of all possible
outcomes. The model assumes that the return on a stock is normally distributed with a mean
return that produces an average price equal to the forward price. The volatility or standard
deviation of return establishes probabilities for all possible returns.

The following equation explains the process of valuing defaultable debt:

Debt of Levered Firm = Risk Free Debt — Put Option on Firm’s Assets

Example 1

A firm has $100 million in assets and $40 million in equity value. The company has a
zero-coupon bond maturing in one year with a face value of $70 million. A similar U.S.
Treasury STRIPS (Separate Trading of Registered Interest and Principal of Securities)
(riskless) sells for 95% of its face value. What is the value of the firm’s debt and a one-
year put option on the firm’s assets with a strike price of $70 million?

Solution

The risky debt is worth $60 million, $100 million less the equity that is worth
$40 million, because assets = equity + risky debt. The riskless bond is worth
$66.5 million ($70 million x .95), and the put option must be worth $6.5 million.

Binomial Tree Models as an Alternative to the Black-Scholes Option Pricing Model

Binomial trees can approximate options prices, capturing the probability and the time value
of money built into the Black-Scholes option pricing model. It can be shown that a binomial

439
© 2020 Wiley
STRUCTURED PRODUCTS

estimate converges on the Black-Scholes value when the number of branches on the tree is
sufficiently large.

Binomial trees have several advantages over the Black-Scholes model. In particular, it is
helpful to create two trees—one representing the stock price and another valuing the rate of
interest on zero-coupon bonds, reflecting the credit risk of the company at each point. The
two trees permit the valuation of coupon-bearing bonds.

Advantages and Disadvantages of Structural Credit Risk Models

Advantages
• The inputs for structural models come from the equity and equity options markets,
which are very transparent and efficient for many companies.
• The technique can value a complex capital structure involving several levels of
seniority from the same distribution of possible asset prices.

Disadvantages
• The value of some stock prices and volatilities may not be observable (e.g., real estate
or private equity).
• Data about a firm’s capital structure may not be available or may be inaccurate. The
concept is not well defined for assessing sovereign risk.
• Valuation of debt is sometimes unreasonable. The technique can provide poor results
for short-term debt on companies that have very little risk of default. It also can
produce poor results for companies that have a very high risk of default.

Learning Objective: Demonstrate knowledge of interest rate options.

Interest Rate Options

Here we describe and value interest rate caps and floors. The interest rate derivatives market
is the largest derivative market in the world.

In an interest rate cap, one party agrees to pay the other when a specified reference rate is
above a predetermined rate (termed the cap rate).

A caplet is an interest rate cap guaranteed for only one specific date. In turn, a cap (also
known as ceiling) is a series of caplets. The price of a cap is equal to the sum of the prices
of the caplets. The later can be valued using various term-structure models and following a
process similar to the Black-Scholes option pricing model.

Interest rate caps are often purchased by issuers of floating-rate debt to hedge against the
possibility of increases in short-term interest rates. Caps represent a form of insurance.
Equation 23.5 denotes the periodic payment for a cap (based on m periods per year):

Cap Payment = Max [(Reference Rate — Strike Rate), 0] x Notional Value/m (23.5)

Example 2

Firm ABC buys an interest rate cap from Bank XYZ. The cap is for four years, has a
strike rate of 4%, is settled quarterly, and has a notional value of $70 million. What are
the payments, if any, from Bank XYZ to Firm ABC in the first four quarters, if the
reference rates for those quarters are, respectively, 3%, 4%, 5%, and 6%?

440
© 2020 Wiley
 INTRODUCTION TO STRUCTURING

Solution

The solution is found using Equation 23.5, with m = 4 and the strike rate equal to 4%.
For the third quarter, the formula is (5% - 4%) x $70,000,000/4, which is equal to
$175,000. The four answers are $0, $0, $175,000, and $350,000. The formula for a cap
generates no payment when the strike rate equals or exceeds the reference rate.

CAIA Level I, 4th ed., Application 23.6.1 A. Copyright © 2009, 2012, 2015 by The
CAIA Association.

In an interest rate floor, one party agrees to pay the other when a specified reference rate is
below a predetermined rate (termed the floor rate). A floorlet is an interest rate floor
guaranteed for only one specific date. In turn, a floor is a series of floorlets, and its price is
equal to the sum of the prices of the floorlets. Floors can be valued using derivative pricing
models like the Black-Scholes option pricing model.

These options contracts are often purchased by lenders in floating-rate debt to hedge against
the likelihood of declining short-term interest rates. A seller in an interest rate floor is
compensated for guaranteeing the interest rate. Equation 23.6 denotes the periodic payment
for a cap (based on m periods per year):

Floor Payment = Max [(Strike Rate — Reference Rate), 0] x Notional Value/m (23.6)

Example 3

Firm ABC buys an interest rate floor from Bank XYZ. The floor is for five years, has a
strike rate of 6%, is settled quarterly, and has a notional value of $20 million. What are
the payments, if any, from Bank XYZ to Firm ABC in the first four quarters, if the
reference rates for those quarters are, respectively, 3%, 5%, 7%, and 9%?

Solution

The solution is found using Equation 23.6, with m = 4 and the strike rate equal to 6%.
For the first quarter, the formula is (6% - 3%) x $20,000,000/4, which is equal to
$150,000. The four answers are $150,000, $50,000, $0, and $0. The formula for a floor
generates no payment when the strike rate is equal to or less than the reference rate.

CAIA Level I, 4th ed., Application 23.6.2A. Copyright © 2009, 2012, 2015 by The
CAIA Association.

Since caps and floors are not typically traded on exchanges, there will be some exposure to
counterparty risk (the likelihood that one of the parties might default on its contractual
obligation).

441
© 2020 Wiley
STRUCTURED PRODUCTS

Learning Objective: Demonstrate knowledge of collateralized debt obligations.

MAIN POINT: CDOs create subordination to transfer the risk of default to some investors
and reduce the risk of default for other investors.

A CDO is organized much like the capital structure of an operating company having equity
and one or more types of debt securities. The CDO is not an operating company and may
have hired no employees. It is described as a special purpose vehicle (SPV) or entity. The
assets of the SPV are a portfolio of bonds and a small amount of cash. The SPV sells
various debt securities, which, along with some equity, fund the purchase of the bonds.

Attachment Points and Detachment Points

Consider the CDO described in the Typical CDO Structure table.

Typical CDO Structure

CDO Tranches Attachment Points Detachment Points
70% Senior 30% 100%
20% Mezzanine 10% 30%
10% Equity 0% 10%

This CDO has issued two bonds. The senior bond funded 70% of the portfolio. A subordinated
bond, described as a mezzanine issue, funded 20% of the portfolio. Equity owners funded the
remaining 10% of the portfolio. These owners each have different claims on coupon, income,
and principal that range in seniority from the senior layer to the mezzanine layer and then to
the equity tranche. Each of these layers is called a tranche, which generally means “slice” in
French and here refers to the different parts of the capital structure.

Income from the portfolio is allocated first to the senior tranche, which expects to receive a
fixed coupon on the outstanding principal amount. Income is allocated next to the
mezzanine tranche. In each case, if the income is insufficient to pay the required amount,
that tranche generally receives income in kind by increasing the face amount of bonds. If
there is income left after paying the senior and mezzanine tranches, it is paid to the equity
owners.

Principal payments are also allocated first to the senior tranche until all of the senior bonds
are redeemed. Principal then is paid to the mezzanine tranche. If all of the senior and
mezzanine bonds are redeemed, the equity owners would own the portfolio.

Losses are applied in the opposite order, reducing the residual equity claim, the mezzanine,
and if necessary, the senior tranche.

Lower attachment points refer to the points at which losses begin to be allocated to a
tranche. For example, losses are applied immediately (0%) to the equity tranche. Loss are
applied to the mezzanine layer once they exceed the 10% equity layer, the mezzanine
attachment point. Losses are applied to the senior tranche when portfolio losses exceed
30%, the value of equity and mezzanine losses.

Upper attachment points or detachment points refer to the points at which losses stop
being allocated to a tranche. For example, losses greater than 10%, the equity detachment
point, are no longer applied to the equity tranche because the equity tranche will have lost
all of its claim on the portfolio. Losses above 30%, the mezzanine detachment point, are no
longer applied to the mezzanine layer because the mezzanine tranche will have lost all of its

442
© 2020 Wiley
 INTRODUCTION TO STRUCTURING

claim on the portfolio. The detachment point for the senior tranche is 100%. If the senior
tranche begins to be allocated losses, these losses can accumulate until the portfolio has lost
100% of its value.

Mezzanine Tranche as an Option Combination

From a previous lesson, we know that a collar is a combination of a long position in the
underlying asset, a long position in an out-of-the-money put, and a short position in an out-
of-the-money put. The position is tied directly to the price of the underlying asset between
the lower and upper strikes but is decoupled outside the collar.

The mezzanine tranche behaves much like the collar. The value of the tranche is not
impaired as long as the losses on the portfolio do not exceed the attachment point (or 10%
in the previous example). Losses on the portfolio translate into losses on the mezzanine
tranche until losses reach the detachment point.

Note that the payoffs on an option collar are the same as on a bull call spread—a long
position in a call with one strike and a short position in another call with the same expiration
but with a higher strike. The payoffs on an option collar are also the same as on a bull put
spread—a long position in a put with one strike and a short position in another put with the
same expiration but with a higher strike.

443
© 2020 Wiley
 C r e d it R is k a n d C r e d it D e r iv a t iv e s

Credit risk is dispersion in financial outcomes associated with the failure or

potential failure of a counterparty to fulfill its financial obligations.

Positions exposed to credit risk have payoff distributions that are skewed to the left, because
in the event of a default losses can be total.

LESSON MAP
• Demonstrate knowledge of credit risk.
• Demonstrate knowledge of reduced form modeling of credit-risk.
• Demonstrate knowledge of credit derivatives markets.
• Demonstrate knowledge of interest rate swaps.
• Demonstrate knowledge of credit default swaps.
• Demonstrate knowledge of credit options and credit-linked notes.
• Demonstrate knowledge of credit default swap indices.
• Demonstrate knowledge of the five key risks of credit derivatives.

KEY CONCEPTS
Credit derivatives transfer credit risk that arises from the possibility of defaults and is
reflected in credit spreads. The expected credit loss of a credit exposure is the product of the
probability of default, the exposure at default, and the loss at default. If the recovery rate is
zero (i.e., there is a total loss at default), the credit spread is approximately equal to the risk-
neutral probability of default. One of the most important types of credit derivatives is the
credit default swap (CDS), in which the credit protection buyer pays a periodic fee, like an
insurance premium, and receives a payment from the seller if a credit event occurs.

Learning Objective: Demonstrate knowledge of credit risk.

Credit risk arises from both economic conditions and company-specific risk.

• Default risk is the risk that the issuer of a bond or the debtor on a loan will not repay
the interest and principal payments of the outstanding debt in full.

General economic conditions, such as a liquidity crisis or the financial crisis of 2007-2009,
influence credit risk and can lead to defaults. Even under good economic conditions, firm-
specific, idiosyncratic risks such as an obsolete business plan or poor management can lead
to deterioration in credit quality and a higher probability of default. As will be seen, credit
risk also results from the structuring of cash flows.

The “spread product market” refers to fixed-income securities that are not U.S. Treasury
securities because they have yields with a spread (difference from the Treasury rate). The
Treasury securities are considered default free. For all other fixed-income securities, larger
spreads generally reflect larger degrees of default or credit risk when compared to Treasury
securities of the same maturity.

In this topic, the default premium or credit spread is denoted by a small . For example: 5

This equation describes a bond value today, at time zero (0), that has a face value K and that
matures in one year (1). The risk-free rate is denoted by the small r, and the credit spread by . 5

445
© 2020 Wiley
STRUCTURED PRODUCTS

Learning Objective: Demonstrate knowledge of approaches of reduced-form

modeling of credit risk.

MAIN POINTS: Structural models use option pricing to value securities, whereas reduced-
form models take prices, yields, and recovery rates that are largely observable from other
securities and apply the relationships to value potentially illiquid securities or other credit-
risky securities. The expected credit loss of a credit exposure is the product of the
probability of default, the exposure at default, and the loss at default. A risk-neutral
probability is the same as the probability of default for risk-neutral investors. The risk-
neutral approach to pricing risky debt uses the risk-neutral probability of an event
happening (e.g., default) and the probability of the event not happening to compute a
weighted average to the discounted values of the (e.g., debt) security in each case. The risk
premium (spread above the risk-free rate) is equal to the risk-neutral probability in the case
where the recovery rate is zero, and declines as the recovery rate increases.

This learning objective focuses on reduced-form credit models.

• Reduced-form credit models focus on default probabilities based on observations

of market data of securities having similar risk.

Structural models of credit risk were covered separately, but it is important to understand the
difference between structural models, which use option theory, and reduced-form models.
Inputs to structural models are variables that drive the default process, such as volatility of
cash flows and structural characteristics such as leverage. In contrast, reduced-form credit
models’ inputs are yields, spreads, and probabilities of default (hazard or default rates), and
rely on observations. One of the disadvantages of reduced-form models is that sometimes
there are not enough observations (i.e., historical defaults) to estimate a default rate. The
probability of default is denoted by PD, and within the risk-neutral approach to credit
modeling as X. (They are not, however, strictly interchangeable: the statistical probability of
default is equal to the risk-neutral probability, X, only when investors are risk neutral.)

• Hazard rate is a term often used in the context of reduced-form models to denote the
default rate.

Credit risk models are used in relative value and arbitrage strategies to calculate hedge ratios
and to price illiquid securities. Soon reduced-form models will be applied using risk neutrality
to price bonds with credit risk. First, the following three factors establish terminology and
provide a framework to determine the expected credit loss of a credit exposure.

1. Probability of default (PD) specifies the probability that the counterparty fails to
meet its obligations.

Suppose a bank extends a loan to a client with a BB+ credit rating and, based on historical
data, that corresponds to a probability of default of 8%.

2. Exposure at default (EAD) specifies the nominal value of the position that is
exposed to default at the time of default.

Further assume the bank loan is a one-year loan for $100 million at an interest rate of 12%.
Then the exposure at default is ($100 million)(l + .12) = $112 million.

3. Loss given default (LGD) specifies the economic loss in case of default.This is
expressed as a percentage (of the exposure). Let’s assume LGD = 60%.

446
© 2020 Wiley
 CREDIT RISK AND CREDIT DERIVATIVES

We can now compute the expected credit loss using the following equation:

Expected Credit Loss = PD x EAD x LGD

Using our numbers, the expected credit loss is (.08)($ 112 million)(.6) = $5,376,000.

We can also express the loss given default as 100% minus the recovery rate.

The recovery rate is the percentage of the credit exposure that the lender ultimately
receives through the bankruptcy process and all available remedies.

Expected Credit Loss = PD x EAD x (1 —RR)

Example 1: Factors of Expected Credit Loss

An analyst is trying to determine the expected credit loss of a one-year bond issue with a
face value of $100 million, a credit spread of 7%, a probability of default of 10%, and a
recovery rate of 20%. What is the exposure at default and what is the expected credit loss
if the risk-free rate is 2%?

Solution

The exposure at default = EAD = ($100 million)(l + .02 + .07) = $109 million.

The expected credit loss = (. 1)($ 109 million)(l - .2) = $8.72 million.

Risk-Neutral Modeling
A risk-neutral approach is powerful because modeling is simplified since differentiating
between systematic and idiosyncratic risks is not required.

A risk-neutral approach models financial characteristics, such as asset prices,

within a framework that assumes that investors are risk neutral.

Since in this approach investors are risk neutral, the risk-free rate is used as the discount rate.

A risk-neutral investor is an investor that requires the same rate of return on all
investments, regardless of levels and types of risk, because the investor is indifferent
with regard to how much risk is borne.

Pricing Risky Bonds Using Risk-Neutral Modeling

In this approach to pricing a risky bond (with a one-year maturity for simplicity) there are
two states: (1) default with a probability of X and (2) no default with a probability of (1 - X).
In the first case of default, only a portion, RR, of the face value, K, is received and is
discounted by the riskless rate r. In the second, the entire face value is received. The price of
the bond is the sum of both states as represented in this equation:

«7
© 2020 Wiley
 . . K x RR „x K

This can be rearranged to emphasize that a risky bond price is equal to the no default case
discounted by the risk-free rate, times an adjustment factor to account for the risk (i.e., credit
spread):

K
B(0,1) [RR x A+ (1 —A)}
(1 + r)
Recall that the statistical probability of default is equal to the risk-neutral probability, A, only
when investors are risk neutral. Generally, the value used for A is higher than the statistical
probability of default in order to discount risky cash flows.

To calibrate a model means to establish values for the key parameters in a model,
such as a default probability or an asset volatility, typically using an analysis of
market prices of highly liquid assets.

Recall the equation presented in the previous learning objective to illustrate a credit spread:

If we set the preceding two equations equal to each other and solve for A, we have:

so that an approximation for the risk-neutral probability is:

We can see that if the recovery rate is zero (i.e., total loss given default [LGD]), the credit
spread is approximately equal to the risk-neutral probability of default.

Additionally, we can view the credit spread as the product of the probability of default and
one minus the recovery rate, RR, or loss given default (LGD = 1 - RR):

Example 2: Risk-Neutral Bond Pricing—A

A one-year zero-coupon bond with a face value of $1,000 is trading with a risk premium
of 6%. The recovery rate is 80% and the risk-free rate is 2%. What is the risk-neutral
probability of default and what is the price of the bond?

© 2020 Wiley
 CREDIT RISK AND CREDIT DERIVATIVES

Solution

Using the following equation,

1 1 .06
2 = ,we have 2 = = .277778
1 —RR V1 + r + s 1 - . 8 V1 + .02 + .06

.06
Using the approximation X , we have X = .3
1 - RR 1 .8
-

We can price the bond as 5(0,1) = K/(\ + r + s) = $1,000/(1 + .02 + .06) = $925.93

We could also use the risk-neutral formula:

, K xR R /: ,x K
X X t ------t—h (1 —2) X
B ( 0 ,1 )
(1 + r) (l + r)
1,000 x .8 1,000
5(0,1) = .278 x + (1 - .278) x = $235.29 + 686.27
(1 + .02 ) (1 + .02 )
= $925.92

If we wanted to use the approximate risk-neutral probability, we’d have:

, . 1,000 x .8 . 1,000
5(0,1) = . 3 x 2 - -----— + ( l - . 3 ) x ^ __ = $235.29 + 686.27
(1 + .02 ) (1 + .02 )
= $921.56

Example 3: Risk-Neutral Bond Pricing—B

If the risk-neutral probability of default for a one-year zero-coupon bond is 40%, the
recovery rate is 70%, and the risk-free rate is 3%, what is the price of the bond and what
is its yield?

Solution

To price the bond, we can use:

, . „ K x RR , K
5(0,1) = X x —----- - + ( 1 — X) x
(1 + r) (l + r)

or its equivalent:
K 1,000
B(0,1) [RR x 2 + (1 -2)] [.7 x .4 + (1 - .4)] = $854.37
(1 + r) (1 + .03)

To find the yield we can use the formula for the premium, or since there is only one cash
flow, solve for the yield to maturity (YTM) directly:

$1,000/(1 + YTM) = $854.37; YTM = 1,000/854.37 - 1 = 17%, which implies a

premium, 5, of 14%.

Note: If we use the approximation formula, we are off by 2%.

5 - 2 x (1 - RR) = .4(1 - .7) = .12

© 2020 Wiley
STRUCTURED PRODUCTS

The exact relationship, X = --------- ----------- , can be rearranged to isolate , and

5
1 —RR + r + s)
wouldprovide s = .14; however, this is not highlighted in the CAIA curriculum and is
not expected to appear on the exam. The approximation formula is more likely to be
tested in the format of the next example for finding credit spreads using recovery rates.

Example 4: Finding Credit Spreads Using Recovery Rates

A corporation has three classes of debt, one of which trades frequently at a spread of 4%
and a recovery rate of 80%. An analyst wishes to estimate credit spreads for the other
two classes of debt, which are infrequently traded: senior debt with a recovery rate of
90% and subordinated debt with a recovery rate of 60%. Use the approximation formula
to find the spreads.

Solution

Using the spread of 4% and the recovery rate of 80%, we can obtain the probability of
default:

(1 - R R ) 1 —.8

This risk-neutral probability is used to find the other two spreads. The senior debt
credit spread is s ~ X x (1 —RR) = .2(1 —.9) = 2%. The subordinated debt credit
spread is .2(1 - .6) = 8%.

Section Summary
This section has covered a lot, but there are only four equations from this section that you
need to memorize:

1. Expected Credit Loss = PD x EAD x LGD

2. LGD = 1 - RR
1
3. X=
1 —RR V1 + r + s

4. s ~ X x (1 —RR) and X
(l - R R )

Note: You do not need to memorize this equation

. . K x RR K
5(0,1) = X x —----- - + ( 1 — X) x
(1 + r )

It is on the “equations exception list” so, if needed, it will be provided to you during the
exam. Since all examples were for one-period zero-coupon bonds, the simple bond pricing
formula you are already familiar with will most likely suffice: 5(0,1) = K/(l + r + s).

450
© 2020 Wiley
 CREDIT RISK AND CREDIT DERIVATIVES

Advantages of reduced-form models are that (1) they can be calibrated (e.g., finding values
for risk-neutral probabilities of a credit event) using liquid asset prices of other securities,
and (2) they are tractable and can be used to incorporate credit changes quickly without
needed balance sheet information.

Disadvantages of reduced-form models are that (1) liquid assets may be limited, (2) they are
very sensitive to recovery rate and other assumptions, (3) default events may be limited, and
(4) historical default rates may not persist in the future.

The Reduced-Form Models versus Structural Models table summarizes differences between
structural models and reduced-form models.

Reduced-Form Models versus Structural Models

Reduced-Form Models Structural Models

Focus Observable metrics and relationships Valuation using option pricing
between them and the security being models
analyzed
Common Bond yields, spreads, ratings, and Value and volatility of underlying
Inputs historical recovery rates; riskless rate assets (e.g., equity, face value of
and time to maturity of debt debt); riskless rate and time to
maturity of debt

Learning Objective: Demonstrate knowledge of credit derivatives markets.•*

MAIN POINTS: Economic roles of credit derivatives include (1) facilitating risk
management, (2) providing liquidity, and (3) providing price revelation. Three major
methods for grouping credit derivatives are by (1) single-name or multiname instruments,
(2) unfunded or funded instruments, and (3) sovereign or nonsovereign entities. The four
stages of the evolution of credit derivative activity are briefly labeled here as (1) defensive
(pre-1991), (2) intermediated market (starting about 1991), (3) maturation aided by the
International Swaps and Derivatives Association (ISDA) (1999), and (4) development of a
liquid market (beginning about 2003^1).

• Derivatives are cost-effective vehicles for the transfer of risk, with values driven by
an underlying asset.

Economic Roles of Credit Derivatives

Credit derivatives transfer credit risk from one party to another such that both
parties view themselves as having an improved position as a result of the derivative.

Credit derivatives play three economic roles:

1. Risk management, particularly through diversification of credit risk

2. Providing liquidity during periods of credit stress
3. Providing price revelation, also known as price discovery

Price revelation, or price discovery, is the process of providing observable prices

being used or offered by informed buyers and sellers.

45.
© 2020 Wiley
STRUCTURED PRODUCTS

Methods for Grouping Credit Derivatives

There are three major methods for grouping credit derivatives, as outlined next.

1. Single-name versus multiname instruments

Single-name credit derivatives transfer the credit risk associated with a single entity.

Multiname instruments, in contrast to single-name instruments, make payoffs that are

contingent on one or more credit events (e.g., defaults) affecting two or more reference
entities.

2. Unfunded versus funded instruments

Unfunded credit derivatives involve exchanges of payments that are tied to a notional
amount, but the notional amount does not change hands until a default occurs.

Funded credit derivatives require cash outlays and create exposures similar to those gained
from traditional investing in corporate bonds through the cash market.

3. Sovereign versus nonsovereign entities.

Credit derivatives are either on corporations or on sovereign nations. Credit derivatives on

sovereign nations are more complex than those on corporations since the country may be
unwilling to pay, and there are political and macroeconomic risks involved.

Evolution of Credit Derivative Activity

Evolution of credit derivative activity is relatively recent and involves four stages:

1. Defensive (late 1980s to 1991): Activity is characterized by ad hoc attempts by

banks to hedge credit exposure.
2. Intermediated market (starting about 1991): Dealers emerged to transfer credit risk
using derivatives, encouraging investor participation (e.g., total return swaps).
Innovations occurred at this time as well, such as synthetic securitization
(structuring credit derivatives) (e.g., collateralized debt obligations [CDOs], which
take credit risk by selling credit default swaps instead of buying bonds).
3. Maturation aided by the ISDA (1999): Standardization brought about by the
International Swaps and Derivatives Association and financial regulators allowed
credit derivatives to become more like other derivatives instead of being a novel
product.
4. Development of a liquid market (beginning about 2003-4). New ISDA definitions
allowed dealers to trade according to even more standardized practices (relative to
other over-the-counter [OTC] products) and led to index trading and more liquid
markets attractive to hedge funds. There soon may be a fifth stage where they are
traded on derivatives exchanges.

Learning Objective: Demonstrate knowledge of interest rate swaps.

Interest Rate Swaps

Interest rate swaps exchange cash flows based on the difference between a fixed interest
rate and a specified floating interest rate. Payments are based on a notional principal and a
specified number of years, which typically range from 2 to 15 years.

452
© 2020 Wiley
 CREDIT RISK AND CREDIT DERIVATIVES

Interest rate swaps are subject to interest rate risk and credit (counterparty) risk. In a “plain
vanilla” interest rate swap, party A agrees to pay party B cash flows based on a fixed
interest rate, in exchange for receiving from B cash flows in accordance with a specified
floating interest rate.

The payer in a vanilla swap is the party that agrees to pay a fixed rate in exchange for
receiving a floating rate. The receiver (i.e., the counterparty) is the party that agrees to pay a
floating rate in exchange for receiving a fixed rate. The most common motivation offered to
explain the rationale of an interest rate swap is the comparative advantage argument. Note
that, in recent years, pension funds have become active users of interest rate swaps.

A swap rate refers to the fixed rate of an interest rate swap. Initially, the swap rate is set so
that the present value of expected floating payments is equal to the present value of
expected fixed payments.

A swap rate curve displays the relationship between swap rates and the maturities of their
corresponding contracts, having a concept analogous to that of the yield curve.

The payer in a vanilla or simple swap is the party that agrees to pay a fixed rate in exchange
for receiving a floating rate. The receiver is the counterparty that agrees to pay a floating
rate in exchange for receiving a fixed rate. Interest rate swaps entail interest rate risk and
credit risk (counterparty risk). The payer in a vanilla swap will gain from a rise in interest
rates and will be harmed by a decline in interest rates (ignoring the counterparty risk).

Use of Interest Rates by Pension Funds

Pension funds have become active users of interest rate swaps. Pension funds calculate the
present value of their liabilities to find out the funding status of the fund. A pension fund
may be regarded as underfunded if the present value of its liabilities exceeds the value of its
assets. Everything else being the same, a fall in interest rates will increase the present value
of a pension fund’s liabilities, thus increasing the gap between its assets and its liabilities.
Pension funds have two broad options to manage this risk. First, they could invest in long-
term bonds to help reduce the interest rate risk. Second, they may invest in asset classes that
are expected to generate higher returns (e.g., hedge funds, private equity, or public equities)
and use interest rate swaps to manage the inherent interest rate risk.

The swap rate curve is an important benchmark for interest rates in the United States. It is
also frequently used in Europe as the benchmark for European government bonds. Suppose
that pension fund A has entered into an agreement to pay six-month LIBOR in exchange for
receiving (from bank B) a fixed interest rate of 4% per annum every six months for four
years, on a notional principal of $100 million. The following example shows the resulting
cash flows from the point of view of the pension fund, assuming the six-month LIBOR rates
(expressed as rates per year with semiannual compounding) depicted in the second column
of the table.

453
© 2020 Wiley
STRUCTURED PRODUCTS

Example 5: Interest Rate Swap

Six-Month Floating Fixed Net

Date LIBOR Cash Flow Cash Flow Cash Flow

April 3, year 1 3.20%

October 3, year 1 3.50% -$1,600,000 $ 2 ,000,000 $400,000
April 3, year 2 4.00% -$1,750,000 $ 2 ,000,000 $250,000
October 3, year 2 4.50% - $ 2 , 000,000 $ 2 ,000,000 $ 0
April 3, year 3 4.60% -$2,250,000 $ 2 ,000,000 -$250,000
October 3, year 3 4.10% -S2,300,000 $ 2 ,000,000 -$300,000
April 3, year 4 3.90% -$2,050,000 $ 2 ,000,000 -$ 50,000
October 3, year 4 3.70% -$1,950,000 $ 2 ,000,000 $ 50,000
April 3, year 5 -$1,850,000 $ 2 ,000,000 $150,000
Source: CAIA Level I, 4th ed., Exhibit 24.1. Copyright © 2009, 2012, 2015 by The CAIA Association.

On April 3 of year 1, the six-month LIBOR rate was 3.20%. This is the rate that would
have been applied to the floating payment made six months later, on October 3.
Therefore, the first floating cash flow paid by the pension fund is equal to $1,600,000.
This payment was calculated as follows: (3.20%/2) x $100,000,000. The same procedure
can be followed to find the floating rate payments to be made in future periods. The net
cash flow to the pension fund is equal to the difference between the fixed cash flow to be
received and the floating cash flow to be paid.

The principal in a swap contract (known as notional principal) is not exchanged at the end
of the life of the swap, and is used only for the computation of interest payments. In
practice, only the net cash flows, or the difference between the fixed and floating rate
payments, are exchanged.

Example 6

On January 1, ABC pension fund enters a one-year swap, agreeing to pay 4.3464% fixed
rate on a notional amount of $ 10 million and receive a floating payment based on three-
month LIBOR. Both the fixed and the floating payments will be made on a quarterly
basis. The three-month LIBOR rate on January 1 is observed as 4%. In addition, the
interest rate futures market indicates the following rates for the next three quarters:
4.20%, 4.40%, and 4.80%.

Calculate the expected payments for the swap. The expected payments for both fixed and
floating payments are displayed in the following table.

454
© 2020 Wiley
 CREDIT RISK AND CREDIT DERIVATIVES

Fixed and Floating Payments

(8) =
4.3464% x
(7) = (3)/360 x
(1) (2) (3) (4) (5) (6) (6) x 10M 10M
Future Quarterly
Number LIBOR Future Floating Fixed
of Rates LIBOR Payment Payment
Quarter Quarter Days in Current Start of Start of End of End of
Starts Ends Quarter LIBOR Quarter Quarter Quarter Quarter
January 1 March 31 90 4.00% 1.00% 100,000 108,660
April 1 June 30 90 4.20% 1.05% 105,000 108,660
July 1 September 30 90 4.40% 1.10% 110,000 108,660
October 1 December 31 90 4.80% 1.20% 120,000 108,660
Source: CAIA Level I, 4th ed., Exhibit 24.2. Copyright © 2009, 2012, 2015 by The CAIA Association.

Solution

Notice that floating payments are made at the end of each quarter based on the three-
month LIBOR rate observed at the beginning of the same quarter. For instance,
90
100.000 = — x 4.0% x $10,000,000
90
105.000 = — x 4.2% x $10,000,000

Similarly, the fixed payments are calculated using the swap rate of 4.3464%. For
instance,
90
108,660 = ---- x 4.3464% x $10,000,000
360
Source: CAIA Level I, 4th ed., Application 35.4.4A. Copyright © 2009, 2012, 2015 by The CAIA Association.

Consider yet one more example.

Example 7

Given the cash flows and interest rates from the previous example, calculate the value of
the swap as the discounted values of the expected cash flows.

To value the expected future cash flows of the swap, the discount rate needed to apply to
future cash flows must be specified. The interest rates obtained from the futures contracts
can provide the information for calculating these present values. Three new columns
have been added and columns 3-5 have been removed for space concerns. The following
table displays all the information needed to calculate the present values of the two
streams of cash flows.

455
© 2020 Wiley
STRUCTURED PRODUCTS

Present Values of Fixed and Floating Payments

(10) = (H) =
(1) (2) (6) (7) (8) (9) (7) x (9) (8) x (9)
Quarterly
Future Floating Fixed
LIBOR Payment Payment PV of PV of
Quarter Quarter Start of End of End of Forward Floating Fixed
Starts Ends Quarter Quarter Quarter Discount Payments Payments
January 1 March 31 1.00% 100,000 108,660 0.990099 99,010 107,584
April 1 June 30 1.05% 105,000 108,660 0.979811 102,880 106,466
July 1 September 1.10% 110,000 108,660 0.969150 106,607 105,307
30
October 1 December 1.20% 120,000 108,660 0.957658 114,919 104,059
31
Total 423,416 423,416
Note: There is a slight rounding error in the last column of this exhibit.
Source: CAIA Level I, 4th ed. Exhibit 24.3. Copyright © 2009, 2012, 2015 by The CAIA Association.

Solution

Note that the sum of the present values of the floating payments in column 10 is equal to
the sum of the present values of the fixed payments in column 11. This demonstrates that
the swap has an initial value of zero. Note that a twelfth column of the netted expected
cash flows could be formed and used to calculate the same net value. The key to the
calculations is the forward discounts that appear in column 9. They are based on the
quarterly three-month LIBOR rates that appear in column 6. For instance,
1
0.990099 =
1+ 1.00 %
1
0.979811 =
(1 + 1.00%) x (1 + 1.05%)

In other words, the denominator of each discount factor is compounded using the current
and previous three-month LIBOR rates. The present values of the two streams are
calculated using these discount rates. When using 4.3464% as the swap rate, the present
values of the two streams are equal when the swap contract is initiated.

Source: CAIA Level I, 4th ed. Application 35.4.4B. Copyright © 2009, 2012, 2015 by The CAIA Association.

Valuation of Interest Rate Swaps

Interest rate swaps are worth zero at time zero, this it, when the two parties agree to the
transaction. Once the contract is entered into, and as market interest rates change, payments
from the floating-rate leg will also change.

An interest rate swap can be regarded as a bond transaction in which the fixed-rate party
issues a fixed-coupon bond and invests the proceeds in a floating-rate bond having the same
payment dates and maturity. Thereafter, on each payment date, the floating-rate payment is
received and the fixed-coupon payment is made. The swap can be valued as the difference
between the market value of the fixed-coupon bond and the market value of the floating-rate

456
© 2020 Wiley
 CREDIT RISK AND CREDIT DERIVATIVES

bond. Interest payments are netted in the actual swap, and the contract does not require
principal payments.

Risks Associated with Interest Rate Swaps

Credit risk on a two-leg swap exists when one of the parties to the contract is in-the-money,
because that leg of the contract will face the possibility of default by the other party.
However, when a swap is agreed upon through an intermediary (i.e., a financial institution),
typically the intermediary will bear the default risk in exchange for a fixed percentage of the
value of the contract in the form of a bid-ask spread.

The risk exposure of a swap due to unanticipated interest rate changes is another potentially
important risk. The credit risk of an interest rate swap can be managed according to the
following two dimensions: (1) contractual provisions, documentation, collateral, and
contingencies; and (2) diversification of the swap book across industry and market sectors.

Prior to the financial crisis of 2007, it was assumed that LIBOR was both a reasonable
proxy for the credit quality of counterparties when the contract is not collateralized and
could be used to determine suitable discount factors for the risk-free term structure when the
contract is collateralized. Both of these assumptions are no longer valid. Since 2007, large
banks entering into swaps are assumed to have credit risk and now, swap rates contain a
spread over the LIBOR discount rates.

The Global Financial Crisis of 2007-2009 and Interest Rate Swaps

The traditional approach to pricing and valuing standard interest rate swaps is based on two
key assumptions regarding the LIBOR discount factors: (1) if the contract is
uncollateralized, there exist reasonable proxies for the credit quality of the counterparty, and
(2) in the case where the contract is collateralized, there exist suitable measures for the risk-
free term structure.

According to evidence presented in the book, the Global Financial Crisis defies the second
assumption because collateralization is now a usual feature of the swap market, and also
because the existence of considerable and persistent differences between LIBOR and other
proxies for risk-free rates indicates that discount factors implied from LIBOR can no longer
be regarded as risk-free. As a result, fixed rates on overnight indexed swaps are now
regarded as more appropriate for valuing collateralized contracts. Finally, the spread can
arise as a liquidity premium to compensate for liquidity risk and as a credit spread. The
Global Financial Crisis showed that it is unreasonable to assume top-tier banks cannot
default.

Learning Objective: Demonstrate knowledge of credit default swaps.

MAIN POINTS: Credit default swaps (CDSs) are different from total return swaps. While
both are used to transfer credit risk, the buyer of a CDS pays a fixed premium and receives
cash if an event occurs, whereas the buyer of a total return swap pays the uncertain total
return and receives a fixed return. The standard ISDA agreement is a template for negotiated
credit agreements to specify the referenced asset, the notional amount, the quoted rate
(spread), maturity/tenor, and, importantly, the trigger events. A marked-to-market (MTM)
gain is realized when the market premium moves wider than the contract premium, and a
loss is realized when it narrows. Three methods for unwinding credit default swap
transactions are: (1) enter an offsetting position, (2) assign the contract, or (3) terminate the
contract. Typical participants in the CDS market include banks, hedge funds, other asset
managers, life insurance and property insurance companies, monolines (providers of bond

457
© 2020 Wiley
STRUCTURED PRODUCTS

guarantees) and reinsurers, and corporations. The motivations for using CDSs can be placed
in five groups: (1) risk decomposition, (2) synthetic shorts, (3) synthetic cash positions,
(4) market linking, and (5) providing liquidity during stress.

Within the credit market the most important development was the CDS, the focus of this
learning objective.

A credit default swap (CDS) is an insurance-like bilateral contract in which the

buyer pays a periodic fee (analogous to an insurance premium) to the seller in
exchange for a contingent payment from the seller if a credit event occurs with
respect to an underlying credit-risky asset.

Most credit-risky assets underlying CDSs are corporate bonds, but need not be.

Credit Default Swaps and Total Return Swaps

Within the context of a CDS:

The credit protection buyer pays a periodic premium on a predetermined amount

(the notional amount) in exchange for a contingent payment from the credit
protection seller if a specified credit event occurs.

The credit protection seller receives a periodic premium in exchange for delivering
a contingent payment to the credit protection buyer if a specified credit event occurs.

The credit protection buyer and seller of a total return swap differ from those of a CDS in
terms of what they pay and receive, as shown in the CDS versus Total Return Swap table.

In a total return swap, the credit protection buyer, typically the owner of the credit-
risky asset, passes on the total return of the asset to the credit protection seller in
return for a certain payment.

CDS versus Total Return Swap—Both Referencing an Underlying Risky Asset

CDS Total R eturn Swap

Buyer pays seller Fixed premium Total return
Buyer receives from seller Cash if event occurs Fixed return

Mechanics of Credit Default Swaps: Terms and the Standard ISDA Agreement
Four key terms define any particular CDS contract:

1. The referenced asset (also called the referenced bond, referenced obligation, or
referenced credit) is the underlying security on which the credit protection is
provided.
2. The notional amount is analogous to the face value of a bond.
3. The CDS spread is the rate quoted, not a credit spread. The annual spread is quoted
in basis points and typically paid quarterly. For example, if the notional amount is
$20 million and the spread is 200 basis points, then the buyer pays (2%/4)
($20,000,000) = $100,000, four times per year.
4. The CDS maturity, or tenor, is often for five years, expiring on the 20th of March,
June, September, or December.

Yet at the heart of any CDS contract is the intensely negotiated definition of trigger events,
as outlined below. The standard ISDA agreement provides a framework for establishing

458
© 2020 Wiley
 CREDIT RISK AND CREDIT DERIVATIVES

terms. While it is not required that parties use the framework provided by the industry body
for derivatives documentation (the ISDA), the framework has facilitated the growth of this
market in privately negotiated contracts.

The standard ISDA agreement serves as a template to negotiated credit agreements

that contains commonly used provisions used by market participants.

Components of the ISDA agreement include:

1. The CDS spread or CDS premium is paid by the credit protection buyer to the
credit protection seller and is quoted in basis points per annum on the notional value
of the CDS.
2. Contract size (notional amount).
3. Trigger events:
o Bankruptcy
o Failure to pay
o Restructuring
o Obligation to acceleration
o Obligation default
o Repudiation/moratorium (applies to sovereign bonds when a country refuses
to pay)
o Government intervention
4. Settlement may be cash or physical:
o In a cash settlement, the credit protection seller makes the credit protection
buyer whole by transferring to the buyer an amount of cash based on the
contract.
o Under physical settlement, the credit protection seller purchases the
impaired loan or bond from the credit protection buyer at par value.
5. Delivery. Most CDS settlements are physical where the face value of the bond or
several assets are transferred from the protection buyer’s balance sheet to the seller’s
in exchange for cash. The buyer will receive cash in the amount of the face value of
the asset while delivering an impaired asset, thus realizing the credit protection.
There are choices regarding which assets to deliver, so selecting the cheapest-to-
deliver assets becomes an issue. Deliverables may include direct obligations, those
of a subsidiary, or even those of a third party that the party of the referenced asset has
guaranteed.

Example 8: Credit Default Swap Cash Flows

What cash flows occur in the following scenario?

A bank purchases a credit default swap from a fund. The notional value (or face value of
referenced debt, in this case an industrial company bond) is $100 million, and the
premium is 4% paid quarterly. The term is five years, and the contract is to be settled
physically. After one year, there is a credit event.

Solution

During the first year, the bank pays the fund (.04/4)($100 million) = $1 million each
quarter. The credit event causes the following exchange: the bank delivers the face value
of the distressed bond (with a lower market value) to the fund and the fund pays the bank
$100 million. The contract ends.

459
© 2020 Wiley
STRUCTURED PRODUCTS

• The process of altering the value of a CDS in the accounting and financial systems of
the CDS parties is known as a mark-to-market adjustment.

The three main reasons the parties do this is for financial reporting, realizing economic gains
or losses, and managing collateral. A marked-to-market (MTM) gain is realized when the
market premium moves wider than the contract premium, and a loss is realized when it
narrows.

Marked-to-Market CDS Valuation

Assume an investor has purchased a five-year CDS with a 100-basis-point premium. A
year later, the same CDS protection can be purchased for 120 basis points. Hypothetically,
the investor could sell a CDS at 120 basis points, using the 120 basis points received to pay
the 100 basis points of the first CDS purchased, providing an annuity of 20 basis points.
The MTM gain is the present value of the annuity, adjusted for a possibility of default.

Unwinding Credit Default Swap Transactions

Three methods for unwinding credit default swap transactions are:

1. Enter an offsetting position.

2. Assign the contract.
3. Terminate the contract.

In the MTM valuation example it was assumed that the investor could hypothetically enter
an offsetting position. The investor could unwind the CDS transaction if he or she actually
did enter the offsetting position. In the MTM example, another CDS was sold, leaving a
residual counterparty risk and an associated spread. The position could also be offset using
bonds, and residual interest rate risk may need to be hedged.

To unwind a contract by assigning it a dealer or another party, permission must be granted

by the original counterparty because a contract with a new party gives rise to different
counterparty risk.

• A novation or an assignment is when one party to a contract reaches an agreement

with a third party to take over all rights and obligations to a contract.

In the third method of unwinding a CDS, both parties must agree to terminate the contract
and how to compensate for any resulting losses from doing so.

Credit Default Swap Market Participants

There are many participants and motivations for transacting in the growing CDS market:•

• Banks, as market makers, hedge single-name and broader credit risk in their loan
portfolios.
• Hedge funds began using CDSs primarily in convertible arbitrage strategies but now
use them more broadly across several strategies.
• Other asset managers may use credit securities to hedge credit risk or express macro
views.
• Life insurance and property insurance companies often sell CDSs to enhance
portfolio returns.
• Monolines (providers of bond guarantees) and reinsurers also sell credit protection to
both enhance and diversify their portfolios.

460
© 2020 Wiley
 CREDIT RISK AND CREDIT DERIVATIVES

• Corporations use CDSs to hedge credit risk of counterparties (e.g., in accounts

receivables), and to monitor their own spreads to manage bond issuance and
minimize funding costs.

The motivations for using credit default swaps can be placed in five groups:

1. Risk decomposition. Corporate bonds bundle interest rate risk, credit risk, and other
potential risks such as call risk and currency risk, whereas CDS spreads reflect only
credit risk. The ability to separate and hedge out credit risk allows for more efficient
interest rate arbitrage strategies, for example in convertible arbitrage strategies.
2. Synthetic shorts. Shorting credit risk to hedge it away is easily accomplished with
CDSs.
3. Synthetic cash positions. CDSs can be used as loan or bond substitutes. While often
the reference entity is a risky bond, they may refer to senior secured debt. A view on
the company’s prospects can be expressed by having a portfolio of CDSs on
different classes of bonds within the same company’s capital structure, effectively
serving as a substitute for equity.
4. Market linking. CDS spreads provide information about the probability of defaults
and therefore information relevant to pricing of assets trading in other markets and
structurally linking them with the CDS market.
5. Liquidity during stress. Holders of distressed bonds that might otherwise have
difficulty selling them in illiquid markets can now buy protection in the form of a
CDS, instead of needing to sell the bond when it is potentially very difficult to do.

Other Credit Derivatives

Learning Objective: Dem onstrate knowledge o f credit options and credit-linked

notes.

MAIN POINTS: Credit default swaps pay premiums regularly, usually quarterly, but credit
options make one up-front premium payment. The terminology of credit derivatives
generally refers to underlying rates rather than prices. A credit put option on a bond pays the
holder nothing if in default and pays the difference between the exercise price and the
market price of the bond if not in default. Call options on credit default swaps offer
protection against declines in the value of the underlying bond, but that protection comes at
a cost (the option premium). Credit-linked notes are for all practical purposes synonymous
with bonds or notes with coupon payments, but the issuer is not the same entity as the
referenced asset, so credit risk is separated.

This learning objective focuses on credit derivatives that behave like options. First, consider
how CDSs are similar and dissimilar to options. They both have potentially asymmetric
payouts. However, a CDS pays several premiums whereas traditional options make one
premium payment. Additionally, a trigger event results in a payout for CDSs whereas a
traditional option buyer has the right, but not the obligation, to exercise the option.
(However, not all credit options have this traditional option feature; one that doesn’t is the
binary option described shortly.)

Credit options may be the right to “buy” (call) or “sell” (put) an underlying credit-risky
asset (price) or the asset’s rate (which is why “buy” and “sell” are in quotation marks). Note
that prices and spreads move inversely, so opposite bets are represented by call options on a
price and those on a rate. Credit protection can be obtained via a put option on a bond price

© 2020 Wiley
STRUCTURED PRODUCTS

or a call option on the spread. As with other options, credit options may be purchased on a
stand-alone basis, or may be embedded in another security or contract.

Binary options (sometimes termed digital options) offer only two possible payouts, usually
zero and some other fixed value. These do not offer the right, but rather the obligation, to
exercise the option. Furthermore, they offer a fixed payout when exercised so do not have
the large upside payout pattern of classic options. The usual European/American
terminology applies to credit options:

European credit options are credit options exercisable only at expiration, and
American credit options are credit options that can be exercised prior to or at
expiration.

Credit Put Option on a Bond

An example of a credit put option is one on a bond that pays the holder nothing if in
default and pays the difference between the exercise price and the market price of the
bond if not in default. This type of credit put option could be useful in hedging the credit
risk of the underlying bond. Note that this example does not fit the description of the
binary credit option, which pays out a fixed value.

Two other types of credit-based securities outlined in this section are call options on CDSs
and credit-linked notes.

What might a call option on a CDS look like? Consider a call option on a CDS with a strike
equal to a spread of 3%. If the credit-worthiness of the company issuing the underlying asset
declines, the spread increases to, for example, 4% and the holder may choose to exercise the
option. Thus, when held in combination with the underlying bond, it offers protection against
declines in the value of the bond, but that protection comes at a cost (the option premium).

Structuring allows notes to be linked to the value of virtually anything: commodities,

equities, and credit-linked notes.

• Credit-linked notes (CLNs) are bonds issued by one entity with an embedded credit
option on one or more other entities.

A CLN on a company (e.g., company ABC) is not issued by that company. (This CLN is
not to be confused with a commodity-linked note.) Rather, these CLNs are legally distinct
from the referenced asset and engineered, like a CDS, to have payoffs related to the
referenced asset. Investors in CLNs are interested in taking on credit risk but not directly as
is possible by selling a CDS. While most credit derivatives’ notional values are off-balance-
sheet items, the CLN is listed on the balance sheet of the investor, and the investor receives
coupon payments as agreed if there is no default on the underlying asset. In the event of a
default by the referenced asset (e.g., company ABC), the coupon payments may be lowered
or eliminated. These coupon payments are not delivered by company ABC, since ABC did
not issue the CLN. The issuer of the note is a credit protection buyer and pays the coupons
to the CLN buyer. The appeal of issuing a CLN, beyond the loan itself, is the credit
protection, because in the event of default there is no bankruptcy participation since the
issuer is a separate legal entity from the referenced asset.

462
© 2020 Wiley
 CREDIT RISK AND CREDIT DERIVATIVES

Learning Objective: Demonstrate knowledge of credit default swap indices.

CDS Index Products

CDS indices are indices or portfolios of single-name CDSs.

The CDX and iTraxx indices cover the major corporate bond markets globally. The CDX
(North America and emerging markets) and iTraxx (Europe and Asia) CDS indices are
tradable and allow investors to take long and short positions in a basket of 125 equally
weighted credit names.

A credit name is removed from the indices if it experiences a credit event. The maturity of
the basket of credits is fixed, so that every six months the indices roll. The most recent
index series is termed on-the-run, and has the longest maturity and market value since the
credit spread curves are generally upward sloping. The market is highly liquid: trades reflect
bullish or bearish bets more quickly than is reflected in the underlying single-name CDSs.
Premiums paid are on the total notional value of the portfolio. A credit event of any single
name in the portfolio results in its removal and lowers the notional value.

Learning Objective: Demonstrate knowledge of the five key risks of credit

derivatives.1*

Five Key Risks of Credit Derivatives

MAIN POINT: The five key risks of credit derivatives are (1) excessive credit exposure
using off-balance-sheet derivatives, (2) pricing risk of OTC derivatives, (3) liquidity risk of
OTC derivatives, (4) counterparty risk of OTC CDSs, and (5) the basis risk of CDSs.

1. Excessive risk taking may occur because the notional value of most credit
derivatives are off-balance-sheet items that are not as noticeable as when liabilities
are listed on the balance sheet.
2. Pricing risk is more difficult with OTC securities than with exchange-traded products.
3. Liquidity risk is also higher for OTC credit derivatives: the contracts usually prevent
the buyer from selling to a third party.
4. Counterparty risk is not generally a concern for exchange-traded products, because
the brokerage firms and clearinghouses back the contracts. However, this is not true
with OTC contracts. Ironically, just when credit protection is needed most, such as
during a crisis, a new risk, counterparty risk, becomes significant to credit protection
buyers because the seller may not pay as agreed. The degree of this type of risk
became apparent during the 2007 financial crisis. For credit options, only the long
position (holder) is subject to counterparty risk. For swaps, both parties may be
concerned with counterparty risk, but the buyer has more to be concerned about than
the seller. If an option writer defaults, only the holder loses. For swaps, as market
prices (and rates) move from where they were after the swap was initiated, values on
one side become positive and the other negative. Therefore, the positive side is like
the option holder, but even on the negative side there is counterparty risk to the
extent that value could become more positive.
5. Basis risk can arise when using credit derivatives referencing assets that are not
perfectly correlated with the asset containing the credit risk that was meant to be
hedged. For example, a bank may use a CDS that references a five-year bond to
hedge credit risk of a four-year bond. The imperfect correlation would give rise to
basis risk. This could be avoided by negotiating a more customized contract, but
may increase the liquidity risk.

463
© 2020 Wiley
 CDO S t r u c t u r in g o f C r e d it R is k

Beginning in the 1980s, financial institutions began using collateralized debt obligations
(CDOs) to transfer risk. The resulting marketplace extended the number of investors willing
to invest in certain types of securities and increased the opportunity of lenders to adjust their
credit exposure.

LESSON MAP
• Demonstrate knowledge of collateralized debt obligations (CDOs).
• Demonstrate knowledge of balance sheet CDOs and arbitrage CDOs.
• Demonstrate knowledge of the mechanics of and motivations for arbitrage CDOs.
• Demonstrate knowledge of cash-funded CDOs and synthetic CDOs.
• Demonstrate knowledge of cash flow and market value CDOs.
• Demonstrate knowledge of credit risk and enhancement of CDOs.
• Demonstrate knowledge of new developments in CDOs.
• Demonstrate knowledge of the risks of CDOs.

KEY CONCEPTS
CDOs divide default risk between different tranches, creating large tranches of highly rated
securities backed by relatively small tranches. The structuring enhanced the credit protection
for many investors and created a marketplace where lenders could transfer some of the
credit risk they didn’t wish to carry.

Learning Objective: Demonstrate knowledge of collateralized debt obligations

(CDOs).

MAIN POINT: A CDO is a portfolio financed with two or more issues of different
seniority. The structuring creates securities many investors are willing to buy even though
they are backed by securities they would not be willing to buy separately.

The name collateralized debt obligation or CDO includes collateralized loan obligations
(CLOs) and collateralized bond obligations (CBOs).1 A similar-sounding structure, the
collateralized mortgage obligation (CMO), is rather different. A CDO, including either a
CLO or a CBO, is primarily enhancing credit or transferring the risk of default. A CMO is
primarily dealing with guaranteed loans and focuses on allocating maturity risk, including
extension risk and contraction risk.

CDOs were first created in the late 1980s to finance high-yield portfolios. The portfolio is
alternatively called collateral or the reference portfolio. The structure sought to reduce risk
to some of the bondholders by diversification, including an equity layer and one or more
layers of subordinated bonds, as well as excess collateral.

Motivations for Investors to Buy CDO Bonds

The high credit ratings assigned to senior tranches (when the underlying collateral pool
consists of non-investment-grade bonds) are justified by three primary reasons: (1) the
senior position, (2) the diversification provided by the collateral portfolio, and (3) credit
enhancements that were structured into the deal.

1A CDO may include both bonds and loans in the portfolio.

465
© 2020 Wiley
STRUCTURED PRODUCTS

• Structured products allow investors to manage credit risk.

• Customers with greater market knowledge can take risks that will enhance their risk-
adjusted returns.
• The CDO may contribute more diversification than investors can achieve
independently.
• The structures may allow some investors to bypass some regulations restricting their
investing.
• Investors benefit from the management of the CDO.
• CDOs may be more liquid than the bonds in the portfolio.

General Structure of a CDO

• Sponsor—a bank that sets up a trust and pays setup fees.
• Manager—performs portfolio management services.
• Trustee—an entity charged with looking out for the interests of the investors in the
bonds issued by the CDO. The trustee should not also serve as the sponsor or
manager.
• Special purpose vehicle (SPV)—generally a business trust or special purpose
corporation (SPC):
o Owns the portfolio of bonds.
o Issues bonds and equity tranches.
o Is bankruptcy remote—SPV is isolated from a possible bankruptcy of
sponsor or manager.

Life Cycle of a CDO

• Ramp-up period—managers invest the newly raised cash in specific issues.
• Revolving period—managers may swap assets in the portfolio and reinvest
maturing proceeds.
• Amortization period—managers use proceeds of maturities to pay off investors in
the CDO.

Some Terminology and Details of CDOs

• Weighted average rating factor (WARF)—average credit score for bonds in the
SPV’s portfolio. Individual bonds are rated between 1 (AAA bonds) and 10,000
based on the probability of default. The scale is tightly spaced for high-grade bonds
and broadly spaced for low-grade bonds. CDO indentures usually specify a
maximum WARF.
• Weighted average spread(WAS)—value-weighted average spread over LIBOR for
bonds in the SPV’s portfolio.
• Diversification score—this index of correlation estimates the number of
uncorrelated securities to acquire to have the same probabilities of losses as the CDO
portfolio.
• Lower attachment points—the points at which losses begin to be allocated to a
tranche.
• Upper attachment points or detachment points—the points at which losses stop
being allocated to a tranche.
• Tranche width—the difference between the upper attachment point and the lower
attachment point on a tranche.

© 2020 Wiley
 CDO STRUCTURING OF CREDIT RISK

Learning Objective: Demonstrate knowledge of balance sheet CDOs and

arbitrage CDOs.

MAIN POINT: Balance sheet CDOs provide an opportunity for financial institutions to
reduce their exposure to loans or bonds they hold. Arbitrage CDOs create structured
securities that match the investment needs of various investors while making potentially
profitable transactions.

Balance sheet CDOs are created from bonds or loans at a financial institution (generally a
bank or insurance company). The institution contributes the assets to reduce the size of its
balance sheet. The institution may retain the equity tranche, in which case the institution
will retain significant risk exposure and can expect to earn a return for carrying that risk.
The selling bank may also be hired as the CDO manager.

The financial institution that contributes the assets may be seeking to reduce its credit
exposure to certain borrowers. Some institutions are looking for the capital they will receive
from the tranche buyers. Some institutions are seeking to reduce regulatory capital.

These portfolios may be allowed to passively pay down. Alternatively, the manager may
actively manage the portfolio if there is a reinvestment period.

Arbitrage CDOs are created by the manager, who retains the equity tranche. Managers
create the CDO to earn excess spread, which they keep. That spread is the difference
between the return on the portfolio and the returns paid on the tranches. The manager also
earns a spread on the assets under management in the portfolio.

The CDO will invest in a portfolio of high-yield bonds. The manager trades off the higher
potential income against a high chance of credit losses. The CDO is created with a large
portion sold as AA or perhaps AAA bonds. These bonds have relatively low coupons
because the other tranches, diversification, and excess collateral reduce the chance of credit
loss. At least one additional tranche, called a mezzanine tranche, will be sold. In most cases,
several tranches are created with different seniorities. The additional tranches provide
protection against credit loss on the senior bonds.

Losses are applied to the most junior tranches first. If losses exceed the principal amount of
the most junior tranche, losses are applied to the next junior tranche. Note that the equity
tranche does not have a face value. Instead, equity owners have a claim on the residual, the
balance of the portfolio after all notes are repaid. Because they have a residual claim, the
equity tranche absorbs the first losses.

Learning Objective: Demonstrate knowledge of the mechanics of and

motivations for arbitrage CDOs.

MAIN POINT: Managers create arbitrage CDOs because they can make money doing so—
by selling collateral to the deal, by managing the CDO for fee income, and by investing in
the equity tranche to profit from the residual.

Managers have three ways to make money in creating an arbitrage CDO. First, they may
sell bonds to the deal to earn an up-front profit. Second, the manager is paid fees each
period based on the assets under management. Finally, the manager usually retains the
equity tranche. The manager hopes to accumulate a spread net of credit losses.

467
© 2020 Wiley
STRUCTURED PRODUCTS

Learning Objective: Demonstrate knowledge of cash-funded CDOs and

synthetic CDOs.

MAIN POINT: Cash-funded CDOs rely on the purchase of actual bonds to form a portfolio.
A synthetic CDO builds a portfolio simulating a portfolio with credit derivatives.

A cash-funded CDO uses the proceeds of bond sales to buy a portfolio of bonds. Maturing
bonds and coupons provide cash flow to make regular coupon payments to the tranches and
to redeem the bonds. Cash-funded CDOs are usually associated with balance sheet
transactions because the financial institution is motivated to sell bonds.

In contrast, a synthetic CDO will sell protection with a credit default swap (CDS). Because
the CDS does not use up the cash raised by the CDO, the manager will invest the cash in
floating-rate investments. The resulting portfolio behaves much like an actual portfolio of
bonds. Arbitrage deals could be constructed as either cash-funded or synthetic CDOs. With
a cash-funded portfolio of bonds, managers are limited to the bonds available for sale but
are able to invest in many more issues as a synthetic CDO. Financial institutions may also
facilitate synthetic CDOs as arbitrages to take advantage of the different return on the
portfolio versus the cost to borrow in the CDO. These institutions may use CDSs to transfer
the economic risk of their positions to the CDO because the transfer is much simpler than a
cash sale.

Advantages of synthetic CDOs over cash-funded CDOs are:

• It is often difficult to transfer loans, which may require consent from the borrowers.
• The managers may be able to include assets in the portfolio via CDS or total return
swap that may be hard to locate as actual assets.
• Managers can create leveraged exposure to assets using derivatives.

Challenges of using synthetic CDOs are:

• Synthetic transactions are exposed to counterparty risk.

• Derivatives make the SPV somewhat less bankruptcy remote.

Cash-Funded CDOs and Regulatory Capital

When a financial institution uses bonds it holds to create a cash-funded CDO, the bonds are
removed from the institution’s balance sheet and replaced with cash. Removing the bonds
reduces required regulatory capital, which must be provided as equity. For example, placing
loans from its portfolio into a CDO may reduce the regulatory capital by 8% of that amount.
However, if the bank has to retain a first-loss position (an equity investment), regulatory
capital would be 100% of that amount. The equity tranche would, in most cases, be
significantly less than 8%.

Example 1

Consider a bank with a $400 million loan portfolio that it wishes to sell. It must hold
risk-based capital equal to 7% to support these loans. If the bank sponsors a CDO trust in
which the trust purchases the $400 million loan portfolio from the bank for cash, how
much reduction in risk-based capital will the bank receive if it finds outside investors to
purchase all of the CDO securities?

468
© 2020 Wiley
 CDO STRUCTURING OF CREDIT RISK

Solution

Since the bank no longer has any exposure to the basket of commercial loans, it has now
freed $28 million of regulatory capital (7% x $400 million = $28 million) from the need
to be held to support these loans.

Adapted from CAIA Level I, 4th ed., 2020. Application 25.4.IB. Copyright © 2009,
2012, 2015 by The CAIA Association.

Example 2

Consider a bank with a $300 million loan portfolio that it wishes to sell. It must hold
risk-based capital equal to 9% to support these loans. If the sponsoring bank has to retain
an $8 million equity piece in the CDO trust to attract other investors, how much
reduction in regulatory capital will result?

Solution

Since the bank must take a one-for-one regulatory capital charge ($8 million) for this
first-loss position, only $19 million ($27 million - $8 million) of regulatory capital is
freed by the CDO trust.

Adapted from CAIA Level I, 4th ed., 2020. Application 25.4.1 A. Copyright © 2009,
2012, 2015 by The CAIA Association.

Learning Objective: Demonstrate knowledge of cash flow and market value

CDOs.

MAIN POINT: A cash flow CDO is an arbitrage CDO that sets up a mostly passive
portfolio with carefully matched cash flows in the assets and liabilities. Market value CDOs
are not committed to matching cash flows, preferring instead to actively manage the
collateral for maximized return.

There are two ways to operate an arbitrage CDO. Cash flow CDOs seek to match the cash
flows of the portfolio to the cash flows required by the tranches. In particular, the manager
chooses maturities for bonds in the portfolios so as to have sufficient cash to service the
tranches while minimizing the amount of excess cash, which earns a much lower return.
Once a portfolio is constructed, the manager focuses on credit exposure.

Cash flow CDOs may be static, in which case there is very little change to the positions over
time. Most CDO portfolios are actively managed to enhance return and mitigate changing
credit exposure.

A market value CDO does not seek to match cash flows of the assets and the liabilities.
Instead, the manager trades the bonds to maximize the returns and to generate cash to
service the tranche payments.

469
© 2020 Wiley
STRUCTURED PRODUCTS

Learning Objective: Demonstrate knowledge of credit risk and enhancement

of CDOs.

MAIN POINT: Subordination is the main tool used to transfer risk. Overcollateralization is
an important part of credit enhancement. The income earned on the portfolio net of the
interest expense on the liabilities contributes to the protection against losses. Other factors,
such as reserve accounts and external risk transfer, can be used to mitigate risk. An internal
credit enhancement is a mechanism that protects tranche investors and is made (or exists)
within the CDO structure, such as a large cash position.

Subordination
Subordination is the most important tool used by structurers to enhance the credit quality of
certain tranches by transferring some of the risk of default to other tranches, including the
equity tranche. Subordination transfers the risk between different bonds in a CMO structure,
so some investors are exposed to less risk and others are exposed to more risk. Because
losses are applied first to the most junior tranche and then to successively more senior
tranches, a relatively senior tranche is exposed to credit losses only if and when the losses
are large enough to be allocated to that tranche.

Subordination is also used to transfer extension risk or contraction risk between different
bonds in a CMO. Recall from the Introduction to Structuring lesson that CMOs are
generally structured from agency pass-throughs that are guaranteed by a federal agency.
These securities are not exposed to credit losses, but the risks to investors from changes in
prepayments are still significant. As explained in the Introduction to Structuring lesson,
sequential-pay CMOs, PACs, TACs, and other provisions allocate this risk to or from
certain bonds.

Overcollateralization
Rating agencies and investors require that the value of the portfolio exceeds the value of the
liabilities (tranches). This difference is called overcollateralization. The difference provides
a cushion to allow for a certain amount of losses on the portfolio.

Subordination also provides overcollateralization to individual tranches. The Typical CDO

Structure table reproduces a table presented in the Introduction to Structuring lesson.

Typical CDO Structure

CDO Tranches Attachment Points Detachment Points
70% Senior 30% 100%
20% Mezzanine 10% 30%
10% Equity 0% 10%

The equity tranche is, of course, the overcollateralization described earlier. There is more
value in the portfolio supporting the mezzanine and senior tranches, and the equity tranche
has a claim on the residual. The collateralization of the entire deal is 100/90 or 111%, and
this is the perspective of the mezzanine investors.

The senior tranche has first claim on 100% of the portfolio but makes up only 70% of the
bonds issued by the CDO. The collateralization seen from the perspective of the senior
tranche is 100/70 or 143%.

.70
© 2020 Wiley
 CDO STRUCTURING OF CREDIT RISK

Excess Spread
The average return on bonds in the portfolio is greater than the average coupon paid by the
SPV. The excess income compensates the equity holders for anticipated credit losses. The
spread may exist because the default risk is higher on the portfolio than with the tranches (in
which case, the equity tranche is assuming greater risk and has a claim on excess return).
The manager may mismatch the maturities of the assets and liabilities to create more spread.
Also, the portfolio may earn a liquidity premium on some of the bonds it holds.

The excess spread accumulates in the SPV until the senior tranche has been fully repaid.
This cumulative excess spread acts to support the more senior tranches just as much as
additional equity capital.

Reserve Accounts
Managers may place some funds in high-quality securities, such as U.S. Treasuries. These
reserve accounts can be significant when a deal is first funded because the manager invests
in temporary, liquid securities. Over the long term, holding such assets as credit
enhancement lowers the return on the portfolio, lowering the residual expected by the equity
holders and not earning a spread available to support the deal.

External Credit Enhancements

The portfolio may contain bonds that are protected by a third party. A bond may be insured
against default, or the manager may have bought protection with a credit derivative. In
either case, the effect is to transfer risk away from all of the investors, including the most
junior investors.

Learning Objective: Demonstrate knowledge of new developments in CDOs.

OTHER TYPES OF CDOs

MAIN POINT: The use of CDOs in new settings continues to expand. Distressed debt
CDOs apply the techniques to a portfolio containing securities in default. The technique can
be applied to hedge funds and other risky assets. Single-tranche CDOs are highly
customizable ways to transfer a narrow part of the risk.

Distressed Debt CDOs

Distressed debt CDOs are CDOs constructed from a portfolio made up of distressed debt.
This includes debt that is already in default, impaired debt, and a mix of safer bonds. The
supply of this distressed debt is somewhat limited during ordinary times, but following the
dot-com bust in 2000-2001 and in 2008 distressed debt CDOs were valuable to banks that
found them helpful in handling issues in their portfolios. Banks can reduce the amount and
distribution of nonperforming loans in their portfolios, although they almost certainly sell
the loans at a loss. Cleaning up their balance sheets will reduce regulatory capital and
provide cash to make new loans and meet cash needs.

Distressed debt CDOs are structured much like other CDOs. Lower-rated bonds are often
priced well below par, so the face amount of bonds in the portfolio is greater than the face
amount of bonds issued. Subordinated tranches provide enough protection against losses
that the most senior tranches can be rated AA.

Collateralized Fund Obligations (CFOs)

A collateralized fund obligation (CFO) is a variant of the CDO where a portfolio of hedge
funds is funded with a CDO structure. The portfolio adds diversification, much like a fund

47,
© 2020 Wiley
STRUCTURED PRODUCTS

of funds or a multistrategy fund. The subordination creates different levels of risk and
reward.

Single-Tranche CDOs
Single-tranche CDOs are structured much like the CDOs described earlier. Despite the
name, these structures usually contain several tranches. However, only one tranche is sold to
an outside investor. They are also called bespoke CDOs or CDOs on demand. The seller of
the collateral (usually a synthetic portfolio) retains the other tranches. In this way, a narrow,
highly customizable slice of risk is transferred.

Learning Objective: Demonstrate knowledge of the risks of CDOs.

MAIN POINT: Investing in CDOs involves many potential risks. The largest risk is the
default risk present in the collateral. Another important risk is the level of correlation
between assets in the portfolio. Several additional risks are explored.

Underlying Collateral
The single largest risk for a CDO comes from the risks present with a portfolio of collateral.
Most of the marketplace focuses on credit risk, and CAIA will certainly focus on credit risk.
However, the collateral can be very different with very different risks. Examples include
private equity, commodity prices, hedge funds, interest rates, and the timing of mortgage
prepayments.

For credit-sensitive portfolios, the two factors that can change and lead to more or less
portfolio risk are the frequency of default and the recovery rate given default.

Financial Engineering Risk

Financial engineering risk refers to the risk of loss linked to securitization, structuring of
cash flows, option exposures, and other consequences tied to structuring. Financial
engineering and structuring led to a cavalier attitude about underwriting subprime loans,
whose default risk became significantly different from the assumptions made by the
financial engineers.

Asset Correlations
The level of correlation between assets in the collateral portfolio significantly impacts the
risk of the entire portfolio. Lower correlations are linked with lower portfolio risk because
the low correlation improves diversification. Likewise, higher correlations are linked with
higher portfolio risk because high correlations limit the benefit of diversification.

Correlations based on historical data are not very stable over time. CDO performance can be
significantly impacted by the level of correlation.

Risk Shifting and Its Implications

Risk shifting is the process of modifying the risk of an asset (or a portfolio) in such a way
that it differentially affects the risks and values of related securities and the investors who
own those securities. The possibility to transfer risk creates conflicts of interest. For
example, the issuer of a CDO is incentivized to include collateral that is riskier than is
perceived by investors. Managers are not strongly incentivized to change the portfolio if the
underlying risks of the portfolio change (for example, during the liquidity crunch in
2008-2009) if they have no investment in the structure.

472
© 2020 Wiley
 CDO STRUCTURING OF CREDIT RISK

The manager of a CDO may hold the equity tranche of a CDO. Many people believe that
this aligns the incentives of the manager with the incentives of the investors, generally. By
this logic, a manager that holds the equity tranche may favor less credit risk, which matches
the preferences of owners of the other tranches. However, the equity tranche resembles an
option more than a debt instrument—with limited downside (though the loss can be as much
as 100% of their investment) and potentially leveraged upside. Each successively more
junior tranche has more optionality than the tranche immediately more senior. More
generally, if the risk of the portfolio rises, the lower-rated tranches benefit relative to the
more senior tranches.

For related reasons, reducing the diversification score (reducing the ability to diversify)
benefits the more junior tranches relative to the more senior tranches. A less diversified
portfolio is more volatile than a well-diversified portfolio. This volatility favors the more
junior tranches.

Other Risks
Cash flow mismatching can be a risk. Imperfectly matched cash flows create a need for
liquidity. The mismatch is greater if the frequency or periodicity of the coupons received
doesn’t match the periodicity of the required payments. An interest rate swap can
significantly mitigate this risk.

A CDO can have basis risk, where different procedures are used to set the rates on the assets
and the liabilities. For example, bank loans are usually tied to LIBOR, but other assets may
be pegged to bank rates on certificates of deposit.

The collateral or portfolio can perform poorly for many reasons such as change in yield
spreads or change in the shape of the yield curve. These changes can limit portfolio income
and risk producing insufficient cash to service the debt.

Modeling CDO Credit Risk

Default risk is quite different from other types of risk, such as equity, interest rate,
commodity, or currency levels risks. These market factors change continuously by small
amounts. In contrast, default is infrequent, but defaults also tend to cluster. In addition,
many financial institutions are limited in their ability to hold broadly diversified portfolios.
Finally, some defaults (for example, sovereign defaults) may be driven by factors other than
the ability to pay.

To quantify the risk of changing default rates, analysts use copula functions, which help to
assign probabilities to specific outcomes. A copula approach to analyzing the credit risk of
a CDO is analogous to a simulation analysis of the effects of possible default rates on the
cash flows to the CDO’s tranches and the values of the them. The techniques rely on Monte
Carlo simulation to correlate company-specific default to broad market forces. Rating
agencies are using copula functions to improve their assessment of risk with different
tranches.

473
© 2020 Wiley
 E q u it y -L in k e d St r u c t u r ed P r o d u c t s

The material in this lesson assumes that you are familiar with the option payoff diagrams
covered in the Foundations of Financial Economics: Forward Contracts and Options lesson.

LESSON MAP
• Demonstrate knowledge of structured products and types of wrappers.
• Demonstrate knowledge of potential tax effects of wrappers.
• Demonstrate knowledge of structured products with exotic option features.
• Demonstrate knowledge of popular structured products types.
• Demonstrate knowledge of the EUSIPA classification.
• Demonstrate knowledge of global structured products cases.
• Demonstrate knowledge of structured product valuation.
• Demonstrate knowledge of motivations of structured products.

KEY CONCEPTS
Equity-linked structured products usually come in a wrapper, such as a fund or insurance
policy, and these wrappers can help to lessen the impact of taxes on returns through tax
deferral and deductibility. Many types of structured products are available globally, and the
payoffs can be replicated with combinations of the underlier (e.g., linked equity index) and
simple or exotic options. A vast array of exotic options exists. Consider only barrier options:
they can be knock-in or knock-out, up or down, puts or calls. There are three major methods
for pricing structured products: (1) with partial differential equations, (2) with simulation,
and (3) with a building blocks approach. Some evidence suggests that structured products
are overpriced. Their complex payoffs can be diagrammed, and the level of the diagram can
indicate the attractiveness of the investment.

Learning Objective: Demonstrate knowledge of structured products and types

of wrappers.•*

MAIN POINT: Equity-linked structured products are usually tailored to meet the needs of
the individual investor (although some are standardized and listed on exchanges), provide
fees to the issuer, and come in wrappers such as funds and life insurance policies.

A simple example of an equity-linked product is a certificate of deposit (CD) issued by a

bank where the investor receives a minimum guaranteed interest rate, but a potentially
higher rate based on movement in the S&P 500 Index. Structured products can be
significantly more complex, spanning a wide variety of payoff patterns.

• Equity-linked structured products, as defined in this chapter, are distinguished

from the structured products in previous chapters by one or more of the following
three aspects: (1) They are tailored to meet the preferences of the investors and to
generate fee revenue for the issuer; (2) they are not usually collateralized with risky
assets; and (3) they rarely serve as a pass-through or simple tranching of the risks of a
long-only exposure to an asset, such as a risky bond or a loan portfolio.

Rather than transfer of risk being a primary motivation, equity-linked structured products
are issued for fee generation.

A w rapper is the legal vehicle or construct within which an investment product is

offered.

© 2020 Wiley
STRUCTURED PRODUCTS

Tax or legal impacts are generally associated with wrappers, as emphasized in the next
learning objective. There are the six basic types of wrappers:

1. Over-the-counter (OTC) contracts (private negotiated contracts usually formed

under the IS DA framework)
2. Medium-term notes, certificates, and warrants
3. Funds
4. Life insurance policies
5. Structured products
6. Islamic wrappers (sharia-compliant legal envelopes generally avoiding interest and
speculation)

Learning Objective: Demonstrate knowledge of potential tax effects of

wrappers.

MAIN POINTS: There are several potential tax effects of wrappers. Four cases of what the
after-tax rate of return is relative to the pre-tax rate of return are covered here. When there is
no tax, the after-tax rate of return equals the before-tax rate of return. When the investment
is fully taxed, the after-tax rate of return is lower than the before-tax rate. When tax is
deferred and/or deductible, the tax impact is lessened. Importantly, when tax is both
deferred and deductible, the after-tax rate of return can be larger than the before-tax rate of
return. This occurs when the initial tax rate is higher than the terminal tax rate.

In the absence of tax wrappers, income is generally taxed as it is distributed, and gains are
taxed as they are realized. Wrappers can change that. We consider four cases: (1) tax-free
wrapper (e.g., Roth IRA in the United States), (2) fully taxed, (3) tax deferral, and (4) both
tax deferral and tax deductibility.

In the tax-free case, r* = r, where r is before-tax return, and r* is the after-tax rate of return.

In the case where the investment is fully taxed,

Tax deferral refers to the delay between when income or gains on an investment
occur and when they are taxed.

When taxes are deferred for N years, the relationship becomes:

The equation for the after-tax rate of returns when taxes are deferred collapses to r* =
r(l — T) when N = 1.

Tax deduction of an item is the ability of a taxpayer to reduce taxable income by the
value of the item.

When taxes are both deductible and deferred for N years, the relationship becomes:

476
© 2020 Wiley
 EQUITY-LINKED STRUCTURED PRODUCTS

where T0 is the initial tax rate (before N) and TN is the terminal tax rate (after N).

The After-Tax Returns under Different Wrapper Impact Assumptions table illustrates that
rd&d > rd > r* when T = T0 = TN, and when T0 > TN, then r*d&d > r. That rd&d can be even
greater than the pre-tax return is a powerful result.

After-Tax Returns under Different Wrapper Impact Assumptions

^0 > Tn

£
ii
Pre-Tax Return r 8% 8%
Constant Tax Rate T 30% 30%
Initial Tax Rate T0 30% 30%
Terminal Tax Rate tn 30% 20%
Years Deferred N 20 20
*
r 5.60% 5.60%
*
rd 6.56% 6.56%
*
rd&d 8.00% 8.72%

Unfortunately, the equations for r*d&d and rd are not on the CAIA equation exception list
and therefore do need to be memorized.

Example 1: Tax Impacts of a Wrapper—I

An investor has an income tax rate of 40%, which he expects to drop to 25% upon
retirement, at which time he will withdraw money from an annuity with a pre-tax return
of 9%. This investment is in a tax wrapper so that it is both tax deductible and tax
deferred until the investor’s retirement in 10 years. What is the expected after-tax rate of
return?

Solution

When the initial tax rate T0 is greater than the terminal tax rate T}v, and the investment is
in a wrapper that provides for both tax deductions of contributions and tax deferral, the
after-tax rate of return is actually greater than the pre-tax rate of return. The following
equation is used for the after-tax rate of return when there is both tax deductibility and
deferral:
1
N
rd&d

The after-tax rate is 9.71%.

Adapted from CAIA Level I, 4th ed., 2020. Application 26.2.4A. Copyright © 2009,
2012, 2015 by The CAIA Association.

.77
© 2020 Wiley
STRUCTURED PRODUCTS

Learning Objective: Demonstrate knowledge of structured products with exotic

option features.

MAIN POINTS: Exotic options have one or more features that prevent them from
being classified as simple options, including payoffs based on values prior to the
expiration date (i.e., path-dependent), and/or payoffs that are nonlinear or
discontinuous functions of the underlying asset (as with binary options) and can, in
combinations often with the underlier, replicate many types of structured products.
Principal-protected structured products can be replicated with simple options. They
often specify a participation rate. For example, a 50% participation rate means that if
the underlying asset increases 10%, the investor receives 5% and has 50% exposure on
the upside. Due to put-call parity, both the cash and call strategy and the strategy of
investing in the underlying combined with a protective put have the same payoff
diagram that looks like a simple long call option and a principal-protected structured
product. There are eight types of barrier options: up-and-in, down-and-out, and so on.
When the underlying asset hits the barrier, the option either becomes active if it is a
knock-in option, or becomes inactive if it is a knock-out option. If the underlying asset
price is less than the barrier price at inception, then it must move up to the barrier to
be triggered, so it is also called an up option. If the underlying asset price is greater
than the barrier price at inception, then it must move down to the barrier to be
triggered, so it is also called a down option. Spread options, look-back options, and
quanto options are further examples of exotic options.

Understanding exotic options is a starting point for appreciating the potential

complexity in some structured products discussed in the next learning objective.
First, we compare and contrast simple options and exotic options.

A simple option has (1) payoffs based only on the value of a single underlying asset
observed at the expiration date, and (2) linear payoffs to the long position of the calls
and puts based on the distance between the option’s strike price and the value of the
underlying asset.

478
© 2020 Wiley
 EQUITY-LINKED STRUCTURED PRODUCTS

Although there is no universally accepted definition of an exotic option, a useful

definition is that an exotic option is an option that has one or more features that
prevent it from being classified as a simple option, including payoffs based on
values prior to the expiration date, and/or payoffs that are nonlinear or discontinuous
functions of the underlying asset.

Many structured products provide some degree of principal protection without the use
exotic options. A structured product without exotic options is defined as one that has a
payoff diagram defined exclusively in terms of the payoff to the value of a single underlier
at termination.

A principal-protected structured product is an investment that is engineered to

provide a minimum payout guaranteed by the product’s issuer (counterparty).

Principal protection is easily provided with simple options as in a cash-and-call strategy or

a position in the underlying combined with a protective put.

A cash-and-call strategy is a long position in cash, or a zero-coupon bond,

combined with a long position in a call option.

Due to put-call parity, both the cash-and-call strategy and the strategy of investing in the
underlying combined with a protective put have the same payoff diagram that looks like a
simple long call option.

Example 3: Call Value Embedded in a Principal-Protected Security

Consider a $1,000 investment in a cash-and-call position on the S&P 500. It has a

maturity of two years and offers $1,000 guaranteed protection. The riskless rate is 4%.
What is the value of the call option?

Solution

Let r be the rate of return on the S&P 500. In two years, this investment offers either
$1,000(1 + r)2 or $1,000, whichever is greater. The present value of $1,000 using the
riskless rate of 4% is $1,000/(1.04)2 = $924.56. Since the investment costs $1,000, the
value of the call is $1,000 - $924.56 = $75.44.

Adapted from CAIA Level I, 4th ed., 2020. Application 26.3.1 A. Copyright © 2009,
2012, 2015 by The CAIA Association.

Another popular feature of equity-linked structured products is the participation rate.

The participation rate indicates the ratio of the product’s payout to the value of the
underlying asset.

For example, a 50% participation rate means that if the underlying asset increases 10%, the
investor receives 5% and has 50% exposure on the upside.

Path-Dependent Options
An American option is a path-dependent option because the value of the underlying asset
prior to expiration can impact the payoff.

479
© 2020 Wiley
STRUCTURED PRODUCTS

A path-dependent option is any option with a payoff that depends on the value of
the underlying asset at points prior to the option’s expiration date.

An Asian option is another example of a path-dependent option.

An Asian option is an option with a payoff that depends on the average price of an
underlying asset through time.

An option that depends on the average price of several assets is simply an option on a
portfolio. The average price of an asset through time is what distinguishes an Asian option.
For example, an Asian option that pays X - K where X is the average of 12 month-end
prices of oil over a year and K is the strike price might be used by a company that purchases
oil to cap the price. An advantage is that, although offering less protection, the Asian option
can be less expensive than a series of European options.

Binary Options
Binary options, discussed earlier in the credit risk and credit derivatives chapter, are
dependent on a credit event. Here, we consider binary options that are dependent on prices.
A key feature of binary options is that there is a discontinuous jump in the option payoff
relative to the underlying asset at expiration. A binary option pays off just one of two prices
depending on the value of underlying asset relative to the strike price. At expiration
(structured product’s maturity), a binary call option will have a negative payoff if the
underlying is below the strike price and a single positive payoff if the underlying asset is
above the strike price. The payoff diagram looks like two horizontal lines: one below zero to
the left of the strike price and one above zero to the right of the strike price.

B arrier Options
An example of a structured product that contains a barrier option is one that permanently
loses principal protection if the underlying asset reaches a specified loss level.

A barrier option is an option in which a change in the payoff is triggered if the

underlying asset reaches a prespecified level (barrier price) during a prespecified
time period.

There are eight types of barrier options:

1. Up-and-in call
2. Up-and-out call
3. Down-and-in call
4. Down-and-out call
5. Up-and-in put
6. Up-and-out put
7. Down-and-in put
8. Down-and-out put

Up versus Down
If the underlying asset price is less than the barrier price at inception, then it must move up
to the barrier to be triggered, so it is called an "up" option. Similarly, if the underlying asset
price is greater than the barrier price at inception, then it must move down to the barrier to
be triggered, so it is termed a "down" option.

480
© 2020 Wiley
 EQUITY-LINKED STRUCTURED PRODUCTS

In versus Out
When the underlying asset price hits the barrier, the option either becomes active if it is a
knock-in option, or becomes inactive if it is a knock-out option.

A knock-in option is an option that becomes active if and only if the underlying
asset reaches a prespecified barrier.

An active option in a barrier option is an option for which the underlying asset has
reached the barrier.

A knock-out option is an option that becomes inactive (i.e., terminates) if and only
if the underlying asset reaches a prespecified barrier.

Summary of Eight Barrier Option Types

Conditional Correlations in Up and Down Markets

Underlier < B arrier B arrier < Underlier
Knock-in Up-and-in call or put Down-and-in call or put
Knock-out Up-and-out call or put Down-and-out call or put
Source: CAIA Level I, 4th ed., 2020. Exhibit 26.2. Copyright © 2009, 2012, 2015 by The CAIA
Association.

Example 4: Barrier Option Payoffs

Consider four barrier put options, each with a strike price of $50:

1. Up-and-in with a barrier of $55

2. Up-and-out with a barrier of $55
3. Down-and-in with a barrier of $45
4. Down-and-out with a barrier of $45

A. What is the total payoff to holding the four options if the underlying asset started
at $49 and steadily declined to $44 at expiration?
B. What is the total payoff to holding the four options if the underlying asset started
at $49 and steadily rose to reach $57 at expiration?
C. Which options are superfluous in the sense that if they become active the payoff
is still zero?

Solution

A. Total payoff is $12.

Ending price = $44. If active, put payoffs are max[X - 5,0] = max[50 - 44,0]
= 6.
The option that becomes active is #3 because the barrier was hit and it is an
“in” option. The payoff is $6. (The barrier was hit for #4 but it becomes
inactive.)
The option that remains active is the "out" option #2 since the barrier was not
hit, and its payoff is also $6 since it has the same strike price as option #3.
The total payoff is $12.
B. Total payoff is $0.
Ending price = $57. If active, put payoffs are max[X - 5,0] = max[50 - 57,0]
= 0.

© 2020 Wiley
STRUCTURED PRODUCTS

Only the up barrier of $55 was hit, so the only "in" option that becomes active
is option #1. The put payoff for option #1 is zero: max[X - 5,0] = max[50 -
57,0].
Since the $45 barrier was not hit, option #4 remains active. The put payoff for
option #4 is also zero since the strike is below the ending underlying price.
Options #2 and #3 expire worthless: option #2 was knocked out and option #3
never became active.
C. None of the options are superfluous in the sense that they cannot offer a payout.
It is true that options #1 and #4 have payoffs of zero in both cases A and B.
Option #1 may appear to be superfluous because when it becomes active the
payoff is still zero in case B. However, if the price subsequently dropped below
the strike price after reaching the barrier and before expiration, there would be a
nonzero payoff. Option #4 remains active as long as the barrier is not hit, so there
could be a payoff if the final price were below the strike of $50 and above the
barrier of $45.

The value of a barrier option is always equal to or less than a simple option with the same
underlying, strike, and maturity.

A spread option has a payoff that depends on the difference between two prices or
two rates.

Spread options are different from option spreads, which require multiple option positions.
In a spread option, the strike price is a rate difference between two underlying reference
assets. A call spread option pays the difference between the spread and the strike (times the
option’s notional amount) when the spread exceeds the strike. A put spread option pays
when the spread is below the strike.

Example 5: Spread Option

Consider a call spread option on the difference between a small-cap equity index and a
large-cap index with a strike rate of 2%. If at expiration the large-cap return is 8% and
the small-cap return is 12%, what is the payoff?

Solution

The spread is 12% - 8% = 4%. The payoff is the spread minus the strike = 4% - 2% =
2 %.

A look-back option has a payoff based on a minimum or maximum price that occurs over a
certain period. A look-back call option pays the maximum price over the look-back period
minus the strike price. A look-back put option pays the strike price minus the minimum
price over the look-back period. It is another type of path-dependent option.

A quanto option is a very specialized option defined to further illustrate the wide variety of
exotic options.

A quanto option is an option with a payoff based in one currency using the
numerical value of the underlying asset expressed in a different currency.

482
© 2020 Wiley
 EQUITY-LINKED STRUCTURED PRODUCTS

Learning Objective: Demonstrate knowledge of popular structured

product types.

Two Absolute Return Structured Product Examples

An absolute return structured product offers payouts over some or all underlying
asset returns that are equal to the absolute value of the underlying asset’s returns.
Thus, whether the underlier rises 2% or declines 2%, the structured product pays
+ 2 %.

UK-Based Absolute Return Structured Product

A principal-protected absolute return barrier note offers to pay absolute returns
to the investor if the underlying asset stays within both an upper barrier and a lower
barrier over the life of the product.

As indicated by the description, this absolute return product can be replicated with barrier
options.

Product = At-the-Money Up-and-Out Call + At-the-Money Down-and-Out Put

Many structured products are listed and are therefore liquid alternatives

Learning Objective: Demonstrate knowledge of the EUSIPA classification.

The EUSIPA Classification

The EUSIPA (European Structured Investment Products Association) has developed a
valuable categorization of structured products. The EUSIPA publishes the EUSIPA
Derivative Map which categorizes structured products with two major classifications:
investment structured products (which include capital protection products, yield
enhancement products, and participation products), and leverage structured products.
Actual structured products are often far more complex than the exposures discussed here.

Capital protection structured products tend to offer long call option-like payoffs:
downside protection, upside potential, and below-market interest income. Essentially,
capital protection structured products are similar to long call options. The purchaser usually
compensates the issuer for this call option by accepting little or no interest income on the
buyer’s investment. To varying extents, investing in these products is analogous to buying
call options through the sacrifice of current income.

Yield enhancement structured products tend to offer short put option-like payoffs with
full downside exposure, capped upside potential, and above-market interest income (i.e.,
yield enhancement).

Participation structured products tend to offer exposures (bull or bear) to the underlying
index (or assets) that are not capped in terms of potential profits or losses (i.e., in either the
bull or bear scenarios). Therefore, participation structured products differ from capital
protection products (that tend to be long call options) or yield enhancement products (that
tend to be short put options). The purpose for a purchaser in a participation-structured
product is to use this tracker product (rather than simply establishing a long or short position
directly in the cash market for the index) in an attempt to obtain the exposures inside one of
the various wrappers discussed earlier.

483
© 2020 Wiley
STRUCTURED PRODUCTS

Leverage structured products tend to offer exotic exposures that do not fit precisely in the
map’s investment structured product categories. Leverage with knock-outs use knock-outs
to create limits to profits and losses, thus offering targeted exposures over limited ranges of
the underlier. Other leverage products offer bull spreads and bear spreads, while still others
resemble pure leveraged products that offer participation rates (bull or bear) in excess of
100% .

Learning Objective: Demonstrate knowledge of global structured products

cases.

MAIN POINTS: In this section, six different structured products are described with the
purpose of illustrating the diversity of structured products and availability globally. They are
stylized, hypothetical examples based on real products. After a brief description of each of
the first five products, an equation is provided to show how the payoffs can be obtained
with a combination of the underlying assets and/or options. Many structured products are
standardized and listed on an exchange, which allows their prices and volatility to be
observed over time.

U.S.-Based Structured Product with Multiple Kinks

A product offered by insurance company, MetLife, in an annuity wrapper, offers a payout
with multiple kinks that looks like this:

(a) -100% <; r < -10% Payout = r + 10%

(b) -10% <; r < 0% Payout = 0%
(c) 0% <; r < 20% Payout = r
(d) r > 20% Payout = 20%

where r is the return on the S&P 500.

The 10% addition to the return in payout (a) is referred to as the partial floor, since 10% of
losses are protected. The 20% payout in (d) is the cap. The investor selects the floor for
partial protection (or full protection if the floor = 100%) and the cap. The investor can also
select among different indices other than the S&P 500 and among different maturities (one,
three, or six years).

Although complex, this product can be replicated without exotic options:

Product = Underlying Asset + Bear Put Spread —Out-of-the-Money Call

German-Based Structured Product with Leverage

A Sprint product combines a position in the underlying asset and a long call option with a
low strike price, providing 200% leverage, or upside participation that is capped by short
calls with a high strike price, offering a collar-like payoff. It is in a certificate wrapper that
provides liquidity and lowers trading costs.

Product = Underlying Asset + Bull Spread

484
© 2020 Wiley
 EQUITY-LINKED STRUCTURED PRODUCTS

Japanese-Based Structured Product Based on Multiple Currencies

Nomura Securities in Japan offers a power reverse dual-currency note. This is not
an equity-linked structured product but rather allows an investor to leverage a carry
trade and further illustrates the wide variety of structured products available
globally.

At its core, in a power reverse dual-currency note (PRDC), an investor pays a

fixed interest rate in one currency in exchange for receiving a payment based on a
fixed interest rate in another currency.

An investor who believes that an interest rate differential will persist could potentially
receive higher coupon payments than need to be paid using a PRDC.

Advantages and Disadvantages of Liquid Structured Products

Many structured products are standardized in terms of maturity, participation rates, and so
on, and are listed on exchanges. The advantages of these liquid products are that the prices
and volatility over time are observable. A disadvantage is that they are not tailored to
individual needs (but rather standardized). Liquid alternatives are made available to a wider
audience, but listings have diminished somewhat over recent years.

Learning Objective: Demonstrate knowledge of structured product valuation.

MAIN POINTS: There are three major methods for pricing structured products: (1) with
partial differential equations, (2) with simulation, and (3) with a building blocks approach.
Some evidence suggests that structured products are overpriced. The level of the payoff
diagram for structured products indicates the attractiveness of the payoff to the investor.

Partial Differential Equation Approach

The partial differential equation approach (PDE approach) finds the value to a
financial derivative based on the assumption that the underlying asset follows a
specified stochastic process and that a hedged portfolio can be constructed using a
combination of the derivative and its underlying asset(s).

In a very simplified illustration (valuing a riskless bond that pays F at time t), the first step
is to express the change in price:

This is combined with a boundary condition (value of bond is $F at time t).

A boundary condition of a derivative is a known relationship regarding the value of

that derivative at some future point in time that can be used to generate a solution to
the derivative’s current price.

The PDE approach uses continuous-time mathematics in a similar manner, but PDEs are
based on time and uncertainty and require the construction of a riskless portfolio.

An example of this approach is the Black-Scholes option pricing equation.

485
© 2020 Wiley
STRUCTURED PRODUCTS

The solution is analytica because the model can be exactly solved using a finite set
of common mathematical operations.

Sometimes no analytic solution exists. Then numerical methods are required.

Numerical methods for derivative pricing are potentially complex sets of

procedures to approximate derivative values when analytical solutions are
unavailable.

Some numerical methods are very difficult, and they are approximations rather than exact
solutions. Here we briefly discuss two such approaches.

Simulation Approach
The simulation approach was discussed in the chapters on measures of risk and
performance. Here we describe an application to price complex structured products with no
analytical solution. A series of potential paths of the underlying asset is generated (based on
an assumed stochastic process) and the structured product price is estimated and discounted
to the present value for each path, and then the average of these discounted prices is taken as
the best estimate.

Building Blocks Approach

The building blocks approach (i.e., portfolio approach) models a structured
product or other derivative by replicating the investment as the sum of two or more
simplified assets, such as underlying cash-market securities and simple options.

The PDE approach uses dynamic hedging whereas the building blocks approach uses a
static hedge.

Dynamic hedging is when the portfolio weights must be altered through time to
maintain a desired risk exposure, such as zero risk.

A static hedge is when the positions in the portfolio do not need to be adjusted
through time in response to stochastic price changes to maintain a hedge.

A disadvantage to the building blocks approach is that it may not be possible to find two
efficiently priced assets, which are required to take the approach.

Two Principles from Payoff Diagrams: Shapes and Levels

The payoff diagram shape indicates the risk exposure of a product relative to an
underlier.

The payoff diagram level determines the amount of money or the percentage return
that an investor can anticipate in exchange for paying the price of the product.

Principle 1 is related to the diagram shape and states that a payoff diagram can be
constructed for any given payoff if a sufficient number of types of options are available.
This principle was illustrated in this chapter where the various global structured products
were represented with replicating equations of various simple and exotic options.

Principle 2 is related to the diagram level. The level indicates whether the product is
underpriced, overpriced, or fairly priced.

486
© 2020 Wiley
 EQUITY-LINKED STRUCTURED PRODUCTS

This is important because there is a wide variety of complex products that may be difficult
for investors to properly value on their own. Some investors may suffer from an
overconfidence bias and pay little much attention to high fees. The payoff diagram level
helps to determine the relative attractiveness of the structured product.

An overconfidence bias is a tendency to overestimate the true accuracy of one’s

beliefs and predictions.

Evidence on Structured Product Prices

A key issue, as alluded to earlier, is whether structured products are fairly valued. Two
studies cited in the curriculum suggest that they are overpriced by as much as 4.5% in one
study and 15% to 30% in another. Industry sources, on the other hand, point to fees and
expenses representing 2% to 3% of the products’ price.

Learning Objective: Demonstrate knowledge of motivations of structured

products.

Motivations for equity-linked structured products are income and tax efficiency.

Motivations for using structured products from the side of the investor were discussed in
other lessons. These include risk management, return enhancement, diversification, (in some
cases) circumventing regulatory restrictions, and access to superior mangement and liquity
enhancement. For equity-linked products we reiterate and emphasize that issuer motivations
are important. Equity-linked structured products, as defined in this lesson, are distinguished
from the structured products in previous lessons by one or more of the following three
aspects mentioned earlier, the first of which is that they are often tailored to meet the
preferences of the investors and to generate fee revenue for the issuer. Rather than transfer
of risk being a primary motivation, equity-linked structured products are issued for fee
generation. A wrapper is the legal vehicle or construct within which an investment product
is offered. Earlier in this lesson we discussed the tax implications associated with different
wrappers. These tax savings make higher fees more palatable for investors and more
lucrative for issuers. Issuers may have other motivations as well. For example, issuing an
uncollateralized structured product can be a source of financing.

487
© 2020 Wiley
 WILEY END USER LICENSE AGREEMENT
Go to w w w .w iley.com /go/eula to a ccess W iley's ebook EULA.