CFA 2

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

Transaction costs - due diligence, bank financing, legal

fund setup-up 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

limited partnership provides funding, no active role, limited liability. GP liable for all debts and unlimited liability, 10-12 year lives

"qualified" investors only with > $1.0 mm in assets

management fees: 1.5-2.0%

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 (7-10%)

Target fund size - Signals GP's ability to raise funds, below is negative signal

Vintage: year fund was started

NAV with frequent adjustments

Evaluation of past performance, trends and magnitude

GIPS since inception IRR

money-weighted return

percent of capital used by GP

measure LP realized return, cash on cash return

measure LP's unrealized return

measure LP's realized and unrealized return, sum of DPI and RVPI

Carried Intereset % x (NAV before distributions - committed capital)

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

NAV after distributions = NAV before distributions - carried interest - distributions

DPI = cumulative distributions / paid in capital

measures LP's unrealized return

RVPI = NAV after distributions / paid-in-capital

measures LP's realizsed DPI and unrealized RVPI returns

DPI+RVPI = TVPI

POST = FV / (1+r)^N

the value of the firm today to be future value in X years

PRE = POST - INV

value before investment

f = INV / POST

Svc = S founders [f/(1-f)]

p = INV / Svc

W=INV x (1+r)^N

f = W / FV

post = P x (Spe + Se)

• 
• when futures price > spot prices

futures prices < spot prices

future price = spot price x (1+r)^(T-t)

r = risk free rate

(T-t) represents the time from today (t) to the contract maturity (T) in years

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

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

short-term portfolio diversification benefits - counter cyclical

long-term - natural hedge against inflation

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

1) broad based market indexes

2) hedge fund indexes

3) risk free rate

short HF history

credit spreads - can narrow or widen for extended periods and became a significant risk factor for FI funds

inter-market correlations - FI correlated with equities

intra-market correlations - even "zero-beta" arb funds have exposure

style drift/leverage: risk-return 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

standard deviation: doesn't capture non-symmetrical distribution

maximum drawdown - largest loss in HF history

-doesn't give probability of loss

Value-at-risk - 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

type of credit risk

borrower does not repay obligation

type of credit risk

credit spread increases, bond value falls and/or bond underperforms benchmark

type of credit risk

issue downgraded; bond value falls and/or bond underperforms benchmark

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

industry trends

regulatory environment

operating and competitive position

financial position and liquidity sources

company structure

measure firm's ability to liquidate short term assets to meet short term obligations

short term solvency ratio

current ratio = current assets / current liabilities

short term solvency ratio

(current assets - inventories) / current liabilities

measure use of debt in capital structure

LT Debt / (LT debt + minority interest - SH's equity)

capitalization ratios (financial leverage)

firm's ability to repay debt out of operating CF

Coverage ratios

EBIT / annual interest expense

Coverage ratios

EBITDA / annual interest expense

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

[free operating cash flow + interest] / [interest + annual principal repayment]

higher better

total debt / discretionary cash flow

lower better

1) floating rate: makes scenario analysis under different rates necessary

2) short-term: 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 issuers frequently structured as holding companies

requires analysis of subs

do debt convenants have restrictions on dividends to parent? Asset sale? Intercompany loans?

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)

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)

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)

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

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)

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

balance of payments

external balance sheet

external debt obligations

economic/fiscal policies

traditional view: measured using money aggregates

liquidity as appetite for risk viewed as function of risk aversion. Putting money in shadow bank

marginal sources of liquidity such as hedge funds, REITs, CDOs, etc

incentive for investors to withdraw when risk increases

borrowerer puts no money down

interest payments are optional

interest rate is a 2-year teaser that adjusts up

free "at-the-money" option

the hedge unit

the speculative unit

the ponzi unit

levered investment

backed by sufficient income-generating capacity

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

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

Factor:interest rate risk measured with

• Rate changes: effective duration
• slope changes: key rate duration
• curvature changes: key rate duration

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)

all on-the-run treasury securities

on-the-run + selected other treasureies

all treasury securities

treasury strips

yield curve: typically based on treasury securities

swap rate curve: yield curve based on series of fixed-rate quotes on interest rate swaps

point: increasingly preferred as benchmark

-not affected by government regulation

-more comparable across countries

-quotes at more maturities

1) pure expectations theories: same return over any investment horizon

2) liquidity theory

3) preferred habitat theory

main idea: forward rates are solely a function of expected future spot rates

implication: long-term rates = complex mean of future expected short-term 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

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

Main idea: implied forward rate = expectations + premium

premium not directly related to maturity

measures price risk for small parallel shifts in yield curve

problem: most yield curve shifts have non-parallel charateristics

solution: use key rate duration, measures impact of non-parallel shifts

D impact = -1 * D * change in Yield

sensitivity of price to changes in single spot rate

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

difference between bondyield and yield on comparable-maturity government treasury security

=~z-spread

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

spread added to each rate in binomial rate tree that makes bond value calculated from binomial model equal to market price

OAS = Z-spread - cost of embedded option

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

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

when firm will exercise call option

limit for each node's value

investors get a discount equal to call value

Vcall = Vnoncallable - Vcallable

V put = V putable - V nonputable

investors pay premium equal to put value

value of embedded call increases, value of callable bond falls

only option risk

ibm bond vs. ibm bond

OAS only shows liquidity

credit risk and options risk

OAS only represents credit

bond convertible into fixed number of shares

can't use binomial interest rate model, since depends on stock, not interest rates

number of shares per bond

effective price per share when converting

-market price of bond/conversion ratio

market price of stock after conversion x conversion ratio

PV of CFs if not convertible

greater of conversion value and straight value

market conversion price - market price of stock

market conversion premium / market ratio

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

(ann. $ coupons - [CV ratio x ann. Divs]) / CV ratio

(MV of bond / straight value) -1

BV = straight bond + call on stock

CCBV = straight bond + call on stock - call on bond

limits downside rirsk

if stock price is low convertible is still worth something as a bond

generic annaul prepayment rate

based on historical rates and expected future economic conditions

SMM = 1 - (1-CPR)^(1/12)

single monthly mortality rate

assumes CPR = .2% for first month

increasing by .2% up to month 30

6% there after

200 PSA = 2 x (CPR of 100 PSA)

1) prevailing mortgage rates

2) housing turnover

3) characteristics of underlying mortgages

seasoning: prepayments increase as loags season

property location: prepayments are faster in some locations

increases as rates fall

increases as economic activity rises

-personal income increases, more refinancing/prepayments

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

average life decreases when rates fall and prepayments increase

lower rates lead to more financing

more financing shortens average MBS life

average life increases as rates rise and prepayments fall

rates rise causing prepayment to decline

average MBS life lengthens

sequential pay structure

PAC/support structure

Collateralized Mortgage Obligations

created for investors having different risk needs

CFs reallocated to different tranches, each with different contraction/extension risks

tranches retired sequentially

all tranches receive interest

shortest receives all principal until paid off

Tranche A (shortest)

high contraction risk, low extension risk

tranche B, opposite

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

principal and interest allocated to separate tranches

receive only principal payments, POs win if rates fall

CF stream increases over time as principal payments increase

receive only interest payments

IOs win if rates rise

CF stream decreases over itme as interest payments decrease

agency: MBS based on underlying loans with gov't guarantee (Fanny may)

non-agency: issued by private entities (Goldman)

non-agency have more credit risk and therefore need credit enhancement

backed by income-producing real estate

apartments, warehouses, shopping centers, hotels

vs. residential

non-recourse loan, meaning that analysis is of property income, not borrower metrics

debt-to-service coverage ratio = NOI / debt service (want high)

loan-to-value ratio = mortgage / appraised value (want low)

1) loan level

-prepayment lockout (2-5 years)

-defeasance

-prepayment penalty points

-yield maintenance charges

2) CMBS structure

-sequential tranches

seller: originates assets/receivables and sells to issuer

issuer SPV: sells ABS securities; buys receivables

investors: buys securities; receives CFs

servicer: collects payments

1) prepayment tranching: just like mbs, tranche to redistribute prepayment risk

2) credit tranching

-abs have credit risk , require credit enhancement

-tranching can redistribute

payments include principal and interest

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

type 1: external credit enhancements

1) corporate guarantee by seller

2) bank letter of credit

3) bond insurance

type 2) internal credit enhancements

1) reserve funds: cash reserve funds

2) overcollateralization: face value < underlying collateral value

3) senior/subordinated structure: risk tranching

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

prepayments not sensitive to rates because

-little savings

-high depreciation in early years

prepayments significant, but not related to interest rates

ABS collateralized by pool of debt obligations

below investment grade corporate bonds, EM bonds, distresssed, MBS and ABS, etc

Senior tranches:70-80% of deal, floating rate

mezzanine tranches: fixed coupon

equity tranche: provides prepayment and credit protection

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

spread added to each treasury spot rate, so price = PV of CF

CFY vs. z-spread

CFY: considers one interest rate

Z-spread: considers one interest rate path

-not adequate for valuing BS

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

large OAS

low option cost

measures interest rate risk

larger duration = more interest rate risk

refines estimate

larger convexity = lower interest rate risk

nominal-never

z-spread: non callable bonds

OAS: binomial - callable bonds, CFs not path dependent

OAS: Monte Carlo - MBS, CFs are path dependent