1. security market line (def, equ, chart)
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  2. SML vs CML (risk measure, application, definition, slope) table
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  3. beta (def and change in beta, equ)
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  4. Risks in PE Investing (9)
    liquidity risk - not publicly traded

    competition environment risk - fewre deals with good prospects

    agency risk - principal agent conflict

    capital risk - withdrawal of capital due to increase busienss/financial risk

    regulatory risk - adverse gov't regulation

    tax risk - treatment of returns changes

    valuation risk - reflects subjective judgement

    diversification risk - poorly diversified across stage, vintage, and strategy

    market risk - long term factors such as interest rates/exchange rates
  5. Costs of PE Investing (8)
    Transaction costs - due diligence, bank financing, legal

    fund setup-up costs: usually amortized over life of fund

    admin costs - custodian, transfer agent, and accounting costs

    audit fees: reporting

    Management fee = 2% typical

    performance fee = 20%

    dilution costs : resulting from additional rounds of financing and stock options

    placement fees: as much as 2% upfront fee or annual trailer paid to placement agents
  6. PE Structure
    limited partnership provides funding, no active role, limited liability. GP liable for all debts and unlimited liability, 10-12 year lives
  7. PE Terms (7)
    "qualified" investors only with > $1.0 mm in assets

    management fees: 1.5-2.0%

    carried interest - GP's share of profits

    Ratchet - allocation of equity between shareholders and fund management

    Hurdle Rate - IRR target before GP can receive carried interest (7-10%)

    Target fund size - Signals GP's ability to raise funds, below is negative signal

    Vintage: year fund was started
  8. PE Valuation
    NAV with frequent adjustments
  9. PE Due Diligence
    Evaluation of past performance, trends and magnitude
  10. financial performance of PE Funds (how measured) 2
    GIPS since inception IRR

    money-weighted return
  11. Paid-in-Capital (PIC)
    percent of capital used by GP
  12. Distributed to PIC (DPI)
    measure LP realized return, cash on cash return
  13. Residual Value to PIC (RVPI)
    measure LP's unrealized return
  14. Total value to PIC -
    measure LP's realized and unrealized return, sum of DPI and RVPI
  15. carried interest (equ)
    Carried Intereset % x (NAV before distributions - committed capital)
  16. NAV before distributions (equ)
    NAV before distributions = previous year NAV after distribution + capital called down - management fee + operating results
  17. NAV after Distributions (equ)
    NAV after distributions = NAV before distributions - carried interest - distributions
  18. Distributed to PIC (DPI) equ
    DPI = cumulative distributions / paid in capital
  19. Residual Value to PIC (RVPI) equ and def
    measures LP's unrealized return

    RVPI = NAV after distributions / paid-in-capital
  20. Total Value to PIC (TVPI)
    measures LP's realizsed DPI and unrealized RVPI returns

  21. post-money valuation (equ)
    POST = FV / (1+r)^N

    the value of the firm today to be future value in X years
  22. Pre-money valuation (equ)
    PRE = POST - INV

    value before investment
  23. required fractional ownership (equ)
    f = INV / POST
  24. shares required for PE firm
    Svc = S founders [f/(1-f)]
  25. stock price per share (equ)
    p = INV / Svc
  26. investor's future wealth (W) equ
    W=INV x (1+r)^N
  27. required fractional ownership for the PE firm (equ)
    f = W / FV
  28. POST-money valuation (IRR) equ
    post = P x (Spe + Se)
  29. contango
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    • when futures price > spot prices
  30. backwardation
    futures prices < spot prices
  31. futures price (equ)
    future price = spot price x (1+r)^(T-t)

    r = risk free rate

    (T-t) represents the time from today (t) to the contract maturity (T) in years
  32. Roll yield:
    roll yield is the return from closing out a maturing futures contract at one price and entering into another contract at another price
  33. main arguments against commodity futures as asset class (5)
    1) commodity prices have tended to decline in the long run

    2) roll yield is not guarangeed (and may be eliminated)

    3) rolling costs reduce returns

    4) rebalancing, rather than any change in the asset price, drives returns

    5) commodity futures do not produce cash flows
  34. main arguments for commodity futures as asset class
    short-term portfolio diversification benefits - counter cyclical

    long-term - natural hedge against inflation
  35. Basic HF characteristics
    leverage changes in freq and amount used having a significant impact on return and risk of the fund

    varied hedging techniques such as short selling with unlimited loss potential, and buying puts with only a premium loss in a rising market

    style drifts:

    portfolio turnover: rises rapidly during market turmoil

    very difficult to evaluate HF performance
  36. 3 hedge fund benchmarks
    1) broad based market indexes

    2) hedge fund indexes

    3) risk free rate
  37. types of hedge fund risk (7)
    short HF history

    credit spreads - can narrow or widen for extended periods and became a significant risk factor for FI funds

    inter-market correlations - FI correlated with equities

    intra-market correlations - even "zero-beta" arb funds have exposure

    style drift/leverage: risk-return tradeoff not favorable for manager straying from style that reflects particular expertise, leverage increases risk

    fraud risk - manager misrep quals, too good to be true, probably is

    operational risk: deficient procedures, counterparty risk
  38. Meaure risk?
    standard deviation: doesn't capture non-symmetrical distribution

    maximum drawdown - largest loss in HF history

    -doesn't give probability of loss

    Value-at-risk - Provides an estimate of both the magnitute and probability of left tail loss over a time horizon

    -prediction of future based historical data

    -assumes normal distribution
  39. Default Risk
    type of credit risk

    borrower does not repay obligation
  40. Credit spread risk
    type of credit risk

    credit spread increases, bond value falls and/or bond underperforms benchmark
  41. downgrade risk
    type of credit risk

    issue downgraded; bond value falls and/or bond underperforms benchmark
  42. 4 c's of credit analysis
    1) Character: management integrity, qualifications, track record, corporate gov structure

    2) covenants: terms/conditions of issue restricting some of management's discretion

    -affirmative: will do

    -negative: can't do

    3) collateral: assetss offered as security

    4) capacity to pay: ability to generate cash or liquidate assets to repay obligations
  43. Capacity to Repay factors (5)
    industry trends

    regulatory environment

    operating and competitive position

    financial position and liquidity sources

    company structure
  44. Short term solvency ratios (def)
    measure firm's ability to liquidate short term assets to meet short term obligations
  45. current ratio
    short term solvency ratio

    current ratio = current assets / current liabilities
  46. acid test ratio or quick ratio
    short term solvency ratio

    (current assets - inventories) / current liabilities
  47. capitalization ratios (financial leverage)
    measure use of debt in capital structure
  48. LT debt-to-cap ratio
    LT Debt / (LT debt + minority interest - SH's equity)

    capitalization ratios (financial leverage)
  49. Coverage ratios
    firm's ability to repay debt out of operating CF
  50. EBIT Coverage ratio
    Coverage ratios

    EBIT / annual interest expense
  51. EBITDA coverage ratio
    Coverage ratios

    EBITDA / annual interest expense
  52. S&P Framework (14)
    Net income

    + depreciation

    +/- other noncash items

    Funds from operations

    -increase in NWC

    Operating Cash Flow

    -capital expenditures

    Free operating cash flow

    - cash dividends

    Discretionary cash flow


    + asset disposals

    +other sources (uses)

    Prefinancing cash flow
  53. 3 cash flow analysis ratios
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  54. debt service coverage
    [free operating cash flow + interest] / [interest + annual principal repayment]

    higher better
  55. debt payback period
    total debt / discretionary cash flow

    lower better
  56. 3 issues with high yield bond debt structure
    1) floating rate: makes scenario analysis under different rates necessary

    2) short-term: means analysis of ability to pay off/rollover is necessary

    3) seniority: bank debt is repaid first in bankruptcy

    point: high yield borrowers typically have more bank debt
  57. high yield bond, corporate structure issue
    high-yield issuers frequently structured as holding companies

    requires analysis of subs

    do debt convenants have restrictions on dividends to parent? Asset sale? Intercompany loans?
  58. 4 steps of credit analysis for Asset-backed securities
    1) collateral quality - most important

    2) seller/servicer quality: higher quality means higher rating

    3) CF stress/payment structure: CF/repayemnt complex: "Waterfall"

    4) legal structure: special purpose entity (SPE)
  59. municipal bond credit - Tax backed debt def and 4 factors to analyze
    secured by some form of tax revenue

    1) issuer's debt structure (debt per capita)

    2) budgetary policy (balanced budget?)

    3) local tax and intergovernmental revenue availablity (tax collection rates)

    4) issuer's socioeconomic environment (employment trends)
  60. municipal bond credit - Revenue Bonds def and 3 factors to analyze
    finance specific projects; backed by revenue or specific tax revenue

    analysis similar to corp bonds

    1) project revenue: Amont, reliability

    2) flow of funds structure: will debt repayment be the primary use of rev

    3) other covenants (rate covenante, additional bonds test)
  61. sovereign bond credit analysis - def and 2 risks
    debt of foreign national govt

    economic risk: ability to meet debt obligations

    Political risk: willingness to meet debt obligations

    -political stability

    -integration into global economy

    -internal and external security risks

    -form of gov't/degree of participation
  62. sovereign bond credit analysis
    two ratings assigned to each national gov't

    government has more control over local currency debt repayment (tax policy, domestic spending)

    local currency depreciation increases difficulty of repaying foreign currency debt

    (one rating for local currency, one for foreign currency)
  63. Rating #1 (sov. Debt)
    local currency debt ratings

    1) political stability

    2) income base and growth

    3) economic infrastructure

    4) tax and budgetary discpline

    5) monetary policy

    *ceiling of rating 2
  64. Rating # 2 (Sov. Credit)
    balance of payments

    external balance sheet

    external debt obligations

    economic/fiscal policies
  65. Types of credit - corporate, ABS, tax-based muni, revenue muni, sovereign KEY FACTORS (table)
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  66. 2 views of liquidity
    traditional view: measured using money aggregates

    liquidity as appetite for risk viewed as function of risk aversion. Putting money in shadow bank
  67. shadow banks
    marginal sources of liquidity such as hedge funds, REITs, CDOs, etc

    incentive for investors to withdraw when risk increases
  68. 2/28 adjustable rate def(3)
    borrowerer puts no money down

    interest payments are optional

    interest rate is a 2-year teaser that adjusts up

    free "at-the-money" option
  69. 3 steps in Minsky's financial instability hypothesis
    the hedge unit

    the speculative unit

    the ponzi unit
  70. the Hedge Unit
    levered investment

    backed by sufficient income-generating capacity
  71. Speculative Unit
    riskier than a hedge unit

    backed by enough cash flow to pay interest, but not principal

    less stable as borrower is speculating that interest rates wont rise and property will not decline
  72. The Ponzi Unit

    asset cash flow can't cover interest or principal

    speculating that the property value will rise

    2006 marginal unit of debt was a ponzi unit in U.S. mortgage markets
  73. parallel shift:
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  74. Twists
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  75. butterfly shifts
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  76. 3 factors affecting treasury returns
    Factor:interest rate risk measured with

    • Rate changes: effective duration
    • slope changes: key rate duration
    • curvature changes: key rate duration
  77. bootstrapping
    calculating spot rates from securities with different maturities using yields on Treasury bonds from the yield curve

    treasury bond yields -> bootstrapping -> spot rate curve (theoretical)
  78. several options of yields to calculate term structure (4)
    all on-the-run treasury securities

    on-the-run + selected other treasureies

    all treasury securities

    treasury strips
  79. Swap rate curve (LIBOR Curve)
    yield curve: typically based on treasury securities

    swap rate curve: yield curve based on series of fixed-rate quotes on interest rate swaps

    point: increasingly preferred as benchmark

    -not affected by government regulation

    -more comparable across countries

    -quotes at more maturities
  80. 3 term structure theories (why yield curve is shaped what way)
    1) pure expectations theories: same return over any investment horizon

    2) liquidity theory

    3) preferred habitat theory
  81. Pure expectation theory
    main idea: forward rates are solely a function of expected future spot rates

    implication: long-term rates = complex mean of future expected short-term rates

    problem: assumes no interest rate uncertainty; fails to recognize:

    -price risk (if horizon < maturity)

    -reinvestment risk (if horizon > maturity)

    yield curve implications:

    upward sloping: short term rates are going to rise

    flat: interest rates stay

    downward: interest rates falling
  82. Liquidity Theory
    Main idea: implied forward rate = expectations + liquidity premium

    larger for longer maturities

    can't tell what expectation are from upward sloping curve (since it could all be liquitiy premium)

    however, can say that downward means ST rates expected to fall
  83. Preferred Habitat Theory
    Main idea: implied forward rate = expectations + premium

    premium not directly related to maturity
  84. Effective Duration
    measures price risk for small parallel shifts in yield curve

    problem: most yield curve shifts have non-parallel charateristics

    solution: use key rate duration, measures impact of non-parallel shifts
  85. Duration Impact equ
    D impact = -1 * D * change in Yield
  86. rate duration
    sensitivity of price to changes in single spot rate
  87. binomial interest rate model
    tree of up or down interest rate moves (50% each)
  88. Nominal Spread
    difference between bondyield and yield on comparable-maturity government treasury security

  89. z-spread
    spread added to each rate on spot rate curve that makes PV of bond CFs equal to market price

    spread from each spot rate that makes up for greater discount rate used in market

    use for any bond without option
  90. Option-adjusted spread (OAS)
    spread added to each rate in binomial rate tree that makes bond value calculated from binomial model equal to market price

    OAS = Z-spread - cost of embedded option
  91. over or under valued?
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  92. Benchmark interest rates
    interpretation of spread depends on benchmark rates used to create interest rate tree

    -U.S. treasury or

    - Bond sector with higher credit rating

    -specific issuer
  93. backward induction methodology
    value bond by moving backward from last period to time zero

    things to know:

    -value at maturity

    -value at any node is average PV of two possible values from next period

    -discount rate is forward rate for that node
  94. call rule:
    when firm will exercise call option
  95. call price:
    limit for each node's value
  96. embedded calls (equ)
    investors get a discount equal to call value

    Vcall = Vnoncallable - Vcallable
  97. embedded puts (equ)
    V put = V putable - V nonputable

    investors pay premium equal to put value
  98. rate volatility increases? What happens to call/puts
    value of embedded call increases, value of callable bond falls
  99. risks when benchmark = specific issuer
    only option risk

    ibm bond vs. ibm bond

    OAS only shows liquidity
  100. risks when benchmark = higher-rated bond spread
    credit risk and options risk

    OAS only represents credit
  101. Effective Duration (equ) and Effective convexity (equ)
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  102. convertible bond def
    bond convertible into fixed number of shares

    can't use binomial interest rate model, since depends on stock, not interest rates
  103. conversion ratio
    number of shares per bond
  104. market conversion price
    effective price per share when converting

    -market price of bond/conversion ratio
  105. Conversion value
    market price of stock after conversion x conversion ratio
  106. straight value
    PV of CFs if not convertible
  107. minimum value of a convertible bond
    greater of conversion value and straight value
  108. market conversion premium
    market conversion price - market price of stock
  109. market conversion premium ratio (equ)
    market conversion premium / market ratio
  110. premium payback period
    period needed to offset market conversion premium with coupons: market conversion premium / favorable income difference
  111. favorable income difference (equ)
    (ann. $ coupons - [CV ratio x ann. Divs]) / CV ratio
  112. Premium over straight value: (equ)
    (MV of bond / straight value) -1
  113. (noncallable/nonputtable) convertible bond value equ
    BV = straight bond + call on stock
  114. callable convertible bond value (equ)
    CCBV = straight bond + call on stock - call on bond
  115. CCBV if rate increases? Stock vol increases? Rates volatility increases? rates increase?
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  116. CV bonds does what to downside risk
    limits downside rirsk

    if stock price is low convertible is still worth something as a bond
  117. Conditional prepayment rate (CPR)
    generic annaul prepayment rate

    based on historical rates and expected future economic conditions
  118. CPR equ
    SMM = 1 - (1-CPR)^(1/12)

    single monthly mortality rate
  119. 100 PSA def
    assumes CPR = .2% for first month

    increasing by .2% up to month 30

    6% there after

    200 PSA = 2 x (CPR of 100 PSA)
  120. 3 main factors affecting prepayments
    1) prevailing mortgage rates

    2) housing turnover

    3) characteristics of underlying mortgages
  121. characteristics of underlying mortgages (2)
    seasoning: prepayments increase as loags season

    property location: prepayments are faster in some locations
  122. Housing turnover
    increases as rates fall

    increases as economic activity rises

    -personal income increases, more refinancing/prepayments
  123. prevailing mortgage rates
    spread between current mortgage rates and original mortgage rates

    most important factor, when rates fall, refinancing increases

    Path of mortgage rates => refinancing burnout

    known as "path dependence"

    implication: can't value MBS with the binomial model
  124. Contraction Risk
    average life decreases when rates fall and prepayments increase

    lower rates lead to more financing

    more financing shortens average MBS life
  125. Extension Risk
    average life increases as rates rise and prepayments fall

    rates rise causing prepayment to decline

    average MBS life lengthens
  126. two typical structures of CMOs
    sequential pay structure

    PAC/support structure
  127. CMOs
    Collateralized Mortgage Obligations

    created for investors having different risk needs

    CFs reallocated to different tranches, each with different contraction/extension risks
  128. Basic sequential pay CMO
    tranches retired sequentially

    all tranches receive interest

    shortest receives all principal until paid off
  129. Risk for long/short tranche
    Tranche A (shortest)

    high contraction risk, low extension risk

    tranche B, opposite
  130. PAC CMO Structure
    PAC tranches: "Guaranteed" principal payments based on sinking fund schedule

    PAC tranche has more predictable CFs and average life

    support tranche: provides prepayment protection to PAC tranches
  131. Stripped MBS
    principal and interest allocated to separate tranches
  132. Principal-only strips
    receive only principal payments, POs win if rates fall

    CF stream increases over time as principal payments increase
  133. Interest-only strips
    receive only interest payments

    IOs win if rates rise

    CF stream decreases over itme as interest payments decrease
  134. Agency vs. non-agency (3)
    agency: MBS based on underlying loans with gov't guarantee (Fanny may)

    non-agency: issued by private entities (Goldman)

    non-agency have more credit risk and therefore need credit enhancement
  135. Commercial MBS (2)
    backed by income-producing real estate

    apartments, warehouses, shopping centers, hotels
  136. difference in commercial MBS
    vs. residential

    non-recourse loan, meaning that analysis is of property income, not borrower metrics
  137. debt-to-service coverage ratio

    loan-to-value ratio
    debt-to-service coverage ratio = NOI / debt service (want high)

    loan-to-value ratio = mortgage / appraised value (want low)
  138. CMBS: call protection (2)
    1) loan level

    -prepayment lockout (2-5 years)


    -prepayment penalty points

    -yield maintenance charges

    2) CMBS structure

    -sequential tranches
  139. asset securitization parties (4)
    seller: originates assets/receivables and sells to issuer

    issuer SPV: sells ABS securities; buys receivables

    investors: buys securities; receives CFs

    servicer: collects payments
  140. two types of tranching
    1) prepayment tranching: just like mbs, tranche to redistribute prepayment risk

    2) credit tranching

    -abs have credit risk , require credit enhancement

    -tranching can redistribute
  141. amortizing assets
    payments include principal and interest
  142. non-amortizing assets
    like credit cards: no scheduled principal payments means no prepayment risk
  143. credit enhancements
    type 1: external credit enhancements

    1) corporate guarantee by seller

    2) bank letter of credit

    3) bond insurance
  144. credit enhancements
    type 2) internal credit enhancements

    1) reserve funds: cash reserve funds

    2) overcollateralization: face value < underlying collateral value

    3) senior/subordinated structure: risk tranching
  145. HEL ABS def and 2 types
    Home equity loan

    first lien on property owned by borrower with marginal credit history

    2 types:

    1) closed end: fixed rate, fully amortizing loans

    2) open end: revolving equity lines

    prepayment and tranching similar to MBS
  146. Why prepayments not sensitive to rates in HEL or Auto loan
    prepayments not sensitive to rates because

    -little savings

    -high depreciation in early years
  147. Auto Loan ABS
    prepayments significant, but not related to interest rates
  148. Collateralized debt obligations
    ABS collateralized by pool of debt obligations

    below investment grade corporate bonds, EM bonds, distresssed, MBS and ABS, etc
  149. Typical CDO Structure
    Senior tranches:70-80% of deal, floating rate

    mezzanine tranches: fixed coupon

    equity tranche: provides prepayment and credit protection
  150. Cash flow yield
    discount rate that makes market price equal to PV of cash flows (like IRR)

    major deficiencies:

    -reinvestment assumption: reinvestment risk

    -assumed held to maturity = price risk

    -CF will be realized = prepayment risk
  151. zero-volatility spread (z-spread)
    spread added to each treasury spot rate, so price = PV of CF

    CFY vs. z-spread

    CFY: considers one interest rate

    Z-spread: considers one interest rate path

    -not adequate for valuing BS
  152. monte carlo simulation model

    def, mbs value, oas
    computer simulates many rate paths

    for each path: MBS value = PV of CF along path

    need prepayment model

    MBS value = average of path values

    OAS: spread so model value = market price
  153. buy signal using OAS (2)
    large OAS

    low option cost
  154. Duration
    measures interest rate risk

    larger duration = more interest rate risk
  155. convexity
    refines estimate

    larger convexity = lower interest rate risk
  156. When to use which spread measure

    z-spread: non callable bonds

    OAS: binomial - callable bonds, CFs not path dependent

    OAS: Monte Carlo - MBS, CFs are path dependent
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