PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted BooK - ALTERNATIVE INVESTMENTS AND FIXED INCOME Readings and Learning Outcome Statements v Study Session 13 - Alternative Investments Self-Test - Alternative Investments 129 Study Session 14 - Fixed Income: Valuation Concepts 132 Study Session 15 - Fixed Income: Topics in Fixed Income Analysis 219 Self-Test - Fixed Income 23 Formulas 242 Index 248 ©2015 Kaplan, Inc Page iii PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted SCHWESERNOTES™ 2016 LEVEL II CFA® BOOK 4: ALTERNATIVE INVESTMENTS AND FIXED INCOME ©2015 Kaplan , Inc All rights reserved Published in 2015 by Kaplan, Inc Printed in the United States of America ISBN: 978-1-4754-3532-0 PPN: 3200-6844 If this book does not have the hologram with the Kaplan Schweser logo on the back cover, it was distributed without permission of Kaplan Schweser, a Division of Kaplan , Inc., and is in direct violation of global copyright laws Your assistance in pursuing potential violators of chis law is greatly appreciated Required CFA Institute disclaimer: "CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by Kaplan Schweser CFA ® and Chartered Financial Analyst® are trademarks owned by CFA Institute." Certain materials contained within this text are the copyrighted property of CFA Institute The following is the copyright disclosure for these materials: "Copyright, 2015, CFA Institute Reproduced and republished from 2016 Learning Outcome Statements, Level I, II, and III questions from CFA ® Program Materials, CFA Institute Standards of Professional Conduct, and CFA lnstitute's Global Investment Performance Standards with permission from CFA Institute All Rights Reserved." These materials may not be copied without written permission from the author The unauthorized duplication of these notes is a violation of global copyright laws and the CFA Institute Code of Ethics Your assistance in pursuing potential violators of this law is greatly appreciated Disclaimer: The Schweser Notes should be used in conjunction with the original readings as set forth by CFA Institute in their 2016 Level II CFA Study Guide The information contained in these Notes covers topics contained in the readings referenced by CFA Institute and is believed to be accurate However, their accuracy cannot be guaranteed nor is any warranty conveyed as to your ultimate exam success The authors of the referenced readings have not endorsed or sponsored these Notes Page iv ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted READINGS AND LEARNING OUTCOME STATEMENTS READINGS The following material is a review of the Alternative Investments and Fixed Income principles designed to address the learning outcome statements set forth by CFA Institute STUDY SESSION 13 Reading Assignments Alternative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2015) 39 Private Real Estate Investments 40 Publicly Traded Real Estate Securities 41 Private Equity Valuation 42 A Primer on Commodity Investing page page 34 page 61 page 109 STUDY SESSION 14 Reading Assignments Alternative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2015) 43 The Term Structure and Interest Rates Dynamics 44 The Arbitrage-Free Valuation Framework 45 Valuation and Analysis: Bonds with Embedded Options page 132 page 164 page 185 STUDY SESSION 15 Reading Assignments Alternative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2015) 46 Credit Analysis Models ©2015 Kaplan, Inc page 219 Page v PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Readings and Learning Outcome Statements LEARNING OUTCOME STATEMENTS (LOS) The CFA Institute Learning Outcome Statements are listed below These are repeated in each topic review; however, the order may have been changed in order to get a better fit with the flow of the review STUDY SESSION 13 The topical coverage corresponds with the following CFA Institute assigned reading: 39 Private Real Estate Investments The candidate should be able to: a classify and describe basic forms of real estate investments (page 1) b describe the characteristics, the classification, and basic segments of real estate (page 2) c explain the role in a portfolio, economic value determinants, investment characteristics, and principal risks of private real estate (page 4) d describe commercial property types, including their distinctive investment characteristics (page 6) e compare the income, cost, and sales comparison approaches to valuing real estate properties (page 7) f estimate and interpret the inputs (for example, net operating income, capitalization rate, and discount rate) to the direct capitalization and discounted cash flow valuation methods (page 9) g calculate the value of a property using the direct capitalization and discounted cash flow valuation methods (page 9) h compare the direct capitalization and discounted cash flow valuation methods (page 17) calculate the value of a property using the cost and sales comparison approaches (page 18) j describe due diligence in private equity real estate investment (page 23) k discuss private equity real estate investment indices, including their construction and potential biases (page 23) l explain the role in a portfolio, the major economic value determinants, investment characteristics, principal risks, and due diligence of private real estate debt investment (page 4) m calculate and interpret financial ratios used to analyze and evaluate private real estate investments (page 24) The topical coverage corresponds with the following CFA Institute assigned reading: 40 Publicly Traded Real Estate Securities The candidate should be able to: a describe types of publicly traded real estate securities (page 34) b explain advantages and disadvantages of investing in real estate through publicly traded securities (page 35) c explain economic value determinants, investment characteristics, principal risks, and due diligence considerations for real estate investment trust (REIT) shares (page 37) d describe types of REITs (page 39) e justify the use of net asset value per share (NAVPS) in REIT valuation and estimate NAVPS based on forecasted cash net operating income (page 43) Page vi ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Readings and Learning Outcome Statements f describe the use of funds from operations (FFO) and adjusted funds from operations (AFFO) in REIT valuation (page 46) g compare the net asset value, relative value (price-to-FPO and price-to-AFFO), and discounted cash flow approaches to REIT valuation (page 47) h calculate the value of a REIT share using net asset value, price-to-FPO and price-toAFFO, and discounted cash flow approaches (page 48) The topical coverage corresponds with the following CFA Institute assigned reading: 41 Private Equity Valuation The candidate should be able to: a explain sources of value creation in private equity (page 62) b explain how private equity firms align their interests with those of the managers of portfolio companies (page 63) c distinguish between the characteristics of buyout and venture capital investments (page 64) d describe valuation issues in buyout and venture capital transactions (page 68) e explain alternative exit routes in private equity and their impact on value (page 72) f explain private equity fund structures, terms, valuation, and due diligence in the context of an analysis of private equity fund returns (page 73) g explain risks and costs of investing in private equity (page 78) h interpret and compare financial performance of private equity funds from the perspective of an investor (page 80) calculate management fees, carried interest, net asset value, distributed to paid in (DPI), residual value to paid in (RVPI), and total value to paid in (TVPI) of a private equity fund (page 83) j calculate pre-money valuation, post-money valuation, ownership fraction, and price per share applying the venture capital method 1) with single and multiple financing rounds and 2) in terms ofIRR (page 85) k demonstrate alternative methods to account for risk in venture capital (page 90) The topical coverage corresponds with the following CFA Institute assigned reading: 42 A Primer on Commodity Investing The candidate should be able to: a describe types of market participants in commodity futures markets (page 109) b explain storability and renewability in the context of commodities and determine whether a commodity is storable and/or renewable (page 111) c explain the convenience yield and how it relates to the stock (inventory level) of a commodity (page 111) d distinguish among capital assets, store-of-value assets, and consumable or transferable assets and explain implications for valuation (page 112) e compare ways of participating in commodity markets, including advantages and disadvantages of each (page 113) f explain backwardation and contango in terms of spot and futures prices (page 116) g describe the components of return to a commodity futures and a portfolio of commodity futures (page 118) h explain how the sign of the roll return depends on the term structure of futures prices (page 120) compare the insurance perspective, the hedging pressure hypothesis, and the theory of storage and their implications for futures prices and expected future spot prices (page 121) ©2015 Kaplan, Inc Page vii PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Readings and Learning Outcome Statements STUDY SESSION 14 The topical coverage corresponds with the following CFA Institute assigned reading: 43 The Term Structure and Interest Rate Dynamics The candidate should be able to: a describe relationships among spot rates, forward rates, yield to maturity, expected and realized returns on bonds, and the shape of the yield curve (page 132) b describe the forward pricing and forward rate models and calculate forward and spot prices and rates using those models (page 134) c describe how zero-coupon rates (spot rates) may be obtained from the par curve by bootstrapping (page 136) d describe the assumptions concerning the evolution of spot rates in relation to forward rates implicit in active bond portfolio management (page 138) e describe the strategy of riding the yield curve (page 141) f explain the swap rate curve and why and how market participants use it in valuation (page 142) g calculate and interpret the swap spread for a given maturity (page 144) h describe the Z-spread (page 146) describe the TED and Libor-OIS spreads (page 147) j explain traditional theories of the term structure of interest rates and describe the implications of each theory for forward rates and the shape of the yield curve (page 148) k describe modern term structure models and how they are used (page 151) l explain how a bond's exposure to each of the factors driving the yield curve can be measured and how these exposures can be used to manage yield curve risks (page 153) m explain the maturity structure of yield volatilities and their effect on price volatility (page 155) The topical coverage corresponds with the following CFA Institute assigned reading: 44 The Arbitrage-Free Valuation Framework The candidate should be able to: a explain what is meant by arbitrage-free valuation of a fixed-income instrument (page 164) b calculate the arbitrage-free value of an option-free, fixed-rate coupon bond (page 165) c describe a binomial interest rate tree framework (page 166) d describe the backward induction valuation methodology and calculate the value of a fixed-income instrument given its cash flow at each node (page 168) e describe the process of calibrating a binomial interest rate tree to match a specific term structure (page 169) f compare pricing using the zero-coupon yield curve with pricing using an arbitragefree binomial lattice (page 171) g describe pathwise valuation in a binomial interest rate framework and calculate the value of a fixed-income instrument given its cash flows along each path (page 174) h describe a Monte Carlo forward-rate simulation and its application (page 175) Page viii ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Readings and Learning Outcome Statements The topical coverage corresponds with the following CFA Institute assigned reading: 45 Valuation and Analysis: Bonds with Embedded Options The candidate should be able to: a describe fixed-income securities with embedded options (page 185) b explain the relationships between the values of a callable or putable bond, the underlying option-free (straight) bond, and the embedded option (page 186) c describe how the arbitrage-free framework can be used to value a bond with embedded options (page 186) d explain how interest rate volatility affects the value of a callable or putable bond (page 189) e explain how changes in the level and shape of the yield curve affect the value of a callable or putable bond (page 190) f calculate the value of a callable or putable bond from an interest rate tree (page 186) g explain the calculation and use of option-adjusted spreads (page 190) h explain how interest rate volatility affects option adjusted spreads (page 192) calculate and interpret effective duration of a callable or putable bond (page 193) j compare effective durations of callable, putable, and straight bonds (page 194) k describe the use of one-sided durations and key rate durations to evaluate the interest rate sensitivity of bonds with embedded options (page 195) l compare effective convexities of callable, putable, and straight bonds (page 197) m describe defining features of a convertible bond (page 198) n calculate and interpret the components of a convertible bond's value (page 198) o describe how a convertible bond is valued in an arbitrage-free framework (page 201) p compare the risk-return characteristics of a convertible bond with the risk-return characteristics of a straight bond and of the underlying common stock (page 201) STUDY SESSION 15 The topical coverage corresponds with the following CFA Institute assigned reading: 46 Credit Analysis Models The candidate should be able to: a explain probability of default, loss given default, expected loss, and present value of the expected loss and describe the relative importance of each across the credit spectrum (page 219) b explain credit scoring and credit ratings, including why they are called ordinal rankings (page 220) c explain strengths and weaknesses of credit ratings (page 222) d explain structural models of corporate credit risk, including why equity can be viewed as a call option on the company's assets (page 222) e explain reduced form models of corporate credit risk, including why debt can be valued as the sum of expected discounted cash flows after adjusting for risk (page 224) f explain assumptions, strengths, and weaknesses of both structural and reduced form models of corporate credit risk (page 226) g explain the determinants of the term structure of credit spreads (page 228) h calculate and interpret the present value of the expected loss on a bond over a given time horizon (page 228) compare the credit analysis required for asset-backed securities to analysis of corporate debt (page 230) ©2015 Kaplan, Inc Page ix PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted The following is a review of the Alternative Investments principles designed to address the learning outcome statements set forth by CFA Institute Cross-Reference to CFA Institute Assigned Reading #39 PRIVATE REAL ESTATE INVESTMENTS Study Session 13 EXAM Focus This topic review concentrates on valuation of real estate The focus is on the three valuation approaches used for appraisal purposes, especially the income approach Make sure you can calculate the value of a property using the direct capitalization method and the discounted cash flow method Make certain you understand the relationship between the capitalization rate and the discount rate Finally, understand the investment characteristics and risks involved with real estate investments LOS 39.a: Classify and describe basic forms of real estate investments CFA ® Program Curriculum, Volume 5, page FORMS OF REAL ESTATE There are four basic forms of real estate investment that can be described in terms of a two-dimensional quadrant In the first dimension, the investment can be described in terms of public or private markets In the private market, ownership usually involves a direct investment like purchasing property or lending money to a purchaser Direct investments can be solely owned or indirectly owned through partnerships or commingled real estate funds (CREF) The public market does not involve direct investment; rather, ownership involves securities that serve as claims on the underlying assets Public real estate investment includes ownership of a real estate investment trust (REIT), a real estate operating company (REOC), and mortgage-backed securities The second dimension describes whether an investment involves debt or equity An equity investor has an ownership interest in real estate or securities of an entity that owns real estate Equity investors control decisions such as borrowing money, property management, and the exit strategy A debt investor is a lender that owns a mortgage or mortgage securities Usually, the mortgage is collateralized (secured) by the underlying real estate In this case, the lender has a superior claim over an equity investor in the event of default Since the lender must be repaid first, the value of an equity investor's interest is equal to the value of the property less the outstanding debt Each of the basic forms has its own risk, expected returns, regulations, legal issues, and market structure Private real estate investments are usually larger than public investments because real estate is indivisible and illiquid Public real estate investments allow the property to ©2015 Kaplan, Inc Page PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Study Session 13 Cross-Reference to CFA Institute Assigned Reading #39 - Private Real Estate Investments remain undivided while allowing investors divided ownership As a result, public real estate investments are more liquid and enable investors to diversify by participating in more properties Real estate must be actively managed Private real estate investment requires property management expertise on the part of the owner or a property management company In the case of a REIT or REOC, the real estate is professionally managed; thus, investors need no property management expertise Equity investors usually require a higher rate of return than mortgage lenders because of higher risk As previously discussed, lenders have a superior claim in the event of default As financial leverage (use of debt financing) increases, return requirements of both lenders and equity investors increase as a result of higher risk Typically, lenders expect to receive returns from promised cash flows and not participate in the appreciation of the underlying property Equity investors expect to receive an income stream as a result of renting the property and the appreciation of value over time Figure summarizes the basic forms of real estate investment and can be used to identify the investment that best meets an investor's objectives Figure 1: Basic Forms of Real Estate Investment Debt Equity Private Mortgages Direct investments such as sole ownership, partnerships, and other forms of commingled funds Public Mortgage-backed securities Shares of REITs and REOCs LOS 39.b: Describe the characteristics, the classification, and basic segments of real estate CFA® Program Curriculum, Volume 5, page REAL ESTATE CHARACTERISTICS Real estate investment differs from other asset classes, like stocks and bonds, and can complicate measurement and performance assessment Heterogeneity Bonds from a particular issue are alike, as are stocks of a specific company However, no two properties are exactly the same because of location, size, age, construction materials, tenants, and lease terms High unit value Because real estate is indivisible, the unit value is significantly higher than stocks and bonds, which makes it difficult to construct a diversified portfolio Page ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted SELF-TEST: FIXED INCOME Use the following information for Questions through Jonathan Song is a CFA candidate who recently took the Level II exam and is currently waiting to receive his test results Song is also pursuing his MBA at a prestigious Ivy League university He has accepted a position as an intern at a large brokerage firm in New York for this year's summer break Over the course of his internship, he will rotate among the different areas of the firm, spending two weeks in each His current rotation is in the brokerage firm's research department where he will report to Bill Dixon, a managing director whose group is responsible for bond analytics Dixon is evaluating all of the interns who rotate through his department this summer to identify possible candidates for future permanent positions at the brokerage firm Song has successfully completed several courses in finance and economics, and Dixon seeks to assess Song's knowledge of various concepts that are of specific importance to his group Dixon decides to focus first on valuation of fixed income securities To this end, Dixon supplies Song with some fundamental market information Figure shows paths from a three-year binomial interest rate tree for risk-free securities using current market data Figure 1: Benchmark Interest Rate Paths for 3-year horizon Path Year Year Year 2% 2.8050% 4.0787% 2% 2.8050% 3.0216% 2% 2.0780% 3.0216% 2% 2.0780% 2.2384% Dixon wants Song to value three-year, 4% annual pay, $100 face value Zena, Inc., bonds The bonds have a Bermudan-style call option that can be exercised at par in one and two years Comparable bonds have an OAS of 1OObps Dixon explains to Song that investments in callable bonds have special interest rate risk considerations Dixon states, "Callable bonds exhibit negative convexity When the underlying option is at- or nearthe-money, a callable bond will have lower one-sided down-duration than one-sided upduration." While discussing spread measures, Song states, "Everything else constant, higher OAS indicates better compensation for risk However, OAS estimation for callable bonds can be biased upward if the analyst uses too high an estimate of interest rate volatility." Song says that an analyst could use structural models to analyze credit risk of Zena, Inc., bonds, and that one of the ways to evaluate credit risk is to look at the economic exposure of the equity investors Specifically, owning equity is similar to owning a European option on the assets of the company When Dixon asks about term structure of interest rates, Song mentions that he had attended a seminar on that topic at university the previous semester While Song could not remember the specific model, he recalled that it had a drift term ensuring mean reversion of rates and a constant level of volatility Page 238 ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Self-Test: Fixed Income Using the information in Figure 1, the values of the bond under Path and Path for a three-year, 3% annual-pay benchmark security is closest to: Path Path A $99.98 $100.15 B $100.18 $101.15 C $102.32 $103.98 Using the information given in the case and in Figure 1, the value of 4% Zena, Inc., callable bond is closest to: A $97.12 B $100.00 C $100.82 Dixon's statement about interest rate risk of callable bonds is most accurately described as: A correct B incorrect about convexity C incorrect about one-sided duration Song's statement regarding OAS is most accurately described as: A correct B incorrect about higher OAS indicates better compensation for risk C incorrect about OAS estimation for callable bonds can be biased upward While discussing structural models, the European option that Song discusses is most likely a: A conversion option B put option C call option The term structure model that Song is referring to is most likely the: A Cox-Ingersoll-Ross model B Vasicek model C Ho-Lee model ©2015 Kaplan, Inc Page 239 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Self-Test: Fixed Income SELF-TEST ANSWERS: FIXED INCOME B Pathwise valuation discounts each cashflow with its corresponding spot or forward rate A three-year, 3% annual pay bond would have cash flows of $3, $3, and $103 in years l, 2, and 3, respectively The values for each path and the average value is shown below Path Year Year Year Value 2% 2.8050% 4.0787% $100.18 2% 2.8050% 3.0216% $101.15 2% 2.0780% 3.0216% $101.85 2% 2.0780% 2.2384% $102.58 Average $101.44 (1.02) Path value = - - + C 103 -100.18 + (1.02)(1.02805) (l 02)(1.02805)(1.040787) The value of Zena, Inc., callable bond is $100.82 as shown below The interest rate tree is updated by adding a constant spread (OAS) of 1OObps at each node $98.97 $4.0 4.0787% + 1% $99.68 $4.0 2.8050% + 1% $100.82 2.00%+ 1% 104 (1.050787) 104 V2,UL = V2,LL = $188.?'i $100.00 $4.0 2.2384% + 1% ;.;;;- i.Yii•M V2,UU = $188.88 $100.00 $4.0 2.0780% + 1% $9.98 $4.0 3.0216% + 1% (1.040216) 11111 $100.00 $4.0 $100.00 - $4.0 $100.00 $4.0 ;.;;;- = $98.97 $99.98 l0 = $100.74 (1.032384) Because at node V LL> call price, the call option is exercised and we replace the node value with the call price of $100 Page 240 ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Self-Test: Fixed Income v, u = ' V _!_x[98.97 +4 + 99.98 + 4] = $99 _68 1.038050 1.038050 2-x[99.98+4 + 100+4]=$l00 88 1.03078 1.03078 = l,L Because at node v,,L > call price, the call option is exercised and we replace the node value with call price of $100 Vo= 2-x[99.68 + + 100+4] = $l00_ 82 1.03 1.03 A Dixon is correct about callable bonds exhibiting negative convexity This occurs when the option is at or near money Dixon is also correct that when the underlying option is at or near money, for a given decrease in rates, the price appreciation of a callable bond will be lower than loss in value for an equal amount of increase in rates Hence, the callable bond will have lower one-sided down-duration than one-sided up-duration C Song is correct about higher OAS reflecting higher compensation for risk Song is incorrect about the relationship between assumed volatility and computed OAS for a callable bond If the assumed volatility is too high, the computed OAS for a callable bond would be too low and hence the bias would be on the downside C Equity investors can be thought of as holders of a European call option on the assets of the company with a strike price equal to the face value of debt At the maturity of debt, if the assets of the company are worth more than the face value of debt, the option is exercised (i.e., debt is paid) However, if the assets are insufficient to pay the debt, due to limited liability of shareholders, the option is allowed to expire (i.e., the company defaults) B Drift term to ensure mean reversion of interest rates is a feature of the Cox-IngersollRoss model and the Vasicek model The Cox-Ingersoll-Ross model has volatility increasing with rates (and hence not constant) The Vasicek model assumes constant level of volatility over the period of analysis (i.e., independent of the level of interest rates) ©2015 Kaplan, Inc Page 241 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted FORMULAS STUDY SESSION 13: ALTERNATIVE INVESTMENTS net operating income: rental income if fully occupied + other income = potential gross income - vacancy and collection loss = effective gross income - operating expense = net operating income capitalization rate: cap rate = discount rate - growth rate NOI cap rate = - value or cap rate = NOI comparable sales price value of a property using direct capitalization: NOI value = V0 = - - ~ cap rate or value = Vo = stabilized NOI cap rate rent value of a property based on net rent and "all risks yield": value = V0 = - -1 ARY value of a property using gross income multiplier: I gross mcome mu up 11er = value = sales price gross mcome gross income x gross income multiplier term and reversion property valuation approach: total value = PV of term rent + PV reversion to ERV layer approach: total value = PV of term rent + PV of incremental rent NCREIF Property Index (NPI) calculation: NOI - capital expenditures+ ( end market value - beg market value) return= beginning market value Page 242 ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Formulas debt service coverage ratio (DSCR): DSCR loan-to-value (LTV) ratio: LTV = first-year NOi debt service loan amount = -appraisal value capitalization rate based on comparable recent transactions: capita11zat1on rate = net operating income property value capitalization of a property's rental stream: property va1ue = net operating income cap1talizat10n rate Net Asset Value approach to REIT share valuation: estimated cash NOi -, assumed cap rate = estimated value of operating real estate + cash and accounts receivable - debt and other liabilities = net asset value -, shares outstanding = NAY/share price-to-FPO approach to REIT share valuation: funds from operations (FFO) -, shares outstanding = FFO/share x sector average P/FFO multiple = NAY/share price-to-AFFO approach to REIT share valuation: funds from operations (FFO) - non-cash rents: - recurring maintenance-type capital expenditures =AFFO -, shares outstanding = AFFO/share x property subsector average P/AFFO multiple = NAY/share ©2015 Kaplan, Inc Page 243 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Formulas discounted cash flow approach to REIT share valuation: value of a REIT share = PV(dividends for years through n) + PV(terminal value at the end of yearn) exit value: investment cost earnings growth + + mcrease m price multiple + reduction in debt exit value NAV before distributions: NAV after distributions in prior year + capital called down management fees carried interest distributions + operating results NAV after distributions: NAV before distributions venture capital method: the post-money portion of a firm purchased by an investment is: _ investment f1 PV1 (exit value) the number of new shares issued is: sharesvc = sharesEQUI1Y ( ) l - f1 where sharesEQUITY is the pre-investment number of shares, and share price is: investment pnce = - - - - sharesvc forward price (F ) vs spot price (S ) of a commodity: return components of commodity futures investments: total return Page 244 = spot return + roll return + collateral return + rebalancing return ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Formulas excess return, reflecting an uncollateralized futures investment: excess return = spot return + roll return = futures return total return, representing a fully cash-collateralized commodity investment: total return = = F -FT t- ,t t, Ft- 1,t = roll return collateral return + futures return collateral return + spot return + roll return = t -FT t, St STUDY SESSIONS 14 AND 15: FIXED INCOME price of a T-period zero-coupon bond forward price (at t Ii· - (j,k) - = j) of a zero-coupon bond maturing at (j+k) [l+f(j,k)f forward pricing model p (j+k) = Pl (j ,k) Therefore: Ii · - p(j+k) p (J,k) - J forward rate model [l + S(j+k)J C+k) J = (1 + · k S?· [l + fi.J,k)J or · k [l + fi.J,k)J [l + S(j+k)J C+k) J = I (1 + S?· swap spread swap spreadt = swap rater - Treasury yieldt ©2015 Kaplan, Inc Page 245 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Formulas TED Spread TED Spread (3-month LIBOR rate) - (3-month T-bill rate) = Libor-OIS spread Libor-OIS spread = LIBOR rate - "overnight indexed swap" rate Portfolio value change due to level, steepness, and curvature movements callable bond v eal! = v straight - v callable putable bond v puta bl e = v stra1g h t + v put V put = V putabl e -Vstra1g ht effective duration = ED BV_ y - BV+ y = - x BV0 x ~y effective convexity = EC BV_ y + BV+ y - (2 x BV0 ) = BV0 x ~y2 capped/floored floaters value of a capped floater = value of a "straight" floater - value of the embedded cap value of a floored floater = value of a "straight" floater + value of the embedded floor convertible bond minimum value of convertible bond market convers10n pnce Page 246 = = greater of conversion value or straight value market price of convertible bond convers10n rauo ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Formulas market conversion premium per share price = market conversion price - stock's market market conversion premium ratio market conversion premmm ratio = market conversion premium per share market price of common stock h l ( market price of convertible bond premmm over stra1g t va ue = straight value J- callable and putable convertible bond value = straight value of bond + value of call option on stock value of call option on bond + value of put option on bond credit analysis recovery rate = percentage of money received upon default of the issuer loss given default (%) expected loss = = 100 - recovery rate probability of default x loss given default present value of expected loss = (value of a credit-risky bond) - (value of otherwise identical risk-free bond) ©2015 Kaplan, Inc Page 247 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted INDEX A active management adjusted funds from operations (AFFO) 46 administrative costs 80 agency risk 79 all risks yield (ARY) 11 American-style option 185 arbitrage-free models of the term structure of interest rates 152 arbitrage-free valuation 164 arbitrage-free values 169 arbitrageurs 110 asset-backed securities 230 audit costs 80 availability of information B backwardation 116 backward induction 168 Bermudan-style option 185 binomial interest rate tree 166, 169 board representation 63 bootstrapping 136, 171, 228 business conditions buyout investments 64 buyout valuation issues 67 D c calibration 224 callable bonds 185 capital appreciation capital asset pricing model (CAPM) 121 capital assets 112 capitalization rate 10, 43 capital risk 79 carried interest 74, 84 clawback 75 co-investment 76 collateralized debt obligation (CDO) 63 collateralized loan obligation (CLO) 62 collateral return 119 commingled real estate funds (CREF) commodity index certificate 115 commodity markets 113 Commodity Trading Advisors 114 competitive environment risk 79 consumable or transferable (CIT) assets 112 Page 248 contango 116 control mechanisms 63 convenience yield 111 conversion period 198 conversion price 198 conversion ratio 198 conversion value 198 convertible bond 198 corporate debt 230 corporate governance 75 cost and availability of capital cost and availability of debt capital cost approach Cox-Ingersoll-Ross model 151 credit ratings 221, 222 credit risk 219 credit scoring 221 credit spread 220 current income curvature of the yield curve 153, 154 debt service coverage ratio (DSCR) 24 demographic factors depreciation and desirability difficulty in determining price dilution costs 80 direct capitalization method discounted cash flow (DCF) analysis 66, 67 discounted cash flow method distributed to paid-in capital (DPI) 81, 84 distribution waterfall 75 diversification diversification risk 79 diversified REITs 41 dominance 164 drift adjusted 175 due diligence 23, 78 E earn-outs 64 economic life 19 effective age 19 effective convexity 193, 197 effective duration 153, 193 embedded options 185 environmental issues equilibrium term structure models 151 ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Index equity dividend rate 25 equity REITs 34 equivalent yield 16 estate put 186 European-style option 185 excess return index 119 exchange-traded fund (ETF) 115 exit routes 72 exit timing 73 exit value 68 expected loss 219 expected return 134 expected terminal value 92 extendible bond 185 investment vehicle fund setup costs 80 IRR method 86 I-spread 144 issuer-pays model 222 K key man clause 75 key rate duration 153, 195 L lack of liquidity 3, layer method 15 LBO model 68 level of the yield curve 153, 154 leverage leveraged buy-out (LBO) 66, 67 LIBOR-OIS spread 148 liquidation 72 liquidity preference theory 149 liquidity risk 79 loan-to-value (LTV) 24 local expectations theory 149 loss given default 219 F FICO scores 221 forward curve 133 forward pricing model 134 forward rate 132, 133 forward rate model 135 funds from operations (FFO) 46 future parity 116 G M Global Investment Performance Standards (GIPS) 80 gross income multiplier technique 12 gross IRR 80 hazard rate estimation 226 health care REITs 40 hedgers 109 hedging pressure hypothesis 122 hedonic index 24 heterogeneity high transaction costs high unit value hotel REITs 41 hurdle rate 74 management and performance costs 80 management buyout (MBO) 67, 72 management expertise management fees 84 market approach 66 market conversion premium ratio 200 market risk 79 mezzanine finance 67 minimum value of a convertible bond 198 modern interest rate term structure models 151 Modigliani-Miller 62 Monte Carlo forward-rate simulation 175 Moody's 221 mortgage-backed securities (MBS) 35 mortgage REITs 35 multi-family I N illiquidity 66 implicit estimation techniques 224 income approach industrial industrial REITs 40 inflation hedge initial public offering (IPO) 72 insurance perspective 121 internal rate of return (IRR) 80 investment restrictions 76 NAV, distributions 84 net asset value (NAV) 77 net IRR 80 new property lead time no-fault divorce 76 noncompete clauses 63 NPV method 86 H ©2015 Kaplan, Inc Page 249 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Index retail or shopping center REITs 39 reversionary potential 14 "riding the yield curve" 141 "rolling down the yield curve" 141 roll return 119, 120 office office REITs 40 one-sided duration 195 option adjusted spread (OAS) 191 option-free bond 186 ordinal rankings 220 s paid-in capital (PIC) 81, 84 par curve 136 par rate 136 par rate curve 136 partial durations 195 path dependent 175 path wise valuation 174 performance disclosure 75 placement fees 80 post-money (POST) valuation 70 post-money value 85 preferred habitat theory 150 premium over straight value 200 pre-money (PRE) valuation 70 pre-money value 85 present value of expected loss 220, 228 priority in claims 63 private equity 61 private equity fund terms 73 private equity valuation 66 probability of default 219 probability of loss 230 pure expectations theory 148 putable bonds 185 sales comparison approach scenario analysis 92 secondary market sale 72 segmented markets theory 150 shape of the yield curve 148 shaping risk 153 sinking fund bonds 186 speculators 110 spot curve 132, 171 spot rates 132 spot return 118 spot yield curve 132 Standard & Poor's 221 steepness of the yield curve 153, 154 storabili ty 111 storage REITs 41 store of value assets 112 straight bond 186 straight value 198 stripping 164 structural model of corporate credit risk 222, 226 structured products 114 swap fixed rate 142 swap rate 142 swap rate curve 142 swap spread 144 R T ratchet 74 real estate investment trust (REIT) real estate operating company (REOC) real option analysis 66 rebalancing return 119 reconstitution 164 recovery rate 219 reduced form model of corporate credit risk 224, 225 , 227 regulatory risk 79 relative value 66 removal for cause 76 renewability 111 repeat-sales index 24 replacement cost 66 residential (multi-family) REITs 40 residual cap rate 13 residual value to paid-in capital (RVPI) 81, 84 retail tag-along, drag-along 63, 76 target fund size tax benefits tax risk 79 TED spread 147 term and reversion approach 14 terminal value 13 term of the fund term sheet 63 term structure of credit spreads 228 term structure of interest rate volatility 15 theories of the term structure of interest rates 148 theory of storage 112, 122 total return index 120 total value to paid-in capital (TVPI) 81, 84 trailer fee 80 transaction costs 79 p Page 250 ©2015 Kaplan, Inc PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Book - Alternative Investments and Fixed Income Index u y unbiased expectations theory 148 unexpected inflation unquoted investments risk 79 yield to maturity 133 v zero-coupon yield curve 171 Z-spread 146 z value additivity 164 Vasicek model 152 venture capital 64 venture capital investments 70 venture capital method 66, 85 vintage 74 ©2015 Kaplan, Inc Page 251 PRINTED BY: Xiangzhi Zeng Printing is for personal, private use only No part of this book may be reproduced or transmitted without publisher's prior permission Violators will be prosecuted Notes ... this book may be reproduced or transmitted without publisher''s prior permission Violators will be prosecuted SCHWESERNOTES™ 2016 LEVEL II CFA? ? BOOK 4: ALTERNATIVE INVESTMENTS AND FIXED INCOME. .. page 34 page 61 page 109 STUDY SESSION 14 Reading Assignments Alternative Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2015) 43 The Term Structure and. .. Investments and Fixed Income, CFA Program Curriculum, Volume 5, Level II (CFA Institute, 2015) 39 Private Real Estate Investments 40 Publicly Traded Real Estate Securities 41 Private Equity Valuation 42