Last Revised: 05/05/2021

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Level I - Derivatives and Alternative

Investments
Readings Page

Derivative Markets and Instruments 2

Basics of Derivative Pricing and Valuation 15

Introduction to Alternative Investments 37

Reviews 60

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 Last Revised: 05/05/2021

Derivative Markets and Instruments

a. define a derivative and distinguish between exchange-traded and over-the-

counter derivatives;

b. contrast forward commitments with contingent claims;

c. define forward contracts, futures contracts, options (calls and puts), swaps,
and credit derivatives and compare their basic characteristics;

d. determine the value at expiration and profit from a long or a short position in
a call or put option;

e. describe purposes of, and controversies related to, derivative markets;

f. explain arbitrage and the role it plays in determining prices and promoting
market efficiency.
 Last Revised: 05/05/2021

Derivative

Derivative a financial contract between 2 parties whose value LOS a

-define
depends on the value of some other underlying asset
-distinguish
- similar to insurance as they allow the transfer of risk Pg-1
e.g./ Buyer agree Buy a specific - at a specific - on a specific
Seller to Sell asset price date

legal contact underlying strike or expiration

asset contract date
- rights (contingencies)
price
& obligations (commitments)
of the parties

LOS a
zero-sum game - derivatives do not create wealth, they simply -define
transfer it -distinguish
- when one party makes $1, the other must lose $1 Pg-2
- used for hedging or speculation
risk mgmt. risk assumption
Structure of Derivative Markets/
Exchange-Traded - futures/options
- standardized contracts - terms/conditions specified by the exchange
- no counterparty risk - clearing corp. takes the opposite side of
every transaction
 Last Revised: 05/05/2021

Structure of Derivative Markets/ LOS a

-define
Clearing
-distinguish
House Pg-3
long short
Buyer Contract Seller
i.e. performance bond
posts margin posts margin

· daily settlement mark-to-market

· transparency - full information on all transactions
is disclosed to exchanges & regulatory bodies
· highly regulated

Structure of Derivative Markets/ LOS a

OTC (Over-the-Counter) markets -define
· dealer market -distinguish
- forwards, swaps
Pg-4
- mostly banks (members of International
Swap & Derivations Assoc. - ISDA)
· customization of contracts
- result in a lack of liquidity
long multiple contacts
Buyer Dealer
or
short hedged with another
Seller derivative with
same underlying
different und.
 Last Revised: 05/05/2021

Structure of Derivative Markets/ LOS a

-define
OTC (Over-the-Counter) markets
-distinguish
· lower degree of regulation - lightly regulated Pg-4
· privacy
Note/ Dodd-Frank
· some OTC contracts which can be standardized
will be, and a number of contracts will have
to be cleared through central clearing agencies

Commitment vs. Contingent

Forward Commitments/ LOS b, c

-contrast
-define
Buyer agree Buy a specific - at a specific - by a specific
Pg-1
Seller to Sell asset price date

both parties are forward or

obligated to perform future price
Forward
Price at a price
agreed on here exp. date
-

T1 T2

Buyer &
trade on this date
Seller
 Last Revised: 05/05/2021

Forward Commitments/ an OTC LOS b, c

-contrast
contract that obligates both parties
-define
Note/ an Pg-2
future price at T agreed exchange-traded
on at t0 forward is called
F0(T) a ‘futures’
r=0 i=$0 $0
contract
-

-
0 T
S0 - spot price at t0 ST - spot price at T

Payoff
- if ST > F0(T) long profits
ST - F0(T) zero-sum
short loses
- (ST - F0(T)) Note/
- if ST < F0(T) short profits
F0(T) - ST ST - S0
long loses
- (F0(T) - ST) ≠ ST - F0(T)

Forward Commitments/ LOS b, c

-contrast
-define
Pg-3

· forwards do
not require $
0 0 to change hands
on inception
ST ST
Day 1 Day 1
· value of a
Payoff from Buying Payoff from Selling forward = $0
ST - F0(T) - [ST - F0(T)] at inception
- ST + F0(T)
F0(T) - ST
 Last Revised: 05/05/2021

Forward Commitments/ LOS b, c

- not all underlying assets are delivered/deliverable -contrast
-define
· non-deliverable forwards (NDFs)
same payoffs Pg-4
· cash-settled forwards
as delivery
· contracts for differences
Futures/
· an exchange-traded forward
· introduces mark-to-market settlement
- conducted
settlement daily
- both parties post price determined
a margin/performance by the exchange
bond, typically < 10% of the value of
underlying

Forward Commitments/ LOS b, c

-contrast
Futures/ e.g.
-define
Buyer CL Seller
Pg-5
(1000 bbls WTI)
Initial 4,500 $44.00 4,500 both sides post
Margin Initial Margin
+ 360 close at - 360
4860 $44.36 4140
back up to
Maintenance + 640 Initial Margin
close at - 640
Margin 5500 $45 3500
(75% of initial)
$3375 + 150 close at - 150
margin call
5650 $45.15 3350
triggered
MTM
 Last Revised: 05/05/2021

Forward Commitments/ LOS b, c

Futures/ -contrast
upper -define
· daily price limits
last settlement price Pg-6
lower
e.g./ Dec. LE $1.18075
121.075 limit up trades can occur
quoted as 118.075
within the band
115.075 limit down
but not at the
limit
(i.e. limited is locked)
· offsetting - closing out a
position before delivery

May 31 Buy 1 Dec. LE Aug. 31 Sell 1 Dec. LE

(open) (close)

Forward Commitments/ LOS b, c

-contrast
Futures/
-define
· open interest # of outstanding contracts Pg-7
e.g./ Buyer Seller Volume OI
A B 10 10
C A 5 10
B C 5 5
B A 5
· delivery
- short position must deliver to a specific location
during the delivery period Cushing, Okla.
- long takes delivery
 Last Revised: 05/05/2021

Forward Commitments/ LOS b, c

Futures/ -contrast
-define
· delivery
Pg-8
· futures and spot
futures (H0) spot
prices converge on
the final day
spot futures

delivery delivery

· no counterparty risk
· highly regulated
· transparent

Forward Commitments/ LOS b, c

Swaps/ an OTC contract in which 2 parties agree to -contrast
swap a series of cash flows -define
Pg-9
- one party pays a variable rate (determined by an asset or rate)
variable rate
- other party pays
or
fixed rate
- most common: fixed for floating: Plain vanilla swap
notional principal ×
floating payments
Corporation Swap Dealer - value of swap
fixed payment at inception = 0
floating interest notional - as the floating
payments × rate changes, the
principal
typically Lender value of the
Libor swap changes
- term of the swap set
to match term of the loan
 Last Revised: 05/05/2021

exercise or LOS b, c, d
Contingent Claims/ strike price -contrast
Options/ at a pre- by a pre- -define
call has a buy an
Buyer of a - specified - a specified -determine
put right to sell asset Pg-10
price date
- seller has the obligation expiration date
- buyer pays seller an option ‘premium’
- options can be OTC or exchange-traded
· American-style options - can be exercised anytime before expiration
· European style options - can only be exercised on the expiration date
- payoff of a call at expiration ST - x if ST > 0, else 0
CT = max (0, S T - x) π = max (0, ST - x) - C0
S0 = 45
ST = 45 payoff = profit = -1.50 OTM (out-of)
e.g. X = 50
ST = 50 payoff = profit = -1.50 ATM (at)
T = 3 mos.
ST = 55 payoff = profit = 3.50 ITM (in)
C0 = 1.50

Contingent Claims/ LOS b, c, d

Options/ 51.50 -contrast
payoff and profit to seller -define
S0 = 45 -determine
ST = 45 payoff = profit = 1.50 OTM (out-of)
e.g. X = 50 Pg-11
ST = 50 payoff = profit = 1.50 ATM (at)
T = 3 mos.
ST = 55 payoff = -5 profit = -3.50 ITM (in)
C0 = 1.50
Note: Call buyer payoff + Call seller payoff = 0
zero-sum
profit profit = 0
(example #4)
(gain is not
limited) (limited gain)
Profit Selling a Call
C0
Payoff Payoff
0 0
-
-

Profit x x
- C0 (loss is not
(limited loss)
limited)

Buying a Call
 Last Revised: 05/05/2021

Contingent Claims/ LOS b, c, d

Options/ 51.50
-contrast
payoff and profit to seller -define
S0 = 45 -determine
ST = 45 payoff = profit = 1.50 OTM (out-of)
e.g. X = 50 Pg-12
ST = 50 payoff = profit = 1.50 ATM (at)
T = 3 mos.
ST = 55 payoff = -5 profit = -3.50 ITM (in)
C0 = 1.50
Note: Call buyer payoff + Call seller payoff = 0
zero-sum
profit profit = 0
(example #4)
(gain is not 5
limited)
(limited gain)
SU +1.50 Profit Selling a Call
C0
Payoff X + C0 Payoff
0 x
0 x

-
Profit 51.50
-

- C0 (loss is not
(limited loss)
-5 limited)
Buying a Call

LOS b, c, d
Contingent Claims/
-contrast
Options/ payoff of a put at expiration X - ST if ST < X, else -define
PT = max (0, x - ST ) π = max (0, x - ST) - P0 -determine
Pg-13
e.g. X = 20 ST = 18 payoff = profit = 0.50 payoff = -2, profit = -0.50
P0 = 1.50 ST = 22 payoff = profit = -1.50 payoff = 0, profit = 1.50

(example #5)
seller
Buying a Put Selling a Put
(not a limited gain)
(limited gain)
- sort of
P0 -
Payoff Profit
0 0 Payoff
-

x Profit x
-

- P0 -
x

(limited loss)
(not a limited loss)
- sort of
 Last Revised: 05/05/2021

Credit Derivatives/ · avoids many of LOS b, c

the regulatory constraints of insurance -contrast
- credit protection seller provides credit -define
Pg-14
protection against a specific loss to the
credit protection buyer
· Credit Default Swap/
compensation for
credit losses
banks
Lender (CDS buyer) CDS Seller
periodic insurance
interest
payments protection cos.
+ protection
CDS fee seller
principal buyer
Borrower or
credit
CDS spread
obligation

Credit Derivatives/ LOS b, c

· Credit Default Swap/ -contrast
-define
60 bps Qtly. Pg-15
My Fund Seller
$10M protection
5-yr. @ par · every Q, we pay $ ×.
= ,
ABC · if default occurs, payments stop and
the CDS is settled

a) physical b) Cash
- we get $10M - receive Par - Post Default
- deliver bonds to market value
the seller
 Last Revised: 05/05/2021

Purposes/Controversies
LOS d
· Risk allocation, transfer, management -describe
· Information discovery Pg-1
- some derivatives provide an indication of
the direction of the underlying
- involves less capital, info can be
reflected in prices faster
- derivatives allow strategies unavailable with
the underlying
· Operational Advantages
- lower transaction costs, more liquid than spot markets
- easy to go short the underlying
- leverage

· Market efficiency LOS d

-describe
· when prices deviate from fundamental
Pg-2
values, derivatives offer a less costly trade
· ability to hedge increases willingness to trade
Criticisms/
· Destabilization and systematic risk
- the very benefits of low cost, leverage
result in excessive speculation
· speculation & gambling
often seen in an unfavourable light
· complexity
 Last Revised: 05/05/2021

Arbitrage

· whenever similar assets or combinations LOS d

of assets are selling for different prices -describe
arbitrageurs’ step in, buy the lower
priced asset, sell the higher priced asset,
until prices converge
- Arbitrage helps/ · determine prices
· law of one price - 2 securities
that generate the same cash flows, regardless
of future events, should have the same price today
· improves market efficiency
 Last Revised: 05/05/2021

Basics of Derivative Pricing and Valuation

a. explain how the concepts of arbitrage, replication, and risk neutrality are used in
pricing derivatives;

b. explain the difference between value and price of forward and futures contracts;

c. calculate a forward price of an asset with zero, positive, or negative net cost of
carry;

d. explain how the value and price of a forward contact are determined at expiration,
during the life of the contract, and at initiation;

e. describe monetary and nonmonetary benefits and costs associated with holding the
underlying asset and explain how they affect the value and price of a forward
contract;

f. define a forward rate agreement and describe its uses;

g. explain why forward and futures prices differ;

h. explain how swap contracts are similar to but different from a series of forward
contracts;

i. explain the difference between the value and price of swaps;

j. explain the exercise value, time value, and moneyness of an option;

k. identify the factors that determine the value of an option and explain how each
factor affects the value of an option;

l. explain put-call parity for European options;

m. explain put-call-forward parity for European options;

n. explain how the value of an option is determined using a one-period binomial

model;

o. explain under which circumstances the values of European and American options
differ.
 Last Revised: 05/05/2021

Arbitrage, Replication, Risk Neutrality

LOS a
- Derivative - financial instrument that derives its
-explain
performance from the performance of an Pg-1
underlying asset forward - OTC
commitments futures - exchange-traded
- 2 principle types swap - OTC
contingent claims options - OTC/exchange-tr.
credit derivatives - OTC
asset-backed securities
Pricing the Underlying/ dealer
equities
4 main types fixed income/interest rates
commodities
currencies - pays no
· forming expectations/ income
E(ST)
0 T
-

-
()
S0
( + + )
risk-free risk required rate of return
rate premium (assume risk aversion)

· forming expectations/ ( ) LOS a

= - no income -explain
+ + Pg-2
- underlying assets generate or incur/
these benefits
· Income (div., interest) and costs
- primarily financial assets tend to be certain
· convenience yields
primarily commodities (assume they
· storage costs
accrue at the
· opportunity costs - typically the risk-free rate
end of the
( )
holding period)
+ + E(ST)
+ + benefits PV (benefits) =
- costs PV (costs) =
-

( - )
( ) +
∴ = − +
( + + ) cost of carry
 Last Revised: 05/05/2021

Principles of Arbitrage/ - a transaction used when LOS a

two assets produce identical results but sell -explain
for different prices Pg-3

- buy low, sell high

upward price pressure downward price pressure

continues until prices converge

- Law of One Price assets that produce identical results can have
only one true market price
- arbitrage results in much more efficient markets
· Arbitrage & derivatives/ - payoffs on derivatives come directly from
the underlying asset
derivatives can be used to perfectly hedge the asset
position in underlying Underlying payoff
+ opposite position in derivative - Derivative payoff
= Risk-free return
-

-
0 T

· Arbitrage & derivatives/ LOS a

- all derivatives are prices such that, given S0, -explain
Pg-4
a combination of S0 + derivative returns rf
Arbitrage & Replication/ - the creation of an asset/portfolio from
another asset/portfolio/derivative
Asset + Derivative = Risk-Free Bond
short/long long/short
Asset - Risk-Free Bond = -Derivative buy low/sell high
long short
- Asset + Risk-Free Bond = Derivative
short long

· in the absence of arbitrage (e.g. everything is correctly

replication would not produce excess return priced)
- replication can reduce transaction costs (rather than sell an
equity portfolio to invest in gov’t. bonds, just use a derivative)
 Last Revised: 05/05/2021

Risk Aversion, Risk Neutrality & Arb-Free Pricing/ LOS a

- investor’s risk aversion is not a factor in -explain
determining the price of a derivative Pg-5
( ) risk aversion is relevant in
- recall: =
( + + ) pricing assets
S0 already reflects risk-aversion - since a derivative derives its price
from S0, no need to incorporate risk aversion into the price of the derivative

- prices of derivatives therefore assume risk neutrality

expected payoff of a derivative at time T can be discounted
at rf
- as such, derivative pricing is sometimes called risk-neutral pricing
or arbitrage-free pricing
- Limits to Arbitrage/
- transaction costs, ability to borrow/lend at rf, ability to short sell,

Value vs. Price

- forwards/futures do not require the outlay of cash LOS b

at contract initiation -distinguish
Pg-6
V0 = $0 (forwards/futures/swaps)
- as the underlying moves, value changes
- forward/future price or swap rate represents the fixed price or
rate at which the underlying will be purchased at a later date
(not an amount that will be paid at the start)
- the value of the contract is the change in the contract price/rate
from inception to the valuation date.
 Last Revised: 05/05/2021

Pricing & Valuation

- PV benefits LOS c, d
-explain
- PV costs
-describe
-

-
0 T Pg-7
S0 ST spot price
F0(T) - forward price VT(T) = ST - F0(T)
V0(T) = 0
( )= ( + ) · borrow @ rf, buy S0, at time T we
- the forward price is owe ( + )
the spot price compounded - if ( ) > ( + )
at the risk-free rate over - sell - buy
the life if the contract - if ( ) < ( + )
- buy - sell
- introduce costs + benefits
( )=( − + )( + )

- PV benefits VT(T) LOS c, d

- PV costs = ST - F0(T) -explain
-describe
-

0 t T Pg-8
t T-t
S0 - spot price F0(T) - contract price, agreed
today on at t = 0, for a
transaction at T
Valuation
bring & bring F0(T)
St
(1 + r)t (1 + r)-(T - t)

( )= ( )
− ( − )( + ) − ( )( + )

e.g./ S0 = $50, rf = 3%, T = .25 · one month later St = $52

e.g.2/ S0 = $50, rf = 3%, T = .25, = $3, = $4 · one month later St = $52

 Last Revised: 05/05/2021

Forward Rate Agreement

LOS e
- FRA underlying is an interest rate
-define
r (1) implied forward
Pg-9
f (1,1) rate
r (1) - one yr. Libor
-

-
r (2) - two-yr. Libor
r (2)
[ + ( )] = [ + ( )][ + ( , )] e.g./ r (1) = 3%
[ + ( )] r (2) = 4%
( , )= −
[ + ( )] ( . )
( , )= −
· The FRA rate is the .
forward rate (implied by the = .
current term Proof/
structure of rates) (1.04)2 = (1.03)(1.05009)
1.0816 = 1.0816

Futures Pricing & Valuation

- futures are marked-to market daily LOS f

F0(T) = 100 -explain
-

forward profit = $10 Pg-10

spot 100 110
F0(T) = 100 F0(T) = 104 F0(T) = 108
-

futures profit > $10

spot 100 104 108 110

marked marked 4 (1 + r)(T -t)

4 (1 + r)(T -t)
- differences in the CFs between futures & forwards can also lead to
pricing differences
the more volatile rates are, the greater the differential
- if futures prices are positively correlated with interest rates, futures
contracts are more desirable vs. forwards (neg. corr. then forwards)
to the long position
long positions + rising prices = MTM profits reinvested at higher rates
+ falling prices = MTM losses financed at lower rates
- this difference is generally ignored in practice
 Last Revised: 05/05/2021

Swaps

- involves the exchange of cash flows LOS g, h

-explain
fixed rate -distinguish
-

-
FS0(n,T) FS0(n,T) FS0(n,T) FS0(n,T)
Pg-11

floating rate S - floating

-

-
S1 S2 S3 S4
FS - fixed
- netted S1 - FS0(n,T) S3 - FS0(n,T) n - # of periods
out S2 - FS0(n,T) S4 - FS0(n,T) T - term

1 yr. swap w/ quarterly resets

pay F0(1) at T, get S1
3 mos.
-

F0 (1) ≠ F0 (2) ≠ F0 (3) ≠ F0 (4)

pay F0(2) at T, get S2
but Uswap = $0 at inception
6 mos. & FS0(n,T) must be
-

pay F0(3) at T, get S3

fixed
9 mos. - select a fixed rate such
-

pay F0(4) at T, get S4

that
Bfx = 100
-

12 mos.

- using replication/ LOS g, h

- a swap is economically identical to being long -explain
a floating rate bond and short a fixed rate bond -distinguish
Pg-12
for Uswap = $0, Bfl = Bfx and since Bfl = 100,
solve for
+
= = + + + PMT
[ + ( )] [ + ( )] [ + ( )] [ + ( )]
×
[ + ( )] price of
e.g. quarterly resets, 1yr. the swap
spot rates
need 1 = PMT × DF1 + PMT × DF2 + PMT × DF3 + PMT × DF4 + DF4
L (90) ➞ = DF 1 1 = PMT (ΣDFn) + DF4
( ).
PMT (ΣDFn) = 1 - DF4
L (190) . = DF2 PMT =
( ) − PMT = −
L (270) = DF 3
( ).
L (360) = DF4
( )
PMT = F0(1) = F0(2) = F0(3) = F0( )
off-market forwards
 Last Revised: 05/05/2021

Option Value

· Call Option/ LOS i, j

-explain
buyer - has a right - to buy at a
a specific by a Pg-13
seller - has an obligation - to sell certain
asset certain
price date
underlying
strike expiration
price
European - last day exercise
anytime trading
American - anytime exercise

Notation/ C0, CT - value of Eur. call

C0, CT AM. call
at time (0,T)
P0, PT Eur. put
P0, PT AM. put

· Call Option/ LOS i, j

e.g./ A buys a 6-mos. call on XYZ from B for $2 -explain
Pg-14
(i.e. Nov $20 call on XYZ) strike = $20
$2 - option premium (C0)
$20 - strike/exercise price (X)
Scenario 1/ ST = 35 Scenario 2/ ST = 15
Value of the option A B
VT = 15 - 35 VT = 0 VT = 0
in of the
money
Profit on the trade - 20 - 20 out of the
for A money
= −( − ) - 15
π = VT - C0 πA = - C0 πB = + 2
= 15 - 2 = 13 = − = -2
 Last Revised: 05/05/2021

· Call Option/ LOS i, j

-explain
Payoff Pg-15

ST > X ST < X
- holder will - holder will not
exercise exercise
long call ST - X 0

short call - (ST - X) 0

Profit
long call (ST - X) - C0 -C0

short call - (ST - X) + C0 C0

· Call Option/ LOS i, j

long call short call -explain
Pg-16
ST X max (0, ST - X) - max (0, S T - X)

5 0 -2 0 2
OTM 10 0 -2 0 2
15 0 -2 0 2
ATM - 20 20 0 -2 0 2
25 5 3 -5 -3
30 10 8 -5 -8
ITM
35 15 13 -10 -13
40 20 18 -20 -18
π π
moneyness π
π
C0 = $2
 Last Revised: 05/05/2021

· Call Option/ LOS i, j

-explain
Pg-17
long call
(VT)
ST - X
C0
Intrinsic
C0 BEP = X + C0 Value
0 ST
X
-
- C0

ST < X ST > X short call

OTM ITM IV = max (0, ST = X)
IV = 0 ATM (VT)
IV = 0

· Put Option/ LOS i, j

buyer - has a right - to sell at a by a -explain
a certain
seller - has an obligation - to buy certain
certain Pg-18
asset
price
date
e.g./ A buys a 12-month put from B for $5, strike $50 on XYZ
(May 2017 $50 put on XYZ)
Scenario 1/ ST = 30 Scenario 2/ ST = 85
A - 85
out of the
VT = X - ST = 20
money
π = (X - ST) - P0 = 15 - 50
- 50
in the
B money A B
- 30 V = 0 V T = 0
VT = -20 T

π = -15 π = 0 - P0 π = P0 = 5
= -5
 Last Revised: 05/05/2021

· Put Option/ LOS i, j

-explain
Payoff Pg-19

ST < X ST > X
- holder will - holder will not
exercise exercise

long put X - ST 0

short put - (X - ST) 0

Profit
long put (X - ST) - P0 -P0

short put - (X - ST) + P0 P0

· Put Option/ LOS i, j

long put short put -explain
Pg-20
ST X Max (0, X - ST) - Max (0, X - ST)
10 40 35 -40 -35
20 30 25 -30 -25
ITM
30 20 15 -20 -15
40 10 5 -10 -5
49.99
ATM - 50 50 0 -5 0 5
60 0 -5 0 5
P0 P1
OTM 70 0 -5 0 5
80 0 -5 0 5

P0 = $5
 Last Revised: 05/05/2021
LOS i, j
· Put Option/
-explain
Pg-21

BEP = X - P0

short put
P0
0 ST
X
-
long put

X > ST ST > X
ITM OTM
IV = X - ST ATM IV = 0
IV = 0

S0 = $50 X1= 45 X2 = 55 LOS i, j

C1 = 7 C2 = 3 -explain
Pg-22
P1 = 3 P2 = 7

Calls Puts
Value of
an option =
IV + TV
OTM ITM
- 55 - 55
IV = 0, TV = 3 IV = 5, TV = 2
ATM - S0 ATM - S0
IV = 5, TV = 2 IV = 0, TV = 3
- 45 - 45
ITM OTM
 Last Revised: 05/05/2021

Effects on Value

1) So - the value of the underlying LOS k

-identify
- value of a call is directly related to ST
Pg-23
- value of a put is inversely related to ST

Note: S0 serves as an upper boundary for C0

C0, C0 ≤ S0 , CT, CT ≤ ST
2) Exercise price
Calls Puts
less expensive more expensive
IV + TV

- S0 - TV only
- S0 - TV only
more expensive
IV + TV less expensive

LOS k
2) Exercise price - X
-identify
X sets an upper bound on the price of a put Pg-24

i.e./ ≤
r - risk-free rate, t – time in yrs.
( + )

· call option values are inversely related to X

· put option values are directly related to X
Note/
Upper Bounds
Call ST
Put [⇒ ]
( + ) ⇒

Hull
 Last Revised: 05/05/2021

3) r - risk free rate LOS k

-identify
- when rates fall, call option prices fall
Pg-25
put option prices rise
put- call parity
= + − = − +
( + ) ( + )
as r ↓,
4) Time becomes larger
· value of a call option is directly related to time
Eur/
· value of a put option is generally directly
related to time, but longer time decreases
the PV of a payoff (X - ST)

5) Volatility LOS k
-identify
- greater volatility in the underlying
Pg-26
increases both call & put prices
Note: X & S 0 determine an option’s intrinsic value
Time & Volatility determine an option’s time value
 Last Revised: 05/05/2021

Put-Call Parity

Let us begin with 2 portfolios LOS l

A B -explain
· call, put and bond Pg-27
long call long put all have the same
+ + time to maturity
zero coupon bond long stock · X is the same
that pays X
for all 3
②
at maturity protective put
· call & put have the
fiduciary call same underlying
(also the structure of · call & put are
a principal protected note) European

at expiration LOS l
ST > X ST < X -explain
Payoff Payoff Pg-28
A. Call exercised A. Call not exercised
payoff = ST - X ST - X + X Payoff = 0 0 +X

= ST · zero worth X = X
· zero worth X ②
B. put exercised
B. put not exercised
0 + ST Payoff = X - ST X - ST + ST
payoff = 0
= ST · Share worth ST = X
· stock worth ST
- both A & B have the same payoff at expiration
A & B should have the same cost today!
 Last Revised: 05/05/2021

- if A & B are not identical in terms of LOS l

value, arbitrage opportunity appears -explain
Pg-29
- buy the cheaper, sell the more expensive
∴ + = +
( + )
= − +
( + )
= + −
②
( + )
- we would typically know S0 & X, so if we have
either C0 or P0, we can solve for the other
Synthetics/
= + − = + −
( + ) ( + )

e.g./ ABC $60 6-mos. call = $5.80 LOS l

r = 6% 6-mos. put = $4.30 -explain
Pg-30
Mispricing?

= + − = − +
( + ) ( + )

= . + − = . − +
( . ). ② ( . ).
= . = .
Sell, Buy, Sell, Buy
Buy C0, Sell P0, Sell S0, long P0, C0 S0
( + ) ( + )

-5.8 +4.30 + 60 -58.277 +4.30 -5.8 +60 58.277

6.0228 4.077
 Last Revised: 05/05/2021

Lowest prices of calls and puts LOS l

C0, c0, P0, p0 ≥ 0 -explain
Recall, Pg-31

= + − = − +
( + ) ( + )

②
+ − ≥ − + ≥
( + ) ( + )

≥ −
≥ − ( + )
( + )

≥ , −
≥ , − ( + )
( + )

Put-Call Forward Parity

A B LOS m
-explain
long call long put
Pg-32
long a zero that long forward on the underlying
matures at X ST < X + long a zero with FV = forward price

0 X - ST
= X
+X + S T - F0 = X
+ F0
ST > X
②

ST - X 0
= ST
+X + S T - F0 = ST
+ F0
−
+ = + ⇒ −
( + ) ( + ) ( + )
 Last Revised: 05/05/2021

Binominal Model

$22 LOS n
$20 · we want to set up a -explain
$18 portfolio of the stock and Pg-33

an option in such a way that

there is no uncertainty about
let = # of shares the value at termination

sell a call at $21

②

for example
$22
20 CT = -1
- C0 22 -1 = 18 22(.25) - 1 = $4.50
$18
4 = 1
CT = 0 18(.25) = $4.50
= .25

LOS n
· riskless portfolio/
-explain
Long: 0.25 shares @ $20 Pg-34
Short: 1 call at @ $21

in the absence of arbitrage, riskless portfolios

must earn rf

if rf = 2% and T = 3 mos.
②

.
=$ . $4.48
( . )

So… $20 × .25 - 1 × C0 = $4.48

C0 = 5 - 4.48 = $0.52
stock
 Last Revised: 05/05/2021

more generally LOS n

-explain
SU Pg-35
S0 c+ = max (0, SU - X) i.e. 30% up u = 1.3
20% down d = .8
Sd
c- = max (0, S d - X) 22
t = 0 u = 1.1
c+ = 1
t =T 20
②
18 d = .9
Buy nS − = − c = 0
Sell c − = −
−
( − )= − = =
( . −. ) . ( )
− −
= =
− ( − ) = = .

LOS n
−
= − -explain
( − ) − =
nSU - c +
( + ) Pg-36

nS
−
- c − ( − )×
× −
× − =
nSU - c- ( − )× ( + )
②
−
− × −
( − )
− =
( − ) ( + )
−
− × −
( − )
= −
( − ) ( + )
 Last Revised: 05/05/2021

Y LOS n
-explain
− Pg-37
− × −
( − ) + − − − +
= − +
( − ) ( + ) + −
X ( + − )− ( + − )
= − [ − ] +
( + ) ( + ) −
( + − ) ( + − )
= − + − +
( + ) − −
②
( + ) ( + )

( + ) = ( − )− + + −
=
−
− ( + ) −
= − × + ( − + )
( + ) − ( − ) ( + )

+ − − − + +( − )
= + =
+ − +

LOS n
+( − ) + −
= where = -explain
( + ) − Pg-38

π & (1- π) risk neutral probabilities

- volatility is captured by (u -d)
e.g./ S0 = $40 find ATM C0 given that S0 can
r = 6% go up by 60% or down by 37.5%

u = 1.6 ②
d = .625 SU = 64 +. −.
= = .
40 c+ = 24 . −.
− = .
Sd = 25
c- = 0 . ( ) + (. )
= =$ .
.
 Last Revised: 05/05/2021

One Period Binomial Arbitrage Opportunity/ LOS n

- If C0 > model price, option is overpriced -explain
Pg-39
Sell C0, buy n units of the underlying
- if C0 < model price, option is underpriced
Buy C0, sell n units of the underlying
e.g./ same example C = $10.10 (model)
What if C0 = $11.50? ②
− −
Buy = = = . (615 × 64)
− −
- (1000 × 24)
Sell 1000 options @ 11.50 = 11,500 15,360
Buy 615 shares @ $40 = − ,
− , (615 × 25)
= , = . % - (1000 × 0)
,
15,375

LOS n
e.g./ same example C = $10.10 (model) -explain
What if C0 = $11.50? Pg-40
− −
Buy = = = . (615 × 64)
− −
- (1000 × 24)
So Sell 1000 options @ 11.50 = 11,500 15,360
Buy 615 shares @ $40 = − ,
②
− , (615 × 25)
,
= , = . % - (1000 × 0)
15,375
So/ t = 0
Sell 1000 options @ 11.50 regardless of ST, the portfolio
Buy 615 chares @ 40 will be worth 15,360

Borrow 13,100 @ rf Repay 13,100(1.06) 13,886

1,474 arb. profit
 Last Revised: 05/05/2021

Binomial Put Option Pricing/ LOS n

· same process, instead we use -explain
p = max (0,X - ST) instead of c+/-= max (0, S T - X)
+/- Pg-41

e.g./ S0 = $50 X = $55 : find p0 given that S0 can go

r = 6% up by 40% or down by 25%

u = 1.4
= + ② +. −.
SU = 70 =
−
=
. −.
= .
p+ = 0 − = .
d = .75 Sd = 37.50
p- = 17.50 = +( − ) . ( )+ .
= ( × )
+ .
= $8.64

European vs. American

LOS o
-explain
CE CA PE PA Pg-42

Upper Bound
≤ ≤ ≤ ≤
( + )

Lower Bound ≥ −
( + )
≥ − ≥
( + )
− ≥ −
②

AM. Op. −
= IV + TV ( + ) - before expiration, better
Value
to sell option than exercise
exercise => max (0, S - X)
T
value
Note: X k

- Options Ch #11, Part 2 next

( + )
 Last Revised: 05/05/2021

Introduction to Alternative Investments

a. describe types and categories of alternative investments;

b. describe characteristics of direct investment, co-investment, and fund

investment methods for alternative investments;

c. describe investment and compensation structures commonly used in

alternative investments;

d. explain investment characteristic of hedge funds;

e. explain investment characteristic of private capital;

f. explain investment characteristic of natural resources;

g. explain investment characteristic of real estate;

h. explain investment characteristic of infrastructure;

i. describe issues in performance appraisal of alternative investments;

j. calculate and interpret returns of alternative investments on both before-fee

and after-fee bases.
 Last Revised: 05/05/2021

Introduction to Alternative Investments

LOS a (5p) Types of Alternative Investments - describe

LOS b (8.5p) Investment Methods - describe

LOS c (7.5p) Investment and Compensation Structures - describe

LOS d (10.5p) Hedge Funds - explain

LOS e (13p) Private Capital (Equity and Debt) - explain

LOS f (16p) Natural Resources - explain

LOS g (16p) Real Estate - explain

LOS h (9.5p) Infrastructure - explain

LOS i (11.5p) Issues in Performance Appraisal - describe

LOS j (9p) Calculating Fees and Returns - calculate/interpret

Page 1
AI - anything other than long-only publicly-traded investments
LOS a
in stocks, bonds, and cash - describe
not just assets but strategies/approaches (i.e. HF/PE)
typically involve active management (more inefficient pricing)

Characteristics/ narrow specialization of mgrs.

low correlations of returns with traditional investments
limited historical risk and return data
unique legal and tax considerations
higher fees mgmt. + performance fees
concentrated portfolios
restrictions on redemptions

Offer (potentially) broader diversification

enhanced returns (risk-adjusted)
increased income through higher yields (pub. vs. pr., illiquid)
 Last Revised: 05/05/2021

Page 2
Categories/ LOS a
Hedge Funds - private investment vehicles - describe
- can use traditional investments
- absolute return investments (most commonly)
(Private Capital)
Private Equity - direct investments or through PE funds
- PE funds private or public-to-private
majority typically involve LBOs
- VCs invest in start-ups (small portion of PE mkt.)
Private Debt debt provided to private entities

Real Estate - directly or indirectly

private CRE equity/debt
public RE equity/debt

Page 3
Categories/ LOS a
Natural Resources Commodities - futures, ETFs - describe
Agricultural Land - farmland (lease or cropshare)
Timberland - natural forests or managed tree plantations

Infrastructure - capital intensive, long-lived assets

- intended for public use and provide essential services

Others - Tangibles (art, wine, collectibles)

- Intangibles (patents, litigation actions)

LOS b
Fund Investing investor contributes capital to a fund
- describe
fund makes investments
involves mgmt. + performance fees

Co-Investing investor in a fund has the right to invest directly in the

same assets
Direct Investing no intermediary, typically large and more sophisticated
investors
 Last Revised: 05/05/2021

Page 4
LOS b
- describe

Page 5
Due Diligence: Direct Inv. - requires considerable expertise LOS b
Fund Investing - skill in manager selection - describe
Co-Investing - can rely on DD performed by the fund

LOS c
most funds are structured as limited partnerships
- describe
GP - general partner fund manager - unlimited liability

LP - limited partner investor - limited liability as long as they

do not get involved in day-to-day operations)

- governed by a Limited Partnership Agreement (LPA)

may also be side letters: agreements between the GP and
certain LPs that exist outside the LPA

e.g./ extra reporting

first right-of-refusal (for co-investments)
fee matching
 Last Revised: 05/05/2021

Page 6
Infrastructure - public-private partnerships
LOS c
Real Estate funds - unitholders (trusts) - describe
JVs - direct real estate

Compensation/
management fee 1% to 2% of AUM (HF) or committed
capital (PE)
performance fee (incentive fee, carried interest)
- based on excess return above a hurdle rate

e.g./ 20% of return above a hard hurdle rate

or 20% of total return if soft hurdle is met

may also be consulting and monitoring fees for certain types

of PE (i.e. LBO)

- typically, GPs do not earn performance fees until LPs are made
whole and hurdle rate exceeded

Page 7
Catch-up clause (PE) : e.g. 18% IRR, 8% HR LOS c
- describe
GP
with: GP = 2% + 1.6%
8% 10% 18%
LPs = 3.6%
GP = 20%
LPs = 80%
without: GP = 2%
8% 18%
LPs
GP = 20%
LP = 80%
High-Water Mark (HF): highest value used to calculate an incentive fee
- incentive fees are only available above this level

- possible that LPs have different HWMs depending on

when they invested

Distribution Method (PE) waterfall

1/ Deal-by-deal (or American)
2/ Whole-of-fund (or European)
 Last Revised: 05/05/2021

Page 8
Distribution Method (PE) waterfall LOS c
- describe
Deal-by-Deal

called a clawback
(LPs made whole on
inv. #8)

Whole-of-Fund

both end with

the same outcome
(LPs made whole on
inv. #6)

Page 9
Hedge Funds/ LOS d
Characteristics - explain
- creatively (actively) managed, involved in one or more
asset classes and geographic regions, use of leverage,
short positions, and derivatives
- goal is to generate high returns on an absolute or
risk-adjusted basis
- very few investment restrictions
- private investment partnership open to a limited number
of accredited investors
- lightly regulated
- minimum investments
- restrictions on redemptions
- hard lockup - no redemptions
- soft lockup - redemption for a fee (penalty)
- notice periods - 30 to 90 days notice of a
redemption
 Last Revised: 05/05/2021

Page 10
Hedge Funds/
LOS d
Fund-of-Funds: - explain
- invest in HFs
- DD expertise + manager diversification
- better able to negotiate redemption or fee terms
- 1% mgmt. fee, 10% incentive fee on top of underlying HF fees

- all HF fees have moderated over time

HF : 1.3% mgmt. fee + 15.5% incentive (avg.)
FoF: 1% flat or 50 bps mgmt. + 5% incentive (avg.)

HF Strategies/
Equity Hedge: public equities, long and short positions, derivatives
bottom-up or top-down approach
quantitative or fundamental

Page 11
HF Strategies/ Equity Hedge LOS d
- explain
a) Market Neutral: identify over and under-valued securities
- take long and short positions, target =
- typically use significant leverage
b) Fundamental Long/Short growth:
- identify companies expected to exhibit high growth
and capital appreciation for long positions
- short companies under downward pressure
- typically net long
c) Fundamental Value - identify undervalued companies (unloved)
for long positions
- possibly short overvalued growth
- typically long-biased ( > ), value + small-cap factor
exposure
 Last Revised: 05/05/2021

Page 12
HF Strategies/ Equity Hedge
LOS d
d) Short-biased: short overvalued equity with no or - explain
some long exposure (index ETFs)
e) Sector-Specific: manager expertise in a particular sector

Event-Driven - seek to profit from defined events, typically changes

in corporate structures
- bottom-up, security specific analysis

a) Merger Arbitrage: long the target, short the acquirer

- deal spread narrows as closing date approaches
- typically use leverage
- risk deal may fall through

b) Distressed/Restructuring: securities of companies in or near

bankruptcy

Page 13
HF Strategies/ Event-Driven LOS d
b) Distressed/Restructuring: - explain
- buy debt at discount that is expected to have a
higher recovery rate (money good)
- buy debt that is expected to become the new equity of
the restructured company (fulcrum securities)
c) Special Situations: - equity of companies restructuring other than
M&A or bankruptcy
d) Activist: take large enough positions to affect change
(divestitures, capital distributions, mgmt. change)

Relative Value - seek to profit from pricing discrepancies between

related securities

a) Convertible Bond Arbitrage - buy the bond, sell the stock

 Last Revised: 05/05/2021

Page 14
HF Strategies/ Relative Value LOS d
b) Fixed-Income (general) long/short trades between - explain

2 issuers, between 2 issues at different parts of

the capital structure, or between different parts of
an issuers YC

c) Fixed-Income (ABS, MBS, HY) - higher coupon + relative mispricing

between securities and assets backing them

d) Volatility - long/short market volatility

e) Multi-Strategy - combinations of strategies above

Macro and CTA Strategy/ macro: top-down approach to identify

economic trends
- use all asset classes, long and short
- managed futures (a.k.a. commodity trading advisers) - primarily trade
futures contracts on commodities and beyond (eq./fix.-inc./forex)

Page 15
Private Capital - funding provided to companies not LOS e
sourced from public markets - explain

Private Equity/ - investments in private companies or public companies

with the intent to take them private

a) LBOs (Leveraged Buyouts)

- acquire public companies or established private companies with a
significant %’age of the purchase price financed through debt
- target’s assets serve as collateral
- target’s cash flows expected to service the debt
- MBO - current mgmt. involved in the buyout
- MBI - management buy-in : new mgmt. involved in the buyout
b) Venture Capital - investments in private companies with high growth
potential
- typically start-ups or young companies
- active involvement in portfolio companies
 Last Revised: 05/05/2021

b) Venture Capital Page 16

LOS e
i) formative stage
- explain
- pre-seed capital/angel investing idea stage
typically F/F and not VC
- seed stage - support product development and marketing
earliest VC stage efforts

- early stage - moving towards operations but pre-revenue

ii) later-stage financing - post-revenue, pre-IPO

- support growth

iii) mezzanine financing - prepares a company to go public

- bridge financing

- equity investments typically made through convertible preferred shares

- later stage may involve convertible debt

Page 17
c) Other PE strategies/ LOS e
growth capital - minority stakes in more mature - explain
companies to expand or restructure operations,
enter new markets, or finance major acquisitions

Exit Strategies/
a) Trade Sale: sale to a strategic buyer
- auction or private negotiation
- immediate cash exit for the PE fund
- higher valuation from a strategic buyer (VS. financial buyer)
- lower costs that IPO
- lower levels of disclosure

-/ possible opposition by mgmt.

less attractive to employees
limited # of strategic buyers
lower valuation than IPO
 Last Revised: 05/05/2021

Page 18
Exit Strategies/
LOS e
b) IPO highest valuation - explain
mgmt./staff buy-in
publicity for the PE firm
future upside if PE firm retains shares

-/ high costs
long lead times
high disclosure requirements
lockup periods that require PE firm to hold shares for a period of
potential weak market on IPO time

c) Recapitalization - lever up the portfolio company, pay a

dividend to the PE firm
- not a true exit but still a liquidity event
d) Secondary Sale - sale to another PE firm
e) Write-off/Liquidation

Page 19
Private Debt: debt provided by investors to private entities LOS e
a) Direct Lending: typically senior secured - explain
- carry higher rates than public debt
- many loans will be leveraged loans
(e.g. Lend $20M at 6%, borrow $10M at 4%, $10M equity)

b) Mezzanine Loan: subordinate to senior secured but senior to equity

- often used for LBOs, recapitalizations and acquisitions
- higher rate than sen. sec. and may also have equity kickers
(warrants, options, conversion rights)

c) Venture Debt: provided to start-up or early stage companies

- typically convertible or has warrants

d) Distressed Debt: buying the debt of mature companies with financial

difficulty that have prospects for turnaround
 Last Revised: 05/05/2021

Page 20
e) Other: CLOs - private debt that becomes securitized LOS e
into various tranches of credit quality and - explain
equity

unitranche debt - partially secured debt - lower than

senior secured but above senior unsecured

real-estate debt - mortgage

infrastructure debt
specialty loans, e.g. litigation loans

Risk/Return PE/
PE riskier than public equity plus illiquid, should offer higher
- but is it higher risk-adjusted return? return
- historical data problematic
self report, ∴ subject to survivorship bias which
overstates returns
lack of market prices leads to understatement of
volatility

Page 21
Risk/Return - PD/ illiquidity, higher POD, private market LOS e
inefficiencies lead to potential higher return - explain
but with higher risk

moderate
diversification benefits
for stocks/bonds
P .47 to .75
 Last Revised: 05/05/2021

Page 21a
Growth LOS e
GDP (30.4%, 1.7x)
- explain
Oriented VC
Growth Equity
(13.3%, 1.6x)
Growth Buyouts
Buy-and-Build
Low to no
Leverage

LBO
Leverage increase
Value
Oriented Mezzanine (9.1%, 1.3x)

Infrastructure
Recapitalizations
Distressed
(11.5%, 1.5x) may
include
leverage

Page 22
Natural Resources/ LOS f
commodities and raw land used for farming and timber - explain
hard those that are mined/extracted
soft those that are grown/cultivated
timberland ownership of land and harvesting of trees for
lumber (income + cap. gain)
farmland leased or crop shared

Characteristics/
i) commodities - physical standardized products
- cap. gains (price) returns

e.g. precious/base metals, energy, agriculture, cash crops

- each may be divided further by physical location and
grade or quality
- commodity indexes typically use futures prices rather than spot prices
- different indexes have different constituents with different weights
 Last Revised: 05/05/2021

Page 23
LOS f
i) commodities
- explain
- traded either physically (rare) or through ETFs/futures
> , futures curve is upward sloping - contango
< , futures curve is downward sloping - backwardation
- some ETFs try to avoid contango markets

ii) Timberland/Farmland:
Timberland - income stream based on sale of trees/wood
- factory and warehouse (growth ~ 5%/yr.)
- return from growth, commodity price, cap. gains

Farmland - row crops and permanent crops (nuts, fruits)

- must be harvested regardless of price
- return from quantities, price, land

Page 24
Risk/Return/ LOS f
Commodities - price return, diversification, inflation - explain
protection but with high volatility
- price affected by supply and demand - each commodity
has its own drivers of supply and demand

- supply moves in long cycles (30 year supercycles)

- demand changes much faster than supply
Timber/Farmland - price appreciation + yield
risk = weather, climate, global supply
Diversification benefits:
Commodities - hedge against inflation
- low correlation with other asset classes

Timberland/Farmland - low/no correlation with stocks/bonds

- does add ESG considerations to a portfolio
 Last Revised: 05/05/2021

Page 25
Instruments/ Commodities LOS f
derivatives - forwards, futures, options, swaps - explain
Exchange-traded products (funds or notes) - futures or physical
- may use leverage, be long or short
Managed futures (CTA)
Specialized funds - private energy partnerships, energy MFs,

- Timberland/Farmland
Investment funds (REITs) or private funds

LOS g
Real Estate/
- explain
owner-occupied residential housing
commercial rental properties leased to tenants (including residential)
income producing

Investments can be direct or indirect, equity or debt

Page 26
Real Estate/ LOS g
bond-like long-term income + equity-like capital gains - explain
low correlation with other asset classes
inflation hedge (income and property value)

- direct investing requires large capital investments, illiquid markets,

location sensitive, high transaction costs, low diversification,
professional property management, specialized expertise by area

- basic forms of
real estate
investments
 Last Revised: 05/05/2021

Page 27
Direct Real Estate Investing/ LOS g
- purchasing a property or making a loan - explain

- each can be levered

+/ control (tenants, lease, when to sell, what to buy, CAPEX)

taxes depreciation and interest tax shield
- may be possible to be CF positive but taxable inc. neg.

-/ property management, large capital investments, expertise required

Indirect Real Estate Investing pooled investment vehicles, public or

private
LLPs, MFs, REITs, ETFs
equity mortgages (mREITS)

Mortgages - loans against property

- fixed or floating, fully/partially amortizing, residential or
- private or public (MBS) commercial

Page 28
Private Fund Investing Styles LOS g
infinite-life open-ended funds - explain
- investors can enter and exit at any time
- offer exposure to core real estate (well-leased, high quality)
- stable returns, primarily from income

core-plus strategies
- non-core markets (secondary or tertiary cities) or properties
with slightly higher leasing risk (hotels, nursing homes)

finite-life closed-end funds

value-added require modest redevelopment, upgrades or
repositioning
opportunistic development or major redevelopment

- involves the selling of the real-estate asset

 Last Revised: 05/05/2021

Page 29
REITs/ - eliminates double corporate taxation as long as LOS g
REIT distributes 90%-100% of taxable rental income - explain
- may also require 75% or more of income produced by
real estate assets (property, debt) or 75% or more of net income
- investors gain liquidity, lower trading costs, and better transparency

Characteristics/
1/ Residential Property - owner-occupied, typically leveraged equity position

2/ Commercial Real Estate - suitable for investors with long investment

horizons and low liquidity needs
- requires day-to-day active mgmt.
- debt typically limited to a max. loan-to-value (LTV)
- property cash flows critical to service debt ratio ~ 75%

3/ REITs - mREITs - invest in mortgage securities

- equity REITs - invest in properties

Page 30
Characteristics/ 4/ MBS - covered in fixed income LOS g
- explain
Risk/Return Characteristics/

Real Estate Indexes

listed REIT indexes - basically like any other
equity index, also investable

Private investment performance

- based on either funds or underlying property performance
- indexes are not investable
- most property-based indexes are appraisal-based which
smooths out volatility
- fund indexes rely on self-report (sample selection bias)

Repeat-sales indexes - transaction-based

- more reliable the greater the number of sales per period
- sold properties may not be representative of the
entire market (a form of sample selection bias)
 Last Revised: 05/05/2021

Page 31
Risk/Return Characteristics/
LOS g
Risks interest rate risk - explain
economic conditions (leasing, rates)
operating risk (costs)
financial risk (leverage, securing debt)

Diversification/ ~ 50% of returns (private core, listed real estate)

derived from income
~ moderate correlations with equities and bonds
question remains does public RE overstate volatility
or does private RE understate volatility

LOS h
Infrastructure/ assets intended for public use, mostly financed, - explain
owned and operated by governments
- growing share being financed privately through
public-private partnerships (PPPs)

Page 32
Infrastructure/
LOS h
- lease assets back to the gov’t., sell assets to the - explain
gov’t., or hold and operate the assets

Investment characteristics/
stable long-term cash flows, inelastic demand, adjusts for inflation
significant capital investment
high barriers to entry
monopolistic and regulated
long operational lives
strategically important allows for
highly leveraged financial structure
defined risks

Categories/
Social - directed towards human activity (education, health care,
social housing, correctional facilities)
- income derived from lease payments called availability pmts.
- based on the ability of the asset to provide the service
 Last Revised: 05/05/2021

Page 33
Categories/ LOS h
Economic - explain
1/ transportation assets - roads, bridges, tunnels, airports,
seaports, rail
- income based on usage - tolls, fees, charges
(thus has market risk)

2/ ICT assets - stores, broadcasts, transmits information or data

(telecom towers, data centers)

3/ Utility and energy assets - generate and transmit power and

produce potable water
(solar, wind, waste-to-energy)
- may also be classified by stage of development
greenfield investments - need to be developed
- build to sell, build to lease, build to operate
- financial investors + strategic investors

Page 34
Categories/ LOS h
brownfield investments - existing assets - explain
- privatized, sale and leaseback, sale from
greenfield project
- financial or strategic investors

Forms of Investment/
direct investment - provides control, large capital investments,
concentration risk, liquidity risk
indirect investment - infrastructure finds, ETFs, company shares
- through equity (77%) or debt
publicly-traded infrastructure securities
master limited partnerships (MLPs)

Diversification/ income + some growth

some inflation protection, low exposure to GDP growth
issues
 Last Revised: 05/05/2021

Page 35
Risk/Return Characteristics
LOS h
- explain

LOS i
- describe
Issues in Performance Appraisal/ AI are generally actively managed
(although there are passive choices)

Sharpe ratio - requires normally distributed returns

- return profiles tend to be asymmetric and skewed
- standard deviation is not a good measure of dispersion
∴ SR is not a good measure of risk-adjusted return

Page 36
Issues in Performance Appraisal/ LOS i
Sharpe Ratio - regardless of shortcomings, ratios of 1-2 - describe
are targeted
- higher is a signal of significant volatility smoothing
(model-based pricing, short-option strategies)

Sortino Ratio - return relative to only downside volatility

- both do not consider the correlation of the AI program with the

rest of the portfolio
- may improve risk/return relationship in a portfolio context
(or not)
Treynor Ratio - measure of excess average return relative to its
beta to a relevant benchmark
- the lower the , the higher the TR
(note: is historical and may be different in the future)
 Last Revised: 05/05/2021

Page 37
Issues in Performance Appraisal/ LOS i
Calmer Ratio − . ( .) - describe

MAR = . . .( ) max. loss peak to

trough

PE/RE Performance Evaluation

Return J-curve - measurement of success

depends far more on the
timing and magnitude of
liquidity events
time
cash flows in and out of
- capital calls investments
- fee drag - use of IRR as a key metric
(since timing of CFs are a key
part of the investment decision)
cash cash inflows
outflows

Page 38
PE/RE Performance Evaluation LOS i
MOIC - multiple of invested capital (money multiple) - describe
+
ignores timing of CFs
− −
- less emphasis placed on correlation benefits over shorter periods
NAV may not reflect short-term changes in value
thus understating volatility
- appear to deliver smooth returns over time thus making
PE/RE appear less correlated than they actually are

Quartile Ranking - performance against cohort of peer investments

with same vintage year (year funded)

RE managers also evaluated by the cap rate being earned on properties

Capital loss ratio =

- probability of permanent
impairment of an investment
 Last Revised: 05/05/2021

Page 39
Hedge Funds/ LOS i
Leverage - performance measures won’t capture use of - describe
leverage but it may be critical to the strategy

Illiquidity and Potential Redemptions - valuations are important for

calculating performance and NAV
- redemptions have to be met at NAV, so NAV
should reflect liquidation effects

Level 1 asset pricing - exchange-traded, publicly available pricing

Level 2 - broker quotes - use of bid for long positions,
Level 3 - mark-to-model ask for short positions
- funds typically have 2 NAVs performance (L1/L2)
redemption

Tail-events - low probability, high severity events

- stress testing, scenario analysis used

Page 40
Hedge Funds/ LOS i
- redemptions increase during times of poor performance - describe
- funds charge redemption fees or suspend redemptions
during stress times
- notice periods allow orderly liquidations
- lock-up periods allow time for a strategy to work

LOS j
Custom Fee Arrangements
- calculate
1/ Fees based on liquidity terms and asset size - interpret
- longer lockups = lower fees
- larger investment = lower fees

2/ Founder’s shares - entitle early investors to a lower fee structure

(e.g. first $100M)
or/ - early investors get a lower fee once a
certain level of AVM is reached
 Last Revised: 05/05/2021

Page 41
Custom Fee Arrangements LOS j
3/ Either/or fees - 1% mgmt. fee or 30% incentive above - calculate
- interpret
the hurdle, whichever is greater
- if the 1% mgmt. fee is paid, it reduces the 30% incentive
fee for next year

HF databases and indexes report performance net of fees

(fees can differ by investor, so each investor may
realize a different return)

Example 4, 5, 6
Last Revised: 05/05/2021
 Last Revised: 05/05/2021

Derivative Markets & Instruments

Derivative - financial contract whose value depends on the Pg-1

value of some other underlying asset (transforms value) - review

Buyer Buy - at a specific - on a specific

agree to a specific
Seller Sell price date
asset
legal contact underlying strike or expiration date
asset contract price
rights contingencies
obligations commitments
· zero-sum game
· used for hedging or speculation
Structure of Derivative Markets/
1) Exchange Traded - futures/options
- standardized contracts
- no counterparty risk - clearing corp. takes the
opposite side of all contracts

Structure of Derivative Markets/ Pg-2

1) Exchange Traded - review
- daily settlement - mark-to-market
- transparency
- highly regulated
2) OTC (Over-the-Counter)
- dealer market - mostly banks
- customization of contracts - lack of liquidity
- lower degree of regulation
- privacy
Forward Commitments/ - both parties are obligated to perform

agree on price for trades on this

date
-

t = 0 t =T
 Last Revised: 05/05/2021

Forward Commitments/ - linear payoffs Pg-3

an OTC contract (an exchange-traded forward is called a - review

if ST > F0(T) long profits futures contract

zero-sum
if ST < F0(T) short profits

loser pays the winner

- no exchange of money at inception
- value of a forward = $0 at inception
- settled by delivery, cash or by closing out before expiration

not all underlying assets

are deliverable called cash-settled forwards or
contracts for differences
Futures has mark-to-market settlement (daily)
- both parties post a margin, typically < 10% of the
underlying value

Futures/ Pg-4
limit up trades can occur within - review
· daily price limits
limit down the bands but not at the limit
· offsetting - closing a position before expiration by taking another
position opposite the first
· open interest # of outstanding contracts
· delivery - short position must deliver to a specific location during
the delivery period
· convergence - futures and spot prices converge on the expiration date
spot futures

futures spot

exp. exp.
-

· no counterparty risk
· highly regulated
· transparent
 Last Revised: 05/05/2021

Swaps/ - OTC contracts for the exchange of cash flows Pg-5

e.g./ interest rate swap - review
floating rate - typically Libor
Plain vanilla
A B
fixed rate swap

- payments are netted out - only one side pays

· notional amount principal is not exchanged, but interest
payments must be based on some amount
- Uswap = 0 at inception
- other swaps currency swaps, equity swaps

· Contingent Claims/ Pg-6

- review
Credit Derivatives/ - seller provides credit protection
against a loss to the credit protection buyer
- credit default swap (CDS)
compensation for loss - protection leg
protection protection
buyer seller
periodic - premium leg
payments
- if default occurs, payments stop, CDS is settled
a) physical - buyer gets paid, delivers bonds
b) cash - buyer gets paid (Par - MVbonds), buyer can
then hold or sell
- Other Types/ · Total return swaps
· credit spread options
· credit linked notes
 Last Revised: 05/05/2021

· Options/ - buyers have a right but not an obligation Pg-7

- review
call to buy a specific - at a specific - by a certain
Type a right
put to sell asset price date
buyer - long underlying strike expiration
seller - short security date
price (k)
(obligation)
American - anytime exercise
· style anytime trading
European - last day exercise only
- buyer pays the seller a premium
- can be OTC or exchange traded
- Payoff & Profit/ - non-linear payoffs (asymmetrical) if:
Buying Calls Selling Calls ST > X -ITM
CT = Max (0, ST - X) -CT = -Max (0, ST - X) ST < X -OTM
π = Max (0, ST - X) - C0 π = -Max (0, ST - X) + C0

- Payoff & Profit/ Pg-8

- review
Buying Puts Selling Puts if:
PT = Max (0, X - ST) -PT = Max (0, X - ST) X > ST - ITM
π = Max (0, X - ST) - P0 π = -Max (0, X - ST) + P0 X < ST - OTM
- call/put buyer limited loss, unlimited gain
- call/put seller limited gain, unlimited loss
· Asset-Backed Securities/ - covered in Fixed Income
Derivative Underlyings/
· equities · currencies · credit
· fixed income/interest rates · commodities · other
(weather)
Purpose/Benefits/
· Risk allocation, risk transfer, risk management
· Information Discovery - info can be reflected in prices faster
 Last Revised: 05/05/2021

Purpose/Benefits/ Pg-9
· allow strategies unavailable with the underlying - review

· operational advantages - lower transaction costs, more

liquid than spot markets, leverage, easy to take
a short position
· market efficiency - arbitrage vehicle

Criticisms · destabilization & systematic risk

· speculation & gambling
· complexity
Principles of Pricing/

· Arbitrage pricing - improves market efficiency

- relies on the ability to buy & carry the
underlying, or to short
 Last Revised: 05/05/2021

Derivative Pricing & Valuation

· Derivative - a financial instrument that derives its Pg-1

performance from the performance of an underlying asset - review

- can be commitments or contingent claims

( )
= - assumes risk aversion
( + + )
div./int.
- underlying assets generate or incur: convenience yields
storage costs
= PV (benefits) =
opportunity costs
+
= PV (costs) =
+
( )
∴ = − + ( - ) - cost of carry
+ +
Arbitrage - a transaction used when 2 assets produce identical results but
sell for different prices (buy low, sell high)
- Law of One Price assets that produce identical results can have
only one true market price

Arbitrage - a perfectly hedged portfolio should return the Pg-2

risk-fee rate - review
Replication Asset + Derivative = Risk-Free Bond in the absence
short/long long/short of arbitrage,
Asset - Risk-free Bond = -Derivative replication would
long short not produce
- Asset + Risk-free Bond = Derivative excess return
short long

Risk Neutrality/ - investor’s risk aversion is not a factor in determining

the price of a derivative
- prices of derivatives assume risk neutrality
Limits to Arbitrage - transaction costs, ability to short, ability to
borrow/lend at rf, liquidity of the underlying
Forwards/Futures - contract price price at which the underlying
will be bought/sold at time T
 Last Revised: 05/05/2021

Forwards/Futures - value of the contract is the change in the Pg-3

contract price from inception to the valuation date - review

( )=$
value V0(T) = 0
VT(T) = ST - F0(T) ( )= ( + ) - no benefits/costs
( )=( − + )( + ) - benefits & costs
no costs
no benefits
( )
( )= − ( ) +

S0 t T
-

-
benefits F0(T)
& costs ( )
( )= −( − ) + − ( ) +
Forward Rate Agreement/ - underlying is an interest rate
- price of an FRA - implied r (1) implied forward
forward rate f (1,1) rate
-

-
r (2)

Pg-4
Forward vs. Futures Price/ - may differ due to:
- review
· MTM process of the futures contract
- the more volatile interests rates are, the greater the
differential
- if futures prices are positively correlated with interest rates,
futures are more desirable, to the long position (neg. corr. - then forwards)
Swaps/ involves the exchange of cash flows e.g. fixed-for-floating

· swap rate is
-

F0(1) ≠ F (2) F0(1)

F0(2) fixed, so rate =
≠ F0(3) ≠ F0(4)
F0(3) F0(1) = F0(2) = F0(3) = F0(4)
F0(4) (price of swap is
off market forwards the fixed rate)

−
· Vswap = 0 at initiation, so ()=$ PMT =
∑
 Last Revised: 05/05/2021

Pg-5
Options/ calls buyer has a right
- review
puts seller has an obligation

· American - anytime exercise

anytime trading
· European - last day exercise only
intrinsic value
Call Put
OTM ITM long pos.: short pos.:
CT = Max (0, ST - X) - CT
S0 - X - ATM S0 - X - ATM PT = Max (0, X - ST) - PT

ITM OTM
c = CT - C0 - c

0 0 P = PT - P 0 - P

BEPc = X + C0 BEP = X - P0 limited loss but limited gain

not limited gain but not limited
loss

Pg-6
- factors affecting the value of options:
- review
1. St - value of a call is directly related to St
- value of a put is inversely related to St
C0 ≤ S0 - upper bound on a call
2. Exercise Price (X)
- value of a call option is inversely related to X
- value of a put option is directly related to X
≤ - upper bound on a put
( + )
3. Time to expiration (T)
- value of a call is directly related to T
- value of a put either directly or inversely
related to T more - higher rf
common - deeper ITM
4. rf - value of a call is directly related to rf
- value of a put is inversely related to rf
 Last Revised: 05/05/2021

- factors affecting the value of options: Pg-7

- review
5. Volatility of the underlying - the greater the volatility of
the underlying, the more options are worth (both puts and
calls)
Note: combined effects of time and volatility = time value of an option
6. effects of payments & costs of carry on the underlying
benefits costs
- options receive no benefits and pay no costs
- calls are worth less the more benefits are paid
and worth more the more costs are paid
- puts are worth more the more benefits are paid
and worth less the more costs are incurred
- Lower Bounds on Calls/Puts/

≥ , −
( + )

≥ , −
( + )

Put-Call Parity/ Pg-8

+ = +
( + ) - review
= − + long put = long call, short asset, long bond
( + )

= + − long call = long put, long asset, short bond

( + )

= − +
( + ) long asset = long call, short put, long bond

= + − long bond = long stock, long put, short call

( + )

- C0 & P0 have the same strike & expiration

Put-Call Forward Parity/ options on forwards/futures
underlying is another derivative
+ = +
( + ) ( + )

− =
− if X = F0, then P0 = C0
( + )
 Last Revised: 05/05/2021

Binomial Model/ Pg-9

SU - review
u
portfolio of c+ − = −
S0
stock + option such
-C0 − = −
that there is no d Sd −
uncertainty about value c- =
−
at termination
−
=
+( − ) ( − )
=
( + ) = # of shares to buy
+ −
=
− & (1 - ) - risk neutral
- if C0 > model price probabilities
sell C0, buy units of stock
- volatility is captured
C0 < model price
by (u - d)
buy C0, Sell units of stock

Pg-10
European vs. American option/ - review
CE CA PE PA
Upper ≤ ≤ ≤
≤
bound ( + )
( = ) - anytime
last day
exercise
exercise
( = ) ( > )
Lower ≥ −
( + )
≥ − ≥
( + )
− > −
bound anytime
anytime exercise exercise
- however, early exercise ( > )
is never beneficial
- would lose TV
- better to sell
∴≥ −
( + )
 Last Revised: 05/05/2021

Introduction to Alternative Investments

Review - 1

LOS a - describe/ AI - anything other than long-only investments

in stocks, bonds, cash (assets or strategies)
Characteristics/
narrow specialization of mgrs., low correlation w/traditional assets,
higher fees (mgmt. + incentive), concentrated portfolios,
restrictions on redemptions, limited historical data
Offer: diversification, enhanced risk-adjusted returns, higher yields

Categories: Hedge funds - att. or traditional assets

Private Equity
Private Capital
Private Debt
Real Estate - Private funds or direct investment
Natural Resources - commodities, timberland, farmland
Infrastructure
Others - art, wine, patents, litigation actions

Review - 2
LOS b - describe/ +/ fund mgmt., lower level of investor involvement,
1/ Fund Investing diversification, no expertise required, lower cap. inv.
-/ mgmt. + incentive fees, mgmt. due diligence

+/ follow fund’s lead, lower mgmt. fees, more active investor

2/ Co-Investing
-/ lack of control over investment selection, adverse mgmt.
selection bias, more active investor mgmt.

3/ Direct Investing +/ no mgmt. fees, flexibility, control

-/ expertise required, low diversification, higher DD, higher
cap. inv.
LOS c - describe/ most funds structured as partnerships
GP - general partner LP - limited partner (limited liability)

- governed by LPA - may also be side letters (agreements outside the LPA)

- Real estate funds - trusts/corporations/funds/JVs

- Infrastructure - public/private partnerships
 Last Revised: 05/05/2021

Review - 3
LOS c - describe/ Compensation:
- mgmt. fee 1% - 2% AVM or committed capital
- performance fee (carried interest) - based on excess return above
a hurdle rate
hard hurdle - 20% above that
soft hurdle - 20% of total return if met

- catch-up clause - with without

8% 10% 18% 8% 18%
LP LP
GP 20% GP GP = 20%
80% LP LP = 80%
high-water mark highest value used to calculate an incentive fee
incentive fees only available above this

Distribution method waterfall

1/ Deal-by-deal (American) 2/ Whole of funds (European)
- may be subject to a - LPs made 100% whole first
clawback

Review - 4
LOS d - explain/ Hedge funds:
Characteristics - active mgmt., one or more asset classes, use of leverage,
short positions, derivatives, absolute return mandate,
private investment structure, accredited investors, lightly
regulated, restrictions on redemptions (hard lockup - none,
soft lockup - exit for a fee, notice periods of 30-90 days)

Fund-of-funds - invest in HFs: DD expertise, mgr. diversification, 1/10

Strategies: Equity hedge - public equities, long and short

Market neutral ( = )
fundamental long/short - typically net long
fundamental value - typically long biased
short-biased - net short
sector-specific - mgr. expertise
Event-Driven - corporate structure events typically
merger arbitrage distressed/restructuring
 Last Revised: 05/05/2021

Review - 5
LOS d - explain/ Hedge funds:
Strategies: Event-Driven
Special situations Activist

Relative Value - profit from price discrepancies between

related securities
Convertible bond arbitrage (buy bond, sell stock)
Fixed Income (general) - between 2 issuers, between 2
issues, between 2 parts of the YC
Fixed Income - ABS/MBS
Volatility
Multi-Strategy

Macro and CTA Strategy - economic trends, all asset classes,

long and short
- managed futures - primarily trade futures

Review - 6
LOS e - explain/ Private Capital

Private equity - investments in private companies or public companies

with the intent to take them private

a) LBO (Leveraged Buyout) - buy a company with a significant

amount of debt
MBO - mgmt. buyout
MBI - mgmt. buy-in
b) Venture Capital - investments in private companies with high
growth potential
- typically start-ups/young companies

formative stage later-stage mezzanine financing

post-rev. pre-IPO
pre-seed seed later stage
idea stage development pre-rev.

c) Others - growth capital - expansion, new markets, restructuring

Exit Strategies/ Trade Sale - strategic buyer
+/ cash exit lower costs than IPO -/ limited # of buyers
higher valuation vs. financial buyer lower valuation than IPO
 Last Revised: 05/05/2021

Review - 7
LOS e - explain/ Private Capital
Exit Strategies/ IPO +/ highest valuation, mgmt. buy-in
-/ high costs, long lead times, disclosures
Recapitalization - use debt to issue a dividend to the PE firm
Secondary Sale - sale to a financial buyer
Write-off/Liquidation
Private Debt:
Direct Lending - typically senior secured
Mezzanine Loans - subordinate to senior (LBOs, recaps)
Venture Debt - typically convertible or warrants included
Distressed Debt
Other CLOs unitranche debt (partially secured debt)
mortgages infrastructure debt specialty loans

Risk/Return - PE: riskier than public, illiquid

- indexes are self-report - survivorship bias problem

Review - 8
LOS e - explain/ Private Capital
Risk/Return PD: illiquid, higher POD, higher yield

Private Equity/Co investments

increasing risk
Mezzanine Debt
and return
Unitranche Debt
Senior Direct Lending
Senior Mortgage
Infrastructure Debt

LOS f - explain/ Natural Resources - commodities, farmland, timberland

Commodities - physical standardized products (price returns)
- indexes typically use futures prices, different constituents
- exposure gained through futures of ETFs and weights

Timberland - income + cap. appreciation - both a factory and a warehouse

price land
Farmland - income + cap. app.
crop yield price land
 Last Revised: 05/05/2021

Review - 9
LOS f - explain/ Natural Resources low corr. w/other asset classes
Risk/Return - commodities - price return, diversification, inflation protection,
high volatility (supply/demand determined pricing)

- timberland/farmland - price appreciation + yield

risks - weather, climate, global supply

- low corr. with stocks/bonds, adds ESG component

Instruments - commodities - derivatives, ETFs, managed futures, specialized

funds
- timberland/farmland - REITs, private funds, direct investment

LOS g - explain/ Real Estate

owner occupied - residential
income
commercial - any income producing property
capital gains
- Public or private, debt or equity

- low corr. with other asset classes, inflation hedge

Review - 10
LOS g - explain/ Real Estate
Direct Investing - large capital outflows, illiquid, location sensitive, high
transactions costs, low diversification, mgmt. required

Indirect Investing - pooled investment vehicles - public or private

LLPs, MFs, REITs, ETFs

Mortgages - public or private (LLPs, MBS)

LLPs-funds - infinite-life open-ended - core real estate, stable returns
core-plus strategies - non-core markets or properties
finite-life closed-end - value-added or opportunistic
(upgrades) (development)

REITs/ - no corporate tax if > 90% of taxable income paid as dividends

> 75% of assets in real estate
> 75% of income from rental or interest income
+ liquidity, lower trading costs, exp. mgmt., diversification, transparency
 Last Revised: 05/05/2021

Review - 11
LOS g - explain/ Real Estate
1/ Residential Property - owner occupied, leveraged
2/ Commercial Real Estate - long IH, low liquidity needs
- requires active mgmt. + leverage
3/ REITs - equity REIT - own properties
- mREITs - lend money against properties

Real Estate Indexes/

REIT indexes - like any other equity index
Private Investments - based on funds or underlying properties
- most appraisal-based
self-report
- smooths volatility
Repeat Sales Index - transaction-based
- relies on regression with time as the IV (time series)
- more reliable as # of transactions increase
Risks - interest rates, economic conditions, operations, financial
costs leverage, securing debt
Diversification - moderate corr. with equities/bonds

Review - 12
LOS h - explain/ Infrastructure - assets intended for public use
- growing share being financed through public/private partnerships

Investment - lease assets back to gov’t., sell to gov’t., or operate

- stable, long-term CFs, adjusts for inflation, long lived assets,
highly leveraged financial structure

Categories: Social (education, health care, social housing, correctional facilities)

- lease payments called availability payments

Economic (transportation, ICT assets, utility/energy assets)

- may also be classified by stage of development
greenfield - new development (highest risk)
brownfield - existing assets (low - medium risk)

Forms of Investment: Direct investment - large capital investments

Indirect investment - infrastructure funds, ETFs, company
shares
 Last Revised: 05/05/2021

Review - 13
LOS h - explain/ Infrastructure - income, some growth, inflation
protection, low exposure to GDP growth issues

LOS i - describe/ Issues in performance appraisal

Sharpe ratio AI return profiles generally not normally distributed
(1-2 targeted) ∴ sd is not a good measure of risk
Sortino ratio return relative to downside volatility
- both do not consider correlation of AI with rest of portfolio
Treynor ratio excess avg. return relative to its , lower , higher TR
(3 yrs.)
Calmer ratio (avg. annual comp. ret.)/max. drawdown

MAR = (avg. comp. ret.)/avg. drawdown

(full history)

- Performance - J-curve effect

- depends on timing of cash flows
∴ use of IRR liquidity events
- capital calls
- fee drag

Review - 14
LOS i - describe/ Issues in performance appraisal
Hedge funds: perf. measures don’t capture use of leverage

Illiquidity & Redemptions - NAV should reflect liquidation effects

- funds typically have 2 NAVS performance
redemption
Tail events - captured by VaR, stress testing, scenario analysis.

Redemptions - increase during times of poor performance (funds may

even suspend redemptions)
- notice periods, lock-up periods
LOS j - calculate/interpret/ Custom Fee Arrangements
longer lockups lower
1/ Fees based on liquidity terms and asset size
larger inv. fees
2/ Founders shares - entitle early investors to a lower fee structure
3/ Either/or fees - 1% mgmt. or 30% incentive, whichever is greater
- if the 1% is paid, reduces 30% incentive fee for
next period