# 3. Quantitative Foundations Flashcards

## practice questions

What is the general term denoting compound interest when the interest is not continuously

compounded?

Discrete compounding

What is the primary challenge that causes difficulty in calculating the return performance of a forward

contract or other position that requires no net investment? How is that challenge addressed?

If the forward contract has a starting value of zero, it would cause division by zero. One solution

to the problem of computing return for derivatives is to base the return on notional principal.

Another is to include collateral.

Consider a position in a single forward contract. What distinguishes a fully collateralized position in

this forward contract from a partially collateralised position?

A fully collateralized position is paired with a quantity of capital equal in value to the notional

principal of the contract whereas a partially collateralized position is paired with collateral lower

in value than the notional value.

An IRR is estimated for a fund based on an initial investment when the fund was created, several

annual distributions and an estimate of the fund’s value prior to its termination. What type of IRR is this?

Since Inception IRR

An investment has two solutions for its IRR. What can be said about the investment and the usefulness

of the two solutions?

There are two sign changes in the cash flow stream of the investment. None of the IRRs should

be used.

Two investments are being compared to ascertain which investment would add the most value to a

portfolio. Both investments have simplified cash flow patterns of an initial cost followed by positive cash

flows. Why might the IRRs of the investment provide an unreliable indication of which investment adds

more value?

The major challenge with comparing IRRs across investments is when investments have scale

differences. Scale differences are when investments have unequal sizes and/or timing of their

cash flows.

An analyst computes the IRR of one alternative to be 20% and another to be 30%. When the analyst

combines the cash flows of the two alternatives into a single investment, must the IRR of the combination

be greater than 20% and less than 30%?

No. The answer is not immediately apparent because the IRR of a portfolio of two investments is

not generally equal to a value-weighted average of the IRRs of the constituent investments. If the

cash flows from two investments are combined to form a portfolio, the IRR of the portfolio can

vary substantially from an average of the IRRs of the two investments.

Is an IRR a dollar-weighted return or a time-weighted return? Why?

The IRR is the primary method of computing a dollar-weighted return.

In which scenario will a clawback clause lead to payments?

A clawback clause, clawback provision or clawback option is designed to return incentive fees to

LPs when early profits are followed by subsequent losses. A clawback provision requires the GP to return cash to the LPs to the extent that the GP has received more than the agreed profit split. A GP clawback option ensures that if a fund experiences strong performance early in its life and weaker performance at the end, the LPs get back any incentive fees until their capital contributions, expenses, and any preferred return promised in the partnership agreement have been paid.

What is the difference between a hard hurdle rate and a soft hurdle rate?

A hard hurdle rate limits incentive fees to profits in excess of the hurdle rate. A soft hurdle rate

allows fund managers to earn an incentive fee on all profits, given that the hurdle rate has been

achieved.

What is the difference between simple interest, continuous compounding?

Simple interest: is an interest rate computation approach that does not incorporate compounding.

Continuous compounding assumes that earnings can be instantaneously reinvested to generate additional earnings.

The rate of return that discounts a value of $110 to be received in the future to a present value of $100 expressed as a total (non-annualized) rate is 0.10.

? Logarithmic returns

What are the three other IRRs based on the time after since-inception IRRs?

- Lifetime IRRs: a lifetime IRR contains all of the cash flows, realised or anticipated, occurring over the investment’s entire life, from period o to period T.
- Interim IRRs: the interim IRR is a computation of IRR based on realised cash flows from an investment and its current estimated residual value.
- Point-to-point IRR: is a calculation of performance over part of an investment’s life. All cash flows are based on realised or appraised values rather than expected cash flow over the investment’s projected life. Although any IRR is calculated from one point in time to another, a point-to-point IRR would typically not be used to refer to a lifetime iRR.

Investment A is expected to cost $100 and to be followed by cash inflows of $10 after one year and then $120 after the second year, when the project terminates. The IRR is based on the anticipated cash flows and is an anticipated lifetime IRR.

2 N 100 +/- PV 10 PMT 120 - 10 = 110 FV CPT I/Y = 14.65%

Fund B expended $200 million to purchase investments and distributed $30 million after one year. At the end of the second year, it is being appraised at $180million.

2 N 200,000,000 +/- PV 30,000,000 PMT 180,000,000 - 30,000,000 150,000,000 FV CPT I/Y = 2.66%