BOOK 4- ALTERNATIVE INVESTMENTS AND FIXED INCOME Readings and Learning Outcome Statements Study Session 13 -Alternative Investments Self-Test- Alternative Investments •.•.• •.•.•.•.•.•.•.•.••••.•.•.•.•.•.•.•.• •.•.•.•.•.•.•.•.•••• 103 Study Session 14 - Fixed Income: Valuation Concepts •.•.•.•.•.•.•.• •.•.•.•.•.•.•.•.•••• 107 Study Session 15 - Fixed Income: Structun:d Securities •.•.•.•.•.•.• •.•.•.•.•.•.•.•.•••• 196 Self-Test- Fixed Income ••••.•.•.•.•.•.•.•.• •.•.•.•.•.•.•.•.••••.•.•.•.•.•.•.•.• •.•.•.•.•.•.•.•.•••• 275 Formulas 278 Index 282 SCHWESERNafESTM 2012 CFA LEVEL II BOOK 4: ALTERNATIVE INVESTMENTS AND FIXED INCOME ©2011 Kaplan, Inc All rights reserved Published in 20 II by Kaplan Schweser Printed in the United States of America ISBN: 978-1-4277-3617-8/1-4277-3617-0 PPN: 3200-1732 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® and Chartered Financial Analyst® are trademarks owned by CFA Institute CFA Institute (formerly the Association for Investment Management and Research) does not endorse, promote, review, or warrant the accuracy of the products or services offered by Kaplan Schweser."' Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: "'Copyright, 2012, CFA Institute Reproduced and republished from 2012 Learning Outcome Statements, Level I, II, and III questions from CFAIZ Progtam Materials, CFA Institute Stand.ard.s of Professional Conduct, and CFA Institute's Globallnvesnnent Perfotmance Standards with permission from CFA Institute All Rights Reserved." These materials may not be copied without wtitten permission from the author The unauthorized duplication of these notes is a violation of global copytight laws and the CFA Institute Code of Ethics Your assistance in pursuing potential violatots 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 2012 CFA Level II Study Guide The information contained in these Notes covers topics contained in the readings refetenced by CFA Institute and is believed to be accutate However, their accuracy cannot be guaranteed nor is any wartanty conveyed as to yout ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes READINGS AND LEARNING OUTCOME STATEMENTS READINGS The following material is a review ofthe Alternative Investments and Fixed Income principles designed to address the learning outcome statements set forth by CPA Imtitute STUDY SESSION 13 Reading Assignments Alternative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2012) 44 45 46 47 Investment Analysis Income Property Analysis and Appraisal Private Equity Valuation Investing in Hedge Funds: A Survey page9 page 27 page 40 page 88 STUDY SESSION 14 Reading Assignments Alurnative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2012) 48 General Principles of Credit Analysis 49 Term Structure and Volatility oflnterest Rates 50 Valuing Bonds with Embedded Options page 107 page 135 page 162 STUDY SESSION 15 Reading Assignments Alternative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2012) 51 Mortgage-Backed Sector of the Bond Market 52 Asset-Backed Sector of the Bond Market 53 Valuing Mortgage-Backed and Asset-Backed Securities ©20 11 Kaplan, Inc page 196 page 227 page 252 Page3 Book -Alternative Investments and Fixed Income Reading< and Learning Outcome Statements LEARNING OUTCOME STATEMENTS (LOS) Tht CFA lmtitutt Ltarning Outcomt Stattmmts art listtd btlow Thtst art rtptattd in tach topic rtVitw; howtvtr, tht ordtr may havt bun changtd in order to gtt a bttttr fit with tht flow oftht rtvitw STUDY SESSION 13 Tht topical covtragt cormponds with tht following CFA lnstitutt assigntd rtading: 44 Investment Analysis The candidate should be able to: a explain, for each type of real property investment, the main value determinants, investment characteristics, principal risks, and most likely investors (page 9) b evaluate a real estate investment using net present value (NPV) and internal rate of return (IRR) from the perspective of an equity investor (page 18) c calculate the a&er-tax cash flow and the after-tax equity reversion from real estate properties (page 14) d explain potential problems associated with using IRR as a measurement tool in real estate investments (page 20) Tht topical covtragt cormponds with tht following CFA lnstitutt assigntd rtading: 45 Income Property Analysis and Appraisal The candidate should be able to: a explain the relation between a real estate capitalization rate and a discount rate (page 27) b estimate the capitalization rate by the market-extraction method, band-ofinvestment method, and built-up method, and justify each method's usc in capitalization rate determination (page 28) c estimate the market value of a real estate investment using the direct income capitalization approach and the gross income multiplier technique (page 31) d contrast limitations of the direct capitalization approach to those of the gross income multiplier technique (page 32) Tht topical covtragt corrtsponds with tht following CFA lnstitutt assigntd rtading: 46 Private Equity Valuation The candidate should be able to: a explain sources of value creation in private equity (page 41) b explain how private equity firms align their interests with those of the managers of portfolio companies (page 42) c distinguish between the characteristics of buyout and venture capital investments (page 43) d describe valuation issues in buyout and venture capital transactions (page 47) e explain alternative exit routes in private equity and their impact on value (page 51) f explain private equity fund structures, terms, valuation, and due diligence in the context of an analysis of private equity fund returns (page 52) g explain risks and costs of investing in private equity (page 57) h interpret and compare financial performance of private equity funds from the perspective of an investor (page 59) Page4 ©2011 Kaplan, Inc Book -Alternative Investments and Fixed Income Readings and Learning Outcome Statements 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 62) j calculate pre-money valuation, post-money valuation, ownership fraction, and price per share applying the venture capital method I) with single and multiple financing rounds and 2) in terms of!RR (page 64) k demonstrate alternative methods to account for risk in venture capital (page 69) The topical coverage corresponds with the following CPA lmtitute assigned reading: 47 Investing in Hedge Funds: A Survey The candidate should be able to: a distinguish between hedge funds and mutual funds in terms of leverage, use of derivatives, disclosure requirements and practices, lockup periods, and fee structures (page 88) b describe hedge fund strategies (page 89) c explain possible biases in reported hedge fund performance (page 91) d describe factor models for hedge fund returns (page 92) e describe sources of non-normality in hedge fund returns and implications for performance appraisal (page 93) f describe motivations for hedge fund replication strategies (page 94) g explain difficulties in applying traditional portfolio analysis to hedge funds (page 95) h compare funds of funds to single manager hedge funds (page 96) STUDY SESSION 14 The topical coverage corresponds with the following CPA lmtitute assigned reading: 48 General Principles of Credit Analysis The candidate should be able to: a distinguish among default risk, credit spread risk, and downgrade risk (page 107) b explain and analyze capacity, collateral, covenants, and character as components of credit analysis (page 108) c calculate and interpret key financial ratios used by credit analysts (page Ill) d evaluate the credit quality of an issuer of a corporate bond, given such data as key financial ratios for the issuer and the industry (page Ill) e analyze why and how cash flow from operations is used to assess the ability of an issuer to service its debt obligations and to assess the financial flexibility of a company (page 114) f explain and interpret typical elements of the corporate structure and debt structure of a high-yield issuer and the effect of these elements on the risk position of thelender (page 116) g describe factors considered by rating agencies in rating asset-backed securities (page 117) h explain how the credit worthiness of municipal bonds is assessed, and contrast the analysis of tax-backed debt with the analysis of revenue obligations (page 119) i describe considerations used by Standard & Poor's in assigning sovereign ratings, and explain why two ratings are assigned to each national government (page 120) j contrast the credit analysis required for corporate bonds to that required for I) asset-backed securities, 2) municipal securities, and 3) sovereigu debt (page 121) ©20 11 Kaplan, Inc PageS Book -Alternative Investments and Fixed Income Reading< and Learning Outcome Statements Th• topical cov