Level III Review, Alternative Investments

Study session 13 in the Level III CFA Program curriculum includes three readings (31-33) on Alternative Investments and is worth between 5% and 15% of your total exam score.
Alternative Investments Portfolio Management
Remember the common features to alternative investments:
1)      Illiquidity and longer time horizon- investors demand a return premium
2)      Diversification from low correlation with traditional investments
3)      High due diligence costs because of complex structures and lack of transparency
4)      Difficulty in establishing a valid benchmark and performance appraisal
5)      Informationally less efficient with possibility of adding value through skill and information
Know the specific characteristics and limitations to each investment type within alternatives. Much of the material has been seen in the curriculum to the previous two exams so it should not be too difficult to pick up.
Real estate: Adds diversification and an inflation hedge but high transaction costs. REITs are highly liquid and more accessible but are correlated with stocks.
Private Equity/Venture Capital: illiquid and relatively high risk but high returns expected. May have lock-up periods or involve long time horizons. Remember the financing stages for private equity and characteristics of each. A few vocabulary here like clawback provision and carried interest.
Commodities: Understand the difference and characteristics of direct versus indirect investment. Direct investment entails carrying and storage costs while indirect investment in the companies may not provide sufficient exposure because of company hedging programs.
Hedge Funds: Understand the basics behind the different strategies (equity neutral, fixed income arbitrage, distressed securities, convertible arb, merger arb, hedged equity, global macro). Remember the advantages/disadvantages of funds of funds. Remember that a high water mark provision requires that incentive fees are only based on returns above the highest value over the life of the fund (i.e. once fees have been paid for achieving that level, the manager must exceed it to earn more incentive fees).
The Level 3 exam places some emphasis on the indexes as well, so remember the basics behind each index to alternative investments as well as strengths/weaknesses to each.
You need to be able to work through a simple swap for the exam. Working through a couple of examples on flash cards will help and will allow you to review it quickly.
Example:  Find the price of a two long forward swaps to guarantee the cost of buying 100,000 barrels of oil in each of the next two years.
The forward price of oil for delivery in one year is $20/barrel.
The forward price for delivery in two years is $21/barrel.
The one-year zero coupon bond yields 6% while the two-year zero yields 6.5%
Present value of the cost per barrel would be: $20/1.06 + $21/1.0652 = $37.383
The two-year swap price would be:  x/1.06 + x/1.0652 = $37.383 à $20.483
Rate swaps are a weighted average of implied forward interest rates. They are less risky relative to commodity swaps because of the fewer number of inputs. The market value is the difference in the present value of payments between the original and the new swap rates. The value of the swap is always zero at initiation and changes as the interest rate changes.
Commodity Swaps are a weighted average of the forward commodity price and is the difference in the present value of payments.
Commodity Forwards and Futures
The math can seem a little intimidating on commodity forwards but you have to be able to work through it because it does show up on the exam. Understand the difference between a commodity that can and cannot be stored.
The lease rate represents a return required to buy and lend a commodity. It is similar to a dividend yield but is not directly observable.
The convenience yield is the non-monetary benefits associated with holding a commodity but is only earned when the commodity is held by a commercial user.
Understand the concept behind the hedging strategies but the calculation is probably secondary to being able to work through the forwards calculation. A few vocabulary items are important like the crush and crack spread.
Study session 14 begins the readings on Risk Management, an extremely important topic in the Level 3 exam and definitely worth a couple of questions on the test.
‘til next time, happy studyin’
Joseph Hogue, CFA


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