Chapter 4: Specialist assets classes Part 2

Question 1

Define securitisation and list the main classes of assets that have been securitised in practice

Answer 1

Securitisation

• Issue of seurities, usually bonds, service and repaid exclusively out of a defined element of future cashflow owned by issuer
• often used to convert a bundle of highly unmarketable assets into negotiable structure financial instrument

Main classes of assets that have been securitised

• Residential and commerical mortgages (with mortgage-backed securities and coolateralised debt obligations)
• Credit card recievables
• Bank loans(within collateralised loan and debt obligations)
• Corporate bonds (within collaterallised bond and debt obligations)
• Credit derivatives (within collateralised debt obligations)

Question 2

State the two main risks facing the invesetor in asset backed seurities

Answer 2

• Default risks - risk that cashflows from underlyinig assets insufficient to cover interest and capital payments on asset backed seurities
• Prepayment risk - risk that loan repaid earlier than originally anticipated because underlying assets redeemed

Question 3

Describe the role of the special purpose vehicle in a typical securitisation

Answer 3

• Original owner of assets sells them to special purpose vehicle
• SPV raises funds to purchase assets by issuing securities to investors
• recievables transferred into SPV meet principal and interest liabilities on debt
• SPV may grant seurity over receivables
• SPV structured to be bankruptcy remote, so that in event of default by SPV, investor has no recourse to assets of the original owner and vice versa

Question 4

Describe how the asset backed seurities are typically structured in a seuritisation and explain why the seurities are typically structured in a securitisation and explain why the seurities are typically structured in this way

Answer 4

• Normally issued in multi-tranche format, with different ranking tranches, eg senior, mezzaine and equity
• credit ratings and or credit default protection obtained for (at least majojr tranches)
• Tranches repaid in order of rating, with actual timing of amortisation/repayments and any default losses and recoveries
• any excess remaining collateralisation return to original asset owner or kept by bond holders

Asset backed securities structured this way so as to package up risks and returns in way that most appeals to different types of investor. This minimises cost of borrowing

Question 5

Explain why a company might raise money via a complex and expensive securitisation as opposed to a straightforward bond issue

Answer 5

• Gives way of crystallising future profits, which can then be invested now to generate greater profits in future
• Bankruptcy remote seuritised bonds don’t appear on balance sheet of issuer so gearing isnt increased
• securitised bonds may appeal to investors who want exposure to particular subset of issuer’s assets
• muti-tranche format enables default and prepayment risks to be structured in a way that most appeals to range of different investors
• securitised bonds may obtain better credit rating than straight bonds secured on general assets of issuer

These factors may enable the issuer to borrow more cheaply than via normal bond issue

Question 6

Define the term private equity adn describe its two main forms

Answer 6

Private equity

• Investment in unquoted companies not listed on stock exchange. Intead shares ussued and traded privately
• No immediate exit route via secondary market

Two main forms

• Venture capital - capital for businesses in conceptual stage or where products are not developed and revenues and or profits not achieved
• Leveraged buyouts - equity capital for acquisition or refinancing of larger company. Typically this involves buying out shareholders of an existing public companh and de-listing it. Acquisition often funded largely by borrowing if buyers have insuifficient personal funds

Question 7

Describe 2 other situations where equity finance may be raised privately

Answer 7

• Where private company requires development capital 0 in order to fund growth or expansion of business in need of product extension and or market expansion
• Development capital may be provided en-route to public issue once company sufficiently large and profitable. Can be used to fund organic growth, ie expansion of existing lines of production or new projects in different markets
  
  • Where a financially or operationally distressed company requires restructuring capital, inorder to carry out restructuring of its finances (liabilities) or assets

Question 8

What s meant by a private equity fund

Answer 8

• Collective investment vehicle that brings together private equity investors
• fund then invests in unlisted invesetments on behalf of its investors
• unlikely to have quoted price and no easy way to sell investment even in small amounts
• Maybe restricted on when how investment may be sold to which investors agree on entry

Question 9

State three circmstances in which might a company choose to isssue shares privately rather than publicly

Answer 9

• Cost of capital lower under private ownership
• Company too risky for public ownnership
• valuation is difficult in public arena perhaps because of lack of information or past history

Question 10

State with reason the two main potential advantages of private equity investment

Answer 10

Private equity investment may offer

• Higher invetment returns
  
  • As compensation for high default risk and low marketability
  • due to inefficient pricing
  • due to highly incentivised magement
  • vecauuse returns are higly leveraged
• Low correlation with existing investments (and os be good for diversification) eg becuase private companies operate in new industries

Question 11

List 6 potential disadvantages of investing in private equity

Answer 11

• HIgh default risk
• lack of marketability
• lack of information
• difficult to value
• may be constrained by regulation
• high gearing in LBOS

Question 12

Summarise the life cycle of a typical private equity fund

Answer 12

• 3 to 6 months fund raising period, prior to launch of fund
• series of further fund raising periods with closing dates over next 3 to 4 years. Monies commited in fund raising periods and called on invested in tranches
• fund may start to make cash dsitributions to investors after about 3 years
• Fund will make all its purchases by end of investment period which may be about 3 years before end of fund
• Fund typically wound up after 8 to 12 years

Question 13

Define the term hedge fund and explain how they have less restrictions than more regulated vehicles such as mutal funds

Answer 13

A hedge fund can be defined as an investment fund that ais to meet high or absolte returns by investing across a number of asset classes of financial instruments

Hedge funds typically have less restrictions on

• Borrowing
• Short selling
• use of derivatives

Than more regulated cehicles such as mutual funds

This allows for investment strategies that differ significantly from the long onlly non leveraged strategies traditionally followed by investors

Question 14

List five other features that originally characterised hedge funds

Answer 14

• The placing of many aggresive position on different assets
• a high level of borrowing given the limited size of the capital of the funds compared to the size of the indifvidual investments
• a mix of investments for which the price movements would be expected mostly to cancel each other out, except for the positive effect the hedge fund is looking for
• A willingness to trade in derivatives, commodities and non - income bearing securities
• a higher risk tolerance than other funds

Question 15

Descrive the four main classes of hedge funds

Answer 15

• Global macro funds - concentrate on macroeconomic changes around the world
• event driven funds - trade either distressed securities or securities of companies involve din mergers and acquistions (risk arbitrage)
• Market neutral funds 0 enter simultaneously into long and short positions, while trying to explit individual price movements
• Multi-strategy funds - a comination of the above

Question 16

Describe the three biases that influence hedge fund performance data

Answer 16

• Survivorship bias - arises when data doesn’t realistically reflect survivors and failures. Means and average returns overestimated and volatility underestimated
• selection bias - arises because funds with good history more likely to apply for inclusion in databases, and may reflect backfilling of good past performance. Means average returns overestimated and volatility underestimated
• Marking to market bias - sinec underlying securities may be relatively illiquid, funds typically use either latest report price or own estimate of current market price for valuaiton. Use of stale prices can lead to underestimation of true variances and correlation

Question 17

Explain why claims of hedge fund superior performance can be questioned

Answer 17

• Claims of hedge fund superior performance can be questioned since return distribution are far from normal - many of them tend to be negatively skewed
• As a result, standard measures of performances such as a portfolio’s aflpha (excess return that cannot be explained by the fund’s beta) and its Sharpe Ratio will be biased upwards

Question 18

Outline the typical level and structure of a hedge fund’s managemennt fees

Answer 18

• Most hedge funds charge fixed annual fee of 1 - 2%, plus incentive fee of 15% - 25% of annual return over some benchmark
• Funds of hedge funds charge similar fees and, although they generally obtain rebates from managers they inveset in, extra layer of fees puts substantial pressure on funds of funds performance

Question 19

List 2 potential advantages and five potential disadvantages of investing in hedge funds

Answer 19

Advantages of investing in hedge funds

• Possibility of high returns
• Low correlation with other investments

Potential disadvantages of investing hedge funds

• High levels of fees
• lock-in and or notice periods
• limited regulation means lack of protection
• lack of information/transparency
• maximium/minium investment size

Question 20

Give four headings under which the key features of hedge funds can be summarised

Answer 20

• Management
• Operations
• Past performance
• Strategies

Question 21

Explain what is meant by the FX market and outline the 2 types of transaction in this market

Answer 21

The FX market exists whenever once currency is traded for another. It is by far the largest maret in the world, in terms of cash value traded, with trillions of dollars changing hands daily between large banks, central banks, currency speculators, multinational corporations, governments and other financial markets and instutions

Currency transactions are either spot transactions of forward transactions.

• Spot FX deals are delivered in 2 working day’s time, with settlement actually taking place in the 2 seperate countries
• Forward transactions involve agreeing the guaranteed price today at which the buyer will take delivery of th ecurrency on a specific future date

Question 22

Explain infrastructure in the context of investment and give examplesof the 2 main forms

Answer 22

The financing of long term infrastructure where project debt and equity used to finance the project is paid back from the cash flow generated by the project. It tends to be seperated into 2 broad subsets

• Economic
  
  • Eg highways, water and sewerage facilities, energy distrubution, techcommunicaiton networks
• Social
  
  • Eg schools & universities, hospitals, public, prisions

Question 23

Describe the characteristics that infrastructure assets display that distinguish them from more traditional equity or debt investments

Answer 23

• Assets tend be single purpose in nature, such as a gas pipeline, toll road or hospital
• investor’s participation in the asset is often for a finite period
• The initial development involves high upfront capital costs with payback occuring over the asset’s generally lengthy life
• tend to be, of exhibit the characteristics of, natural monopolies
• tend to be subject to varying degree of government regulation, depending largely on the degree of natural monopoly

Question 24

Define the term commodity and explain how institutional investors usually invest in commodities

Answer 24

• Commodities can be defined as any products that can be useed in commerce ie any goods that are traded
• The term refers t o interantionally traded agricultural goods such as coffee, feuls such as oil and raw materials such as copper
• Institutional commoedity investment in derivatives based on the price of the underlying commodity (rather than direct investment in the goods theselves, such as the purchase of a warehouse full of corree)

Question 25

Describe the commodities futures market, giving a formula for the price of a commoedity future

Answer 25

• Commoedities derivatives are traded on various markets around the world, primarily in the Chicago and London. Commodity futures are based on the price of the underlying commodities including agricultural produce, energy and metals
• commodity futures and forward contracts are used by producers and consumers who wish to reduce the uncertainity in the amount they will pay or recieve for the product
• Commodity futures are priced as:
• Future Price = Spot price + cost of carry - convenience yield

Question 26

Explain how the specification of a future contract for a commodity differs from that of a futures contract based on an investment index

Answer 26

The specification of a commodity futures contract is considerably more complex than that of a contract for a future based on an investment index. It will be necessary to specify:

• Contract size
• Delivery dates
• quality of the product
• Method of packaging
• package size
• delivery site
• method of resolving disputes about quiality

Question 27

Disscuss the suitaability of commoditiees as an investment class for institutional investors

Answer 27

Advantages

• Commodities offer significant real returns that are produced by doing real economic work within the economy
• returns accrue to the long only investor without the need for active management
• in periods of poor returns, commodities have produced higher returns than any other asset class used by institutional investors
• unlike other asset classes, commodities are concerned with short term supply and demand and short term risk

Disadvantages

• No strong historical evidence for a real return from commodities
• the market are volatile, being driven by a number of factors unrelated to the underlying economic factors that affect institutional liabilities

Question 28

Explain what insurance linked securities are and why an insurer might find them useful

Answer 28

• Insurance linked securities (ILS) - securities whose return depends on the occurence of a specific insurance event, which can be either related to non- life (eg catastrophe bonds) or life risks
• From an insurer’s perspective, ILS offer the ability to transfer risks from its balance sheet to investors in return for payment of a risk premium

Question 29

Outline the process for creating a catastrophe bonds

Answer 29

• The ceding insurance company establishes a special purpose vehicle in a tax efficient jurisdiction
• The SPV establishes a reinsurance agreement with the sponsoring insurance company
• The SPV issues a note to investors; this note has default provisions that mirror the terms of the reinsurance agreement
• The proceeds from the note sale are invested in money market instruments with a segregated collateral account
• if no trigger event occur during the risk period, the SPV returns the principal to investors with the final coupon payment, If trigger events occur, the assets of the SPV are first used to meet the inssurer’s losses, beofre any return of principal (if any)

Question 30

Explain what is meant by a structured products in the context of investment

Answer 30

A structured product is a pre-packaged investment strategy in the form of a a single investment. A typical structured product will consist of two components:

• A note - essentially a zero coupon debt security that provides capital potection
• Aderivative component that provides exposure to one or several underlying assets such as equities, commodities, FX or interest rates

Question 31

Disscuss the suitability of structured products as an investment class for institutional investors over direct investment in the underlying derivatives

Answer 31

Advantages

• Practical - investors may be unable to invest themselves in the underlying derivatives
• legal - designed to satisfy legal or regulatory requirements
• tax - tax treatment maybe more favourable
• accounting - may be structured to avoid income statement volatility from the underlying derivatives

Disadvantage

• Pricing - difficult to assess whether a quoted price is competitve
• Costs - distribution costs are generally not explict and are normally implicit in the quoted price

Question 32

Explain how index funds, exchanged traded funds and contraacts for differences can be used to gain access to traditional asset classes

Answer 32

• Index funds - “Open ended” unitised collective investment scheme that attempts to mimic the performance of a particular index. As such, it is passive management in action
• Exchange - traded funds (ETF) - the listed investment trust equivalents of (mutual) index funds. An ETF represents shares of ownership of a unit investment trust (UIT) which holds portfolios of stocks, bonds, currencies or comodities. The investor purchases the shares on a stock exchange in a process indentical to the purchase or sale of any other listed stock
• Contracts for differences (CFD) - A contract stipulating that the seller will pay to the buyer the difference between the current value of an asset and its value at a specific time

Question 33

Explain why the price of an ETF stays close to its net asset value

Answer 33

• The actions of arbtrageurs result in ETF prices that are kept very close to the NAV of the underlying securities
• when the ETF price starts to deviate from the underlying net asset value (NAV) of the component stocks, market participants can step in and take profit on the differences

Question 34

List the popular types of CFD

Answer 34

Popular ETFs

• SPDRs - which tract the S&P 500 major sectors of this index
• iShare which covers broad based US, international, industry sectors, fixed income and commodities
• VIPERs - which range from broad based to industry sector as well as international and bond ETFs
• PowerSHares including the QQQQ Nasdaq 100 ETF

Popular CFD

Major global indices (Dow Jones, NASDAQ, S&P 500, FTSE, DAX and CAC)