CFA Level 1 (2009) - 5

Study Session 18

Cross-Reference to CFA Institute Assigned Reading #73 - Alternative Investments

ANSWERS - COMPREHENSIVE PROBLEMS

I.A. Assuming a 4-year holding period, the holding period returns for:

Class A shares would	be: (I - 0.04) (1.08)1 (I			-	0.01)1_1 = 25.46%.
Class B shares would	be: (1.08)4 (1	-	0.015)4 (1		- 0.0 I) --I = 2().79%. (Hack-end
load is I % after 4 years)
Class C shares would be: (1.08)4 (I		-	0.02)" -	I = 25.49%.

R.Class B shares would provide the greatest holding period return and therefore the

grea test average an nual com pound rate of retu rn.

c:. Over short holding periods such as one or tWO years, Class C would be the best choice. Although Class C shares have higher annual expenses, the relatively high franc-end charges for Class A shares and redemption charges for Class B shares in the early years will outweigh the savings from lower (Otal annual fees.

2. 134,534 + 7.54 (1,300) + 14,345 (2) - 13,980 (4.3) = $112,912

3.A. The amount borrowed is $4.9 million (0.7 x 7 million). At 9% and with 30 level payments, the paymencs will be $476,948.

Year I (rounding (0 whole dollars):

Interest will be 0.09 x 4.9 million = $441,000

Principal repaymcIlt will be 476,918 - 441,000 = $35,948

After-tax cash flow for year I will be:

[NOr - interest - depreciation](1 - tax rate) - principal repayment + depreciation [675,000 - 441,000 - 200,000] (I - 0.28) - 35,948 + 200,000 = $188,532

At the end of year 1, the remaining principal on the mortgage loan is 4,900,000 - 35,948 = $4,864,052

Year 2 interest will be 4,864,052 x 0.09 = $437,765

Year 2 principal payment will be 476,948 - 437,765 = $39,183

After-tax cash Aow for year 2 will be:

[NOr - interest - depreciation](1 - tax rate) - principal repaymenc + dqJreciation [675,000(1.03) - 437,765 - 200,000] (I - 0.28) - 39,183 + 200,000 = $202,206

At the end of year 2, the remaining principal on the mortgage loan is 4,864,052 - 39,183 = $4,824,869

Year 3 illterest will be 4,824,869 x 0.09 = $434,238

Year 3 principal paymenc will be 476,948 - 434,238 = $42,710

After-tax cash flow for year 3 will be:

[NOr - interest - depreeiation](1 - tax rate) - principal repaymenc + depreciation [675,000(1.03)2 - 434,238 - 200,000] (I - 0.28) - 42,710 + 200,000 = $216,236

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Study Session 18

Cross-Reference to CFA Institute Assigned Reading #73 - Alternative [nvestmel1ls

B.At the time of sale, the remaining mortgage balance is 4,824,869 - 42,710 =

4,782, 159	I
The depreciared book value is: 7,000,000 - (3	x 200,000) = 6,100,000
Cash from sale is: 7,100,000 - 4,782, I '59 = $2,617,841
Capital gains tax is: 7.4 million - 6.4 million	= 1 million (0.15) = 150,000
After-tax proceeds from sale arc: 2,6 \ 7,841 -	150,000 = $2,467 ,81J I

Total after-tax cash Howat the end of year 3 is: 2,467,81J I + 216,2.36 = $2,684,077

C. With a down payment of $2.1 million, and the rhree cash Oows calculated above (in bold), we can calculate the IRR on the investment, which is 14.64%. Since this is an after-tax return, we can compare it 10 the required rate of 15% and conclude that the investment will have a negative NPV and sllOuld not be undertaken.

4.The NCREIF index is based on appraised values and likely underestimates the true volatility of prices and the correlation of real estate returns with U.S. slOck market retums. Both sources of bias will lead to overestimates of rhe optimal allocation to real estate in efficient portfolios based on portfolio optimization models.

5.A. I. 17-1-0.2(17-4.5)=13.5%

II.17-0.2(17)=\3.6%

III.17 - 1 - 0.2 (17 - 9.5) = 14.5%

IV. The fund has never had negative gross returns so its beginning value this year was its previous highest value.

\ 7 -- \ - 0.2 (17) = 12.6%

13.I. Same as p:ut A, 13.5%

II. \7 - 0.2 (17 - 10) = 1'5.6%

III.Same as part A, 14.5%

IV. As an example, assume the fund's value was $1,000 at the beginning of lasr year and it fell 10% to 900. The 17% gross return this year brings the fund's ending value to 900( 1.17) = $1,053. The returns on the fund above irs highest value ($1,000) are therefore 5.3%. Investor rerurns net of fees are: 17 - 0.2 (5.3) - 1= 14.94%.

If your approach to this part of the problem gave you a slightly differenr answer, don't be disheartened. The important part here is to understand the implications of a high watermark provision compared to an incentive structure without such a provtSlon.

C.Because the fund's returns were less than the risk-free rate, under structure (I) there would be no incentive fee, only the fixed 1% fee. Since the fund did not have a positive return, structure (II) would result in no fee and structure (IV) would result in only the 1% fee. Since the fund did outperform the S&P 500 index, structure

(I II) would result in an incentive fee of 20% of the fund return in excess of the index return, 0.2 [-13 - (-20)] = 1.4%. Therefore, structure (III) would result in the lowest retum net offees: -13 - 1 - 1.4 = -15.4%.

6.	R	-R r
	A. Sharpe ratio = p	. Therefore, R r = R p -Sharpe ratioxCJ p '
		0p

Using the hedge fund asset class data: Rr = 17.8 - 0.8(15.0) = 5.8%.

©2008 Kaplan Schweser

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Study Session 18

Cross-Reference to CFA Institutc Assigned Reading #73 - Alternative Investments

B.R p = R r + Sharpe rHio X O"inJn

Using thc S&P 500 Index data: R jndtx '"5.8 + 0.7( I 0.0) = 12.8°1i)

C.By including only funds thar have been in exisrence for hve years and reponed results for the entire f)eriod, the consultant's data ~llT subject to significant hiascs. The d:tta do not include funds whose managers choose not to report results, which arc likely to be the poorer performcrs. Likewise, the managers who do report rcsults can eng:tge in "cherry picking," reponing results only for rheir more successful funds. These charaereristics wililcad to an overesrimate of average fund rccurns.

The data would be inHuCl1ced by survivorship bias as rhey do not include funds thar ceased ro exisr during the S-year period. Funds that ceased to exisr would tend to be those wirh poor returns (biasing average fund rerUrllS upwards) and rhose rhat (Ook on more risk (biasing fund standard deviarion downward). All of these biases would pull rhe average rerurn for funds in rhe database above !Ill: true average return fClI hedge funds as an asset class.

Hedge funds ofren de;d in infrequently rr:tded assets for which market values must be esrimared using a pricing model. This tends 10 smooth Ihe assets' reponed values and m'lke the funds' volariliry appear lower than ir really is. Ar rhe same time, such model pricing will likely lead ro a downward bias in rhe correlarion of fund rerurns wirh the returns of other asset classes.

Also, for funds that use strategies with asymmetrical rermns (i.e., limired upside pOlen rial but unlimitcd downside potential), standard deviatioJl may nor adequ:nely capture the true risk LtkeJl.

The 30% recommended allocation is very likely lOa high for all or rhese reasons. The artificially high expec:red returns and artificially low standard deviarion and correlation will all tend to increase the estimate of rhe allocation to hedge funds in an optimal portfolio.

7. A. The CAPM relation is E(R) = RFR + ~\ [E(Rmk,) - RFR]. A l1egarive bela means the expected return on gold is less than the risk free rate (assuming a positive market risk premium).

R.The question here is why invesrors would choose 10 hold a risky asset rhar has

an expected rerum less than the risk-free rate. The negative systematic risk (bera) of gold gives it attractive hedging properties. When market returns are negative, returns on gold will be less so or even positive. The benehts in rerms of risk

reduction more than compensate for the decrease in portfolio expected returns from including gold in the portfolio.

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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:

INVESTING IN COMMODITIES

Study Session 18

EXAM Focus

This topic has been added this year to both the Level 1 and Level 2 curriculum. The parr you are responsible for at Level 1 includes only three LOS. The concepts of backwardation and conrango are based on the relation between currel1( (spot) prices and futures prices and are imporranr for understanding the COll1pOneIH of returns

called the roll yield, which stems from the necessity to re-establish long commodity positions as they reach their setrlemenr (delivery) dates. The fact that positions must be periodically closed out and reestablished makes even a commodity indexing strategy "active" compared (() a long equity or bond indexing strategy.

LOS 74.a: Explain the relationship betv,:een spot prices and expected futllrc prices in terms of contango and backwardation.

Contango refers to a situation in commodities futures contracts where the futures price is above the spot price, the price for current purchase and delivery of the physical commodity. This is the current situation (as of the time of writing) in the oil futures

marker. One way to view the explanation for this is based on the needs of either long or shon hedgers. With oil prices rising sharply over the last year, users of oil and

oil-related commodities are concerned with the risk they face from rising oil prices. Airlines, for example, sell tickets at prices based on expected fuel prices and are exposed to the financial consequences of increases in fuel prices above those expected to prevail in the furure.

When an end user of a commodity buys futures contracts to protect against unexpected future price increases, we refer to that futures buyer as a "long hedger," as they are hedging commodity price risk with long positions. If the predominant reason for futures positions in a commodity is to hedge the risk of price increases, long hedgers will be paying for the protection of long futures positions, which will produce gains as the futures price increases. In a situation of contango, long hedgers are bidding up the price of commodity futures and, in effect, paying a premium for the hedging benefit they get from taking long futures positions.

Backwardation refers to a situation in commodities futures contracts where the futures price is below the spot price. If the dominant traders in a commodity future are producers of the commodity hedging their exposure to financial losses arising from unexpected price declines in the future, the result will be backwardation. In this

situation, producers are paying for protection against price declines and that is reflected in futures prices which are lower than current market prices (spot prices). Historically, producers hedging the price risk of future production have been dominant in futures markets, so that backwardation was the typical situation and sometimes referred to as normal backwardation.

©2008 Kaplan Schweser

Page 27')

StlIdy Session 18

Cross-Reference to CFA Institute Assigned Reading #74 -Investing in Commodities

LOS !''i.h: Dc~njbe the sources of relurn :l1ld risk fur <1 commodity illvcstmclIt

and (hl' elfnt Oil a pon f"olio of" :llldillg ;\ long-term comll\odity das ....

An invesror who desires long exposure (() a commodity price will Iypically achieve

Ihis exposure through a dcrivalive invcslmenr in forwards or futures. Some physical

commodilies cannol be effectively purchased and slored long lerm, and for olhers, such as precious merals, derivative posilions may be a morc efficient means of gaining long exposure than purchasing Ihe commodities outrighl and storing them long ICI'm,

To take a posilio/1 in forwards or fLllures, a speculalOr or hedger musl POSI collaleral. If U.S, Treasury bills arc deposiled as collaleral, Ihe collateral yield is simply Ihe yield on Ihe Tbills. AClive managemenr of Ihe collaleral, wilhin Ihe bounds of whal is acceplable collalcral, can increase Ihe collarcral yield above Ihe 90-day T-bill raIl',

The price return on a long-only inveslment in commodilies derivalives can be posilive or negalive depending on Ihe direclion of change in the spot price for Ihc commodily over the life of the derivatives conrracl employed.

Since commodily derivalive contracls expire, a speculalOr or hedger who wants 10 maintain a position over lime musl close out the expiring derivative position and

re-establish a new position with a settlement date further in the future. This process is referred 10 as "rolling over" the posilion and leads 10 gains or losses which are termed Ihe roll yield, The roll yield can be positive or negative depending on whether the derivative contract Llsed to establish the long exposure is in backwardalion or contango, You can view this roll yield as the gains or losses that would be realized on the position if Ihe spot price remained unchanged over the life of the contract.

The futures price at expiration must equal Ihe SpOI price at that time, For a future or forward in backwardation (i.e" the futures/forward price is less than Ihe current spot price) the roll yield is positive, since an unchanged SpOI price at contract setdement would mean the futures/forward price increased over the life of the contract, and the inveslOr would have gains at settlement. For a future or forward in contango, the roll yield is negative. Since contango means the forward/futures price is greater than the spot price, an unchanged spot price over the life of the contract means the futures price will have fallen and losses will result when the position is closed out.

When commodity derivative markets were dominaled by short hedgers (commodity producers) and markets were typically in backwardation, Ihe roll yield was positive, In current market conditions, with futures and forwards in typically in contango,

the roll yield is negative. It may be the case that structural changes in the markets for commodities derivatives mean that a zero or negative roll yield has become the new norm for Ihese markets.

Adding a long commodities index position to a portfolio can provide several benefits, particularly for pension fund portfolios, Commodities provide diversification benefits because their prices tend to be uncorrelated with securities prices, and they can serve as a hedge against inflation.

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Study Session 18

Cross-Reference to CFA Institute Assigned Reading 1/74 - Investing in Commodities

LOS 74.c: Explain why cven a commodity index strategy should be considcred an active investment.

An index strategy in equities is considered a passive strategy. While changes may be necessary if one of the component stocks of the index is changed, in the absence of any change in the component stocks, no active management of an index portfolio is required. Because of the necessity of closing out and re-establishing long derivative positions to maintain long exposure to changes in commodity prices, a commodity index strategy is considered an active strategy. Managers can add value to the long-only commodity index strategy by choosing the maturities of the derivative contracts they buy and by their decisions about when to roll over their positions. To the extent that many long-only commodity derivative managers attempt to roll their positions over at the same time, they pay a premium in transactions costs, which reduces both the roll yield and overall yield of their commodity index strategy.

There arc two other aspects of commodity index investing that require active management. The weightings of various commodity and commodity blocks (such as metals or energy) in indexes do not necessarily change with the values of the derivarive positions in the portfolio. Since commodities index weightings, whether hased on commodity production or consumption, change over time, a manager who seeks to match an index must actively manage the size of the exposure to various commodity markets as positions arc rolled over. Additionally, as mentioned earlier, the short-term debt used to collateralize derivative positions must be managed as well. The collateral debt securiries mature and new ones must be purchased, and the collateral yield can be enhanced by taking advantage of market conditions as maturing collateral debt securities arc replaced.

©2008 Kaplan Schwescr

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Study Session 18

CJ'oss-Rcfcrcnce to CPA Institute Assigned Reading #74 - Investing in Commoditics

KEy CONCEPTS

I, < ..... , "

LOS 71.a

A commodity futures market is in contango if furures prices arc greater than the spot price. The market is in backwardation if futures prices arc less than the spot price.

FU(\Ires markets that are dominated by long hedgers (users of the commodity who buy futures to protect against price increases) tend to be in contango. Futurcs markcts that arc dominatcd by shan hedgcrs (produccrs of thc commodity who shan futures to protcer against price decreases) tcnd to be in backwardation.

[OS 7'1.b

The re(llm on a commodity invesUl1ent includes:

Col Lltcral yield: the rerum on the collateral posted to satisfy margin requirements.

•Price return: the gain or Joss due to changes in the spot price .

•Roll yield: the gain or loss resulting from re-establishing positions as contracts expIre.

Roll yield is positive if the futures market is in backwardation and negarive if the marker

IS III contango.

LOS 74.c

A commodity index strategy is considered an aerive investment because the manager has to decide what maturities to use for the forward or futures conrracrs and determine when to roll them over into new contracts. Acrive management is also required to manage portfolio weights to match those of the benchmark index selected and to determine the best choice of securities to post as collateral and how these should be rolled over as they 1l1arure.

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Srudy Session 18

. Cross-Rcfcrcnce to CFA Institutc Assigncd Rcading #74 - Investing in Commoditics

I.A commodiries marker rends ro be in backwardarion if:

A.ir is dominarcd by end users of rhe commodiry.

B.rhe spor price is grearC!" rhan futures prices. C. futures prices arc grearC!" rhan rhe spor price.

2.The source of return on a long-only commodiry invesrmenr rhar represenrs rhe changc in rhe spor price over rhe life of the forward or furures contran used is rhe:

A.roll yield.

B.price return. C. spor yield .

.).	hH a commodity markcr rhar is in conrango, an unchanged spot pllce over rhe
	life of a conrract will result in a roll yield rhar is:

A.zero.

B.poslllve.

C.negatIve.

4.A manager following a long-only commodity index srraregy is frasr li/u:~y to adjusr rhe portfolio:

A.to reduce exposure to a Jeclilling commodity marker.

B.for changes in rhe composirion of rhe commodiry index.

C.by closing our expiring contracts and re-esrablishing posirions in new contracrs.

©2008 Kaplan Schweser

Page 27')

Study Session 18

Cross-Reference to CFA Institute Assigned Reading #74 -Investing in Commodities

I.B Backwardarion refers [Q rhe situarion in which fmures prices are less rhan rhe spar price. Commodiry markers rend to be in backwardarion when lhey are dominared by producers of the commodity.

2.B The price rerurn results from rhe change in rhe spor price. The ro]1 yield is rhe gain or

loss rhar results from closing a posirion in an expiring contract and re-esrablishing it in a new contract, The collateral yield is the return on the collateral deposited to esrablish the posilion.

3.C For a commodiries marker in conrango, if the spor price remains unchanged, rhe furures price will decrease over irs life and rhe invesror will realize a loss ar expirarion. Thus, rhe roll yield is negarive.

1.A A long-only cOlUmodity index srrategy is always long the commodilies in the index and

rhe weighls are nor adjusted based on the performance of the posirions. The manager musr actively manage the roll our of expiring contracts as well as matching any changes in the commodiry index weightings.

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			Self-Test: Derivatives and Alternative Investments
II.	Jeff Stephenson runs a hedge fund that takes offsetting long and short positions
	so that the systematic risk of the portfolio is close to zero. Jane Carroll runs
	a hedge fund that primarily seeks to profit from large leveraged long or shorr
	positions in currencies and interest rate derivatives. These funds would most
	appropriately be classified as:
		Stephenson	Carroll
	A.	Long/short fund	Event-driven fund
	B.	Long/short fund	Global macro fund
	C.	Market neutral fund	Global macro fund

12.Harriet Lansing has used the rccent sales price of a private company to value the shares a client holds in a private company in a similar linc of business. Given that the clicnt's shares represent only 55% of thc issued and outstanding shares, she should:

A.apply a minority discount to the client's shares.

B.adjust the price by adding a liquidity premium.

C. make no adjustment for a minority intercst or lack of liquidity.

©2008 Kaplan Schweser

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