2013 CFA Level 1 - Book 5

Self-Test: Derivatives and Alternative Investments

7.

8.

9.

10.

Survivorship bias in reported hedge fund index returns will most likely result in
index:
A.	returns and risk that are biased upward.
B.	returns and risk that are biased downward.
C.	risk that is biased downward and returns that are biased upward.

A hedge fund with a 2 and 20 fee structure has a hard hurdle rate of 5%. If the incentive fee and management fee are calculated independently and the management fee is based on beginning-of-period asset values, an investor's net return over a period during which the gross value of the fund has increased 22%

is closest to: A. 16.4% B. 16.6% c. 17.0%

Measures of downside risk for asset classes with asymmetric return distributions are least likely to include:

A. value at risk (VaR).

B. the Sortino ratio.

C. kurtosis-adjusted standard deviation.

The type of real estate index that most likely exhibits sample selection bias is a(n):

A. REIT index.

B. appraisal index.

C. repeat sales index.

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Self-Test: Derivatives and Alternative Investments

SELF-TEST ANSWERS: DERIVATIVES AND

ALTERNATIVE INVESTMENTS

1 .	C	Because the FRApays at the expiration of the forward contract, it pays the present value
		ofthe interest savings that would be realized at the end ofthe (hypothetical) loan term.
		The interest rate option will pay the interest savings on the (hypothetical) loan after
		expiration at the end ofthe loan term and its payment will be greater (since it's not
		discounted back to the expiration date).
2.	C	The initial margin is 4 x $4,000 = $ 1 6,000 and the maintenance margin is 4 x $3,200 =
		$12,800. The loss on the position is (672 - 685) x 4 x 100 = -$5,200, leaving a balance
		of $ 16,000 - $5,200 = $ 10,800. Because the account has fallen below the maintenance
		margin, a deposit of $5,200 is required to bring the balance back up to the initial
		margin.
3.	B	A decrease in the risk-free rate of interest will decrease call values. The other changes will
		tend to increase the value of a call option.
4.	B	The net cost of the covered call position is 38 - 2 = 36, so the maximum loss (if the
		stock price goes to zero) is $36. The maximum gain (if the stock price goes to 40 or
		more) is $4. The sum is 36 + 4 = 40.
5 .	B	If the index has risen to 2,805 (+2%), the index payer's liability (2% x $ 1 0 million) just

offsets the fixed rate payer's liability (8% I 4 x $ 1 0 million). The payment at the second settlement date cannot be determined without knowing the change in the index level between the first and second settlement dates. The index level at the first settlement date does not determine the payment at the second settlement date.

6.C Forward contracts typically do not require a margin deposit. They are custom instruments that may require settlement in cash or delivery of the underlying asset, and they have counterparty risk.

7. C Surviving firms are more likely to have had good past returns and have taken on less risk than the average fund, leading to upward bias in index returns and downward bias in

index risk measures.

8.B The management fee is 2% of the beginning asset value, which reduces an investor's gross return by 2% to 22 - 2 = 20%. The incentive fee is 20% of the excess gross return over the hurdle rate, or 0.20(0.22 - 0.05) = 3.4%. The investor return net offees is 22% - 2% - 3.4% = 16.6%.

9.C Value at risk (VaR) and the Sortino ratio based on downside deviations from the mean are measures ofdownside risk. Kurtosis-adjusted standard deviation is not a concept presented in the curriculum.

10. C A repeat sales index includes prices ofproperties that have recently sold. Because these properties may not be representative of overall property values (may be biased toward properties that have declined or increased the most in value of the period), there is the risk of sample selection bias. An appraisal index or a REIT index is generally constructed for a sample of representative properties or REIT property pools.

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INDEX

A

absolute basis 280 absolute yield spread 74

accelerated sinking fund provision 16 accrued interest 14

ad hoc auction 47 affirmative covenants 1 1 , 162 after-tax yield 77

agency bonds 49 alternative investments 278 American options 227 amortizing securities 14 angel investing 284

annual-pay yield to maturity 103 apprrusal index 289 appropriation-backed obligations 54 arbitrage 193

arbitrage-free Treasury spot rates 73 asset-backed securities 59

B

backwardation 292, 303 bankers acceptances 59 bank reserve requirements 69 bankruptcy remote entity 60 best efforts basis 57, 6 1 bid-ask spread 36

bond equivalent yield 103, 1 1 0 bond forwards 202 bondholder rights 56

bond indenture 1 1 bond options 229 bootstrapping 1 1 1 bought deal 61

c

callable bonds 29, 1 17, 137 call option 192, 226, 230

call option profits and losses 268 call protection 15

call provisions 1 5 call risk 25

cap 13, 17, 231 caplet 231

cap risk 30

cash flow yield 107

cash management bill 47

cash settlement (forwards) 198

cash settlement (futures) 218
central bank 69
certificates of deposit (COs) 58
change in spot prices 292
cheapest-to-deliver 219
clawback 285
clean price 14
clearinghouse	214
closing trade	218
collar 13, 232

collateralized debt obligation (COO) 60 collateralized mortgage obligation (CMO) 51

collateral trust bonds			55
collateral yield 292, 304
commercial paper 58
commercial real estate			288
committed capital		285
commodities 290, 303
comparable sales approach 289
contango 292, 303
contingent drum		191
contract multiplier 229
convenience yield		292
conversion option		16
convexity 137, 145
corporate credit ratings				159
corporate family ratings				1 59
cost approach 289
counterparty risk		198
coupon 12
coupon rate	28
coupon strips 49
covenants 1 1
covered call	272
credit curves	170
credit enhancements			55, 56
credit migration risk			158
credit rating	55, 159
credit risk 26, 157, 199
credit spread	35, 75, 169
credit spread risk		35

currency denomination ofa bond 12 currency forward contract 205 currency futures 220

currency options 229 currency risk 37 currency swap 256 current yield 101 curtailment 5 1

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D

dealer-placed paper 58 debentures 50

debt service coverage ratio 177 default risk 35, 157, 198

deferred-coupon bonds 12
deliverable forward contract			198
delivery 218
delivery options	218
derivatives 191
criticism of 192
developmental capital 285
directly-placed paper		58
dirty price 14
discount rate 69
discount to par value		27
distressed investing 285
dollar duration	31
double-barreled bonds 54
downgrade risk	35, 158
duration 28, 30
ofa portfolio	144
duration/convexity approach			134

E

early stage (venture capital) 284 effective convexity 147 effective duration 139 embedded options 16, 28, 76 enterprise value 175

equity forward contracts 200 equity hedge fund strategies 282 equity swap 261

equivalent annual yield 110 Euribor 203

Eurodollar deposit 202 Eurodollar futures 219 European options 227 event-driven strategies 281 event risk 26, 38 exchange for physicals 218 exchange rate risk 26, 37

exchange-traded derivatives 191 exchange-traded options 229 expected loss 157

external credit enhancement 60

F

face value 12

Federal Farm Credit System 50

Federal Home Loan Bank Corporation (Freddie Mac) 50

Federal Home Loan Bank (FHLB) 49 federally related institutions 50

Book 5 - Fixed Income, Derivatives, and Alternative Investments

Index

Federal National Mortgage Association (Fannie Mae) 50

fiduciary call 244 financial options 229 firm commitment 61

floating-rate securities 13, 29 floor 13, 17, 231

floorlet 232

foreign currency options 229 formative stage 284

forward commitment 191 forward contract 192, 197 forward discount factor 1 1 8 forward rate 1 1 8

forward rate agreement 203

four Cs ofcredit analysis	161
full price 1 4
full valuation approach	134
funded investor 79

fund of funds 281

futures contracts 192, 213

G

general obligation bonds 53, 176

Government National Mortgage Association 50 government sponsored enterprises 50

H

high water mark 293 high yield 172 hurdle rate 293

I

incentive fee 292 income approach 289 indenture 1 1

index options 229 inflation-indexed bonds 13 inflation risk 26, 37

initial margin 215 insured bonds 54 interest rate cap 231 interest rate collar 232 interest rate floor 231

interest rate options 229, 230, 234 interest rate policy tools 69 interest rate risk 25, 27

interest rate swaps 258 in-the-money call option 228 intrinsic value ofan option 234, 235 inverse floater 13

investment grade 160 issuer 12

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Book 5 - Fixed Income, Derivatives, and Alternative Investments

Index

J

junior debt 158

K

key rate duration 33

L

later stage (venture capital)			284
law of one price		193
letters ofcredit		56, 60
leveraged buyouts (LBOs)			283
limit move (up, down) 216
liquidity preference theory			71
liquidity risk	26, 36
listed options	229
locked limit 216
lockup period	280

London Interbank Offered Rate (LIBOR) 78, 203, 230, 259

long forward position 197

long-term equity anticipatory securities (LEAPS) 229

loss severity 157

M

Macaulay duration 142 macro strategies 282 maintenance margin 215 management buy-ins 284 management buyouts 284 management fee 292

margin buying by institutional investors 17 market liquidity risk 158

market segmentation theory 71 marking to market 36, 216

maturity, relation to interest rate risk 28 maturity value 12

medium-term notes (MTNs) 56 mezzanine financing (in LBOs) 283

mezzanine-stage financing (venture capital) 284 minimum and maximum values of options 237 minimum value of a European put option 240 minimum value ofan American call option 239 minority equiry investing 285

modified duration 142 moneyness 228

moral obligation bonds 54 mortgage-backed securities 50 mortgage passthrough security 5 1 municipal bonds 53, 176

mutual termination of a swap 255

N

negative convexity 137 negative covenants 1 1, 162 negotiable CDs 58 negotiated offering 61

net asset value 36 nominal spread 74, 1 1 5 non-investment grade 160 nonrefundable bonds 15 normal backwardation 304 notching 160

notice period 280 notional principal 257

0

offsetting contract (to terminate a swap) 255 offsetting trade (to exit a futures position) 218 off-the-run issues 48

on-the-run issues 48

open market operations 69 option-adjusted spread (OAS) 1 17 option contract 226

option payoffs 233 option premium 226

option profit diagrams 268 options 191

options on futures 230 option writer 226

out-of-the-money call option 228 overnight repo 1 8 over-the-counter derivatives 191 over-the-counter options 229

p

parallel shift 33 pari passu 158 par value 12, 27

plain vanilla interest rate swap 258 portfolio companies 284

positive convexiry 137 preferred habitat theory 72 premium ofan option 227 premium to par value 27 prepayable debt 137 prepayment option 14, 17, 34 prepayment risk 25, 51 prerefunded bonds 54

price limits 216 price return 304

price value of a basis point 147 price-yield profile 93

primary market for debt 61 prime brokers 280

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principal strips	49
priority ofclaims 158
Private Export Funding Corporation		50
private investment in public equities		285
private placement 61
protective put 244, 273
public credit enhancement 54
pure expectations theory 71, 72
putable bond	1 17, 138
put-call parity	243, 244, 245
put option 192, 226, 230
put option profits and losses 269
put provisions	16

Q

quality spread 75

R

rating agencies 55, 159

real estate investment trusts (REITs) 288 realized yield 108

real options 230 recovery rate 157 redemption 16

reference rate (for a floating-rate security) 13 regular cycle auction 47

regular redemption 16 reinvestment income 108 reinvestment risk 25, 34, 101, 109 REIT indices 289

relative basis 280

relative value strategies 281 relative yield spread 74 repeat sales index 289

repurchase agreement (repo) 1 8 resale of a swap 256

reset date 29 residential property 288

revenue bonds 53, 54, 176

reverse trade (to exit a futures position) 218 roll yield 292, 304

Rule 144A offering 6 1 s

scenario analysis approach (to measuring interest rate risk) 134

secondary market for debt 61 SEC Rule 415 56

secured debt 55, 158

Securities and Exchange Commission (SEC) 50 seed stage (venture capital) 284

seniority ranking 1 58 serial bonds 53

Book 5 - Fixed Income, Derivatives, and Alternative Investments

Index

settlement date		198, 255, 257
settlement price		215
shelfregistration		56
short forward position 197
sinking fund	15, 17
Sortino ratio	295
sources of return from debt securities 101

sources ofreturn from commodities 292, 304 sovereign bonds 46, 175

sovereign risk 26, 38 special purpose vehicle 60 special redemption 16 spot rate 73, 1 18, 120 spread risk 158

static spread 1 15 step-up notes 12

stock index futures 220 stress testing 134

stripped Treasury securities (STRIPS) 49 structural subordination 160

structured note 57

Student Loan Marketing Association (Sallie Mae) 50

subordinated debentures 56, 158 swaps 191, 255

swaption 256

swap, ways to terminate 255 synthetic options 244

T

tap system 47 taxable-equivalent yield 77 tax-backed bonds 53 tax-free bonds 53

Tennessee Valley Authority 50 tenor 255

terminating a forward contract 199 terminating a futures contract 218 term repo 18

theoretical Treasury spot rate curve 73, 1 1 1 third-party guarantee 56

time value 236 tranches 51, 52

Treasury bill futures 219 Treasury bond futures 219

Treasury Inflation-Protected Securities 48 Treasury securities (bills, notes, bonds) 47

u

unsecured debt 55, 56, 158 upgrade of a bond rating 35 upper bound for call options 237 upper bound for put options 237

©2012 Kaplan, Inc.

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Book 5 - Fixed Income, Derivatives, and Alternative Investments

Index

v

value at risk (VaR) 295 variation margin 215 venture capital 284 volatility risk 26, 38

y

yield curve risk 25, 32, 33 yield curve shapes 70 yield ratio 74

yield spread 157 yield to call 105 yield to first call 105

yield to maturity (YTM) 102

yield to put 106
yield to refunding		106
yield to worst	106
yield volatility	37
z
zero-coupon bonds		12
value of 89
zero-volatility spread 1			1 5

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Notes