Alternative Investments: An Allocator’s Approach, Fourth Edition
By Donald R. Chambers, Hossein B. Kazemi and Keith H. Black
Contents:
Preface xxxix
Acknowlegements xli
About the Authors xlv
PART 1
Ethics Regulations and ESG
CHAPTER 1
Asset Manager Code 3
1.1 General Principles of Conduct 3
1.2 Asset Manager Code 3
1.3 Notification of Compliance 5
1.4 Additional Guidance for the Asset Manager Code 6
1.4.1 Defining a Firm 6
1.4.2 Claiming Compliance 6
1.4.3 Suitability 6
1.4.4 Protecting Client Interests 7
1.4.5 Best Execution 7
1.4.6 Third-Party Confirmation of Client Information 7
1.4.7 Risk Management 8
1.4.8 Valuation of Assets 8
1.4.9 Disclosures 8
1.4.10 Soft Dollars 8
1.4.11 Investment Process 9
1.4.12 Additional Q&As 9
CHAPTER 2
Recommendations and Guidance 11
CHAPTER 3
Global Regulation 27
3.1 Overview of Financial Market Regulation 27
3.1.1 Theories of Regulation 27
3.1.2 Principles of Securities Economic Regulation 27
3.1.3 Importance of Regulation to Some Trading Strategies 28
3.2 Regulation of Alternative Investments Within the United States 28
3.2.1 Overview of Regulatory Bodies in the US 28
3.2.2 Regulatory Framework 29
3.2.3 Regulation of Private Funds: Registration as an
Investment Adviser 30
3.2.4 Regulation of Private Funds: Investment Adviser
Obligations 32
3.2.5 Hedge Fund Registration in the United States 33
3.2.6 Public Securities, Private Securities, and Securities Act
Registration 34
3.2.7 Investment Company Act Registration 34
3.2.8 Compliance Culture and the Role of the Chief
Compliance Officer 35
3.2.9 Review of Marketing Materials 36
3.2.10 SEC Exams 36
3.2.11 Reporting Requirements 36
3.3 Alternative Investment Regulation in Europe 38
3.3.1 An Overview of the Supervisory Framework 38
3.3.2 The European Regulatory Framework 39
3.3.3 Registration and Exemptions in European Regulation 40
3.3.4 Disclosures and Marketing 41
3.3.5 Formal Risk Management 41
3.3.6 Required Reporting in European Regulation 42
3.3.7 Legal Structures 43
3.3.8 Enforcement of European Regulation 43
3.3.9 Non-EU Managers in Europe 44
3.4 Hedge Fund Regulation in Asia 45
3.4.1 Hong Kong 45
3.4.2 Singapore 46
3.4.3 South Korea 47
3.4.4 Japan 47
CHAPTER 4
ESG and Alternative Investments 49
4.1 Background on ESG and Alternative Investing 49
4.1.1 Growth in Alternatives Assets 49
4.1.2 ESG and Institutional Investors 49
4.1.3 ESG Challenges 50
4.2 ESG and Real Assets: Natural Resources 51
4.2.1 Natural Resources and Environmental Issues 51
4.2.2 Natural Resources and Social Issues 52
4.2.3 Natural Resources and Governance Issues 53
4.3 ESG and Real Assets: Commodities 53
4.3.1 Commodity Derivatives and Speculation 53
4.3.2 Commodity Speculation and Volatility 54
4.3.3 Physical Commodities and ESG 54
4.4 ESG and Real Assets: Real Estate 55
4.4.1 Real Estate Development and ESG 55
4.4.2 Real Estate Use and ESG 56
4.4.3 ESG Issues in the Treatment of Tenants, Community,
and Workers 58
4.4.4 ESG Issues in Recovery and Disposal 59
4.4.5 ESG Issues in Refurbishment and Retro-fitting 60
4.4.6 Waste Management, Resource Conservation, and
Recycling During Demolition 60
4.4.7 Land Recovery and Rehabilitation 61
4.5 ESG and Hedge Funds 61
4.5.1 Hedge Fund Investment Strategies and ESG 61
4.5.2 Hedge Fund Governance and ESG 62
4.5.3 Hedge Fund Transparency and ESG 62
4.5.4 Hedge Fund Investment Techniques and Instruments and
ESG 63
4.5.5 Hedge Fund Strategies and Underlying Investments 65
4.5.6 Hedge Fund Strategies and Activism 65
4.5.7 Hedge Fund Strategies and Avoidance 66
4.6 ESG and Private Equity 66
4.6.1 ESG within a Partnership Organization and the GP–LP
Relationship 66
4.6.2 ESG and the Private Equity Investment Process 67
4.6.3 ESG and the Monitoring Process 68
CHAPTER 5
ESG Analysis and Application 71
5.1 Background on ESG 71
5.1.1 History of ESG 71
5.1.2 The Global Reporting Initiative (GRI) Standards 71
5.1.3 Social Responsibility, ESG, and Evidence Regarding
Stakeholder Wealth 72
5.2 ESG Ratings and Scores 73
5.3 ESG Materiality and Disclosure 74
5.3.1 ESG Materiality, ESG Disclosure, and the Global
Reporting Initiative 74
5.3.2 A Framework for ESG Materiality Assessment 75
5.3.3 ESG Materiality Maps 75
5.3.4 ESG Materiality Measurement 76
5.4 The United Nations Role in ESG Issues 76
5.4.1 The Six Principles for Responsible Investment (PRI) 77
5.4.2 The Sustainable Development Goals (SDGs) 77
5.5 ESG Fiduciary Responsibilities and Regulation 78
5.5.1 ESG and Fiduciary Responsibilities in the US 78
5.5.2 ESG and Fiduciary Responsibilities in Europe 79
5.5.3 ESG and Fiduciary Responsibilities in Asia 79
5.5.4 ESG Compliance and Risk Management for Asset
Managers 80
5.6 Methods of ESG Investing 80
5.6.1 Negative versus Positive Screening 80
5.6.2 Engagement and Proxy Voting 81
5.6.3 Impact Investing 81
5.6.3.1 Two Categories Of Impact Investments 82
5.6.3.2 The Five Steps of Implementing Impact
Investing 83
5.6.3.3 Evidence from Research on Impact Investing
in Illiquid Investments 84
5.7 Market-Based Methods of Addressing ESG Issues 85
5.7.1 Background on Externalities and Markets 86
5.7.2 The Coase Theorem 86
5.7.3 Cap and Trade Programs 87
5.8 ESG and Special Investment Consideration 87
5.8.1 Special Consideration, Cash Flows, Returns, and Risk 87
5.8.2 The Case for Special Consideration of ESG Issues 87
5.8.3 The Case Against Special Consideration of ESG Issues 88
PART 2
Models
CHAPTER 6
Modeling Overview and Interest Rate Models 93
6.1 Types of Models Underlying Investment Strategies 93
6.1.1 Normative Strategies versus Positive Strategies 93
6.1.2 Theoretical versus Empirical Approaches 94
6.1.3 Applied versus Abstract Approaches 95
6.1.4 Cross-Sectional versus Time-Series Approaches 95
6.1.5 Importance of Methodology 96
6.2 Equilibrium Fixed-Income Models 96
6.2.1 Vasicek’s Short-Term Interest Rate Process 96
6.2.2 Vasicek’s Model and Expected Interest Rates 97
6.2.3 Vasicek’s Model and the Term Structure of Interest Rates 98
6.2.4 Robustness of Vasicek’s Model of the Term Structure of
Interest Rates 98
6.2.5 The Cox, Ingersoll, and Ross Model of Interest Rates 99
6.3 Arbitrage-Free Models of the Term Structure 99
6.3.1 Overview of Arbitrage-Free Interest Rate Models 99
6.3.2 A Single-Factor Arbitrage-Free Model of Interest Rates 99
6.3.3 The Ho and Lee Model in a Binomial Framework 100
6.3.4 Evaluation of the Ho and Lee Model of Interest Rates 100
6.4 The Black–Derman–Toy Model 100
6.4.1 Evolution of a Binomial BDT Tree 101
6.4.2 Calibrating the Level of Rates Based on Average Returns 101
6.4.3 Calibrating the Spread of Rates Based on Volatilities 102
6.4.4 Summary of BDT Calibration 103
6.5 P-Measures and Q-Measures 103
CHAPTER 7
Credit Risk Models 105
7.1 The Economics of Credit Risk 105
7.1.1 Adverse Selection and Credit Risk 106
7.1.2 Moral Hazard and Credit Risk 106
7.1.3 Probability of Default 107
7.1.4 Expected Credit Loss 107
7.2 Overview of Credit Risk Modeling 109
7.3 The Merton Model 110
7.3.1 Capital Structure in the Merton Model 110
7.3.2 The Merton Model and the Black–Scholes Option
Pricing Model 110
7.3.3 The Role of the Credit Spread in the Structural Model 111
7.3.4 Evaluation of the Merton Model 112
7.3.5 Four Important Properties of the Merton Model 112
7.4 Other Structural Models: KMV 117
7.4.1 Overview of the KMV Credit Risk Model 117
7.4.2 Using the KMV Model to Estimate a Credit Score 118
7.4.3 Using the KMV Model to Estimate an Expected Default
Frequency 119
7.5 Reduced-Form Models 120
7.5.1 Default Intensity in Reduced-Form Models 120
7.5.2 Default Intensity and the Probabilities of Default 120
7.5.3 Valuing Risky Debt with Default Intensity 121
7.5.4 Relating the Credit Spread to Default Intensity
and the Recovery Rate 122
7.5.5 The Two Predominant Reduced-Form Credit Models 123
7.6 Empirical Credit Models 123
7.6.1 Two Features of Empirical Credit Models 123
7.6.2 The Purpose of Altman’s Z-Score Model 124
7.6.3 The Five Determinants of Altman’s Z-Scores 124
7.6.4 Solving for the Z-Score in Altman’s Credit Scoring
Model 125
7.6.5 Interpreting Z-Scores in Altman’s Credit Scoring Model 125
CHAPTER 8
Multi-Factor Equity Pricing Models 127
8.1 Multi-Factor Asset Pricing Models 127
8.1.1 Multi-factor Asset Pricing 127
8.1.2 Asset Factors and the Role of Marginal Investor Utility
in the CAPM 128
8.1.3 Multiple Factors and “Bad Times” 128
8.1.4 Factors Based on Expected Utility or Anomalies 129
8.1.5 Three Major Categories of Factors 129
8.1.6 Theoretically versus Empirically Derived Multifactor
Return Models 129
8.1.7 Fundamentals of Empirical Models 130
8.1.8 The Tradability of Factors and the Intercept 130
8.2 FAMA–French Models 131
8.2.1 The Original Fama–French Model 131
8.2.2 The Fama–French–Carhart Model 131
8.2.3 Models with Numerous Factors 132
8.3 Three Challenges of Empirical Multi-Factor Models 133
8.3.1 False Identification of Factors 133
8.3.2 Factor Return Correlation versus Causation 134
8.3.3 Why the CAPM May Not Be Sufficient 134
8.4 Factor Investing 135
8.4.1 The Emergence of Return Factor Analysis and Three
Important Observations 135
8.4.2 How Return Factors Are Described 136
8.4.3 Risk Premiums Vary across Return Factors 138
8.4.4 Factor Returns Vary across Market Conditions 138
8.4.5 Return Factors and Investability 139
8.4.6 Risk Allocation Based on Return Factors 140
8.4.7 Performance with Allocations Based on Return Factors 140
8.5 The Adaptive Markets Hypothesis 141
8.6 Time-Varying Volatility 142
8.6.1 Equity Market Volatility is Predictable 142
8.6.2 Volatility is Negatively Correlated with Average Returns 142
8.6.3 Time-Varying Volatility and Multiple Factors 143
8.6.4 Time-Varying Volatility and Higher Moments 143
8.7 Stochastic Discount Factors 143
8.7.1 Traditional Discount Factors 144
8.7.2 Stochastic Discount Factors Example 144
8.7.3 Stochastic Discount Factors Present Value Formula 144
8.7.4 The Importance of Stochastic Discount Factors 145
8.8 Summary of Multiple-Factor Asset Allocation 145
CHAPTER 9
Asset Allocation Processes and the Mean-Variance Model 147
9.1 Asset Allocation Processes and the Mean-Variance Model 147
9.1.1 Origin of Mean-Variance Optimization 147
9.1.2 The Tradeoff Between Expected Return and Volatility 148
9.1.3 Evaluating Risk and Return with Utility 149
9.1.4 Risk Aversion and the Shape of the Utility Function 150
9.1.5 Expressing Utility Functions in Terms of Expected
Return and Variance 151
9.1.6 Expressing Utility Functions with Higher Moments 152
9.1.7 Expressing Utility Functions with Value at Risk 153
9.1.8 Finding Investor Risk Aversion from the Asset
Allocation Decision 153
9.1.9 Managing Assets with Risk Aversion and Growing
Liabilities 155
9.2 Implementation of Mean-Variance Optimization 155
9.2.1 Mean-Variance Optimization 155
9.2.2 Mean-Variance Optimization with a Risky and Riskless
Asset 157
9.2.3 Mean-Variance Optimization with Growing Liabilities 157
9.2.4 Mean-Variance Optimization and 𝜆 158
9.3 Mean-Variance Optimization with Multiple Risky Assets 160
9.3.1 A Riskless Asset and the Linearity of Efficient Frontier 160
9.3.2 A Riskless Asset with Multiple Risky Assets 160
9.3.3 Unconstrained Optimization and Unrealistic Weights 161
9.4 Mean-Variance Optimization and Hurdle Rates 162
9.5 Issues in Using Optimization for Portfolio Selection 163
9.5.1 Optimizers as Error Maximizers 163
9.5.2 Portfolio Optimization and Smoothing of Illiquid
Returns 164
9.5.3 Data Issues for Large-Scale Optimization 165
9.5.4 Mean-Variance Ignores Higher Moments 165
9.5.5 Three Ways to Address Skewness and Kurtosis 166
9.6 Adjustment of the Mean-Variance Approach for Illiquidity 166
9.6.1 The Liquidity Penalty Function 166
9.6.2 Examples of Adjusting for Illiquidity 167
9.6.3 Takeaway Points on Illiquidity Adjustments 167
9.7 Adjustment of the Mean-Variance Approach for Factor Exposure 168
9.8 Mitigating Estimation Error Risk in Mean-Variance Optimization 168
9.8.1 Estimation Error Risk Reduction through Objective
Measures of Estimation Error Risk 169
9.8.2 Resampling to Reduce the Effect of Estimation Error 169
9.8.3 Shrinkage to Reduce the Effect of Estimation Error 170
9.8.4 Mean-Variance Optimization and the Black–Litterman
Approach 172
9.8.5 Mean-Variance Optimization and the Use
Of Constraints 172
CHAPTER 10
Other Asset Allocation Approaches 175
10.1 The Core–Satellite Approach 175
10.2 Top-Down and Bottom-Up Asset Allocation Approaches 176
10.2.1 Overview of Bottom-Up and Top-Down Approaches 176
10.2.2 Bottom-Up Approach 176
10.2.3 Top-Down Approach 177
10.2.4 Mixed Approach 177
10.3 Risk Budgeting 178
10.3.1 Overview of Risk Budgeting 178
10.3.2 Specifications in Risk Budgeting 179
10.3.3 Defining Risk in Risk Budgeting and Risk Buckets 179
10.3.4 Defining an Objective to Obtain a Unique Solution 180
10.3.5 Including Correlations and Viewing Marginal Risks 180
10.3.6 Including Expected Returns with Risk Budgeting 180
10.4 A Factor-Based Example of Implementing A Risk Budgeting
Approach 181
10.4.1 Attributing the Risk of a Portfolio to Three Attributes
of Each Asset 181
10.4.2 Using Factor-Based Returns and Factor-Based Risk
Buckets 182
10.4.3 Calculating the Risk Contribution to Each Factor 183
10.5 Risk Parity 183
10.5.1 Overview of Risk Parity 184
10.5.2 Risk Parity with Two Risky Assets 184
10.5.3 Risk Parity, Leverage, and Sharpe Ratios 185
10.5.4 Three Steps in Implementing the Risk-Parity Approach 186
10.5.5 An Example of Creating a Portfolio Using the
Risk-Parity Approach 186
10.5.6 The Primary Economic Rationale for the Risk-Parity
Approach 187
10.5.7 The Volatility Anomaly and Risk Parity 188
10.5.8 Criticisms of Three Popular Rationales for Risk Parity 188
10.6 Other Quantitative Portfolio Allocation Strategies 189
10.6.1 The Market-Weighted Strategy 189
10.6.2 An Equally Weighted or 1/N Diversification Strategy 190
10.6.3 Inverse Volatility-Weighted Portfolio Strategies 190
10.6.4 Minimum Volatility Portfolio Allocation Strategies 191
10.6.5 Equivalence Between Allocation Strategies 191
10.6.6 Risk Allocation Based on Return Factors 192
10.6.7 Four Practical Issues with Allocating Based
on Return Factors 192
10.7 The New Investment Model 193
PART 3
Institutional Asset Owners and Investment Policies
CHAPTER 11
Types of Asset Owners and the Investment Policy Statement 197
11.1 Endowments and Foundations 197
11.2 Pension Funds 198
11.3 Sovereign Wealth Funds 199
11.4 Family Offices 199
11.5 Strategic Asset Allocation: Risk and Return 199
11.5.1 Basing Strategic Asset Allocations on Observation
and Reasoning 199
11.5.2 Reasons That Alternative Assets Raise Return
Estimation Challenges 200
11.5.3 Reasons for Placing Caps and Floors on Asset
Allocations 201
11.6 Asset Allocation Objectives 202
11.7 Investment Policy Constraints 202
11.7.1 Internal and External Constraints 202
11.7.2 Three Types of Internal Constraints 202
11.7.3 Two Types of External Constraints 203
11.8 Investment Policy Statements for Institutional Asset Owners 204
11.8.1 Six Benefits to a Thoughtfully Developed IPS 204
11.8.2 Introduction, Scope, and Purpose 205
11.8.3 Roles and Responsibilities 207
11.8.4 Investment Objectives 209
11.8.5 Time Horizon 210
11.8.6 Risk Tolerance 211
11.8.7 Spending Policy 212
11.8.8 Asset Allocation Guidelines 213
11.8.9 Selection and Retention Criteria for Investment
Managers or Funds 214
11.8.10 Strategic Investment Guidelines 215
11.8.11 Performance Measurement and Evaluation 216
11.8.12 Additional Considerations 217
11.8.13 Conclusion 218
CHAPTER 12
Foundations and the Endowment Model 221
12.1 Defining Endowments and Foundations 221
12.2 Intergenerational Equity, Inflation, and Spending Challenges 224
12.3 The Endowment Model 226
12.3.1 Asset Allocation in the Endowment Model 226
12.3.2 The Endowment Model’s Case Against Bonds 227
12.3.3 Alternative Investments in the Endowment Models 228
12.4 Why Might Large Endowments Outperform? 228
12.4.1 Six Attributes of the Endowment Model 229
12.4.2 An Aggressive Asset Allocation 229
12.4.3 Effective Investment Manager Research 230
12.4.4 First-Mover Advantage 231
12.4.5 Access to a Network of Talented Alumni 232
12.4.6 Acceptance of Liquidity Risk 232
12.4.7 Sophisticated Investment Staff and Board Oversight 233
12.4.8 Outsourced CIO Model 233
12.5 Risks of the Endowment Model 234
12.5.1 Spending Rates and Spending Rules 234
12.5.2 Spending Rates and Inflation 235
12.5.3 Spending Rates and Liquidity Issues 236
12.5.4 Spending Rates and Liquidity-Driven Investors 237
12.5.5 Avoiding Liquidity Losses from a Financial Crisis 238
12.5.6 Leverage Risk and the Endowment Model 238
12.6 Liquidity Rebalancing and Tactical Asset Allocation 239
12.7 Tail Risk 240
12.8 Conclusion 242
CHAPTER 13
Pension Fund Portfolio Management 245
13.1 Development, Motivations, and Types of Pension Plans 245
13.1.1 Development of Pension Plans 245
13.1.2 Motivations for Using Pension Plans 245
13.1.3 Three Basic Types of Pension Plans 247
13.2 Risk Tolerance and Asset Allocation 247
13.2.1 Three Approaches to Managing the Assets of Defined
Benefit Plans 247
13.2.2 Four Factors Driving the Impact of Liabilities
on a Plan’s Risk 248
13.2.3 Five Major Factors Affecting the Risk Tolerance
of the Plan Sponsor 249
13.2.4 Strategic Asset Allocation of a Pension Plan Using Two
Buckets 250
13.3 Defined Benefit Plans 251
13.3.1 Pension Plan Portability and Job Mobility 251
13.3.2 Defining Liabilities: Accumulated Benefit Obligation and
Projected Benefit Obligation 252
13.3.3 Funded Status and Surplus Risk 253
13.3.4 Why Defined Benefit Plans Are Withering 255
13.3.5 Asset Allocation and Liability-Driven Investing 257
13.3.6 Liability-Driven Pension Investing 257
13.4 Governmental Social Security Plans 258
13.5 Contrasting Defined Benefit and Contribution Plans 259
13.5.1 Defined Contribution Plans 259
13.5.2 Plan Differences in Portability, Longevity Risk, and
Investment Options 259
13.5.3 Asset Allocation in Defined Contribution Plans 260
13.5.4 Target-Date Funds and Alternative Investments within
Pension Plans 261
13.6 Annuities for Retirement Income 262
13.6.1 Financial Phases Relative to Retirement 262
13.6.2 Three Important Risks to Retirees 263
13.6.3 Estimating Exposure to Longevity Risk 263
13.6.4 Two Major Types of Annuities 264
13.6.5 Analysis of the Value of a Growth Annuity 264
13.7 Conclusion 266
CHAPTER 14
Sovereign Wealth Funds 269
14.1 Sources of Sovereign Wealth 269
14.1.1 Accounting for Changes in the Reserve Account 269
14.1.2 Changes in the Reserve Account and Five Drivers
of Currency Exchange Rates 270
14.1.3 Fixed versus Floating Rule Policies 271
14.1.4 Commodity Exports and the Reserve Account 271
14.2 Four Types of Sovereign Wealth Funds 272
14.2.1 Stabilization Funds 272
14.2.2 Savings Funds 273
14.2.3 Reserve Funds 273
14.2.4 Development Funds 274
14.3 Establishment and Management of Sovereign Wealth Funds 274
14.3.1 Four Common Motivations to Establishing a Sovereign
Wealth Fund 275
14.3.2 Investment Management of Sovereign Wealth Funds 275
14.3.3 Dutch Disease and Sterilization Policies 276
14.3.4 Managing the Size of a Sovereign Wealth Fund 277
14.4 Governance and Political Risks of SWFs 277
14.4.1 Governance of SWFs 277
14.4.2 Impact of SWF Investments on Portfolio Companies 278
14.4.3 Ten Principles of the Linaburg–Maduell Transparency
Index 278
14.4.4 Santiago Principles 278
14.5 Analysis of Three Sovereign Wealth Funds 279
14.5.1 Government Pension Fund Global (Norway) 279
14.5.2 China Investment Corporation 280
14.5.3 Temasek Holdings (Singapore) 281
14.6 Conclusion 282
CHAPTER 15
Family Offices and the Family Office Model 285
15.1 Identifying Family Offices 285
15.2 Goals, Benefits, and Business Models of Family Offices 286
15.2.1 General Goals of the Family Office 286
15.2.2 Benefits of the Family Office 286
15.2.3 Models and Structure of the Family Office 287
15.3 Family Office Goals by Generations 290
15.3.1 First-Generation Wealth 290
15.3.2 Risk Management of First-Generation Wealth 290
15.3.3 Benchmarking First-Generation Wealth 292
15.3.4 Goals of the Second Generation and Beyond 292
15.4 Macroeconomic Exposures of Family Offices 295
15.5 Income Taxes of Family Offices 297
15.5.1 Tax Efficiency and Wealth Management 297
15.5.2 Taxability of Short-Term and Long-Term Capital Gains 298
15.5.3 Tax Efficiency and Hedge Fund Investment Strategies 299
15.6 Lifestyle Assets of Family Offices 300
15.6.1 Art as a Lifestyle Asset 300
15.6.2 Lifestyle Wealth Storage and Other Costs 301
15.6.3 Lifestyle Assets and Portfolio Management 302
15.6.4 Concierge Services 302
15.7 Family Office Governance 304
15.7.1 Governance Structures of Family Offices 304
15.7.2 The Challenges of Family Wealth Sustainability 305
15.7.3 Strategies to Maintain Family Wealth 305
15.7.4 Family Office Inheritance and Succession Strategies 306
15.8 Charity, Philanthropy, and Impact Investing 307
15.8.1 Charity and Philanthropy 307
15.8.2 Impact Investing 308
15.9 Ten Competitive Advantages of Family Offices 310
PART 4
Risk and Risk Management
CHAPTER 16
Cases in Tail Risk 315
16.1 Problems Driven by Market Losses 315
16.1.1 Amaranth Advisors, LLC 315
16.1.2 Long-Term Capital Management 318
16.1.3 Carlyle Capital Corporation 319
16.1.4 Declining Investment Opportunities and Leverage 320
16.1.5 Behavioral Biases and Risk Taking 321
16.1.6 Volatility of Volatility Derivatives in February 2018 322
16.2 Trading Technology and Financial Crises 324
16.2.1 Quant Crisis, August 2007 324
16.2.2 The Flash Crash of 2010 325
16.2.3 Knight Capital Group 325
16.3 Failures Driven by Fraud 326
16.3.1 Bayou Management 327
16.3.2 Bernie Madoff 329
16.3.3 Lancer Group 331
16.3.4 Venture Capital Startup: Theranos 333
16.4 Four Major lessons From cases in Tail Events 334
CHAPTER 17
Benchmarking and Performance Attribution 337
17.1 Benchmarking and Performance Attribution Overview 337
17.1.1 Active Return in Benchmarking 337
17.1.2 The Bailey Criteria for a Useful Benchmark 338
17.1.3 Selecting a Benchmark for Alternative Investments 338
17.1.4 Benchmarking Liquid Alternative Investments 339
17.2 Single-Factor Benchmarking and Performance Attribution 340
17.2.1 An Example of Single-Factor Benchmarking 340
17.2.2 Three Considerations in Benchmarking 341
17.2.3 Single-Factor Market Model Performance Attribution 341
17.2.4 Examining Time-Series Returns with a Single-Factor
Market-Based Regression Model 343
17.2.5 Application of Single-Factor Benchmarking 343
17.3 Multi-Factor Benchmarking 344
17.3.1 An Example of Multi-factor Benchmarking 344
17.3.2 The Bias from Omitted Factors in Benchmarking 345
17.3.3 Multi-factor versus Single-factor Methods 345
17.4 Distinctions Regarding Alternative Asset Benchmarking 346
17.4.1 Why Not Apply the CAPM to Alternative Assets? 346
17.4.2 Reason 1: Multi-period Issues 346
17.4.3 Reason 2: Nonnormality 347
17.4.4 Reason 3: Illiquidity of Returns and Other Barriers
to Diversification 347
17.4.5 Reason 4: Investor-Specific Assets or Liabilities 348
17.4.6 Summary of Why Multiple-Factor Models May be
Preferable 348
17.5 Benchmarking of Commodities 348
17.5.1 Weighting All Positions on Value versus Quantity 349
17.5.2 The Three Schemes Used to Weight Commodities
Sectors and Components 349
17.5.3 Total Return versus Excess Return 349
17.5.4 Roll Method 350
17.5.5 Three Generations of Commodity Indices 350
17.6 Three Approaches to Benchmarking Managed Futures Funds 351
17.6.1 Benchmarking with Long-Only Futures Contracts 351
17.6.2 Benchmarking CTAs with Peer Groups 351
17.6.3 Benchmarking CTAs with Algorithmic Indices 351
17.6.4 Five Conclusions from Evidence on CTA Benchmarking 352
17.7 Benchmarking Private Equity Funds 352
17.7.1 Listed Asset-Based Benchmarks 352
17.7.2 Public Equity Indices and the Public Market Equivalent
(PME) Method 353
17.7.3 Key Computations in the Public Market Equivalent
(PME) Method 355
17.7.4 Extensions to the PME Method and Other Related
Performance Metrics 357
17.8 Group Peer Returns as Benchmarks 357
17.9 Benchmarking Real Estate 358
17.9.1 Benchmarking Core Real Estate with Cap Rates 358
17.9.2 Benchmarking Core Real Estate with a Risk Premium
Formula 358
17.9.3 Three Approaches to Benchmarking Noncore Real
Estate 359
17.9.4 Examples of Benchmark Return Estimates for Noncore
Style Assets 360
CHAPTER 18
Liquidity and Funding Risks 363
18.1 Margin Accounts and Collateral Management 363
18.1.1 Three Specialized Terms for Futures Account Levels 363
18.1.2 Collateral and Margin for Futures Portfolios 364
18.1.3 Margin Across Multiple Clearinghouses 365
18.1.4 Capital at Risk for Managed Futures 366
18.2 Value at Risk for Managed Futures 367
18.2.1 Value at Risk for a Portfolio as a Quantile 367
18.2.2 VaR Using a Parametric Approach with Variance Based
on Equal Return Weighting 368
18.2.3 Parametric VaR Using a Variance based on Unequal
Return Weighting 368
18.2.4 Confidence Intervals with Parametric VaR 369
18.3 Other Methods of Estimating Liquidity Needs 369
18.3.1 Simulation Analysis and Potential Managed Futures
Losses 370
18.3.2 Omega Ratio and Managed Futures 371
18.3.3 Interpreting the Omega Ratio 372
18.4 Smoothed Returns on Illiquid Funds 373
18.4.1 Smoothed Asset Returns and Unsmoothing 373
18.4.2 Price Smoothing and Arbitrage in a Perfect Market 374
18.4.3 Persistence in Price Smoothing 374
18.4.4 Problems Resulting from Price Smoothing 375
18.5 Modeling Price and Return Smoothing 375
18.5.1 Reported Prices as Lags of True Prices 376
18.5.2 Modeling True Returns from Smoothed Returns 377
18.5.3 Four Reasons for Smoothed Prices and Delayed Price
Changes in an Index 377
18.6 Unsmoothing a Hypothetical Return Series 378
18.6.1 Unsmoothing Returns Based on First-Order
Autocorrelation 378
18.6.2 The Three Steps of Unsmoothing 379
18.6.3 An Example of Unsmoothing with the Three Steps 379
18.7 Unsmoothing Actual Real Estate Return Data 380
18.7.1 The Smoothed Data and the Market Data 381
18.7.2 Estimating the First-Order Autocorrelation Coefficient 382
18.7.3 Unsmoothing the Smoothed Return Series 383
18.7.4 The Relation between the Variances of True and
Reported Returns 383
18.7.5 The Relation between the Betas of True and Reported
Returns 384
18.7.6 Interpreting the Results of Unsmoothing 386
CHAPTER 19
Hedging, Rebalancing, and Monitoring 389
19.1 Managing Alpha and Systematic Risk 389
19.1.1 Separating Alpha and Beta 389
19.1.2 Hedging Systematic Risk 389
19.1.3 Porting Alpha 390
19.2 Managing the Risk of a Portfolio with Options 391
19.2.1 Put–Call Parity as a Foundation for Risk Analysis 391
19.2.2 Option Sensitivities 392
19.2.3 Delta of a Simple Call Option and Put Option 393
19.2.4 Viewing Options as Volatility Bets 393
19.3 Delta-Hedging of Option Positions 394
19.3.1 Construction of a Binomial Stock and Call Option Tree
in a Risk-Neutral World 394
19.3.2 Performing Arbitrage on a Properly Priced Option 395
19.3.3 Performing Arbitrage on a Mispriced Option 396
19.3.4 Geometric Motion and Delta-Hedging 398
19.4 Three Key Observations on Delta-Hedging 399
19.5 Three Observations on Rebalancing Delta-Neutral Option
Portfolios 400
19.6 Rebalancing Portfolios with Directional Exposures 401
19.6.1 Rebalancing, Mean-Reversion, Trending, and
Randomness 401
19.6.2 Rebalancing When Assets Follow a Random Walk 402
19.6.3 Rebalancing When Individual Assets Trend 403
19.6.4 Rebalancing When Individual Asset Prices Mean-Revert 404
19.6.5 Empirical Evidence on the Effect of Rebalancing on
Return 405
19.6.6 The Effects of Rebalancing When Prices Do Not
Mean-Revert 406
19.7 Mean-Reversion and Diversification Return 407
19.7.1 Benefits of Mean-Reversion in Commodity Investing 407
19.7.2 Benefiting from Mean-Reversion through Portfolio
Rebalancing 407
19.7.3 Volatility Reduction Enhances Geometric Mean
Returns, Not Expected Values 408
19.7.4 Summary of Rebalancing 408
19.8 Investment Monitoring 409
19.8.1 Portfolio and Individual Asset Monitoring 409
19.8.2 Six Activities of Monitoring Private Partnerships 410
19.8.3 Monitoring Objectives 410
19.8.4 Forms of Active Involvement in the Fund’s Governance
Process 410
19.8.5 Forms of Active Involvement Outside the Fund’s
Governance Process 411
19.8.6 Three Ways to Create Value through Monitoring 411
19.8.7 Two Limits to the Detail and Extent of Information
Available from Monitoring 412
CHAPTER 20
Risk Measurement, Risk Management, and Risk Systems 413
20.1 Overview of Risk Measurement and Aggregation 413
20.1.1 Risk and the Investment Mandate 413
20.1.2 The Five Components of Risk Measurement 414
20.1.3 Risk Measurement at the Investment/Position Level 414
20.1.4 Risk Measurement and Frequency of Data Collection 416
20.1.5 Risk Aggregation and Systems Development 417
20.1.6 Risk Measurement and Dimensions of Risk 419
20.1.7 An Example of Dimensions of Risk Reporting
for an Alternative Investment 420
20.2 Categories of Information to be Considered 422
20.2.1 Quantitative Information Categories and Associated
Statistics 422
20.2.2 Due Diligence Tracking Matrices 423
20.2.3 Qualitative Information Categories 423
20.3 Risk Measurement with Daily Frequency of Data Collection 424
20.4 Risk Measurement with Weekly Frequency of Data Collection 425
20.5 Risk Measurement with Monthly Frequency of Data Collection 426
20.6 Risk Measurement with Quarterly Frequency of Data Collection 427
20.7 Risk Measurement with Annual Frequency of Data Collection
or Rolling Time Periods 427
20.8 Cybersecurity for Fund Managers 429
20.8.1 Vulnerability of Investment Organizations
to Cybersecurity Issues 430
20.8.2 Achieving a State of Preparedness Regarding
Cybersecurity 430
20.8.3 Evidence on Regularity with Which Cybersecurity
Functions Were Observed 430
20.8.4 Evidence on Areas Requiring Improved Policies 431
20.8.5 Evidence on Robust Policies and Procedures Worth
Emulating 431
20.8.6 Cybersecurity and EU Regulation 432
20.8.7 Cybersecurity and Asian Regulation 432
20.9 Risk Management Structure and Process 432
20.9.1 Three Models of Risk Management Structure 433
20.9.2 The Investment Process as Primarily a Risk Process 433
20.9.3 The Evolution of Risk Reporting 434
PART 5
Methods for Alternative Investing
CHAPTER 21
Valuation and Hedging Using Binomial Trees 439
21.1 A One-Period Binomial Tree and Risk-Neutral Modeling 439
21.1.1 A One-Period Model of Default Risk with
Risk-Neutrality 439
21.1.2 A One-Period Model With A Risk Premium For Default 440
21.1.3 P-measures, Q-measures, and the Power of Risk-Neutral
Modeling 441
21.1.4 Four Key Concepts of Risk-Neutral Modeling 441
21.2 Multi-Period Binomial Trees, Values, and Mean Rates 442
21.2.1 A Trinomial Tree Model Based on Prices 442
21.2.2 Two-Period Binomial Tree Model with Compounded
Returns 443
21.2.3 Three Fallacies Generated by Averaging Compounded
Rates of Return 444
21.3 Valuation of Convertible Securities with a Binomial Tree Model 445
21.3.1 Forming a Tree of Stock Prices 445
21.3.2 The Tree of Prices for a Call Option on an Equity 448
21.3.3 The Tree of Prices for the Bond’s Underlying Stock 449
21.3.4 The Tree of Prices for the Convertible Bond’s Underlying
Stock 450
21.3.5 Valuing the Convertible Bond One Period Prior
to Its Maturity 451
21.3.6 Determining the Current Value of the Convertible Bond 452
21.4 Valuing Callable Bonds with a Tree Model 452
21.4.1 A Two-Period Binomial Tree 453
21.4.2 Modeling the Spread Between Upward and Downward
Shifting Rates 454
21.4.3 Calculating a Two-Period Straight Bond Price with a
Binomial Tree 454
21.4.4 Calculating a Two-Period Callable Bond Price with a
Binomial Tree 456
21.5 Tree Models, Visualization, and Two Benefits to Spreadsheets 458
CHAPTER 22
Directional Strategies and Methods 459
22.1 Efficiently Inefficient Markets 459
22.2 Technical Directional Strategies Overview 460
22.2.1 Metrics of Technical Analysis 460
22.2.2 Trend-Following or Momentum Models 461
22.2.3 Market Divergence 462
22.2.4 Measuring Market Divergence of an Individual Asset 463
22.2.5 Interpreting Market Divergence 463
22.2.6 Measuring Market Divergence 465
22.2.7 Technical Strategies Based on Machine Learning 466
22.2.8 Risks of Directional Technical Strategies 467
22.3 Fundamental Directional Strategies 467
22.3.1 Overview of Fundamental Directional Strategies 468
22.3.2 The Bottom-Up Approach of Fundamental Analysis 468
22.3.3 Fundamental Bottom-Up Equity Valuation Models 468
22.3.4 Four Procedures within the Fundamental Investment
Process 470
22.3.5 Four Mechanics of Fundamental Strategies 471
22.3.6 The Top-Down Approach of Fundamental Analysis 471
22.3.7 Top-Down Managers and Schools of Thought 472
22.3.8 Two Risks of Directional Fundamental Strategies 472
22.4 Directional Strategies and Behavioral Finance 473
22.4.1 Sentiment Sensitivity 473
22.4.2 Overconfidence 474
22.4.3 Behavioral Biases From Over-Reliance on the Past 474
22.4.4 Other Potential Sources of Pricing Anomalies 476
22.5 Directional Trading and Factors 476
22.5.1 Emphasis on Value versus Growth Investing 476
22.5.2 Directional Trading Based on Momentum 477
22.5.3 Emphasis on Illiquidity Premiums 477
CHAPTER 23
Multivariate Empirical Methods and Performance Persistence 479
23.1 Statistical Factors and Principal Component Analysis 479
23.1.1 Principal Component Analysis and Types of Factors 479
23.1.2 The Basics of Principal Component Analysis 480
23.1.3 The Two Primary Outputs of Principal Component
Analysis 480
23.1.4 An Example of Applying and Interpreting a Principal
Component Analysis 481
23.1.5 Three Key Differences Between Principal Component
Analysis and Factor Analysis 483
23.2 Multi-Factor Models and Regression 483
23.2.1 Selecting Factors for Multi-factor Regression 483
23.2.2 Multicollinearity 484
23.2.3 Selecting the Number of Factors and Overfitting 485
23.3 Partial Autocorrelations and Regression 485
23.3.1 Intuition of Partial Autocorrelations 485
23.3.2 Estimation of Partial Autocorrelations 486
23.3.3 Partial Autocorrelations of a Return Series Based
on Appraisals 486
23.4 Three Dynamic Risk Exposure Models 487
23.4.1 The Nonlinear Exposure of Perfect Market-Timing
Foresight 487
23.4.2 The Dummy Variable Approach to Dynamic Risk
Exposures 488
23.4.3 The Separate Regression Approach to Dynamic Risk
Exposures 489
23.4.4 The Quadratic Approach to Dynamic Risk Exposures 489
23.5 Two Approaches to Modeling Changing Correlation 489
23.5.1 Conditional Correlation Modeling Approach 490
23.5.2 Interpreting an Example of Conditional Correlations 490
23.5.3 Variations on Conditional Empirical Analyses 491
23.5.4 Rolling Window Modeling Approach 492
23.6 Four Multi-Factor Approaches to Understanding Returns 493
23.6.1 Understanding Style Analysis and Fund Groupings
Based on Asset Classes 493
23.6.2 Understanding Funds Based on Strategies 494
23.6.3 Understanding Funds Based on Market-wide Factors 495
23.6.4 Understanding Funds Based on Specialized Market
Factors 496
23.7 Evidence on Fund Performance Persistence 496
23.7.1 Performance Persistence Based on Return Correlations 497
23.7.2 Performance Persistence Based on Risk-Adjusted Returns 497
23.7.3 Performance Persistence Based on Portfolio Returns 498
CHAPTER 24
Relative Value Methods 499
24.1 Overview of Relative Value Methods 499
24.1.1 Arbitrage and Risks in Relative Value Strategies 500
24.1.2 Pure Arbitrage and Risk Arbitrage 500
24.1.3 Limits to Arbitrage 500
24.1.4 Two Examples of Nearly Pure Arbitrage 501
24.1.5 Two Examples of Risk Arbitrage 501
24.2 Types of Pairs Trading and the Four Typical Steps 502
24.3 Statistical Pairs Trading of Equities 503
24.3.1 Statistical Pairing using the Co-Integration Approach 504
24.3.2 Identification and Timing of Trade Entry Opportunities 505
24.3.3 The Nature and Performance of Pairs-Trading Strategies 505
24.4 Pairs Trading in Commodity Markets Based on Spreads 506
24.4.1 Commodity Derivatives Calendar Spreads 506
24.4.2 Estimating the Profitability of Calendar Spread Trading 507
24.4.3 Processing Spreads 508
24.4.4 The Economics of Processing Spreads to Producers
and Speculators 509
24.4.5 Substitution Commodity Spreads 509
24.4.6 Quality and Location Spreads 511
24.4.7 Intramarket Relative Value Strategies 512
24.5 Pairs Trading in Rates from Fixed Income and Currency Markets 512
24.6 Relative Value Market-Neutral Strategies and Portfolio Risks 514
24.6.1 Risks of Pairs-Trading Strategies 514
24.6.2 Equity Market-Neutral Strategy 516
24.6.3 Risks Related to Equity Market Neutrality 517
CHAPTER 25
Valuation Methods for Private Assets: The Case of Real Estate 519
25.1 Depreciation Tax Shields 519
25.1.1 Valuation of the Depreciation Tax Shield 520
25.1.2 Computation of the Depreciation Tax Shield 520
25.1.3 Viewing Depreciation as Generating an Interest-Free
Loan 521
25.2 Deferral of Taxation of Gains 522
25.2.1 Return with Annual Taxation of Gains 522
25.2.2 Return with Deferred Taxation of Gains 522
25.2.3 Depreciation, Deferral, and Leverage Combined 523
25.3 Comparing After-Tax Returns for Various Taxation Scenarios 524
25.3.1 Real Estate Example without Taxation 524
25.3.2 After-Tax Returns When Depreciation Is Not Allowed 524
25.3.3 Return When Accounting Depreciation Equals
Economic Depreciation 526
25.3.4 Return When Accounting Depreciation Is Accelerated 526
25.3.5 Return When Capital Expenditures Can Be Expensed 527
25.3.6 Depreciation and Heterogenous Marginal Tax Rates
Among Investors 529
25.4 Transaction-Based Indices: Repeat-Sales 529
25.4.1 Overview and Example of the Repeat-Sales Method 530
25.4.2 Two Advantages of the Repeat-Sales Method 531
25.4.3 Three Disadvantages of the Repeat-Sales Method 531
25.5 Transaction-Based Indices: Hedonic 532
25.5.1 Overview of the Hedonic-Pricing Method 532
25.5.2 Three Steps to Calculating a Hedonic Price Index 532
25.5.3 A Simplified Example of the Hedonic-Pricing Approach 533
25.5.4 Three Primary Advantages of the Hedonic-Pricing
Model 534
25.5.5 Three Primary Disadvantages of the Hedonic-Pricing
Model 535
25.6 Sample Bias and the Repeat-Sales and Hedonic-Price Methods 535
25.7 Appraisal-Based Indices 536
25.7.1 Approaches to Appraisals 536
25.7.2 Two Advantages of Appraisal-Based Models 536
25.7.3 Three Disadvantages of Appraisal-Based Models 537
25.8 Noisy Pricing 537
25.8.1 Random Pricing Errors and Reservation Prices 537
25.8.2 Appraisals and Appraisal Error 538
25.8.3 The Square Root of N Rule 539
PART 6
Accessing Alternative Investments
CHAPTER 26
Hedge Fund Replication 543
26.1 An Overview of Replication Products 543
26.2 Potential Benefits of Replication Products 544
26.3 The Case for Hedge Fund Replication 545
26.3.1 Estimating the Risk and Return of Funds of Funds 545
26.3.2 Three Theories for Increased Beta and Decreased Alpha
in Hedge Fund Returns 545
26.3.3 The Aggregate Alpha of the Hedge Fund Industry 547
26.3.4 Replication Products as a Source of Alpha 548
26.3.5 Replication Products as a Source of Alternative Beta 548
26.4 Unique Benefits of Replication Products 549
26.4.1 Two Reasons to Use Replication Products 549
26.4.2 Two Key Issues Regarding Fund Replication Benefits 549
26.4.3 Eight Potential Unique Benefits from Hedge Fund
Replication 550
26.5 Factor-Based Approach to Replication 552
26.5.1 Four Primary Issues in Constructing a Factor-Based
Replication Product 553
26.5.2 Three Steps to Factor-Based Replication 554
26.5.3 Two Key Concepts Regarding Factor-Based Replication 555
26.5.4 Research on Factor-Based Replication 556
26.5.5 Comparison of Factor-Based Approaches to
Payoff-Distribution Approaches 556
26.6 The Algorithmic (Bottom-Up) Approach 558
26.7 Three Illustrations of the Algorithmic (Bottom-Up) Approach 558
26.7.1 An Illustration of the Algorithmic Approach: Merger
Arbitrage 559
26.7.2 An Illustration of the Algorithmic Approach:
Convertible Arbitrage 560
26.7.3 An Illustration of the Algorithmic Approach:
Momentum Strategies 561
CHAPTER 27
Diversified Access to Hedge Funds 565
27.1 Evidence Regarding Hedge Fund Risk and Returns 565
27.1.1 Evidence Regarding Performance of Hedge Funds
by Strategies 565
27.1.2 Evidence Regarding the Systematic and Total Risk
of Hedge Funds 567
27.1.3 Evidence Regarding Correlations and Diversification
of Hedge Funds 569
27.2 Approaches to Accessing Hedge Funds 569
27.2.1 The Direct Approach and Its Three Advantages 569
27.2.2 The Delegated Approach and Its Five Services 569
27.2.3 The Indexed Approach 572
27.3 Characteristics of Funds of Hedge Funds 573
27.3.1 Approach to Manager Selection 573
27.3.2 Four Types of Funds of Hedge Funds Based on
Diversification 574
27.3.3 Exposure of Funds of Hedge Funds Returns to Four
Potential Biases 574
27.3.4 Four Key Issues Comparing Funds of Hedge Funds
and Multi-strategy Funds 575
27.4 Fund of Hedge Funds Portfolio Construction 577
27.4.1 Assets-Under-Management Weighted Approach
and its Three Challenges 577
27.4.2 Equally Weighted Approach 578
27.4.3 Equal Risk-Weighted Approach 578
27.4.4 Mean-Variance (Unconstrained and Constrained)
Approach 579
27.4.5 Mean-Variance Approach with Constraints on
Higher-Moments 580
27.4.6 Personal Allocation Biases Approach 580
27.5 Ways that Funds of Hedge Funds Can Add Value 580
27.5.1 Evidence on the Three Levels at Which Funds of Hedge
Funds Can Add Value 582
27.5.2 General Evidence on the Performance of Funds of Hedge
Funds 584
27.6 Investable Hedge Fund Indices 584
27.7 Alternative Mutual Funds 585
27.7.1 Three Potential Benefits of Offering Alternative Mutual
Funds 585
27.7.2 Three Benefits of Alternative Mutual Funds to Investors 586
27.7.3 Three Risks of Alternative Mutual Funds 586
27.7.4 Three Advantages of Exchange-Traded Alternative
Funds 587
CHAPTER 28
Access to Real Estate and Commodities 589
28.1 Unlisted Real Estate Funds 589
28.1.1 Open-End Funds 589
28.1.2 Closed-End Real Estate Funds 590
28.1.3 Real Estate Funds of Funds 591
28.1.4 Nontraded REITs 591
28.1.5 Four Potential Advantages of Unlisted Real Estate Funds 593
28.1.6 Three Potential Disadvantages of Unlisted Real Estate
Funds 593
28.2 Listed Real Estate Funds 594
28.2.1 REITs and REOCs 594
28.2.2 Exchange-Traded Funds Based on Real Estate Indices 594
28.2.3 Four Potential Advantages of Listed Real Estate Funds 595
28.2.4 Two Potential Disadvantages of Listed Real Estate Funds 596
28.2.5 Global REITs 596
28.3 Commodities 598
28.3.1 Direct Physical Ownership of Commodities 598
28.3.2 Indirect Ownership of Commodities 599
28.3.3 Commodity Index Swaps 599
28.3.4 Public Commodity-Based Equities 600
28.3.5 Bonds Issued by Commodity Firms 601
28.3.6 Commodity-Based Mutual Funds and Exchange-Traded
Products 601
28.3.7 Public and Private Commodity Partnerships 602
28.3.8 Commodity-Linked Investments 603
28.3.9 Commodity-Based Hedge Funds 605
28.4 Commodity Trade Financing and Production Financing 606
28.5 Leveraged and Option-Based Structured Commodity Exposures 606
28.5.1 Leveraged and Inverse Commodity Index-Based
Products 607
28.5.2 Leveraged Notes 608
28.5.3 Principal-Guaranteed Notes 608
28.6 Key Concepts in Managing Commodity Exposure 609
28.6.1 Roll Return 609
28.6.2 Commodity Prices and Cycles 609
28.6.3 Commodity Prices and Key Economic Variables 610
CHAPTER 29
Access Through Private Structures 613
29.1 Overview of Issues in Private Versus Listed Investment Access 613
29.1.1 Financial Market Segmentation 613
29.1.2 Major Potential Advantages of Listed Assets 614
29.1.3 Major Potential Advantages of Privately Organized
Assets 614
29.1.4 Rational Investing with High Fees 615
29.1.5 Private Structures as a Superior Governance Paradigm 615
29.2 Unlisted Manager–Investor Relationships 616
29.2.1 GP and Fund Economics 616
29.2.2 Fund Term and Structure 617
29.2.3 Key Person 617
29.2.4 Fund Governance 617
29.2.5 Financial Disclosures 618
29.2.6 Notification and Policy Disclosures 619
29.3 Side Letters to Limited Partnership Agreements 619
29.4 Co-Investments 621
29.4.1 Overview of Co-Investing 621
29.4.2 Investment Processes for Co-Investing 622
29.4.3 Evidence on the Performance of Co-Investments 623
29.4.4 Potential Advantages of Co-Investing 624
29.4.5 Potential Expected Disadvantages of Co-Investing 625
29.5 Cash Commitments and Illiquidity 626
29.5.1 The Costs of Excess Liquidity 626
29.5.2 The Costs of Illiquidity 626
29.5.3 Overcommitment Strategies 627
29.5.4 The Challenge of Identifying Illiquidity and Managing
Cash Flows 627
29.5.5 Four Benefits of Private Equity Cash Flow Models 627
29.5.6 The Overcommitment Ratio 628
29.5.7 The Optimal Overcommitment Ratio 628
29.5.8 Commitments, the Global Financial Crisis, and Liquidity 629
29.6 The Secondary Market for PE Partnerships 629
29.6.1 Secondary PE Market Development 629
29.6.2 PE Secondary Market Size 630
29.6.3 PE Buyer Motivations 632
29.6.4 PE Seller Motivations 632
29.6.5 The Secondary Market PE Investment Process 633
29.6.6 Sourcing PE Secondary Opportunities 633
29.6.7 Valuing Secondary PE Stakes 634
29.6.8 Limitations of the PE Secondary Market 635
CHAPTER 30
The Risk and Performance of Private and Listed Assets 637
30.1 Evidence on an Illiquidity Premium from Listed Assets 637
30.1.1 A Factor-Pricing-Based Explanation for an Illiquidity
Premium 638
30.1.2 Empirical Evidence of an Illiquidity Premium in US
Treasuries 638
30.1.3 Empirical Evidence of an Illiquidity Premium in US
Equities 638
30.2 Private Versus Listed Real Performance: The Case of Real Estate 639
30.2.1 The Case Against Unlisted Real Estate Pools based on
Historical Performance 639
30.2.2 Listing: Increased Risk or the Appearance of Increased
Risk? 640
30.2.3 The Case Against Unlisted Real Estate Pools Based on
Risk-Adjusted Performance 641
30.3 Challenges with the PME Method to Evaluating Private Asset
Performance 641
30.3.1 The Interim Internal Rate of Return (IIRR) and Multiple
Solutions 642
30.3.2 The IRRs under the PME Method Cannot be Calculated
in Some Cases 643
30.3.3 IRR Does not Adjust for Scale and Timing 644
30.3.4 The PME Method Can be Effective in Evaluating
Performance 644
30.3.5 The PME Method Can be Manipulated 646
30.4 Multiple Evaluation Tools 648
30.4.1 Simple Cash Flow Multiples 648
30.4.2 Multiples based on the PME Method 650
30.4.3 Private Equity Fund Benchmark Analysis 651
30.4.4 Applying a PME Analysis to the Example PE Funds 652
30.4.5 Summary of Results Using Multiple Evaluation Tools 652
30.5 IRR Aggregation Problems for Portfolios 653
30.5.1 Equally Weighting IRRs or IIRRs 653
30.5.2 Commitment-Weighting IRRs or IIRRs 654
30.5.3 Pooled Cash Flows for Weighting IRRs or IIRRs 655
30.5.4 Time-Zero-Based Pooling 656
30.5.5 Contrasting the Weighting Approaches for IRR
and IIRR 656
30.6 The Case Against Private Equity 657
30.7 Two Propositions Regarding Access Through Private Versus
Listed Structures 658
PART 7
Due Diligence & Selecting Managers
CHAPTER 31
Active Management and New Investments 663
31.1 Tactical Asset Allocation 663
31.2 The Fundamental Law of Active Management 664
31.2.1 The Central Relation of the FLOAM 664
31.2.2 The FLOAM and the Transfer Coefficient 665
31.2.3 The Tradeoff Between the Information Coefficient and
Breadth and Its Key Driver 667
31.3 Costs of Actively Reallocating Across Alternative Investments 667
31.3.1 Incentive Fees and Forgone Loss Carryforward 667
31.3.2 Two Potential Costs of Staying with a Manager Below
its High-Water Mark 669
31.3.3 Two Types of Potential Costs of Replacing Managers
Unrelated to Incentive Fees 669
31.4 Keys to a Successful Tactical Asset Allocation Process 670
31.4.1 The TAA Process and Return Predictability 670
31.4.2 The TAA Process and Model-based Return Prediction 670
31.4.3 Three Important Characteristics of Sound TAA Model
Development 671
31.4.4 SAA Models and Unconditional Analyses 671
31.4.5 TAA Models Based on Conditional Analyses 672
31.4.6 Technical Analysis Underlying TAA Models 673
31.5 Adjusting Exposures to Illiquid Partnerships 674
31.5.1 The Primary Markets for PE Funds 674
31.5.2 PE Funds as Intermediaries 675
31.5.3 PE Fund Incentives and Terms 675
31.6 The Secondary Market for PE LP Interests 676
31.6.1 Secondary PE Market Emergence and Development 676
31.6.2 PE Secondary Market Size and Overview 677
31.6.3 PE LP Seller Motivations 678
31.6.4 PE LP Buyer Motivations 678
31.6.5 Sourcing Secondary PE Fund Opportunities 679
31.6.6 Valuing Secondary Stakes 680
31.6.7 Limitations of the Secondary Market for PE Interests 681
CHAPTER 32
Selection of a Fund Manager 683
32.1 The Importance of Fund Selection Across Managers Through
Time 683
32.2 The Relationship Life Cycle Between LPs and GPs 683
32.2.1 The Relationship Between PE GPs and LPs 684
32.2.2 Adverse Selection and GP–LP Relationships 685
32.2.3 Overview of the Life Cycle Aspect of the GP–LP
Relationship 686
32.2.4 The Entry and Establish Phase 686
32.2.5 The Build and Harvest Phase 687
32.2.6 The Decline or Exit Phase 687
32.3 Fund Return Persistence 688
32.3.1 The Fund Performance Persistence Hypothesis 688
32.3.2 Evidence Regarding Fund Performance Persistence 688
32.3.3 Transition Matrices and Return Persistence in PE Funds 689
32.3.4 Persistence of Return Persistence in PE Funds 690
32.3.5 Six Challenges to the Performance Persistence
Hypothesis 691
32.3.6 Performance Persistence Implementation Issues 693
32.4 Moral Hazard, Adverse Selection, and the Holdup Problem in
Fund Management 694
32.5 Screening with Fundamental Questions 694
32.5.1 Three Fundamental Questions Regarding the Nature
of a Fund’s Investment Program 695
32.5.2 Three Detailed Questions Regarding the Investment
Objective 695
32.5.3 Four Detailed Questions Regarding the Investment
Process 696
32.5.4 Two Detailed Questions Regarding the Value Added
by the Fund Manager 697
32.6 Historical Performance Review 698
32.6.1 Two Critical Decisions Regarding A Performance
Review 698
32.6.2 Reliance on Past Performance 699
32.6.3 Comprehensive Listing of Current and Past Assets under
Management 700
32.6.4 Drawdowns 701
32.6.5 Statistical Return Data and Five Classic Issues 701
32.6.6 Statistical Return Analysis, Computation Horizons,
and Intervals 702
32.7 Manager Selection and Deal Sourcing 703
32.7.1 Determination of the Wish List of Fund Characteristics 703
32.7.2 Classifying Management Teams 704
32.7.3 Deal Sourcing 704
32.8 Fund Culture 705
32.9 Decision-Making and Commitment and Manager Selection 706
CHAPTER 33
Investment Process Due Diligence 709
33.1 Overview of Investment Due Diligence 709
33.1.1 Due Diligence Approaches 709
33.1.2 Importance of Investment Due Diligence 710
33.1.3 Three Internal Fund Functions 711
33.1.4 Differentiating Between Investment Process
and Operational Due Diligence 711
33.1.5 Costs and Importance of Due Diligence 711
33.1.6 Due Diligence Checklists and Questionnaires 712
33.2 The Investment Strategy or Mandate 712
33.2.1 Details on Components of the Investment Strategy 712
33.2.2 The Investment Mandate and Strategy Drift 712
33.2.3 Strategy Drift and Leverage 713
33.2.4 Investment Markets and Securities 713
33.2.5 Competitive Advantage and Source of Investment Ideas 714
33.2.6 Fund Assets Under Management Capacity for Effective
Management 714
33.2.7 Key Persons and Investment Strategy 715
33.3 The Investment Implementation Process and its Risks 715
33.3.1 Implementing the Investment Strategy 715
33.3.2 Investment Process Risk 716
33.3.3 Detecting Investment Process Risk 716
33.4 Asset Custody and Valuation 717
33.4.1 Custody of Fund Assets 717
33.4.2 Current Portfolio Position 718
33.4.3 Principles of Fund Asset Valuation 719
33.4.4 Four Implications of Conflicts of Interest in Fund Asset
Valuation 720
33.4.5 Challenges in Listed Asset Valuation 721
33.4.6 Valuation of Illiquid Assets and Level 1, 2, and 3 Assets 721
33.4.7 Internal Valuation of Assets 722
33.5 Risk Alert’s One Advantage and Six Observations on Third-Party
Information 723
33.5.1 Advantages of Portfolio Information Aggregators 723
33.5.2 The Risk Alert Made Two Observations on Third Party
Information Regarding Asset Values 723
33.5.3 The Risk Alert Made Four Observations on Four Trends
in Due Diligence 724
33.6 Portfolio Risk Review 725
33.6.1 Risk Review Overview 725
33.6.2 Chief Risk Officer 725
33.6.3 Three General Questions of a Risk Review 726
33.6.4 Key Risks of Special Concern in a Risk Review 726
33.6.5 Risk Reviews and Leverage 727
33.6.6 How Leverage Magnifies Losses and Probabilities
of Various Loss Levels 728
33.6.7 Subscription and Redemption Risks 729
33.7 Four Warning Indicators and Awareness Signals Regarding
Investments 729
33.8 Four Warning Indicators and Awareness Signals Regarding Risk
Management 729
CHAPTER 34
Operational Due Diligence 731
34.1 Operations: Overview, Risks, and Remedies 731
34.1.1 Operational Errors, Agency Conflicts, and Operational
Fraud 731
34.1.2 Operational Due Diligence is Driven by Operational
Risk 732
34.1.3 Prevention, Detection, and Mitigation of Operational
Risk by Asset Managers 733
34.1.4 Mitigation of Operational Risk by Investors 733
34.1.5 Perverse Incentives and Internal Control Procedures 733
34.1.6 Oversight of the Trade Life Cycle 734
34.1.7 Potential Veto Power of Due Diligence Teams 734
34.2 Four Key Operational Activities 735
34.2.1 Overview of Due Diligence Regarding Execution 735
34.2.2 Overview of Due Diligence Regarding Posting 736
34.2.3 Overview of Due Diligence Regarding Trade Allocation 736
34.2.4 Overview of Due Diligence Regarding Reconciliation 736
34.3 Analyzing Fund Cash Management and Movement 737
34.3.1 Four Primary Purposes of Fund Cash 737
34.3.2 Analyzing Cash for Fund Expenses 737
34.3.3 Analyzing Cash to Facilitate Trading 738
34.3.4 Four Reasons for Analyzing Cash to And From Investors 738
34.3.5 Analyzing Unencumbered Cash 739
34.4 Analyzing External Parties and Checking Principals 739
34.4.1 Analyzing Fund Prime Brokers 739
34.4.2 Analyzing Fund Administrators 740
34.4.3 Overview of Investigative Due Diligence 741
34.4.4 Three Models of Selecting Personnel for Investigation 741
34.4.5 Five Areas of Background Investigation 741
34.4.6 Organizing and Interpreting Information from
Background and Other Investigations 742
34.4.7 Independent Service Provider Verification of Fund
Operational Data 743
34.4.8 Checks with Other Investors 743
34.5 Analyzing Fund Compliance 743
34.5.1 Personal Trading Compliance of Fund Employees 744
34.5.2 Common Compliance Risks Regarding Personal Trading 744
34.5.3 Compliance Risks Regarding Nonpublic and Inside
Information 745
34.5.4 Electronic Communication Monitoring 746
34.5.5 Analyzing the Work of Third-Party Compliance
Consultants 746
34.6 Onsite Manager Visits 747
34.6.1 Selection of Visit Location 747
34.6.2 Desk Reviews Are Not Best Practice 747
34.6.3 Risk Alert’s Three Tasks on Desk versus Onsite Reviews 748
34.7 Elements and Key Concerns of the Odd Process 748
34.7.1 Eight Core Elements of The ODD Process 748
34.7.2 Five Explanations for the Expanding Scope
of Operational Due Diligence 748
34.7.3 External Sources of Review and Confirmation 748
34.8 Information Technology and Meta Risks 749
34.8.1 Information Technology 749
34.8.2 Five Key Questions Regarding Information Technology 749
34.8.3 Evaluating Meta Risk 750
34.9 Funding, Applying, and Concluding ODD 750
34.9.1 Four Approaches to Resource Allocation
for Operational Due Diligence 750
34.9.2 Documenting the Operational Due Diligence Process 751
34.9.3 Operational Decision-Making and Allocation
Considerations 751
CHAPTER 35
Due Diligence of Terms and Business Activities 755
35.1 Due Diligence Document Collection Process 755
35.2 Fund Governance 757
35.2.1 Fund Governance through Internal Committees 757
35.2.2 Fund Governance through Boards of Directors 757
35.2.3 Limited Partner Control and Communication 758
35.3 Structural Review of the Fund And Fund Manager 758
35.3.1 Fund Organization 759
35.3.2 Master–Feeder Trusts 759
35.3.3 Side Pocket Arrangements 760
35.3.4 Registrations 760
35.3.5 Fund Manager Organization and Ownership 761
35.4 Terms for Liquid Private Funds 761
35.4.1 Redemptions 761
35.4.2 Lockups and Their Two Potential Benefits 762
35.4.3 Gates 763
35.5 Terms for Illiquid Private Funds 763
35.5.1 The LPA, Fund Term, and Distributions 763
35.5.2 Advisory Committee 763
35.5.3 Termination and Divorce 763
35.6 General Terms for Private Funds 764
35.6.1 Type of Investment and Liability Limits 764
35.6.2 Subscription Amount 765
35.6.3 Investor Relations 765
35.7 Private Placement Memorandum (PPM) 765
35.7.1 Four Key Functions of the OM/PPM 765
35.7.2 Side Letters 767
35.7.3 Different Purposes of Legal Counsel Reviews and ODD
Document Reviews 767
35.7.4 Analyzing Other Common Private Placement
Memorandum Terms 768
35.8 Fund Fees and Expenses 769
35.8.1 Timing of Fee Collection 769
35.8.2 Fee Offsets 769
35.8.3 Details Regarding Incentive Fees 769
35.8.4 GP’s Contribution 770
35.9 Private Fund Audited Financial Statement Review 771
35.9.1 Valuation Policies 772
35.10 Business Activities, Continuity Planning, Disaster Recovery,
and Insurance 773
35.10.1 Business Continuity Planning and Disaster Recovery 773
35.10.1.1 Focus on Information Technology 774
35.10.1.2 Fund Insurance 775
PART 8
Volatility and Complex Strategies
CHAPTER 36
Volatility as a Factor Exposure 779
36.1 Measures of Volatility 779
36.1.1 Implied Volatility and Realized Volatility 779
36.1.2 Three Limitations of Realized Volatility as a Measure of
Dispersion 780
36.1.3 Six Properties of Realized Volatility 780
36.2 Volatility and the Vegas, Gammas, and Thetas of Options 781
36.2.1 Option Vegas 781
36.2.2 Scaling of the Vega of an Option 782
36.2.3 Vega as an Approximation for Finite Shifts 782
36.2.4 Four Observations on Option Vegas 783
36.2.5 Option Gammas 784
36.2.6 Putting Option Vegas, Gammas, and Thetas Together 784
36.3 Exposures to Volatility as a Factor 785
36.3.1 Long and Short Volatility 785
36.3.2 Distinctions between Positive Vega and Long Volatility
Exposures 786
36.3.3 Using Volatility Derivatives to Hedge Market Risk 787
36.3.4 Volatility as an Unobservable but Unique Risk Factor 787
36.3.5 The Volatility Factor Has a Negative Risk Premium 788
36.3.6 Evidence That Short Volatility Earns a Positive Risk
Premium 790
36.4 Modeling Volatility Processes 791
36.4.1 Volatility Processes with Jump Risk 792
36.4.2 Volatility Processes and Regime Changes 792
36.4.3 Two Reasons Why Volatility Strategies Tend to Recover
Quickly 793
36.4.4 Reasons Why Volatility Mean-Reversion Cannot
Arbitraged 794
36.5 Implied Volatility Structures 794
36.5.1 Methods of Computing Implied Volatility 794
36.5.2 Implied Volatility Structures and Moneyness 795
36.5.3 Implied Volatility Surfaces 795
36.5.4 Four Key Reasons for Implied Volatility Structures
and Surfaces 796
36.5.5 Two Explanations for High Implied Volatilities
of Out-of-The-Money Puts 797
CHAPTER 37
Volatility, Correlation, and Dispersion Products and Strategies 799
37.1 Common Option Strategies and their Volatility Exposures 799
37.1.1 Option Writing, Theta, and Time Decay 799
37.1.2 Writing Option Straddles and Strangles as a Short
Volatility Strategy 801
37.1.3 Writing Option Butterflies and Condors as Volatility
Strategies 802
37.2 Volatility and Delta-Neutral Portfolios with Options 803
37.2.1 General Performance Drivers of Delta-Neutral Portfolios
with Options 803
37.2.2 Four Key Points Regarding Delta-Neutral Option
Portfolios 804
37.2.3 Delta Normalization and Exposure to Volatility 804
37.3 Advanced Option-Based Volatility Strategies 805
37.3.1 Vertical Intra-Asset (Skew) Option Spreads 805
37.3.2 Vertical Spreads with Delta-Hedging 805
37.3.3 Horizontal Intra-Asset (Skew) Spreads 806
37.3.4 Inter-Asset Option Spreads 806
37.4 Variance-Based and Volatility-Based Derivative Products 807
37.4.1 Variance Swaps and Variance Futures on Realized
Variance 807
37.4.2 Implied Volatility Indices 808
37.4.3 Computation of the CBOE Volatility Index (VIX) 809
37.4.4 Futures Contracts on the CBOE Volatility Index (VIX) 809
37.4.5 The S&P 500 VIX Short-Term Futures Index 811
37.4.6 Options, Exchange-Traded Notes, and Other
VIX-Related Products 813
37.4.7 The VIX Term Structure and Its Slope as a Proxy
for Portfolio Insurance 814
37.5 Correlation Swaps 815
37.5.1 Mechanics of a Correlation Swap 815
37.5.2 Modeling the Relation between Correlations, Security
Volatility, and Portfolio Volatility 816
37.5.3 Motivations to Correlation Trading 817
37.6 Dispersion Trades 818
37.7 Summary and Common Themes of Volatility, Correlation,
and Dispersion Trading 819
37.8 Volatility Hedge Funds and their Strategies 820
37.8.1 Four Subcategories of Volatility Hedge Funds 820
37.8.2 Relative Value Volatility Funds 821
37.8.3 Short Volatility Funds 821
37.8.4 Long Volatility and Tail Risk Funds 821
37.8.5 Returns of the Four Volatility Fund Indices 822
CHAPTER 38
Complexity and Structured Products 825
38.1 Uncertainty, Ambiguity, and Opacity 825
38.1.1 Knightian Uncertainty 825
38.1.2 Ambiguity 826
38.1.3 Opacity and the Theoretical Incentive to Create
Complexity 826
38.2 Asset and Strategy Complexity 827
38.2.1 Complexity, Passive Indexation, and Active
Management 827
38.2.2 Complexity Crashes 827
38.2.3 The Complexity Risk Premium 827
38.2.4 Complexity as a Return Characteristic or Factor 828
38.3 Cases in Complexity and Perverse Incentives 828
38.3.1 Treasury Strips in the 1980s 829
38.3.2 Collateralized Mortgage Obligations in the 1990s 829
38.3.3 Residential Mortgage-Backed Securities in the 2000s 830
38.3.4 Five Key Takeaways from the Three Fixed Income Cases 831
38.4 Asset-Based Lending 831
38.4.1 A Typical Borrower in Asset-Based Lending 831
38.4.2 Why Borrowers Select Asset-Based Lending 832
38.4.3 Features of Asset-Based Lending 832
38.4.4 Discount Rates for Various Assets in Asset-Based
Lending 833
38.4.5 Use of Asset-Based Lending Proceeds 834
38.4.6 Asset-Based Loan Structures and Collateral 834
38.4.7 Asset-Based Lender Protection and Covenants 835
38.5 Risks of Asset-Based Loans 836
38.5.1 Collateral Valuation Risk of Asset-Based Loans
and Lender Remedies 836
38.5.2 Risks Regarding Process and People in Asset-Based
Loans 837
38.5.3 Risks Regarding Hedging of Asset-Based Loans 837
38.5.4 Legal Risks of Asset-Based Loans 837
38.5.5 Risks Regarding Timing of Exits from Asset-Based
Loans 838
38.6 Asset-Backed Securities 838
38.6.1 The Creation of Asset-Backed Securities 838
38.6.2 Growth of Various Types of Asset-Backed Securities 839
38.6.3 Auto Loan-Backed Securities 839
38.6.4 Auto Loan-Backed Securities and Prepayments 841
38.6.5 Credit Card Receivables 841
38.6.6 Credit Card Receivables Credit Enhancements 842
CHAPTER 39
Insurance-Linked Products and Hybrid Securities 845
39.1 Nonlife ILS: Catastrophe Bonds 845
39.1.1 Overview of Catastrophe Bonds 845
39.1.2 Mechanics of Catastrophe Bonds 846
39.1.3 Risks and Returns of Catastrophe Bonds 846
39.1.4 Role of Catastrophe Bonds in Managing Risks
to Insurers 847
39.2 Four Trigger Types of Cat Bonds 847
39.2.1 Indemnity Triggers 847
39.2.2 Industry Loss Triggers 848
39.2.3 Parametric Triggers 848
39.2.4 Modeled Triggers 848
39.3 Cat Bond Valuation, Performance, and Drawbacks 849
39.3.1 Establishing The Coupon Rate To Investors
In Cat Bonds 849
39.3.2 Cat Bond Index Returns 850
39.3.3 Potential Drawbacks and Alpha of Investing
in Cat Bonds 850
39.3.4 Catastrophe-related Derivative Securities 852
39.4 Longevity and Mortality Risk-Related Products 852
39.4.1 Longevity Risk 852
39.4.2 Hedging Longevity Risk 853
39.4.3 Four Longevity Hedging Risks 854
39.4.4 Mortality Risk 854
39.4.5 Mortality Risk and Structured Products 854
39.4.6 Main Risks of Catastrophic Mortality Bonds 855
39.5 Life Insurance Settlements 855
39.5.1 Mechanics and Details of Life Insurance Settlements 855
39.5.2 Path of Life Insurance Policy Values Through Time 856
39.5.3 Modeling Life Insurance Settlements 857
39.6 Overview of Viatical Settlements 857
39.6.1 Viatical Settlements, Life Settlements, and Secondary
Markets 857
39.6.2 Investment Benefits, Risks, and Drawbacks of Viatical
Settlements 858
39.6.3 Returns on Life Insurance Settlements 858
39.7 Hybrid Products: Mezzanine Debt 859
39.7.1 Subordinated Debt with Step-Up Rates 859
39.7.2 Subordinated Debt with PIK Interest 860
39.7.3 Subordinated Debt with Profit Participation 862
39.7.4 Subordinated Debt with Warrants 862
39.7.5 Project Finance and Public–Private Partnerships 863
CHAPTER 40
Complexity and the Case of Cross-Border Real Estate Investing 865
40.1 Traditional View of Currency-Hedging for Cross-Border Real
Estate Investing 865
40.1.1 Cross-Border Return as a Function of Rates 865
40.1.2 The Key Traditional Currency Risk Assumption
of Cross-Border Investing 866
40.1.3 Currency Risks and Return Variances 867
40.1.4 Risk when Domestic Investment Returns Fully Adjust
for Currency Devaluation 868
40.1.5 Risk and a Focus on Single Currency Risk Measures 870
40.2 Fundamentals of Currency Risk And Hedging in Perfect Markets 870
40.2.1 Currency Risk and the Law of One Price 870
40.2.2 Example of No Currency-Hedging Needed 871
40.2.3 Currency Risk and the Law of One Price with
Currency-Hedging 872
40.2.4 Currency Risk and Currency-Hedging of Fixed Income
Securities 873
40.3 Currency Risk and Hedging of Alternative Investments 873
40.3.1 Price Stickiness, Asset Values, and Expected Future
Cash Flows 874
40.3.2 Price Stickiness, Currency Risk, and Unlevered
Corporate Assets 874
40.3.3 Currency Risk and Levered Assets 875
40.4 Accessing Foreign Assets with Futures and Quanto Futures 876
40.4.1 Quanto Financial Derivatives 876
40.4.2 Quanto Futures Contracts 877
40.4.3 Futures-based Strategies versus Direct Cash Investment
in Foreign Assets 877
40.5 Overview of International Real Estate Investing 879
40.5.1 Characteristics of International Real Estate Markets 879
40.5.2 Global Real Estate Taxes and Transaction Costs 879
40.5.3 Benefits Of International Real Estate Investing 880
40.6 Heterogenous Investment Taxation Across Jurisdictions 881
40.7 Challenges to International Real Estate Investing 882
40.7.1 Three Reasons Why Agency Relationships Are
Important 882
40.7.2 Relative Inefficiency of Global Real Estate Markets 883
40.7.3 Information Asymmetries 884
40.7.4 Liquidity and Transaction Costs 884
40.7.5 Political, Economic, and Legal Risks 885
Index 887