CFA level 2 study notebook4 2015

PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted BOOK - ALTERNATIVE INVESTMENTS AND FIXED INCOME Readings and Learning Outcome Statements Study Session 13 - Alternative Investments Self-Test - Alternative Investments , 137 Study Session 14 - Fixed Income: Valuation Concepts 140 Study Session 15 - Fixed Income: Topics in Fixed Income Analysis 230 Self-Test - Fixed Income 273 Formulas 277 Index 283 ©2014 Kaplan, Inc Pagel PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted SCHWESERNOTES™ 2015 CFA LEVEL II BOOK 4: ALTERNATIVE INVESTMENTS AND FIXED INCOME ©2014 Kaplan, Inc All rights reserved Published in 2014 by Kaplan, Inc Printed in the United States of America ISBN: 978-1-4754-2772-1 / 1-4754-2772-7 PPN: 3200-5545 If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was distributed without permission of Kaplan Schweser, a Division of Kaplan, Inc., and is in direct violation of global copyright laws Your assistance in pursuing potential violators of this law is greatly appreciated Required CFA Institute disclaimer: “CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Kaplan Schweser CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.” Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: “Copyright, 2014, CFA Institute Reproduced and republished from 2015 Learning Outcome Statements, Level I, II, and III questions from CFA® Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institutes Global Investment Performance Standards with permission from CFA Institute All Rights Reserved.” These materials may not be copied without written permission from the author The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics Your assistance in pursuing potential violators of this law is greatly appreciated Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth by CFA Institute in their 2015 CFA Level II Study Guide The information contained in these Notes covers topics contained in the readings referenced by CFA Institute and is believed to be accurate However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes Page ©2014 Kaplan, Inc PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted READINGS AND LEARNING OUTCOME STATEMENTS READINGS Thefollowing material is a review of the Alternative Investments and Fixed Income principles designed to address the learning outcome statements setforth by CFA Institute STUDY SESSION 13 Reading Assignments Alternative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2014) 38 Private Real Estate Investments 39 Publicly Traded Real Estate Securities 40 Private Equity Valuation 41 A Primer on Commodity Investing page page 42 page 69 page 117 STUDY SESSION 14 Reading Assignments Alternative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2014) 42 The Term Structure and Interest Rates Dynamics 43 The Arbitrage-Free Valuation Framework 44 Valuation and Analysis: Bonds with Embedded Options page 140 page 170 page 192 STUDY SESSION 15 Reading Assignments Alternative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2014) 45 Credit Analysis Models 46 Introduction to Asset-Backed Securities ©2014 Kaplan, Inc page 230 page 249 Page PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Readings and Learning Outcome Statements LEARNING OUTCOME STATEMENTS (LOS) The CFA Institute Learning Outcome Statements are listed below These are repeated in each topic review; however, the order may have been changed in order to get a better fit with the flow of the review STUDY SESSION 13 The topical coverage corresponds with the following CFA Institute assigned reading: 38 Private Real Estate Investments The candidate should be able to: a classify and describe basic forms of real estate investments, (page 9) b describe the characteristics, the classification, and basic segments of real estate (page 10) c explain the role in a portfolio, economic value determinants, investment characteristics, and principal risks of private real estate, (page 12) d describe commercial property types, including their distinctive investment characteristics, (page 14) e compare the income, cost, and sales comparison approaches to valuing real estate properties, (page 15) f estimate and interpret the inputs (for example, net operating income, capitalization rate, and discount rate) to the direct capitalization and discounted cash flow valuation methods, (page 17) g calculate the value of a property using the direct capitalization and discounted cash flow valuation methods, (page 17) h compare the direct capitalization and discounted cash flow valuation methods (page 25) i calculate the value of a property using the cost and sales comparison approaches (page 26) j describe due diligence in private equity real estate investment, (page 31) k discuss private equity real estate investment indices, including their construction and potential biases, (page 31) explain the role in a portfolio, the major economic value determinants, investment characteristics, principal risks, and due diligence of private real estate debt investment, (page 12) m calculate and interpret financial ratios used to analyze and evaluate private real estate investments, (page 32) The topical coverage corresponds with thefollowing CFA Institute assigned reading: 39 Publicly Traded Real Estate Securities The candidate should be able to: a describe types of publicly traded real estate securities, (page 42) b explain advantages and disadvantages of investing in real estate through publicly traded securities, (page 43) c explain economic value determinants, investment characteristics, principal risks, and due diligence considerations for real estate investment trust (REIT) shares, (page 45) d describe types of REITs, (page 47) e justify the use of net asset value per share (NAVPS) in REIT valuation and estimate NAVPS based on forecasted cash net operating income, (page 51) Page ©2014 Kaplan, Inc PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Readings and Learning Outcome Statements f describe the use of funds from operations (FFO) and adjusted funds from operations (AFFO) in REIT valuation, (page 54) g compare the net asset value, relative value (price-to-FFO and price-to-AFFO), and discounted cash flow approaches to REIT valuation, (page 55) h calculate the value of a REIT share using net asset value, price-to-FFO and price-toAFFO, and discounted cash flow approaches, (page 56) The topical coverage corresponds with thefollowing CFA Institute assigned reading: 40 Private Equity Valuation The candidate should be able to: a explain sources of value creation in private equity, (page 70) b explain how private equity firms align their interests with those of the managers of portfolio companies, (page 71) c distinguish between the characteristics of buyout and venture capital investments (page 72) d describe valuation issues in buyout and venture capital transactions, (page 76) e explain alternative exit routes in private equity and their impact on value, (page 80) f explain private equity fund structures, terms, valuation, and due diligence in the context of an analysis of private equity fund returns, (page 81) g explain risks and costs of investing in private equity, (page 86) h interpret and compare financial performance of private equity funds from the perspective of an investor, (page 88) i calculate management fees, carried interest, net asset value, distributed to paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI) of a private equity fund, (page 91) j calculate pre-money valuation, post-money valuation, ownership fraction, and price per share applying the venture capital method 1) with single and multiple financing rounds and 2) in terms of IRR (page 93) k demonstrate alternative methods to account for risk in venture capital, (page 98) The topical coverage corresponds with thefollowing CFA Institute assigned reading: 41 A Primer on Commodity Investing The candidate should be able to: a describe types of market participants in commodity futures markets, (page 117) b explain storability and renewability in the context of commodities and determine whether a commodity is storable and/or renewable, (page 119) c explain the convenience yield and how it relates to the stock (inventory level) of a commodity, (page 119) d distinguish among capital assets, store-of-value assets, and consumable or transferable assets and explain implications for valuation, (page 120) e compare ways of participating in commodity markets, including advantages and disadvantages of each, (page 121) f explain backwardation and contango in terms of spot and futures prices, (page 124) g describe the components of return to a commodity futures and a portfolio of commodity futures, (page 126) h explain how the sign of the roll return depends on the term structure of futures prices, (page 128) i compare the insurance perspective, the hedging pressure hypothesis, and the theory of storage and their implications for futures prices and expected future spot prices (page 129) ©2014 Kaplan, Inc Page PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Readings and Learning Outcome Statements STUDY SESSION 14 The topical coverage corresponds with the following CFA Institute assigned reading: 42 The Term Structure and Interest Rate Dynamics The candidate should be able to: a describe relationships among spot rates, forward rates, yield to maturity, expected and realized returns on bonds, and the shape of the yield curve, (page 140) b describe the forward pricing and forward rate models and calculate forward and spot prices and rates using those models, (page 142) c describe the assumptions concerning the evolution of spot rates in relation to forward rates implicit in active bond portfolio management, (page 144) d describe the strategy of riding the yield curve, (page 147) e explain the swap rate curve, and why and how market participants use it in valuation, (page 148) f calculate and interpret the swap spread for a default-free bond, (page 150) g describe the Z-spread (page 152) h describe the TED and Libor-OIS spreads, (page 153) i explain traditional theories of the term structure of interest rates and describe the implications of each theory for forward rates and the shape of the yield curve (page 154) j describe modern term structure models and how they are used, (page 157) k explain how a bond’s exposure to each of the factors driving the yield curve can be measured and how these exposures can be used to manage yield curve risks (page 159) explain the maturity structure of yield volatilities and their effect on price volatility (page 161) The topical coverage corresponds with thefollowing CFA Institute assigned reading: 43 The Arbitrage-Free Valuation Framework The candidate should be able to: a explain what is meant by arbitrage-free valuation of a fixed-income instrument (page 170) b calculate the arbitrage-free value of an option-free, fixed-rate coupon bond (page 171) c describe a binomial interest rate tree framework, (page 172) d describe the backward induction valuation methodology and calculate the value of a fixed-income instrument given its cash flow at each node, (page 174) e describe the process of calibrating a binomial interest rate tree to match a specific term structure, (page 176) f compare pricing using the zero-coupon yield curve with pricing using an arbitragefree binomial lattice (page 178) g describe pathwise valuation in a binomial interest rate framework and calculate the value of a fixed-income instrument given its cash flows along each path, (page 180) h describe a Monte Carlo forward-rate simulation and its application, (page 181) Page ©2014 Kaplan, Inc PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Readings and Learning Outcome Statements The topical coverage corresponds with the following CFA Institute assigned reading: 44 Valuation and Analysis: Bonds with Embedded Options The candidate should be able to: a describe fixed-income securities with embedded options, (page 192) b explain the relationships between the values of a callable or putable bond, the underlying option-free (straight) bond, and the embedded option, (page 193) c describe how the arbitrage-free framework can be used to value a bond with embedded options, (page 193) d explain how interest rate volatility alfects the value of a callable or putable bond (page 196) e explain how changes in the level and shape of the yield curve affect the value of a callable or putable bond, (page 197) f calculate the value of a callable or putable bond from an interest rate tree, (page 193) g explain the calculation and use of option-adjusted spreads, (page 197) h explain how interest rate volatility affects option adjusted spreads, (page 199) i calculate and interpret effective duration of a callable or putable bond, (page 200) j compare effective durations of callable, putable, and straight bonds, (page 201) k describe the use of one-sided durations and key rate durations to evaluate the interest rate sensitivity of bonds with embedded options, (page 202) compare effective convexities of callable, putable, and straight bonds, (page 204) m calculate the value of a capped or floored floating-rate bond, (page 204) n describe defining features of a convertible bond, (page 208) o calculate and interpret the components of a convertible bond’s value, (page 208) p describe how a convertible bond is valued in an arbitrage-free framework, (page 211) q compare the risk-return characteristics of a convertible bond with the risk-return characteristics of a straight bond and of the underlying common stock, (page 211) STUDY SESSION 15 The topical coverage corresponds with thefollowing CFA Institute assigned reading: 45 Credit Analysis Models The candidate should be able to: a explain probability of default, loss given default, expected loss, and present value of the expected loss, and describe the relative importance of each across the credit spectrum, (page 230) b explain credit scoring and credit ratings, including why they are called ordinal rankings, (page 231) c explain strengths and weaknesses of credit ratings, (page 233) d explain structural models of corporate credit risk, including why equity can be viewed as a call option on the company’s assets, (page 233) e explain reduced form models of corporate credit risk, including why debt can be valued as the sum of expected discounted cash flows after adjusting for risk (page 235) f explain assumptions, strengths, and weaknesses of both structural and reduced form models of corporate credit risk, (page 237) the determinants of the term structure of credit spreads, (page 239) explain g h calculate and interpret the present value of the expected loss on a bond over a given time horizon, (page 239) i compare the credit analysis required for asset-backed securities to analysis of corporate debt, (page 241) ©2014 Kaplan, Inc Page PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Readings and Learning Outcome Statements The topical coverage corresponds with the following CFA Institute assigned reading: 46 Introduction to Asset-Backed Securities The candidate should be able to: a explain benefits of securitization for economies and financial markets, (page 249) b describe the securitization process, including the parties to the process, the roles they play, and the legal structures involved, (page 250) c describe types and characteristics of residential mortgage loans that are typically securitized, (page 252) d describe types and characteristics of residential mortgage-backed securities, and explain the cash flows and credit risk for each type, (page 254) e explain the motivation for creating securitized structures with multiple tranches (e.g., collateralized mortgage obligations), and the characteristics and risks of securitized structures, (page 257) f describe the characteristics and risks of commercial mortgage-backed securities (page 262) g describe types and characteristics of non-mortgage asset-backed securities, including the cash flows and credit risk of each type, (page 265) h describe collateralized debt obligations, including their cash flows and credit risk (page 266) Page ©2014 Kaplan, Inc PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted The following is a review of the Alternative Investments principles designed to address the learning outcome statements set forth by CFA Institute This topic is also covered in: PRIVATE REAL ESTATE INVESTMENTS Study Session 13 EXAM FOCUS This topic review concentrates on valuation of real estate The focus is on the three valuation approaches used for appraisal purposes, especially the income approach Make sure you can calculate the value of a property using the direct capitalization method and the discounted cash flow method Make certain you understand the relationship between the capitalization rate and the discount rate Finally, understand the investment characteristics and risks involved with real estate investments LOS 38.a: Classify and describe basic forms of real estate investments CFA® Program Curriculum, Volume 5, page FORMS OF REAL ESTATE There are four basic forms of real estate investment that can be described in terms of a two-dimensional quadrant In the first dimension, the investment can be described in terms of public or private markets In the private market, ownership usually involves a direct investment like purchasing property or lending money to a purchaser Direct investments can be solely owned or indirectly owned through partnerships or commingled real estate funds (CREF) The public market does not involve direct investment; rather, ownership involves securities that serve as claims on the underlying assets Public real estate investment includes ownership of a real estate investment trust (REIT), a real estate operating company (REOC), and mortgage-backed securities The second dimension describes whether an investment involves debt or equity An equity investor has an ownership interest in real estate or securities of an entity that owns real estate Equity investors control decisions such as borrowing money, property management, and the exit strategy A debt investor is a lender that owns a mortgage or mortgage securities Usually, the mortgage is collateralized (secured) by the underlying real estate In this case, the lender has a superior claim over an equity investor in the event of default Since the lender must be repaid first, the value of an equity investor’s interest is equal to the value of the property less the outstanding debt Each of the basic forms has its own risk, expected market structure returns, regulations, legal issues, and Private real estate investments are usually larger than public investments because real is indivisible and illiquid Public real estate investments allow the property to estate ©2014 Kaplan, Inc Page PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Study Session 13 Cross-Reference to CFA Institute Assigned Reading #38 - Private Real Estate Investments I remain undivided while allowing investors divided ownership As a result, public real investments are more liquid and enable investors to diversify by participating in more properties estate Real estate must be actively managed Private real estate investment requires property management expertise on the part of the owner or a property management company In the case of a REIT or REOC, the real estate is professionally managed; thus, investors need no property management expertise Equity investors usually require a higher rate of return than mortgage lenders because of higher risk As previously discussed, lenders have a superior claim in the event of default As financial leverage (use of debt financing) increases, return requirements of both lenders and equity investors increase as a result of higher risk Typically, lenders expect to receive returns from promised cash flows and not participate in the appreciation of the underlying property Equity investors expect to receive an income stream as a result of renting the property and the appreciation of value over time Figure summarizes the basic forms of real estate investment and can be used to identify the investment that best meets an investor’s objectives Figure 1: Basic Forms of Real Estate Investment Debt Equity Private Mortgages Public Mortgage-backed Direct investments such as sole ownership, partnerships, and other forms of commingled funds Shares of REITs and REOCs securities LOS 38 b: Describe the characteristics, the classification, and basic segments of real estate CFA® Program Curriculum, Volume 5, page REAL ESTATE CHARACTERISTICS Real estate investment differs from other asset classes, like stocks and bonds, and can complicate measurement and performance assessment • Heterogeneity Bonds from a particular issue are alike, as are stocks of a specific company However, no two properties are exacdy the same because of location, size, • age, construction materials, tenants, and lease terms High unit value Because real estate is indivisible, the unit value is significantly higher than stocks and bonds, which makes it difficult to construct a diversified portfolio Page 10 ©2014 Kaplan, Inc PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Study Session 15 Cross-Reference to CFA Institute Assigned Reading #46 - Introduction to Asset-Backed Securities ANSWERS - CONCEPT CHECKERS I Page 272 A Banks that securitize loans they hold as assets receive cash with which they can make additional loans The primary benefits of securitization to the economy include reducing firms’ funding costs and increasing the liquidity of the financial assets that are securitized A ABS are issued by a special purpose vehicle (SPV), which is an entity created for that specific purpose In a securitization, the firm that is securitizing financial assets is described as the seller because it sells the assets to the SPV The servicer is the entity that deals with collections on the securitized assets C An interest-only lifetime mortgage includes no repayment of principal in its monthly payments so the balloon payment at maturity is equal to the original loan principal A fully amortizing mortgage has no balloon payment at maturity A convertible mortgage gives the borrower an option to change the loan from fixed-rate to adjustable- rate or from adjustable-rate to fixed-rate A Conforming loans that may be securitized in agency RMBS have a maximum loan-tovalue ratio, along with other requirements such as minimum percentage down payments and insurance on the mortgaged property B Issuing CMOs may allow the issuer to raise funds at a lower cost by creating tranches that appeal to investors with different preferences for extension risk and contraction risk CMOs not reduce these risks compared to their pool of collateral; they only distribute the risks among the various CMO tranches Balloon risk is the possibility that a commercial mortgage borrower will not be able to refinance the principal that is due at the maturity date of the mortgage This results in a default that is typically resolved by extending the term of the loan during a workout period Thus, balloon risk is a source of extension risk for CMBS investors B C B During the lockout period on a credit card receivables backed ABS, no principal payments are made to investors A collateralized debt obligation or CDO is backed by an underlying pool of debt securities, which may include emerging markets debt A CMO is backed by a pool of mortgages and an ABS is backed by financial assets CDOs are not classified as ABS ©2014 Kaplan, Inc PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted SELF-TEST: FIXED INCOME Use the following information for Questions through Jonathan Song is a CFA candidate who recently took the Level II exam and is currently waiting to receive his test results Song is also pursuing his MBA at a prestigious Ivy League university He has accepted a position as an intern at a large brokerage firm in New York for this year’s summer break Over the course of his internship, he will rotate among the different areas of the firm, spending two weeks in each His current rotation is in the brokerage firm’s research department where he will report to Bill Dixon, a managing director whose group is responsible for bond analytics Dixon is evaluating all of the interns who rotate through his department this summer to identify possible candidates for future permanent positions at the brokerage firm Song has successfully completed several courses in finance and economics, and Dixon seeks to assess Song’s knowledge of various concepts that are of specific importance to his group Dixon decides to focus first on valuation of fixed income securities To this end, Dixon supplies Song with some fundamental market information Figure shows paths from a three-year binomial interest rate tree for risk-free securities using current market data Figure 1: Benchmark Interest Rate Paths for 3-year horizon Path Year Year Year 2% 2% 2% 2% 2.8050% 2.8050% 2.0780% 2.0780% 4.0787% 3.0216% 3.0216% 2.2384% Dixon wants Song to value three-year, 4% annual pay, $100 face value Zena, Inc., bonds The bonds have a Bermudan-style call option that can be exercised at par in one and two years Comparable bonds have an OAS of 100bps Dixon explains to Song that investments in callable bonds have special interest rate risk considerations Dixon states, “Callable bonds exhibit negative convexity When the underlying option is at- or nearthe-money, a callable bond will have lower one-sided down-duration than one-sided upduration.” While discussing spread measures, Song states, “Everything else constant, higher OAS indicates better compensation for risk However, OAS estimation for callable bonds can be biased upward if the analyst uses too high an estimate of interest rate volatility.” Song says that an analyst could use structural models to analyze credit risk of Zena, Inc., bonds, and that one of the ways to evaluate credit risk is to look at the economic exposure of the equity investors Specifically, owning equity is similar to owning a European option on the assets of the company When Dixon asks about term structure of interest rates, Song mentions that he had attended a seminar on that topic at university the previous semester While Song could not remember the specific model, he recalled that it had a drift term ensuring mean reversion of rates and a constant level of volatility ©2014 Kaplan, Inc Page 273 PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Self-Test: Fixed Income Using the information in Figure 1, the values of the bond under Path and Path for a three-year, 3% annual-pay benchmark security is closest to: Path Path A $99.98 $100.15 B $100.18 $101.15 C $102.32 $103.98 Using the information given in the case and in Figure 1, the value of 4% Zena, Inc., callable bond is closest to: A $97.12 B $100.00 C $100.82 Page 274 Dixon’s statement about interest rate risk of callable bonds is most accurately described as: A correct B incorrect about convexity C incorrect about one-sided duration Song’s statement regarding OAS is most accurately described as: A correct B incorrect about higher OAS indicates better compensation for risk C incorrect about OAS estimation for callable bonds can be biased upward While discussing structural models, the European option that Song discusses is most likely a: A conversion option B put option C call option The term structure model that Song is referring to is most likely the: A Cox-Ingersoll-Ross model B Vasicek model C Ho-Lee model ©2014 Kaplan, Inc PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Self-Test: Fixed Income SELF-TEST ANSWERS: FIXED INCOME B Pathwise valuation discounts each cashflow with its corresponding spot or forward rate A three-year, 3% annual pay bond would have cash flows of $3, $3, and $103 in years 2, and 3, respectively The values for each path and the average value is shown below Path Year 1 2% 2% 2% 2% Path value = C Year 2.8050% 2.8050% 2.0780% 2.0780% (1.02) (1.02X1.02805) Year 4.0787% 3.0216% 3.0216% 2.2384% Average Value $100.18 $101.15 $101.85 $102.58 $101.44 103 = 100.18 (1.02)(1.02805)(1.040787) The value of Zena, Inc., callable bond is $100.82 as shown below The interest rate tree is updated by adding a constant spread (OAS) of 100bps at each node $98.97 $4.0 4.0787% + 1% $100.00 $4.0 $99.68 $4.0 $9.98 $4.0 2.8050% + 1% $100.82 3.0216% + 1% 2.00%+ 1% $100.00 $4.0 $100.88 $100.00 $100.74 $4.0 2.0780% + 1% $100.00 $100.00 $4.0 $4.0 2.2384% + 1% Year Year V2,uu V2,UL _ 104 (1.050787) 104 (1.040216) 104 “ (1.032384) Year Year = $98.97 = $99.98 = $100.74 Because at node V2 > call price, the call option is exercised and we replace the node value with the call price of $100 ©2014 Kaplan, Inc Page 275 PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Self-Test: Fixed Income [98.97 + -x 1.038050 +| 99.98 + 4' = $99.68 1.038050 [99.98 + 100 + = $100.88 1.03078 1.03078J Because at node Vj L > call price, the call option is exercised and we replace the node value with call price of $100 Vtÿ-x [99.68 + Vo=-x 1.03 100 + 1.03 = $100.82 A Dixon is correct about callable bonds exhibiting negative convexity This occurs when the option is at or near money Dixon is also correct that when the underlying option is at or near money, for a given decrease in rates, the price appreciation of a callable bond will be lower than loss in value for an equal amount of increase in rates Hence, the callable bond will have lower one-sided down-duration than one-sided up-duration C Song is correct about higher OAS reflecting higher compensation for risk Song is incorrect about the relationship between assumed volatility and computed OAS for a callable bond If the assumed volatility is too high, the computed OAS for a callable bond would be too low and hence the bias would be on the downside C Equity investors can be thought of as holders of a European call option on the assets of the company with a strike price equal to the face value of debt At the maturity of debt, if the assets of the company are worth more than the face value of debt, the option is exercised (i.e., debt is paid) However, if the assets are insufficient to pay the debt, due to limited liability of shareholders, the option is allowed to expire (i.e., the company defaults) B Page 276 Drift term to ensure mean reversion of interest rates is a feature of the Cox-IngersollRoss model and the Vasicek model The Cox-Ingersoll-Ross model has volatility increasing with rates (and hence not constant) The Vasicek model assumes constant level of volatility over the period of analysis (i.e., independent of the level of interest rates) ©2014 Kaplan, Inc PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted FORMULAS STUDY SESSION 13: ALTERNATIVE INVESTMENTS net operating income: rental income if fully occupied + other income = potential gross income — vacancy and collection loss = effective gross income operating expense = net operating income — capitalization rate: cap rate = discount cap rate = NOI l value rate - growth rate nr cap rate NOI1 comparable sales price value of a property using direct capitalization: value = V0 = NOI l cap rate or value = V0 = stabilized NOI cap rate value of a property based on net rent and “all risks yield”: value = V0 = rentj ARY value of a property using gross income multiplier: sales price gross income multiplier = gross income value = gross income x gross income multiplier term and reversion property valuation approach: total value = PV of term rent + PV reversion to ERV layer approach: total value = PV of term rent + PV of incremental rent NCREIF Property Index (NPI) calculation: return = — — NOI capital expenditures + (end market value beg market value) beginning market value ©2014 Kaplan, Inc Page 277 PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Formulas debt service coverage ratio (DSCR): DSCR = loan-to-value (LTV) ratio: LTV = first-year NOI debt service loan amount appraisal value capitalization rate based on comparable recent transactions: capitalization rate = net operating income property value capitalization of a property’s rental stream: property value = Net Asset Value approach to REIT share valuation: estimated cash NOI assumed cap rate ± = estimated value of operating real estate + cash and accounts receivable - debt and other liabilities = net asset value ± shares outstanding = NAV/share price-to-FFO approach to REIT share valuation: funds from operations (FFO) ± shares outstanding = FFO/share x sector average P/FFO multiple = NAV/share price-to-AFFO approach to REIT share valuation: funds from operations (FFO) non-cash rents: - recurring maintenance-type capital expenditures = AFFO + shares outstanding = AFFO/share x property subsector average P/AFFO multiple = NAV/share - Page 278 ©2014 Kaplan, Inc net operating income capitalization rate PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Formulas discounted cash flow approach to REIT share valuation: value of a REIT share = PV(dividends for years through n) + PV(terminal value at the end of year n) exit value: investment cost increase in price multiple earnings + growth + reduction in debt exit value NAY before distributions: = NAV after distributions in prior year capital called down management + fees operating results NAV after distributions: NAV before distributions venture carried distributions interest capital method: the post-money portion of a firm purchased by an investment is: investment fl = PVj (exit value) the number of new shares issued is: sharesvc = shares EQUITY fl U-fiJ where sharesEQUITY is the pre-investment number of shares, and share price is: price = investment shares vc forward price (F(|) vs spot price (SQ) of a commodity: p r0 _ “ C e(r + U - Y)T J0e return components of commodity futures investments: total return = spot return + roll return + collateral return ©2014 Kaplan, Inc + rebalancing return Page 279 PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Formulas excess return, reflecting an uncollateralized futures investment: excess return = spot return + roll return = futures return total representing a fully cash-collateralized commodity investment: return, total return = collateral return + futures return = collateral return Ft-l,t Ft,T _ St ~ roll return = + spot return + roll return ~ pt,T St STUDY SESSIONS 14 AND 15: FIXED INCOME price of a T-period zero-coupon bond PT = (1+ST)T forward price (at t = j) of a zero-coupon bond maturing at (j+k) %k) = [l+/(j,k)]k forward pricing model P(j+k) - PjF(j,k) Therefore: P(j+k) %k) - -p; forward rate model [1 + S(j+k)] = (1 + Sj)j [1 + /(j,k)]k or [1 + /j,k)]k = [1 + S(j+k)] 0‘+k) / (1 + spi swap spread — swap spreadt = swap ratet Treasury yieldt Page 280 ©2014 Kaplan, Inc PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Formulas TED Spread TED Spread = (3-month LIBOR rate) - (3-month T-bill rate) Libor-OIS spread Libor-OIS spread = LIBOR rate - “overnight indexed swap” rate Portfolio value change due to level, steepness, and curvature movements AP — « -DLAXL - DsAxs - DcAxc callable bond putable bond = Vstraight + Vput effective duration = ED = effective convexity = EC = BV_Ay-BV+Ay X BVQ X Ay BV_Ay + BV+Ay — (2xBV0) BV0xAy2 capped/floored floaters value of a capped floater = value of a “straight” floater value of a floored floater = value of a “straight” floater — value of the embedded cap + value of the embedded floor convertible bond minimum value of convertible bond = greater of conversion value or straight value market conversion price _ market price of convertible bond conversion ratio ©2014 Kaplan, Inc Page 281 PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Formulas — market conversion premium per share = market conversion price stock’s market price market conversion premium ratio market conversion premium ratio = premium over straight value market conversion premium per share market price of common stock _ market price of convertible bond straight value -1 callable and putable convertible bond value = straight value of bond + value of call option on stock - value of call option on bond + value of put option on bond credit analysis recovery rate = percentage of money received upon default of the issuer loss given default (%) = 100 - recovery rate expected loss = probability of default x loss given default present value of expected loss = (value of a credit-risky bond) - (value of otherwise identical risk-free bond) debt-to-service coverage ratio = net operating income debt service loan-to-value ratio loan-to-value ratio = Page 282 current mortgage amount current appraised value ©2014 Kaplan, Inc PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted INDEX co-investment 84 A active management 11 adjustable-rate mortgage (ARM) 252 adjusted funds from operations (AFFO) 54 administrative costs 88 agency risk 87 agency RMBS 254 all risks yield (ARY) 19 American-style option 192 arbitrage-free models of the term structure of interest rates 158 arbitrage-free valuation 170 arbitrage-free values 176 arbitrageurs 118 asset-backed securities 241 audit costs 88 auto loan ABS 265 availability of information 13 average life variability 262 B backwardation 124 backward induction 174 balloon payment 264 Bermudan-style option 192 binomial interest rate tree 172, 176 board representation 71 broken PAC 261 business conditions 12 buyout investments 72 buyout valuation issues 75 c calibration 235 callable bonds 192 cap 204 capital appreciation 12 capital asset pricing model (CAPM) 129 capital assets 120 capitalization rate 18, 51 capital risk 87 capped floater 204 carried interest 82, 92 cash reserve funds 256 clawback 83 CMBS-level call protection 264 CMBS structure 263 collateralized debt obligation (CDO) 71, 266 collateralized loan obligation (CLO) 70 collateralized mortgage obligations (CMO) 257 collateral manager 266 collateral return 127 commercial mortgage-backed securities (CMBS) 262 commingled real estate funds (CREF) commodity index certificate 123 commodity markets 121 Commodity Trading Advisors 122 competitive environment risk 87 conditional prepayment rate (CPR) 255 consumable or transferable (C/T) assets 120 contango 124 control mechanisms 71 convenience yield 119 conversion period 208 conversion price 208 conversion ratio 208 conversion value 208 convertible bond 208 convertible mortgage 252 corporate debt 241 corporate governance 83 cost and availability of capital 12 cost and availability of debt capital 11 cost approach 16 Cox-Ingersoll-Ross model 157 credit card ABS 265 credit enhancement 256 credit ratings 232, 233 credit risk 230 credit scoring 231 credit spread 231 current income 12 curvature 159, 160 D debt service coverage ratio (DSCR) 32, 263 demographic factors 13 depreciation and desirability 11 difficulty in determining price 11 dilution costs 88 direct capitalization method 17 discounted cash flow (DCF) analysis 74, 75 discounted cash flow method 17 ©2014 Kaplan, Inc Page 283 PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Index distributed to paid-in capital (DPI) 89, 92 distribution waterfall 83 diversification 12 diversification risk 87 diversified REITs 49 dominance 170 drift adjusted 182 due diligence 31, 86 E earn-outs 72 economic life 27 effective age 27 effective convexity 200, 204 effective duration 159, 200 hazard rate estimation 237 health care REITs 48 hedgers 117 hedging pressure hypothesis 130 hedonic index 32 heterogeneity 10 high transaction costs 11 high unit value 10 hotel REITs 49 hurdle rate 82 I illiquidity 74 implicit estimation techniques 235 income approach 16 index-referenced mortgage 252 industrial industrial REITs 48 inflation hedge 12 initial PAC collar 261 initial public offering (IPO) 80 embedded options 192 environmental issues 13 equilibrium term structure models 157 equity dividend rate 33 equity REITs 42 equivalent yield 24 estate put 193 European-style option 192 excess return index 127 excess servicing spread funds 256 exchange-traded fund (ETF) 123 insurance perspective 129 interest-only mortgage 253 internal credit enhancements 256 internal rate of return (IRR) 88 investment restrictions 84 investment vehicle fund setup costs 88 IRR method 94 I-spread 151 issuer-pays model 232 exit routes 80 exit timing 81 exit value 76 expected loss 230 expected return 142 expected terminal value 100 extendible bond 192 external credit enhancements 256 K key man clause 83 key rate duration 159, 202 F FICO scores 231 fixed-rate mortgage 252 floor 205 floored floater 205 forward curve 141 forward pricing model 142 forward rate 140, 141 forward rate model 143 fully amortizing 253 funds from operations (FFO) 54 future parity 124 L G Global Investment Performance Standards (GIPS) 88 gross income multiplier technique 20 gross IRR 88 Page 284 H lack of liquidity 11,13 layer method 23 LBO model 76 level 159, 160 leverage 13 leveraged buy-out (LBO) 74, 75 LIBOR-OIS spread 154 liquidation 80 liquidity preference theory 156 liquidity risk 87 loan-level call protection 264 loan-to-value (LTV) 32, 252, 263 local expectations theory 155 lockout period 265 loss given default 230 ©2014 Kaplan, Inc PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Index premium over straight value 210 pre-money (PRE) valuation 78 pre-money value 93 prepayment 253 M management and performance costs 88 management buyout (MBO) 75, 80 management expertise 13 management fees 92 market approach 74 market conversion premium ratio 210 market risk 87 mezzanine finance 75 minimum value of a convertible bond 208 modern interest rate term structure models 157 Modigliani-Miller 70 Monte Carlo forward-rate simulation 182 Moody’s 232 mortgage-backed securities (MBS) 43, 251 mortgage pass-though securities 254 mortgage REITs 43 multi-family 15 N NAV, distributions 92 net asset value (NAV) net IRR 88 85 new property lead time 12 no-fault divorce 84 non-agency RMBS 254 noncompete clauses 71 nonrecourse loans 253, 263 NPV method 94 o office 14 office REITs 48 one-sided duration 202 option adjusted spread (OAS) 198 option-free bond 193 ordinal rankings 231 other factors 13 overcollateralization 256 P paid-in capital (PIC) 89, 92 partial durations 202 partially amortizing 253 pass-through rates 254 path dependent 182 pathwise valuation 180 performance disclosure 83 placement fees 88 planned amortization class (PAC) 261 post-money (POST) valuation 78 post-money value 93 preferred habitat theory 156 prepayment penalty 253 prepayment risk 255 present value of expected loss 231, 239 priority in claims 72 private equity 69 private equity fund terms 81 private equity valuation 74 probability of default 230 probability of loss 241 pure expectations theory 154 putable bonds 192 R ratchet 82 real estate investment trust (REIT) real estate operating company (REOC) real option analysis 74 rebalancing return 127 reconstitution 170 recourse loans 253 recovery rate 230 reduced form model of corporate credit risk 235, 238 regulatory risk 87 relative value 74 removal for cause 84 renewability 119 repeat-sales index 32 replacement cost 74 reserve funds 256 residential mortgage-backed securities (RMBS) 254 residential mortgage loan 252 residential (multi-family) REITs 48 residual cap rate 21 residual value to paid-in capital (RVPI) 89, 92 retail 15 retail or shopping center REITs 47 reversionary potential 22 “riding the yield curve” 147 “rolling down the yield curve” 147 roll return 127, 128 s sales comparison approach 16 scenario analysis 100 secondary market sale 80 securitization 249 securitized mortgage 254 segmented markets theory 156 ©2014 Kaplan, Inc Page 285 PRINTED BY: guidenotes.com - all materials about CFA ACCA FIA CAT CIMA Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Index senior/subordinated structure 257 sequential pay CMO 258 shape of the yield curve 154 shaping risk 159 shifting interest mechanism 257 sinking fund bonds 193 special purpose vehicle (SPV) 250 speculators 118 spot curve 140, 178 spot rates 40 spot return 126 spot yield curve 140 Standard & Poor’s 232 steepness 159, 160 storability 119 storage REITs 49 store of value assets 120 straight bond 193 straight value 208 stripping 170 structural model of corporate credit risk 233, 237 structured finance CDOs 266 structured products 122 support tranches 261 swap fixed rate 148 swap rate 148 swap rate curve 149 swap spread 150 synthetic CDOs 266 T tag-along, drag-along 71, 84 target fund size 82 tax benefits 12 tax risk 87 TED spread 153 term and reversion approach 22 terminal value 21 term of the fund 82 Page 286 term sheet 71 term structure of credit spreads 239 term structure of interest rate volatility 161 theories of the term structure of interest rates 154 theory of storage 120,130 total return index 128 total value to paid-in capital (TVPI) 89, 92 trailer fee 88 tranche 251 transaction costs 87 u unbiased expectations theory 154 unexpected inflation 13 unquoted investments risk 87 V value additivity 170 variable-rate mortgage 252 Vasicek model 158 venture capital 72 venture capital investments 78 venture capital method 74, 93 vintage 82 w waterfall structure 251 weighted average coupon (WAC) 254 weighted average maturity (WAM) 254 Y yield to maturity 141 z zero-coupon yield curve 178 Z-spread 152 ©2014 Kaplan, Inc ... per SF Estimated value $9,000,000 30,000 +27 0,000 +405,000 +480,000 $9,540,000 5 ,26 5,000 $8,880,000 40,000 20 ,000 35,000 $23 8.50 $26 3 .25 $25 3.71 $25 1. 82 $7,554,600 The sales comparison approach... Investing page page 42 page 69 page 117 STUDY SESSION 14 Reading Assignments Alternative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 20 14) 42 The Term Structure... readings as set forth by CFA Institute in their 20 15 CFA Level II Study Guide The information contained in these Notes covers topics contained in the readings referenced by CFA Institute and is believed