Alternative Investments: CAIA Level I, 4th Edition is the curriculum book for the Chartered Alternative Investment Analyst (CAIA) Level I professional examination. Covering the fundamentals of the alternative investment space, this book helps you build a foundation in alternative investment markets. You'll look closely at the different types of hedge fund strategies and the range of statistics used to define investment performance as you gain a deep familiarity with alternative investment terms and develop the computational ability to solve investment problems. From strategy characteristics to portfolio management strategies, this book contains the core material you will need to succeed on the CAIA Level I exam. This updated fourth edition tracks to the latest version of the exam and is accompanied by the following ancillaries: a workbook, study guide, learning objectives, and an ethics handbook.
Table of Contents
Preface xxxiii
Acknowledgments xxxvii
About the Authors xli
Part 1 Introduction to Alternative Investments
Chapter 1 What is an Alternative Investment? 3
1.1 Alternative Investments by Exclusion 3
1.2 Alternative Investments by Inclusion 4
1.3 The Blurred Lines between Traditional and Alternative Investments 8
1.4 A History of Alternative Investing: The U.S. Case 10
1.5 Investments are Distinguished by Return Characteristics 11
1.6 Investments are Distinguished by Methods of Analysis 14
1.7 Eight Other Characteristics that Distinguish Alternative and Traditional Investments 16
1.8 Five Goals of Alternative Investing 18
1.9 Two Pillars of Alternative Investment Management 20
1.10 Overview of This Book 22
Review Questions 23
Chapter 2 The Environment of Alternative Investments 25
2.1 The Participants 25
2.2 Alternative Investment Structures 33
2.3 Key Features of Fund Structures 36
2.4 Financial Markets 40
2.5 Regulatory Environment 42
2.6 Liquid Alternative Investments 43
2.7 Taxation 47
2.8 Short Selling 49
Review Questions 52
Notes 53
Chapter 3 Quantitative Foundations 55
3.1 Return and Rate Mathematics 55
3.2 Returns Based on Notional Principal 57
3.3 Internal Rate of Return 60
3.4 Problems with Internal Rate of Return 64
3.5 Other Performance Measures 73
3.6 Illiquidity, Accounting Conservatism, IRR, and the J-Curve 75
3.7 Distribution of Cash Waterfall 77
Review Questions 85
Note 86
Chapter 4 Statistical Foundations 87
4.1 Return Distributions 87
4.2 Moments of the Distribution: Mean, Variance, Skewness, and Kurtosis 90
4.3 Covariance, Correlation, Beta, and Autocorrelation 94
4.4 Interpreting Standard Deviation and Variance 104
4.5 Testing for Normality 111
4.6 Time-Series Return Volatility Models 114
Review Questions 116
Chapter 5 Foundations of Financial Economics 117
5.1 Informational Market Efficiency 117
5.2 The Time Value of Money, Prices, and Rates 122
5.3 The Three Primary Theories of the Term Structure of Interest Rates 127
5.4 Forward Interest Rates 129
5.5 Arbitrage-Free Models 131
5.6 Binomial Tree Models 134
5.7 Single-Factor Default-Free Bond Models 137
5.8 Single-Factor Equity Pricing Models 143
Review Questions 148
Note 149
Chapter 6 Derivatives and Risk-Neutral Valuation 151
6.1 Foundations of Forward Contracts 151
6.2 Forward Contracts on Rates 155
6.3 Forward Contracts on Equities 157
6.4 Forward Contracts on Assets with Benefits and Costs of Carry 165
6.5 Forward Contracts Versus Futures Contracts 171
6.6 Managing Long-Term Futures Exposures 178
6.7 Option Exposures 180
6.8 Option Pricing Models 186
6.9 Option Sensitivities 188
Review Questions 190
Notes 191
Chapter 7 Measures of Risk and Performance 193
7.1 Measures of Risk 193
7.2 Estimating Value at Risk (VaR) 198
7.3 Benchmarking and Performance Attribution 203
7.4 Ratio-Based Performance Measures 204
7.5 Risk-Adjusted Return Measures 210
Review Questions 214
Notes 214
Chapter 8 Alpha, Beta, and Hypothesis Testing 215
8.1 Overview of Beta and Alpha 215
8.2 Ex Ante Versus Ex Post Alpha 217
8.3 Single-Factor Models and Regression 220
8.4 Inferring Ex Ante Alpha From Ex Post Alpha 225
8.5 Return Attribution, Alpha, and Beta 226
8.6 Ex Ante Alpha Estimation and Return Persistence 230
8.7 Return Drivers 231
8.8 Using Statistical Methods to Locate Alpha 234
8.9 Sampling and Testing Problems 239
8.10 Statistical Issues in Analyzing Alpha and Beta 242
Review Questions 246
Notes 247
Part 2 Real Assets
Chapter 9 Natural Resources and Land 251
9.1 Natural Resources Other Than Land 251
9.2 Land 256
9.3 Timber and Timberland 261
9.4 Farmland 263
9.5 Valuation and Volatility of Real Assets 268
9.6 Pricing and Historic Data Analysis 272
9.7 Contagion, Price Indices, and Biases 275
9.8 Key Observations Regarding Historical Returns of Timberland 278
9.9 Key Observations Regarding Historical Returns of Farmland 278
Review Questions 279
Notes 279
Chapter 10 Commodities 281
10.1 Investing in Commodities Without Futures 281
10.2 The Term Structure of Forward Prices on Commodities 288
10.3 Rolling of Forward and Futures Contracts 296
10.4 Normal Backwardation and Normal Contango 302
10.5 Commodity Exposure and Diversification 307
10.6 Expected Returns on Commodities 310
10.7 Commodity Futures Indices 312
10.8 Commodity Risk Attributes 314
10.9 Observations Based on Historical Returns 318
Review Questions 318
Notes 318
Chapter 11 Other Real Assets 319
11.1 Commodity Producers 319
11.2 Liquid Alternative Real Assets 322
11.3 Infrastructure 325
11.4 Intellectual Property Overview 336
11.5 Cash Flows of Intellectual Property 341
11.6 Visual Works of Art and Historical Performance Data 344
11.7 R&D and Patents as Unbundled Intellectual Property 346
11.8 Intellectual Property Conclusions 349
Review Questions 350
Notes 350
References 350
Chapter 12 Real Estate Assets and Debt 353
12.1 Categories of Real Estate 353
12.2 Advantages, Disadvantages, and Styles of Real Estate Investments 355
12.3 Real Estate Style Boxes 361
12.4 Residential Mortgages 363
12.5 Commercial Mortgages 372
12.6 Mortgage-Backed Securities Market 375
12.7 Liquid Alternatives: Real Estate Investment Trusts 380
12.8 Key Observations Regarding Historical Returns of Mortgage REITs 382
Review Questions 384
Notes 384
Chapter 13 Real Estate Equity 385
13.1 Real Estate Development 385
13.2 Commercial Real Estate Valuation 389
13.3 Details of the Income Approach to Real Estate Valuation 397
13.4 Illustration of the Income Method of Real Estate Valuation 402
13.5 Alternative Real Estate Investment Vehicles 403
13.6 Equity REIT Returns 409
13.7 Key Observations Regarding Historical Risks and Returns of Equity REITs 410
Review Questions 412
Part 3 Hedge Funds
Chapter 14 Structure of the Hedge Fund Industry 415
14.1 Distinguishing Hedge Funds 415
14.2 Hedge Fund Fees 419
14.3 Hedge Fund Classification 431
14.4 Hedge Fund Returns and Asset Allocation 433
14.5 Evaluating a Hedge Fund Investment Program 438
14.6 Three Research Studies on Whether Hedge Funds Adversely Affect the Financial Markets 441
14.7 Hedge Fund Indices 442
14.8 Conclusion 451
Review Questions 451
Notes 451
Chapter 15 Macro and Managed Futures Funds 453
15.1 Macro and Managed Futures Strategies 453
15.2 Global Macro 455
15.3 Managed Futures 459
15.4 Systematic Trading 464
15.5 Four Core Dimensions of Managed Futures Investment Strategies 476
15.6 Systematic Futures Portfolio Construction 479
15.7 Eight Core Benefits of Managed Futures for Investors 483
15.8 Evidence on Managed Futures Returns 485
15.9 Benefits of Managed Futures Funds 493
15.10 Key Observations Regarding Historical Returns of Macro and Systematic Diversified Funds 499
Review Questions 499
Notes 499
Chapter 16 Event-Driven Hedge Funds 501
16.1 The Sources of Most Event Strategy Returns 501
16.2 Activist Investing 505
16.3 Merger Arbitrage 517
16.4 Distressed Securities Funds 524
16.5 Event-Driven Multistrategy Funds 532
Review Questions 534
Notes 534
Chapter 17 Relative Value Hedge Funds 535
17.1 Overview of Relative Value Strategies 535
17.2 Convertible Bond Arbitrage 536
17.3 Volatility Arbitrage 551
17.4 Fixed-Income Arbitrage 565
17.5 Relative Value Multistrategy Funds 575
Review Questions 578
Notes 578
Chapter 18 Equity Hedge Funds 579
18.1 Commonalities of Equity Hedge Funds 579
18.2 Sources of Return 580
18.3 Market Anomalies 584
18.4 Implementing Anomaly Strategies 590
18.5 The Three Equity Strategies 594
18.6 Equity Hedge Fund Risks 605
Review Questions 605
Notes 606
Chapter 19 Funds of Hedge Funds 607
19.1 Overview of Funds of Hedge Funds 607
19.2 Investing in Multistrategy Funds 616
19.3 Investing in Funds of Hedge Funds 619
19.4 Investing in Portfolios of Single Hedge Funds 622
19.5 Multialternatives and Other Hedge Fund Liquid Alternatives 624
19.6 Key Observations Regarding Historical Returns of Funds of Funds 628
Review Questions 631
Notes 631
Part 4 Private Securities
Chapter 20 Private Equity Assets 635
20.1 Introduction to Private Equity Terms and Background 635
20.2 Overview of Three Forms of Pre-IPO Private Equity Investing 637
20.3 Venture Capital 639
20.4 Venture Capital as a Compound Option 647
20.5 Growth Equity 648
20.6 Buyouts and Leveraged Buyouts 651
20.7 Buyouts of Private Companies 653
20.8 Leveraged Buyouts (LBOs) 655
20.9 Merchant Banking 663
20.10 Dynamics of Private Equity Opportunities 663
Review Questions 665
Notes 666
Chapter 21 Private Equity Funds 667
21.1 Overview of Private Equity Funds 667
21.2 Private Equity Funds as Intermediaries 671
21.3 The LP and GP Relationship Life Cycle 677
21.4 Private Equity Fund Fees and Terms 680
21.5 Key Determinants of Venture Capital Fund Risks and Returns 687
21.6 Roles and Three Key Distinctions of Venture Capital and Buyout Managers 689
21.7 Leveraged Buyout Funds 689
21.8 Private Equity Liquid Alternatives 693
21.9 Private Equity Funds of Funds 698
21.10 Private Investments in Public Equity 699
21.11 Private Equity Secondary Markets and Structures 703
Review Questions 706
Notes 707
Chapter 22 Private Credit and Distressed Debt 709
22.1 Types of Fund Private Credit Vehicles 709
22.2 Fixed-Income Analysis 711
22.3 Credit Risk Analysis and the Bankruptcy Process 715
22.4 Leveraged Loans 725
22.5 Direct Lending 727
22.6 Mezzanine Debt 728
22.7 Distressed Debt 737
22.8 Private Credit Performance and Diversification 743
Review Questions 744
Note 744
References 745
Part 5 Structured Products
Chapter 23 Introduction to Structuring 749
23.1 Overview of Financial Structuring 749
23.2 Major Types of Structuring 750
23.3 The Primary Economic Role of Structuring 751
23.4 Collateralized Mortgage Obligations 753
23.5 Structural Model Approach to Credit Risk 761
23.6 Interest Rate Options 766
23.7 Introduction to Collateralized Debt Obligations 768
Review Questions 773
Note 773
Chapter 24 Credit Risk and Credit Derivatives 775
24.1 An Overview of Credit Risk 775
24.2 Reduced-Form Modeling of Credit Risk 776
24.3 Credit Derivatives Markets 783
24.4 Interest Rate Swaps 786
24.5 Credit Default Swaps 793
24.6 Other Credit Derivatives 801
24.7 CDS Index Products 804
24.8 Five Key Risks of Credit Derivatives 805
Review Questions 807
Notes 807
Chapter 25 CDO Structuring of Credit Risk 809
25.1 Overview of CDO Variations 809
25.2 Balance Sheet CDOs and Arbitrage CDOs 812
25.3 Mechanics of and Motivations for An Arbitrage CDO 814
25.4 Cash-Funded CDOs Versus Synthetic CDOs 816
25.5 Cash Flow CDOs Versus Market Value CDOs 820
25.6 Credit Enhancements 821
25.7 Other Types of CDOs 823
25.8 Risks of CDOs 824
Review Questions 829
Chapter 26 Equity-Linked Structured Products 831
26.1 Structured Products and Six Types of Wrappers 831
26.2 Four Potential Tax Effects of Wrappers 832
26.3 Structured Products with Exotic Option Features 835
26.4 Popular Structured Product Types 843
26.5 The EUSIPA Classification 844
26.6 Global Structured Product Cases 848
26.7 Structured Product Valuation 850
26.8 Motivations of Structured Products 854
Review Questions 855
Notes 856
Index 857
