BOOK 4- ALTERNATIVE INVESTMENTS AND FIXED INCOME

Readings and Learning Outcome Statements .......................................................... 3 Study Session 13 -Alternative Investments ............................................................ 9

Self-Test- Alternative Investments •.•.•....•.•.•.•.•.•.•.•.••••.•.•.•.•.•.•.•.•....•.•.•.•.•.•.•.•.•••• 103 Study Session 14 - Fixed Income: Valuation Concepts .•.•.•.•.•.•.•.•....•.•.•.•.•.•.•.•.•••• 107 Study Session 15 - Fixed Income: Structun:d Securities .•.•.•.•.•.•.•....•.•.•.•.•.•.•.•.•••• 196 Self-Test- Fixed Income ••••.•.•.•.•.•.•.•.•....•.•.•.•.•.•.•.•.••••.•.•.•.•.•.•.•.•....•.•.•.•.•.•.•.•.•••• 275 Formulas ............................................................................................................ 278 Index ................................................................................................................. 282

SCHWESERNafESTM 2012 CFA LEVEL II BOOK 4: ALTERNATIVE INVESTMENTS AND FIXED INCOME ©2011 Kaplan, Inc. All rights reserved. Published in 20 II by Kaplan Schweser.

Printed in the United States of America. ISBN: 978-1-4277-3617-8/1-4277-3617-0 PPN: 3200-1732

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READINGS AND LEARNING OUTCOME STATEMENTS

READINGS

The following material is a review ofthe Alternative Investments and Fixed Income principles designed to address the learning outcome statements set forth by CPA Imtitute.

STUDY SESSION 13 Reading Assignments Alternative Investments and Fixed Income, CFA Program Curriculum,

Volume 5, Level II (CFA Institute, 2012) 44. 45. 46. 47.

Investment Analysis Income Property Analysis and Appraisal Private Equity Valuation Investing in Hedge Funds: A Survey

page9 page 27 page 40 page 88

STUDY SESSION 14 Reading Assignments

Alurnative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2012) 48. General Principles of Credit Analysis 49. Term Structure and Volatility oflnterest Rates 50. Valuing Bonds with Embedded Options

page 107 page 135 page 162

STUDY SESSION 15 Reading Assignments

Alternative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2012) 51. Mortgage-Backed Sector of the Bond Market 52. Asset-Backed Sector of the Bond Market 53. Valuing Mortgage-Backed and Asset-Backed Securities

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page 196 page 227 page 252

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Book 4 -Alternative Investments and Fixed Income Reading< and Learning Outcome Statements

LEARNING OUTCOME STATEMENTS (LOS) Tht CFA lmtitutt Ltarning Outcomt Stattmmts art listtd btlow. Thtst art rtptattd in tach topic rtVitw; howtvtr, tht ordtr may havt bun changtd in order to gtt a bttttr fit with tht flow oftht rtvitw.

STUDY SESSION 13 Tht topical covtragt cormponds with tht following CFA lnstitutt assigntd rtading: 44. Investment Analysis The candidate should be able to: a. explain, for each type of real property investment, the main value determinants, investment characteristics, principal risks, and most likely investors. (page 9) b. evaluate a real estate investment using net present value (NPV) and internal rate of return (IRR) from the perspective of an equity investor. (page 18) c. calculate the a&er-tax cash flow and the after-tax equity reversion from real estate properties. (page 14) d. explain potential problems associated with using IRR as a measurement tool in real estate investments. (page 20) Tht topical covtragt cormponds with tht following CFA lnstitutt assigntd rtading: 45. Income Property Analysis and Appraisal The candidate should be able to: a. explain the relation between a real estate capitalization rate and a discount rate. (page 27) b. estimate the capitalization rate by the market-extraction method, band-ofinvestment method, and built-up method, and justify each method's usc in capitalization rate determination. (page 28) c. estimate the market value of a real estate investment using the direct income capitalization approach and the gross income multiplier technique. (page 31) d. contrast limitations of the direct capitalization approach to those of the gross income multiplier technique. (page 32) Tht topical covtragt corrtsponds with tht following CFA lnstitutt assigntd rtading: 46. Private Equity Valuation The candidate should be able to: a. explain sources of value creation in private equity. (page 41) b. explain how private equity firms align their interests with those of the managers of portfolio companies. (page 42) c. distinguish between the characteristics of buyout and venture capital investments. (page 43) d. describe valuation issues in buyout and venture capital transactions. (page 47) e. explain alternative exit routes in private equity and their impact on value. (page 51) f. explain private equity fund structures, terms, valuation, and due diligence in the context of an analysis of private equity fund returns. (page 52) g. explain risks and costs of investing in private equity. (page 57) h. interpret and compare financial performance of private equity funds from the perspective of an investor. (page 59)

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Book 4 -Alternative Investments and Fixed Income Readings and Learning Outcome Statements

i.

calculate management fees, carried interest, net asset value, distributed to paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI) of a private equity fund. (page 62) j. calculate pre-money valuation, post-money valuation, ownership fraction, and price per share applying the venture capital method I) with single and multiple financing rounds and 2) in terms of!RR. (page 64) k. demonstrate alternative methods to account for risk in venture capital. (page 69)

The topical coverage corresponds with the following CPA lmtitute assigned reading: 47. Investing in Hedge Funds: A Survey The candidate should be able to: a. distinguish between hedge funds and mutual funds in terms of leverage, use of derivatives, disclosure requirements and practices, lockup periods, and fee structures. (page 88) b. describe hedge fund strategies. (page 89) c. explain possible biases in reported hedge fund performance. (page 91) d. describe factor models for hedge fund returns. (page 92) e. describe sources of non-normality in hedge fund returns and implications for performance appraisal. (page 93) f. describe motivations for hedge fund replication strategies. (page 94) g. explain difficulties in applying traditional portfolio analysis to hedge funds. (page 95) h. compare funds of funds to single manager hedge funds. (page 96)

STUDY SESSION 14 The topical coverage corresponds with the following CPA lmtitute assigned reading: 48. General Principles of Credit Analysis The candidate should be able to: a. distinguish among default risk, credit spread risk, and downgrade risk. (page 107) b. explain and analyze capacity, collateral, covenants, and character as components of credit analysis. (page 108) c. calculate and interpret key financial ratios used by credit analysts. (page Ill) d. evaluate the credit quality of an issuer of a corporate bond, given such data as key financial ratios for the issuer and the industry. (page Ill) e. analyze why and how cash flow from operations is used to assess the ability of an issuer to service its debt obligations and to assess the financial flexibility of a company. (page 114) f. explain and interpret typical elements of the corporate structure and debt structure of a high-yield issuer and the effect of these elements on the risk position of thelender. (page 116) g. describe factors considered by rating agencies in rating asset-backed securities. (page 117) h. explain how the credit worthiness of municipal bonds is assessed, and contrast the analysis of tax-backed debt with the analysis of revenue obligations. (page 119) i. describe considerations used by Standard & Poor's in assigning sovereign ratings, and explain why two ratings are assigned to each national government. (page 120) j. contrast the credit analysis required for corporate bonds to that required for I) asset-backed securities, 2) municipal securities, and 3) sovereigu debt. (page 121) ©20 11 Kaplan, Inc.

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Book 4 -Alternative Investments and Fixed Income

Reading< and Learning Outcome Statements

Th• topical cov Program Curriculum, Volumt 5, pagt 101

The Hedge Fund Universe Hedge funds follow a wide variety of strategies: I. Arbitrage based: This strategy attempts to profit from security mispricings while matching the characteristics of their short positions to those of their long positions. This hedging structure results in a lower standard deviation of net returns and the

highest Sharpe ratios of all hedge fund strategies. Usually, these hedge funds are said to be short volatility-they experience gains in stable markets but experience losses

in volatile markets. They make money slowly (during stable periods) but lose money rapidly (during market turbulence), which results in negative skewness and fat tails in their return distributions.

2. Convertible bond arbitrage: This strategy goes long a convertible bond and short the underlying equity. The convenible bond provides long exposure to a fixed-income security and a call option on the underlying stock. These funds perform well when stock volatility increases (the long call option gains value) and when credit spreads decline (the long fixed-income position gains value). These funds achieve market neutrality by matching the option delta of the long call position to the shorr stock position. ~

Proftssors Nott: Dtlta htdging using options is covtrtd in tht Dtrivativts stction

~ oftht Ltvtl II curriculum.

3. Equity market neutral: This strategy seeks to hedge market exposure in equity investments through long and short positions with equal beta exposure. Though the long· term goal of this strategy is zero beta exposure, short·term deviations (to betas of +1-0.20) are common. While these strategies minimize beta risk, other equity factor exposures such as size (market capitalization), industry classification, and style

(value or growth) may remain. Many of these funds utilize quantitative strategies. Quantitative strategies using longer holding period (months) may be based on factor ©20 11 Kaplao, Inc.

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Study Session 13 Cross-Reference to CFA lostitute Assigned Reading 1147 -lovming in Hedge Furuh: A SW"'I'

Bootsttapputg - -

Treasury Spot

Rate Curve

For example, suppose that you know a 6-month U.S. Treasury bill has an annualized yield of 4% and a !-year Treasury STRIP has an annualized yield of 4.5% (assume

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Study Session 14 Cross-lkttrena: to CFA lostitutc Assigned Reading #49- Term Structure and Volatility oflotcn:st Rates

annual rates stated on a bond equivalent basis}. Because these are both discount securities, the yields are spot rates. Given these spot rates, we can calculate the spot yield

on a 1.5-year Treasury via bootstrapping. Assume that the 1.5-year Treasury is priced at $95 and carries a 4% coupon ($2 every six months). In this case, to calculate the 1.5year spot rate, solve the following equation:

. pnce=

$2

$2

[I+

6-mon:spot)

D

D

I+

[I+ 12-mo~thspot)

$102

2+

[I+ 18-mo~thspot)

3

$1~

$95=--1 +--+ ~18-monthspotratc=7.66% 2 3 1.02 1.0225 [1+ 18-mo~th spot)

Our abbreviated theoretical spot rate curve looks like this:

6-month spot rate 12-month spot rate 18-month spot rate ~ ~

= 4.00%. = =

4.50%. 7.66%.

ProfessorS Note: The U.S. Treasury currently issues Treasury bills with various maturities including 4 w 0

Overvalued if actual OAS < required OAS; Undervalued if actual OAS > required OAS

Overvalued if actual OAS < required OAS; Undervalued if actual OAS > required OAS

Undervalued

OAS = 0

Overvalued

Overvalued

Fairly priced

OAS < 0

Overvalued

Overvalued

Overvalued

LOS 50.h The binomial model can be used ro compure the value of bonds with embedded options in the equations for effective duration and convexity. The general procedure for calculating BV+uy " (and BV- uy is as follows: A

)

Step 1: Given assumptions about benchmark interest rates, interest rate volatility, and a call and/or put rule, calculate the OAS for the issue using the binomial model. Step 2: Impose a small parallel shift in the on-the-run yield curve by an amount equal tO +lly. Step 3: Build a new binomial interest rate tree using the new yield curve. Step 4: Add the OAS to each of the !-year rates in the interest rate tree to get a modified tree. (We assume that the OAS does not change when interest rates change.) Step 5: Compute BV. c,. using this modified interest rate tree. Step 6: Repeat steps 2 through 5 using a parallel rate shift of - .6. y to obtain a value ofBV- uy A

•

LOS 50 .i Putable bonds are valued using the same procedure as for a callable bond, except that the relevant cash flows are dictated by the rules governing the exercise of the embedded put option. The value of a putable bond is given by: V purable = V nonpu mble + V pur" The value of the embedded put option is: V pur = V pur able - V nonpurable· LOS 50.j The owner of a convertible bond can exchange the bond for the common shares of the issuer. A convertible bond includes an embedded call option giving the bondholder the right to buy the common stock of the issuer. Almost all convertible bonds are callable, and some convertible issues are purable. The conversion ratio is the number of common shares for which a convertible bond can be exchanged. The conversion price is the issue price divided by the conversion ratio. Conversion value is the value of the stock into which the bond can be converted. Conversion value = market price of scock x conversion ratio. ©20 11 Kaplan, Inc.

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Study Session 14 Cross-Reference to CFA Institute Assigned Reading #50 -Valuing Bonds With Embedded Options

Straight value is the value of the bond if it were nor convertible. Marker conversion price is the price that a convertible bondholder would effectively pay if the bond were purchased and immediately convened. Marker conversion price = marker p rice of convertible bond/conversion ratio. Market conversion premium per share is the difference benveen the market conversion price and the current market price. It can also be expressed as the ratio of conversion price to marker price, called the conversion premium ratio : marker conversion premium per share = market conversion price - market price The coupon income from a convertible bond usually exceeds the dividend income that would have been realized if the stock were owned directly. The time it takes to recoup the per-share premium via this extra income is known as the premium payback period. The minimum value at which a convertible bond trades is its straight value or its conversion value, whichever is greater. Straight value is the usual measure of the downside risk for a convertible bond, because it sets a bond price floor char is independent of stock p rice. • Downside risk is often measured using the premium over straight value. • All other factors held consta nt, the greater the premium over straight value, the less attractive the convertible bond.

LOS 50.k T he major reason for investing in convertible bonds is the price appreciation resulting from an increase in the value of the common stock. • The main drawback of investing in a convertible bond versus investing directly in the stock is that when the srock price rises, the bond will underperform because of the conversion premium of the bond. • If the stock price remains stable, the return on the bond may exceed the stock returns due to the coupon payments received from the bond. • If the stock price falls, the straight value of the bond limits downside risk. This is based on the assumption that bond yields remain stable.

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Study Session 14 Cross-Reference to CFA Institute Assigned Reading #50- Valuing Bonds With Embedded Options

CONCEPT CHECKERS 1.

Which of the following statemenrs concerning the calculation of value at a node in a binomial inreresc rate tree is most accurate? The value at each node is the: A. present value of the nvo possible values from the next period. B. average of the present values of the two possible values from the next period. C. sum of the present values of the nvo possible values from the next period.

2.

An A. B. C.

3.

The option-adjusted spread (OAS) on a callable corporate bond is 73 basis points using on-the-run Treasuries as the benchmark rates in the construction of the binomial tree. The best interpretation of this OAS is the: A. cost of the embedded option is 73 basis poinrs. B. cost of the option is 73 basis poinrs over Treasury. C. spread char reflects the credit risk and liquidity risk is 73 basis points over Treasury.

4.

An analyst has gathered the following information on a convertible bond and the common equity of the issuer. • Market price of bond: $925 .00 • Annual coupon: 7 .5% • Conversion ratio: 30 • Markee price of stock: $28.50 • Annual stock dividend: $2.15 per share

increase in inreresc rate volatility: increases the value of bonds with embedded call options. increases the value of bonds with embedded put options. increases the value of low-coupon bonds with embedded options, but decreases the value of high-coupon bonds with embedded options.

The premium payback period for the convertible bond is closest co: A. 4.85 years. B. 5.29 years. C. 6.67 years. 5.

Which of the following statements concerning che comparison between the risk and return of convertible bond investing and common srock investing is least accurate, assuming interest rates are stable? A. When stock prices fall, the returns on convertible bonds may exceed those of the stock because the convertible bond's price has a floor equal to the straight bond value. B. The main drawback of investing in convertible bonds versus direct srock purchases is that when stock p rices rise, the convertible bond will likely underperform due to the conversion premium. C. Buying convertible bonds in lieu of direct stock investing limits upside potenrial to chat of buying a straight bond at the cost of increased downside risk due to the conversion premium.

©20 11 Kaplan, Inc.

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Study Session 14 Cross-Reference to CFA Institute Assigned Reading #50 -Valuing Bonds With Embedded Options

6.

Which of the following statements concerning the option-adjusted spread (OAS) is least accurate? A. The OAS is the interest rate spread that must be added to all of the 1-year forward rates in the binomial tree so that the arbitrage-free value of a bond generated by the tree is equal to its market price. B. The OAS reflects credit and/or liquidity risk differences between the bond and the benchmark securities used to create the interest rare tree. C. The OAS is equal to the Z-spread plus the cost of rhe embedded option.

7.

A convertible bond with a 9o/o annual coupon is currently selling for $1 ,073 with a conversion ratio of 30 and a straight value of $1,031. Assume that the common stock pays a $1.25 dividend and is currently selling for $32. The premium payback period is closest to: A. 2.64 years. B. 3.09 years. C. 2.15 years.

8.

The difference between the value of a callable convertible bond and the value of an otherwise comparable option-free bond is closest to the value of rhe: A. call option on the stock minus value of the call option on the bond. B. put option on the stock plus value of the call option on the bond. C. call option on the stock plus value of call option on the bond.

9.

With respect ro the value of a callable con verrible bond, what are the most likely effects of a decrease in interest rate volatility or a decrease in the underlying stock price volatili ty? A. Both will result in an increase in value. B. One will result in an increase in value, the other a decrease. C. Both will result in a decrease in value.

CHALLENGE PROBLEMS 10.

Data on two convertible bonds are shown in the following table.

Conversion price Current stock price

Convertible Bond ABC

Convertible Bond XYZ

$40

$50

$123

$8

Which factors are mor·e likely tO influence the marker prices of ABC and XYZ: factors that affect equity prices, or factors that affect optio n-free bond prices? A. Both will be more affected by equity factors. B. One will be more affected by equity facrors, the other by bond factors . C. Both will be more affected by bond factors .

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Study Session 14 Cross-Reference to CFA Institute Assigned Reading #50 - Valuing Bonds With Embedded Options

11.

Ron Hyarr has been asked ro do a presentation on how effective duration (ED) and effective convexity (EC) are calculated with a binomial model. His presentation includes the following formulas: effective duration = ED =

effective convexity = EC =

BV+ ~· - BV_~ l

2 x BV0 x t:::.y

Y

BV+~· +BV_fl. -(2xBV0 ) l

Y

2 x BV0 x D.y 2

where:

D.y

= change in required yield, in decimal form

BV- ~y = estimated price if yield decreases by t:::. y BV+ ~y = estimated price if yield increases by t:::. y BV0

= initial observed bond price

Are Hyatt's formulas for effective duration and effective convexity correctly presented? A. The formulas are both correct. B. One formula is correct, the other incorrect. C. Both formulas are incorrect. Use the following binomial interest rate tree to answer Questions 12 through 14. $ 100.000 $ 12.0

$? $? 7.1826%

$? 4.5749%