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security market line (def, equ, chart)

SML vs CML (risk measure, application, definition, slope) table

beta (def and change in beta, equ)

Risks in PE Investing (9)
liquidity risk  not publicly traded
competition environment risk  fewre deals with good prospects
agency risk  principal agent conflict
capital risk  withdrawal of capital due to increase busienss/financial risk
regulatory risk  adverse gov't regulation
tax risk  treatment of returns changes
valuation risk  reflects subjective judgement
diversification risk  poorly diversified across stage, vintage, and strategy
market risk  long term factors such as interest rates/exchange rates

Costs of PE Investing (8)
Transaction costs  due diligence, bank financing, legal
fund setupup costs: usually amortized over life of fund
admin costs  custodian, transfer agent, and accounting costs
audit fees: reporting
Management fee = 2% typical
performance fee = 20%
dilution costs : resulting from additional rounds of financing and stock options
placement fees: as much as 2% upfront fee or annual trailer paid to placement agents

PE Structure
limited partnership provides funding, no active role, limited liability. GP liable for all debts and unlimited liability, 1012 year lives

PE Terms (7)
"qualified" investors only with > $1.0 mm in assets
management fees: 1.52.0%
carried interest  GP's share of profits
Ratchet  allocation of equity between shareholders and fund management
Hurdle Rate  IRR target before GP can receive carried interest (710%)
Target fund size  Signals GP's ability to raise funds, below is negative signal
Vintage: year fund was started

PE Valuation
NAV with frequent adjustments

PE Due Diligence
Evaluation of past performance, trends and magnitude

financial performance of PE Funds (how measured) 2
GIPS since inception IRR
moneyweighted return

PaidinCapital (PIC)
percent of capital used by GP

Distributed to PIC (DPI)
measure LP realized return, cash on cash return

Residual Value to PIC (RVPI)
measure LP's unrealized return

Total value to PIC 
measure LP's realized and unrealized return, sum of DPI and RVPI

carried interest (equ)
Carried Intereset % x (NAV before distributions  committed capital)

NAV before distributions (equ)
NAV before distributions = previous year NAV after distribution + capital called down  management fee + operating results

NAV after Distributions (equ)
NAV after distributions = NAV before distributions  carried interest  distributions

Distributed to PIC (DPI) equ
DPI = cumulative distributions / paid in capital

Residual Value to PIC (RVPI) equ and def
measures LP's unrealized return
RVPI = NAV after distributions / paidincapital

Total Value to PIC (TVPI)
measures LP's realizsed DPI and unrealized RVPI returns
DPI+RVPI = TVPI

postmoney valuation (equ)
POST = FV / (1+r)^N
the value of the firm today to be future value in X years

Premoney valuation (equ)
PRE = POST  INV
value before investment

required fractional ownership (equ)
f = INV / POST

shares required for PE firm
Svc = S founders [f/(1f)]

stock price per share (equ)
p = INV / Svc

investor's future wealth (W) equ
W=INV x (1+r)^N

required fractional ownership for the PE firm (equ)
f = W / FV

POSTmoney valuation (IRR) equ
post = P x (Spe + Se)

contango
 when futures price > spot prices

backwardation
futures prices < spot prices

futures price (equ)
future price = spot price x (1+r)^(Tt)
r = risk free rate
(Tt) represents the time from today (t) to the contract maturity (T) in years

Roll yield:
roll yield is the return from closing out a maturing futures contract at one price and entering into another contract at another price

main arguments against commodity futures as asset class (5)
1) commodity prices have tended to decline in the long run
2) roll yield is not guarangeed (and may be eliminated)
3) rolling costs reduce returns
4) rebalancing, rather than any change in the asset price, drives returns
5) commodity futures do not produce cash flows

main arguments for commodity futures as asset class
shortterm portfolio diversification benefits  counter cyclical
longterm  natural hedge against inflation

Basic HF characteristics
leverage changes in freq and amount used having a significant impact on return and risk of the fund
varied hedging techniques such as short selling with unlimited loss potential, and buying puts with only a premium loss in a rising market
style drifts:
portfolio turnover: rises rapidly during market turmoil
very difficult to evaluate HF performance

3 hedge fund benchmarks
1) broad based market indexes
2) hedge fund indexes
3) risk free rate

types of hedge fund risk (7)
short HF history
credit spreads  can narrow or widen for extended periods and became a significant risk factor for FI funds
intermarket correlations  FI correlated with equities
intramarket correlations  even "zerobeta" arb funds have exposure
style drift/leverage: riskreturn tradeoff not favorable for manager straying from style that reflects particular expertise, leverage increases risk
fraud risk  manager misrep quals, too good to be true, probably is
operational risk: deficient procedures, counterparty risk

Meaure risk?
standard deviation: doesn't capture nonsymmetrical distribution
maximum drawdown  largest loss in HF history
doesn't give probability of loss
Valueatrisk  Provides an estimate of both the magnitute and probability of left tail loss over a time horizon
prediction of future based historical data
assumes normal distribution

Default Risk
type of credit risk
borrower does not repay obligation

Credit spread risk
type of credit risk
credit spread increases, bond value falls and/or bond underperforms benchmark

downgrade risk
type of credit risk
issue downgraded; bond value falls and/or bond underperforms benchmark

4 c's of credit analysis
1) Character: management integrity, qualifications, track record, corporate gov structure
2) covenants: terms/conditions of issue restricting some of management's discretion
affirmative: will do
negative: can't do
3) collateral: assetss offered as security
4) capacity to pay: ability to generate cash or liquidate assets to repay obligations

Capacity to Repay factors (5)
industry trends
regulatory environment
operating and competitive position
financial position and liquidity sources
company structure

Short term solvency ratios (def)
measure firm's ability to liquidate short term assets to meet short term obligations

current ratio
short term solvency ratio
current ratio = current assets / current liabilities

acid test ratio or quick ratio
short term solvency ratio
(current assets  inventories) / current liabilities

capitalization ratios (financial leverage)
measure use of debt in capital structure

LT debttocap ratio
LT Debt / (LT debt + minority interest  SH's equity)
capitalization ratios (financial leverage)

Coverage ratios
firm's ability to repay debt out of operating CF

EBIT Coverage ratio
Coverage ratios
EBIT / annual interest expense

EBITDA coverage ratio
Coverage ratios
EBITDA / annual interest expense

S&P Framework (14)
Net income
+ depreciation
+/ other noncash items
Funds from operations
increase in NWC
Operating Cash Flow
capital expenditures
Free operating cash flow
 cash dividends
Discretionary cash flow
acquisitons
+ asset disposals
+other sources (uses)
Prefinancing cash flow

3 cash flow analysis ratios

debt service coverage
[free operating cash flow + interest] / [interest + annual principal repayment]
higher better

debt payback period
total debt / discretionary cash flow
lower better

3 issues with high yield bond debt structure
1) floating rate: makes scenario analysis under different rates necessary
2) shortterm: means analysis of ability to pay off/rollover is necessary
3) seniority: bank debt is repaid first in bankruptcy
point: high yield borrowers typically have more bank debt

high yield bond, corporate structure issue
highyield issuers frequently structured as holding companies
requires analysis of subs
do debt convenants have restrictions on dividends to parent? Asset sale? Intercompany loans?

4 steps of credit analysis for Assetbacked securities
1) collateral quality  most important
2) seller/servicer quality: higher quality means higher rating
3) CF stress/payment structure: CF/repayemnt complex: "Waterfall"
4) legal structure: special purpose entity (SPE)

municipal bond credit  Tax backed debt def and 4 factors to analyze
secured by some form of tax revenue
1) issuer's debt structure (debt per capita)
2) budgetary policy (balanced budget?)
3) local tax and intergovernmental revenue availablity (tax collection rates)
4) issuer's socioeconomic environment (employment trends)

municipal bond credit  Revenue Bonds def and 3 factors to analyze
finance specific projects; backed by revenue or specific tax revenue
analysis similar to corp bonds
1) project revenue: Amont, reliability
2) flow of funds structure: will debt repayment be the primary use of rev
3) other covenants (rate covenante, additional bonds test)

sovereign bond credit analysis  def and 2 risks
debt of foreign national govt
economic risk: ability to meet debt obligations
Political risk: willingness to meet debt obligations
political stability
integration into global economy
internal and external security risks
form of gov't/degree of participation

sovereign bond credit analysis
two ratings assigned to each national gov't
government has more control over local currency debt repayment (tax policy, domestic spending)
local currency depreciation increases difficulty of repaying foreign currency debt
(one rating for local currency, one for foreign currency)

Rating #1 (sov. Debt)
local currency debt ratings
1) political stability
2) income base and growth
3) economic infrastructure
4) tax and budgetary discpline
5) monetary policy
*ceiling of rating 2

Rating # 2 (Sov. Credit)
balance of payments
external balance sheet
external debt obligations
economic/fiscal policies

Types of credit  corporate, ABS, taxbased muni, revenue muni, sovereign KEY FACTORS (table)

2 views of liquidity
traditional view: measured using money aggregates
liquidity as appetite for risk viewed as function of risk aversion. Putting money in shadow bank

shadow banks
marginal sources of liquidity such as hedge funds, REITs, CDOs, etc
incentive for investors to withdraw when risk increases

2/28 adjustable rate def(3)
borrowerer puts no money down
interest payments are optional
interest rate is a 2year teaser that adjusts up
free "atthemoney" option

3 steps in Minsky's financial instability hypothesis
the hedge unit
the speculative unit
the ponzi unit

the Hedge Unit
levered investment
backed by sufficient incomegenerating capacity

Speculative Unit
riskier than a hedge unit
backed by enough cash flow to pay interest, but not principal
less stable as borrower is speculating that interest rates wont rise and property will not decline

The Ponzi Unit
riskiest
asset cash flow can't cover interest or principal
speculating that the property value will rise
2006 marginal unit of debt was a ponzi unit in U.S. mortgage markets




3 factors affecting treasury returns
Factor:interest rate risk measured with
 Rate changes: effective duration
 slope changes: key rate duration
 curvature changes: key rate duration

bootstrapping
calculating spot rates from securities with different maturities using yields on Treasury bonds from the yield curve
treasury bond yields > bootstrapping > spot rate curve (theoretical)

several options of yields to calculate term structure (4)
all ontherun treasury securities
ontherun + selected other treasureies
all treasury securities
treasury strips

Swap rate curve (LIBOR Curve)
yield curve: typically based on treasury securities
swap rate curve: yield curve based on series of fixedrate quotes on interest rate swaps
point: increasingly preferred as benchmark
not affected by government regulation
more comparable across countries
quotes at more maturities

3 term structure theories (why yield curve is shaped what way)
1) pure expectations theories: same return over any investment horizon
2) liquidity theory
3) preferred habitat theory

Pure expectation theory
main idea: forward rates are solely a function of expected future spot rates
implication: longterm rates = complex mean of future expected shortterm rates
problem: assumes no interest rate uncertainty; fails to recognize:
price risk (if horizon < maturity)
reinvestment risk (if horizon > maturity)
yield curve implications:
upward sloping: short term rates are going to rise
flat: interest rates stay
downward: interest rates falling

Liquidity Theory
Main idea: implied forward rate = expectations + liquidity premium
larger for longer maturities
can't tell what expectation are from upward sloping curve (since it could all be liquitiy premium)
however, can say that downward means ST rates expected to fall

Preferred Habitat Theory
Main idea: implied forward rate = expectations + premium
premium not directly related to maturity

Effective Duration
measures price risk for small parallel shifts in yield curve
problem: most yield curve shifts have nonparallel charateristics
solution: use key rate duration, measures impact of nonparallel shifts

Duration Impact equ
D impact = 1 * D * change in Yield

rate duration
sensitivity of price to changes in single spot rate

binomial interest rate model
tree of up or down interest rate moves (50% each)

Nominal Spread
difference between bondyield and yield on comparablematurity government treasury security
=~zspread

zspread
spread added to each rate on spot rate curve that makes PV of bond CFs equal to market price
spread from each spot rate that makes up for greater discount rate used in market
use for any bond without option

Optionadjusted spread (OAS)
spread added to each rate in binomial rate tree that makes bond value calculated from binomial model equal to market price
OAS = Zspread  cost of embedded option

over or under valued?

Benchmark interest rates
interpretation of spread depends on benchmark rates used to create interest rate tree
U.S. treasury or
 Bond sector with higher credit rating
specific issuer

backward induction methodology
value bond by moving backward from last period to time zero
things to know:
value at maturity
value at any node is average PV of two possible values from next period
discount rate is forward rate for that node

call rule:
when firm will exercise call option

call price:
limit for each node's value

embedded calls (equ)
investors get a discount equal to call value
Vcall = Vnoncallable  Vcallable

embedded puts (equ)
V put = V putable  V nonputable
investors pay premium equal to put value

rate volatility increases? What happens to call/puts
value of embedded call increases, value of callable bond falls

risks when benchmark = specific issuer
only option risk
ibm bond vs. ibm bond
OAS only shows liquidity

risks when benchmark = higherrated bond spread
credit risk and options risk
OAS only represents credit

Effective Duration (equ) and Effective convexity (equ)

convertible bond def
bond convertible into fixed number of shares
can't use binomial interest rate model, since depends on stock, not interest rates

conversion ratio
number of shares per bond

market conversion price
effective price per share when converting
market price of bond/conversion ratio

Conversion value
market price of stock after conversion x conversion ratio

straight value
PV of CFs if not convertible

minimum value of a convertible bond
greater of conversion value and straight value

market conversion premium
market conversion price  market price of stock

market conversion premium ratio (equ)
market conversion premium / market ratio

premium payback period
period needed to offset market conversion premium with coupons: market conversion premium / favorable income difference

favorable income difference (equ)
(ann. $ coupons  [CV ratio x ann. Divs]) / CV ratio

Premium over straight value: (equ)
(MV of bond / straight value) 1

(noncallable/nonputtable) convertible bond value equ
BV = straight bond + call on stock

callable convertible bond value (equ)
CCBV = straight bond + call on stock  call on bond

CCBV if rate increases? Stock vol increases? Rates volatility increases? rates increase?

CV bonds does what to downside risk
limits downside rirsk
if stock price is low convertible is still worth something as a bond

Conditional prepayment rate (CPR)
generic annaul prepayment rate
based on historical rates and expected future economic conditions

CPR equ
SMM = 1  (1CPR)^(1/12)
single monthly mortality rate

100 PSA def
assumes CPR = .2% for first month
increasing by .2% up to month 30
6% there after
200 PSA = 2 x (CPR of 100 PSA)

3 main factors affecting prepayments
1) prevailing mortgage rates
2) housing turnover
3) characteristics of underlying mortgages

characteristics of underlying mortgages (2)
seasoning: prepayments increase as loags season
property location: prepayments are faster in some locations

Housing turnover
increases as rates fall
increases as economic activity rises
personal income increases, more refinancing/prepayments

prevailing mortgage rates
spread between current mortgage rates and original mortgage rates
most important factor, when rates fall, refinancing increases
Path of mortgage rates => refinancing burnout
known as "path dependence"
implication: can't value MBS with the binomial model

Contraction Risk
average life decreases when rates fall and prepayments increase
lower rates lead to more financing
more financing shortens average MBS life

Extension Risk
average life increases as rates rise and prepayments fall
rates rise causing prepayment to decline
average MBS life lengthens

two typical structures of CMOs
sequential pay structure
PAC/support structure

CMOs
Collateralized Mortgage Obligations
created for investors having different risk needs
CFs reallocated to different tranches, each with different contraction/extension risks

Basic sequential pay CMO
tranches retired sequentially
all tranches receive interest
shortest receives all principal until paid off

Risk for long/short tranche
Tranche A (shortest)
high contraction risk, low extension risk
tranche B, opposite

PAC CMO Structure
PAC tranches: "Guaranteed" principal payments based on sinking fund schedule
PAC tranche has more predictable CFs and average life
support tranche: provides prepayment protection to PAC tranches

Stripped MBS
principal and interest allocated to separate tranches

Principalonly strips
receive only principal payments, POs win if rates fall
CF stream increases over time as principal payments increase

Interestonly strips
receive only interest payments
IOs win if rates rise
CF stream decreases over itme as interest payments decrease

Agency vs. nonagency (3)
agency: MBS based on underlying loans with gov't guarantee (Fanny may)
nonagency: issued by private entities (Goldman)
nonagency have more credit risk and therefore need credit enhancement

Commercial MBS (2)
backed by incomeproducing real estate
apartments, warehouses, shopping centers, hotels

difference in commercial MBS
vs. residential
nonrecourse loan, meaning that analysis is of property income, not borrower metrics

debttoservice coverage ratio
loantovalue ratio
debttoservice coverage ratio = NOI / debt service (want high)
loantovalue ratio = mortgage / appraised value (want low)

CMBS: call protection (2)
1) loan level
prepayment lockout (25 years)
defeasance
prepayment penalty points
yield maintenance charges
2) CMBS structure
sequential tranches

asset securitization parties (4)
seller: originates assets/receivables and sells to issuer
issuer SPV: sells ABS securities; buys receivables
investors: buys securities; receives CFs
servicer: collects payments

two types of tranching
1) prepayment tranching: just like mbs, tranche to redistribute prepayment risk
2) credit tranching
abs have credit risk , require credit enhancement
tranching can redistribute

amortizing assets
payments include principal and interest

nonamortizing assets
like credit cards: no scheduled principal payments means no prepayment risk

credit enhancements
type 1: external credit enhancements
1) corporate guarantee by seller
2) bank letter of credit
3) bond insurance

credit enhancements
type 2) internal credit enhancements
1) reserve funds: cash reserve funds
2) overcollateralization: face value < underlying collateral value
3) senior/subordinated structure: risk tranching

HEL ABS def and 2 types
Home equity loan
first lien on property owned by borrower with marginal credit history
2 types:
1) closed end: fixed rate, fully amortizing loans
2) open end: revolving equity lines
prepayment and tranching similar to MBS

Why prepayments not sensitive to rates in HEL or Auto loan
prepayments not sensitive to rates because
little savings
high depreciation in early years

Auto Loan ABS
prepayments significant, but not related to interest rates

Collateralized debt obligations
ABS collateralized by pool of debt obligations
below investment grade corporate bonds, EM bonds, distresssed, MBS and ABS, etc

Typical CDO Structure
Senior tranches:7080% of deal, floating rate
mezzanine tranches: fixed coupon
equity tranche: provides prepayment and credit protection

Cash flow yield
discount rate that makes market price equal to PV of cash flows (like IRR)
major deficiencies:
reinvestment assumption: reinvestment risk
assumed held to maturity = price risk
CF will be realized = prepayment risk

zerovolatility spread (zspread)
spread added to each treasury spot rate, so price = PV of CF
CFY vs. zspread
CFY: considers one interest rate
Zspread: considers one interest rate path
not adequate for valuing BS

monte carlo simulation model
def, mbs value, oas
computer simulates many rate paths
for each path: MBS value = PV of CF along path
need prepayment model
MBS value = average of path values
OAS: spread so model value = market price

buy signal using OAS (2)
large OAS
low option cost

Duration
measures interest rate risk
larger duration = more interest rate risk

convexity
refines estimate
larger convexity = lower interest rate risk

When to use which spread measure
nominalnever
zspread: non callable bonds
OAS: binomial  callable bonds, CFs not path dependent
OAS: Monte Carlo  MBS, CFs are path dependent

