CAIA notes CAIA level II book 2

CAIA Notes

September 2009 Exam

®

CAIA Notes

®

Book 2 (Topics 7-11)

September 2009 Exam Level II Book 2 —Topics 7-11

Level II


II Exam Prep • 225 Park Avenue South • New York, NY 10003 • www.iiexamprep.com
Customer Service 212.224.3800 • e-mail:


CAIA® Notes
CAIA Level II
Book 2 (Topics 7-11)
September 2009 Exam

Copyright © 2009 Institutional Investor, Inc. (ISBN #0-9800485-4-0 978-0-9800485-4-4) POSTMASTER: Send address changes for CAIA® Notes to Circulation
Department, Institutional Investor, Inc., 225 Park Avenue South, New York, NY 10003. Phone (212) 224-3800. Institutional Investor ExamPrep products should be
used together with the original reading materials recommended in the CAIA® Study Guide. Institutional Investor, Inc. is not responsible for the accuracy, completeness,
or timeliness of the information contained in the articles herein. Printed in the United States of America. Reproduction in whole or in part without written permission is
prohibited. No part of this publication may be reproduced or distributed in any form of by any means, or stored in a database or retrieval system, without prior written

consent from Institutional Investor ExamPrep. While Institutional Investor ExamPrep has attempted to provide accurate information in CAIA® Notes, the company
cannot guarantee the accuracy thereof. CAIA® Notes is provided without warranty of any kind, either expressed or implied. Any significant changes necessary and/
or identified corrections will be communicated to all purchasers. No statement in this book is to be construed as a recommendation to buy or sell securities. Product
names mentioned may be trademarks or service marks of their respective owners.


About the ExamPrep Faculty

ERIK BENRUD, CAIA, CFA, FRM
Curriculum Director
Erik Benrud is an associate clinical professor of finance at Drexel University’s LeBow College of
Business, Philadelphia. His research interests are hedge funds, swaps and options, and competition in financial services. Dr. Benrud has earned the CAIA, CFA and FRM designations. He has
extensive experience in teaching and writing exam preparatory material. He has authored several papers in derivatives, financial services, and financial forecasting. Dr. Benrud received his
Ph.D. from the University of Virginia.

VIKAS AGARWAL
Topic Author
Vikas Agarwal, who was Curriculum Director of IIExamPrep for two exam cycles in 2008-09, is
an assistant professor of finance at Georgia State University in Atlanta. He is widely published on
hedge fund strategy and performance, and has been teaching courses on asset pricing and the
financial system at Georgia State University since 2001. He has a Ph.D. in finance from the
London Business School

DONALD R. CHAMBERS, CAIA
Topic Author
Don Chambers, who was Curriculum Director of IIExamPrep until March 2008, is the Walter E.
Hanson/KPMG Peat Marwick Professor of Business and Finance at Lafayette College in Easton,
Penn. He is widely published on investments, corporate finance, risk management, and alternative investments. Dr. Chambers was one of the first candidates to earn the CAIA® designation,
and has played a leading role in designing learning materials for those taking the CAIA® examination.

HENRY A. DAVIS
Topic Author
Henry (Hal) Davis, an independent consultant, is editor of The Journal of Structured Finance
and The Journal of Investment Compliance. He has written and co-authored 15 books and
numerous articles in the areas of corporate finance and the financial markets.

URBI GARAY
Topic Author
Urbi Garay is a professor of finance at the IESA Business School in Caracas, Venezuela, and is currently a visiting professor and researcher at the Isenberg School of Management and the Center
for International Securities and Derivatives Markets (CISDM) at the University of Massachusetts, Amherst. He teaches both MBA and undergraduate courses in investments, derivatives products, corporate finance and international finance.


RAJ GUPTA
Topic Author
Raj Gupta is research director of the Center for International Securities and Derivatives Markets (CISDM) at the
University of Massachusetts, Amherst. He supervises the CISDM Hedge Funds and Managed Futures Database.
He is also a visiting faculty at Clark University. Dr. Gupta is assistant editor for The Journal of Alternative
Investments, and has published widely in leading financial journals and alternative investment books.

SANJAY K. NAWALKHA
Topic Author
Sanjay Nawalkha is an associate professor of finance at the Isenberg School of Management, University of
Massachusetts, Amherst, where he teaches fixed income, asset pricing, and finance theory. He has published several books and articles on interest rate risk and fixed income valuation. His most recent book series The Fixed
Income Valuation Course, includes Dynamic Term Structure Modeling and the forthcoming Credit Risk
Modeling.


TABLE OF CONTENTS
PART 5: CURRENT AND INTEGRATED TOPICS
Topic 7: Structured Products, New Products and New Strategies ........................................................ 1

Topic 8: Asset Allocation .............................................................................................................................. 19
Topic 9: Current Topics .............................................................................................................................. 47
Topic 10: Portfolio and Risk Management .............................................................................................. 73
Topic 11: Research Issues in Alternative Investments .......................................................................... 81

GLOSSARY .............................................................................................................................................................................................................. 105
INDEX............................................................................................................................................................................................................................ 117

CAIAA does not endorse, promote, review or warrant the accuracy of the products or services offered by Institutional Investor ExamPrep
(“II”), nor does it endorse any pass rates claimed by the provider. CAIAA is not responsible for any fees or costs paid by the user to II nor
is CAIAA responsible for any fees or costs of any person or entity providing any services to II. CAIA , CAIA Association , Chartered
Alternative Investment Analyst , and Chartered Alternative Investment Analyst Association , are service marks and trademarks owned
by CHARTERED ALTERNATIVE INVESTMENT ANALYST ASSOCIATION, INC., a Massachusetts non-profit organization with its
principal place of business at Amherst, Massachusetts, and are used by permission.
SM

®

®

®


Navigating the CAIA® Notes
CAIA® Notes are comprehensive study materials organized to prepare you for the
forthcoming CAIA® Exam. The CAIA® Notes are most effective when used in conjunction with the CAIA® Study Guide and original reading materials, and Institutional Investor’s CAIA® Prep software.
CAIA® Notes Level 2, Book 2 (Topics 7-12) is organized around the CAIA® Study
Guide’s “Learning Objectives”: it gives you summaries and explanations of what
our experienced authors believe are the most important issues in the curriculum.
That is, it provides you with the material that is most likely needed to correctly respond to the CAIA® exam questions.

CAIA® Notes begins by listing the CAIA Association® Course Outline by Topic and
Learning Objective. You can quickly reference a particular Learning Objective by
turning to the page number against each Learning Objective.
Each Topic starts by listing the Main Points from the CAIA® Study Guide. Within
that Topic, it then goes through the explanations for each Learning Objective and
its sub-parts. The Learning Objectives are summarized using various explanations,
examples, and calculations, where appropriate. Keywords are highlighted within
each Topic to remind you of these important terms as you read. Each Topic also
lists the original source references.
The Glossary aims to provide useful information directly related to the Keywords.
Each entry in the Glossary refers back to its relevant Topic. The Index at the end
also highlights the Keywords. In the Index, the page numbers in bold are the pages
on which a Keyword is found in its respective Topic.
Various icons are placed throughout the books to point out calculations, references, and note-worthy items. We have also boxed out important equations for quick
reference (you can also find a separate Formula Sheet at www.iiexamprep.com). All
of these features should assist you with your navigation through the various Topics
as you study.
For your convenience, we have produced both a digital and paper version of CAIA®
Notes. This allows you to download CAIA® Notes onto your laptop, or bring the
book with you in your briefcase, so that you can study anytime, anywhere.



CAIA® Study Guide Learning Objectives
This CAIA Association® listing is by Topic and Learning Objective. Each Learning Objective within a Topic has a page number
(in brackets) for this CAIA® Notes book.
PART 5: CURRENT AND INTEGRATED TOPICS
TOPIC 7: Structured Products, New Products and New Strategies
7.1 Describe the characteristics of a special purpose vehicle (SPV) in the context of collateralized obligations. (1)
7.2 Describe the key characteristics of a collateralized fund obligation (CFO). (2)

7.3 Explain the benefits and risks of investing in CFOs. (2)
7.4 Describe the structure of a collateralized commodity obligation (CCO). (3)
7.5 Describe the conceptual characteristics of infrastructure sectors. (3)
7.6 Compare infrastructure with other traditional and alternative assets. (4)
7.7 Critique the evidence on the performance history for infrastructure investments. (5)
7.8 Explain how the composition and construction of the following indices impact their relative performance: (5)
a. RREEF Hypothetical Infrastructure Index
b. UBS Global Infrastructure & Utilities Index
c. Moody’s Economy.com Infrastructure Index
7.9 Identify risks involved with infrastructure investments.(6)
7.10 Explain the economic implications of climate change in terms of its impacts on existing assets, future economic
activity, increased regulation, and consumer behavior. (7)
7.11 Describe the role of financial markets in reducing the economic cost of climate change through (7)
a. markets for catastrophe and weather risks.
b. emissions trading.
c. climate-related investments.
7.12 Explain the economics rationale for using financial instruments to transfer risk. (9)
7.13 Discuss the criteria that need to be fulfilled by instruments employed for risk transfer. (9)
7.14 Describe existing instruments that can be used to transfer risk and identify potential investors and sponsors of
these instruments. (10)
7.15 Describe both exchange traded as well as over-the-counter weather derivatives. (11)
7.16 Describe emissions trading, its project based mechanism, and its potential market participants. (11)
7.17 Compare the factor-based approach to hedge fund replication with the payoff distribution approach to hedge
fund replication, in terms of their: (12)
a. goals.
b. methodology.
c. ability to replicate hedge fund returns.
d. benefits.
e. drawbacks.
7.18 Discuss the term convergence as it is applied to the alternative investments industry. (14)

7.19 Compare and contrast the historical objectives of private equity funds with that of hedge funds. (14)
7.20 Contrast recent hedge fund participation in traditional private equity activities with recent private equity
participation in traditional hedge funds activities. (15)
7.21 Explain why the distressed investment space provides an excellent example of recent convergence of hedge fund
and private equity strategies. (16)
7.22 Describe the emergence of the hybrid hedge fund/private equity fund. (16)
7.23 Discuss the factors that contributed to the convergence of private equity and hedge fund strategies referencing
recent trends in the area. (17)
7.24 Discuss the concerns and risks related to the trend toward convergence of hedge fund and private equity fund
strategies. (18)
TOPIC 8: Asset Allocation
8.1 Calculate the portfolio’s asset values after a given change in the equity value, using: (19)
a. buy-and-hold.
b. constant mix.
c. constant-proportion portfolio insurance.
8.2 Compare the payoff and exposure diagrams of the buy-and-hold, constant mix, constant-proportion portfolio
insurance, and option-based portfolio insurance strategies. (23)
8.3 Determine the expected performance and cost of implementing strategies with concave payoff curves relative to
those with convex payoff curves under: (26)
a. trending markets.
b. flat (but oscillating) markets.
8.4 Discuss the motivations for and impact of resetting the parameters of dynamic strategies. (28)
8.5 Describe examples of undiversified “strategies” that have allowed individuals to become wealthy. (28)

Copyright © 2009 CAIA Association.® All Rights Reserved.

i


Topics and Learning Objectives

8.6
8.7
8.8

8.9
8.10
8.11
8.12
8.13
8.14
8.15
8.16
8.17
8.18
8.19
8.20
8.21
8.22
8.23
8.24
8.25
8.26
8.27
8.28

Describe changes in the financial system have thrust more responsibility upon individuals with regard to wealth
management and asset allocation. (28)
Explain and apply the concept of personal risk and its various components to the asset allocation problem faced
by individuals. (29)
Explain and apply the wealth allocation framework that accounts for various dimensions of risk and leads to an

ideal portfolio that provides: (29)
a. the certainty of protection from anxiety.
b. the high probability of maintaining one’s standard of living.
c. the possibility of substantially moving upward in the wealth spectrum.
Develop and justify an asset and risk allocation for an individual using the information provided to the candidate
during the examination. (30)
Understand the impact of alternative investments, including real estate, executive stock options and human
capital on asset allocation of individual investors. (31)
Describe and apply barbell and option based strategies in the context of asset allocation. (31)
Discuss reasons why the performance of rebalanced equally weighted commodity futures portfolio should not be
used to represent the return of commodity futures asset class. (32)
Explain why the three most commonly used commodity futures indices (GSCI, DJ-AIGCI, CRB) show different
levels of return and volatility over a common time period. (32)
Explain how the returns of a single cash-collateralized commodity futures and a portfolio of cash-collateralized
commodity futures can be decomposed into various sources of return. (33)
Discuss the four theoretical frameworks (CAPM, the insurance perspective, hedging pressure hypothesis, theory
of storage) used to explain the source of commodity futures excess returns. (34)
Explain the concepts of contango, normal backwardation and market backwardation. (35)
Calculate the roll yield of a commodity futures contract in backwardation or contango. (35) Note: The 12th line
from bottom of the left column should read “if inventories are high, the convenience yield may be low.”
Discuss the importance of roll return in explaining the long-run cross-sectional variation of commodity futures
returns and the implication for investors. (36)
Describe the relative importance of volatility of spot return and roll return in determining the volatility of
futures returns. (36)
Describe the impact of inflation and unexpected changes in the rate of inflation on individual commodity
contracts, sectors, and diversified commodity portfolios and indices. (36)
Explain how rebalancing and diversification can impact the geometric rate of return of a portfolio in comparison
to its arithmetic rate of return. (38)
Discuss the effectiveness of tactical asset allocation in commodity portfolios using strategies based on
momentum and term structure of futures prices. (38)

Argue against the use of naïve extrapolation of past commodities returns to forecast future performance and
discuss the importance of formulating forward-looking expectations. (39)
Discuss the role of global commercial real estate in a strategic asset allocation setting. (40)
Identify the components of the commercial real estate asset class and the relative advantages of direct real estate
investment and real estate investment trusts (REITs). (41)
Explain the historical performance and diversification benefits of select asset classes. (41)
Compare the assumptions and results of the CAPM approach to the Black-Litterman approach when
determining forward-looking asset allocations. (42)
Explain the seven caveats identified by the author as considerations for strategic asset allocation to global
commercial real estate. (43)

TOPIC 9: Current Topics
9.1 Understand what is meant by the “term structure of a commodity futures curve” and the terms “backwardation”
and “contango.” (47)
9.2 Understand the derivation of the futures curve for natural gas and the association between the curve and
potential determinants including anticipated production, consumption and seasonal factors. (47)
9.3 Explain a futures calendar-spread strategy and the sources of potential profits, potential losses and risk from this
type of strategy. (48)
9.4. Describe the type of calendar-spread strategy Amaranth employed and explain the rationale for this strategy as it
relates to natural gas pricing. (48)
9.5 Discuss the magnitude of Amaranth’s calendar-spread positions: explain how this hedge fund was able to
accumulate such large positions (including the role of position limits) and describe the effects of the magnitude
of the positions on daily profits and losses. (49)
9.6 Discuss the causes for increased volatility on the natural gas commodity futures market prior to Amaranth’s
liquidation in September 2006. (52)
9.7 Discuss how sophisticated storage operators can manage their storage facilities as a set of options on calendar
spreads. (52)
9.8 Describe how daily volatility as measured by standard deviation can underestimate potential risk (where risk is
defined as the likelihood of experiencing severe loss), and explain how scenario analysis can be used to better
indicate the risk of a fund’s structural position in such circumstances. (53)

Copyright © 2009 CAIA Association.® All Rights Reserved.

ii


Topics and Learning Objectives
9.9
9.10
9.11
9.12
9.13

9.14
9.15
9.16
9.17
9.18
9.19
9.20
9.21
9.22
9.23
9.24
9.25
9.26
9.27
9.28
9.29
9.30
9.31

9.32
9.33
9.34
9.35
9.36
9.37
9.38
9.39
9.40

Describe what is meant by “nodal” or “one-way” liquidity in the commodity markets and how the lack of “twoway” liquidity adversely affected Amaranth. (55)
Understand how forced liquidations can affect market prices and why changes in market prices can be correlated
with the size and direction of the liquidation. (55)
Discuss eight hypotheses explaining the market events of August 2007. (56)
Illustrate an understanding of the terminology used to describe distinct categories of fund strategies that fall
under the broad heading of “long/short equity.” (57)
Describe the anatomy of the long/short equity strategy. Explain how it is simulated in the paper, how the
strategy provides liquidity to the market place, how leveraged portfolio returns are constructed, the relationship
between market capitalization and the strategy’s profitability, and the practical implications of transactions
costs. (58)
Explain the return pattern of the main simulated strategy during the second week of August 2007. (60)
Compare and contrast market events in August 2007 with August 1998. (60)
Explain how the increase in total assets under management and the number of long/short funds over the 1998 to
2007 time period likely impacted expected returns and the use of leverage. (60)
Describe the set of hypotheses that are collectively referred to as the “unwind hypothesis.” (61)
Discuss one proposed measure of illiquidity of long/short equity funds and how the results have changed over
the past decade. (61)
Describe a method for approximating a network view of the hedge-fund industry and what such a view
indicates. (62)
Evaluate the statement: Quant failed in August 2007. (62)

Critique the methodology of the article. (63)
Evaluate the current outlook for systemic risk in the hedge fund industry. (64)
Describe a subprime loan and discuss the four principal reasons for the recent increase in sub-prime loan
delinquencies. (64)
Explain the economic motivations that enabled the waterfall payment structure of an ABS trust or CDO
structure with a collateral pool consisting of high-yield securities to attain an investment grade rating for the
securities they issued and the resulting contribution to the credit crisis. (65)
Explain the role of rating agencies in the credit crisis. (66)
Criticize the incentive compensation system for mortgage brokers and lenders and its adverse effect on the duediligence efforts at the firms. (66)
Explain the factors affecting the rating of a special investment vehicle (SIV). (66)
Describe the role of monolines. (67)
Explain the lack of incentives for banks to perform due diligence on the collateral pool. (67)
Explain the role and actions of central banks in 2007 and early 2008. (67)
Explain the role of valuation methods. (67)
Describe the lack of transparency in the credit markets. (68)
Describe how systemic risk arose in 2007. (68)
Argue how increased transparency in the rating process is necessary. (69)
Argue how standardization can simplify valuation issues. (69)
Assess the hidden risks of implicit and explicit off balance-sheet bank commitments and argue how increased
transparency can provide investors with information regarding financial institutions’ exposure. (69)
Describe how new product design can dampen market disruptions. (70)
Discuss possible regulatory responses. (70)
Describe sound risk management practices. (71)
Describe nonlinearities in the risk of subprime CDO tranches. (71)

TOPIC 10: Portfolio and Risk Management
10.1 Assess the long-run and short-run benefits of hedging the tail risk of a portfolio. (73)
10.2 Explain the relationship between systemic risk, liquidity risk, monetary policy and other macro events. (73)
10.3 Explain why increased correlation among various asset returns during periods of stress could provide
opportunities for free insurance against tail risk. (74)

10.4 Describe the four approaches to hedging or insuring a portfolio against tail risk. (74)
10.5 Explain why dynamic strategies such as portfolio insurance cannot be used to hedge against tail risk. (74)
10.6 Describe the three factors that impact the construction of a tail hedge. (75)
10.7 Explain why long-dated options may provide an inexpensive method for hedging tail risk. (75)
10.8 Evaluate the factors that lead to the underpricing of risk by investors. (75)
10.9 Explain the relationship between the real economy and capital markets and discuss the factors that have made
the real economy less volatile through time. (76)
10.10 Discuss why capital markets are complex and adaptive and explain the implications of these characteristics for
models of risk measurement. (76)
10.11 Compare and contrast the terms risk and uncertainty. (77)
10.12 Explain the role of shadow banking system as a source of liquidity and discuss why during periods of market
stress this source of liquidity may disappear. (77)
10.13 Demonstrate how cognitive biases can lead to errors in judgment by financial market participants. (78)
Copyright © 2009 CAIA Association.® All Rights Reserved.

iii


Topics and Learning Objectives
10.14 Describe factors complicating the establishment and maintenance of target allocations to illiquid asset classes.
(78)
10.15 Explain the role of Monte-Carlo simulation to achieve stable (steady-state) allocation in this study. (79)
10.16 Illustrate the total impact of several individual risk factors on private equity allocation drift. (79)
TOPIC 11: Research Issues in Alternative Investments
11.1 Illustrate how an investment in commodity futures can earn a positive return when spot commodity prices are
falling. (81)
11.2 Compare commodity spot returns and commodity futures returns. (82)
11.3 Compare commodity futures returns with stock returns and bond returns. (83)
11.4 Compare commodity futures risk with equity risk. (83)
11.5 Discuss the use of commodity futures as a hedge against inflation. (84)

11.6 Explain the diversification benefits of commodity futures. (84)
11.7 Describe the performance of commodity futures from a non-US investor’s perspective. (85)
11.8 Describe the difference between normal backwardation and a market that is in backwardation. (85)
11.9 Describe a trading strategy that uses basis in futures markets as an indication of risk premium in futures
markets. (86)
11.10 Describe the factors that cause smoothing and how smoothing impacts asset allocation decisions. (86)
11.11 Compare the results of Stevenson (2004) with previous studies on the impact of smoothing models on
allocations to real estate. (87)
11.12 Compare four approaches to generating an unsmoothed total real estate return series. (87)
11.13 Describe the impact of varying smoothing parameters for UK real estate return data on the optimal allocations
to real estate. (92)
11.14 In the Marcato and Key (2007) study, compare and contrast the results of using UK data with those employing
US and Australia real estate return data. (92)
11.15 Argue the best method of adjusting a real estate return series when conducting an asset allocation study. (93)
11.16 Describe the hedge fund business model presented by the authors. (93)
11.17 Analyze the issues in measuring the growth of the hedge fund industry. (94)
11.18 Evaluate the potential biases in hedge fund databases. (95)
11.19 Review the approach and describe the main findings of bottom-up research on hedge fund risk factors. (96)
11.20 Describe and assess the adequacy of the asset-based style (ABS) risk factor model used by Fung and Hsieh to
analyze hedge fund returns. (98)
11.21 Discuss the broader risks associated with hedge funds and describe the regulatory concerns. (99)
11.22 Describe the role of manager selection in the experience of a private equity investor. (99)
11.23 Discuss the challenges that an investor would face in measuring the risk-adjusted performance of private
equity. (100)
11.24 Explain the implication of the observation that mean and median returns on private equity databases are
significantly different. (101)
11.25 Explain and identify the potential bias in using the performance of liquidated funds to represent the overall
performance of private equity funds. (101)
11.26 Compare the performance of companies in which private equity firms invest with small cap firms listed on
NASDAQ. (101)

11.27 Explain the liquidity characteristics of listed private equity securities. (102)
11.28 Discuss the impacts of adjustment for stale prices on risk, return, and diversification benefits of private equity
(candidates do need to memorize exact figures). (102)
11.29 Identify the impact of IPO under-pricing on the performance of the PVCI. (103)
11.30 Explain how the following issues pose a challenge to private equity investors: (103)
a. Illiquidity.
b. Parameter uncertainty.
c. Absence of an investible index.
d. Cross-sectional differences in private equity managers.

Copyright © 2009 CAIA Association.® All Rights Reserved.

iv


TOPIC

7

Structured Products, New Products
and New Strategies

 Main

Points

 Explaining the structure, characteristics, benefits and risks of investing in
CFOs
 Explaining the characteristics of infrastructure investments and the practical
use of infrastructure indices

 Explaining the potential for financial markets and instruments to play a role in
alleviating negative climate change consequences
 Comparing factor-based and pay-off distribution approaches to hedge fund
replication
 Describing factors that contributed to convergence between private equity and
hedge fund strategies as well as concerns and risks regarding the past trend
1.

Describe the characteristics of a special purpose vehicle (SPV) in the
context of collateralized obligations.
Special purpose vehicles (SPVs) are used as the legal entities (e.g., trusts) that form the
center of every collateralized obligation (CO) structure. “Collateralized obligations” is
the umbrella term for a spectrum of asset-backed structures (e.g., collateralized debt
obligations (CDOs) and collateralized loan obligations (CLOs)) that hold debt obligations
as collateral and are financed with “tranches” or securities that typically have diverse
seniority and/or longevity.
The SPV is the entity that legally owns (holds) the collateral (the underlying debt, credit,
or other instruments), and is the entity that issues the various tranches that have claims to
the cash flows (senior, mezzanine and equity).
The SPVs are usually Delaware based business trusts or special purpose corporations. They
are referred to as “bankruptcy remote”. This means that a bankruptcy of the sponsoring
bank or the money manager will not affect the functioning of the CO structure.
The SPVs hold the collateral and distribute the cash flows from the collateral to the
tranche holders.
SPVs typically hold asset backed securities (ABS), which are bonds that are securitized
or collateralized by the cash flows from an underlying pool of assets—such as credit
cards, home loans, auto loans, equipment leases, or other non-mortgage related assets.
Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

1

Topic 7: Structured Products, New Products and New Strategies

2.

Describe the key characteristics of a collateralized fund obligation
(CFO).
Collateralized fund obligations (CFOs) are the application of the collateralized
obligation (CO) concept to investing in hedge funds and started in 2002. CFOs hold
portfolios of hedge funds and “repackage” the ownership of the portfolio into securities
or tranches with different levels of seniority and/or longevity.
CFOs allow investors to participate in alternative investment opportunities (typically
with diversification) through a spectrum of CFO tranches with various maturities and risk
levels that are potentially more tailored to the preferences of the investor and more easily
understood due to standardization and comparability to other similar programs. The debt
tranches may offer credit ratings and the equity tranches offer leverage.
For example, a CFO might be formed that requires that the portfolio of hedge funds
owned inside the CFO meet a number of minimum diversification requirements (e.g., 25
or more funds, 20 or more managers, no more than 10% with one fund, no more than
15% with one manager, etc.). The level of diversification is an important issue in
determining the relative value (and credit ratings) of the tranches or securities that have
claim to the cash flows generated by the portfolio.
Tranches are securities sold to investors that represent claims to the cash flows from the
portfolio. The tranches are usually denoted with letter names and vary in seniority from
very low risk senior tranches to an equity tranche with high risk. For example, tranche
“A” might represent half of the value of the CFO, might offer a low coupon (e.g., LIBOR
plus 60 basis points), have semi-annual coupon payments and have first priority to the
cash flows from the portfolio of hedge funds. Given this high priority and substantial
diversification of the portfolio's holdings, the tranche might receive a credit rating from a

major agency of AAA.
Less senior tranches would have higher coupons and lower credit ratings. Finally, the
equity tranche would be unrated and would receive the residual cash flows, if any, after
the debt tranches have been satisfied. Certain requirements such as a total net value might
be imposed which, if not met, trigger a liquidation (along with potential diversification
and liquidity requirements). These liquidation triggers are designed, along with the
diversification, to provide protection to the senior tranches so that they can be sold with
high credit ratings.

3.

Explain the benefits and risks of investing in CFOs.
Benefits to CFOs (collateralized fund obligation) to investment company managers that
manage the CFOs can include management fees, incentive fees and gains through
ownership of the equity tranche.
Benefits to CFOs (collateralized fund obligation) to hedge fund managers who view the
CFOs as investors in their hedge fund are that the money is less likely to be withdrawn.
Hedge fund managers prefer investors that are relatively unlikely to withdraw funds
(“sticky” money rather than “hot” money). Using the CFO structure, investors in a
tranche wishing to liquidate can sell their tranche without it affecting the CFO portfolio
and requiring a liquidation of a portfolio holding.
Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

2


Topic 7: Structured Products, New Products and New Strategies

Benefits of CFOs (collateralized fund obligations) to investors include the ability of
institutions such as pension funds, insurance companies and others to diversify into the

hedge fund arena through ownership of tranches rated by a major rating agency. Often,
such institutions are prohibited from direct ownership of unrated investments such as a
hedge fund. Further, CFOs have been shown to have lower systematic risk exposures
(due to their absolute return strategies) than other similarly rated investments (such as
pools of corporate bonds) and so are less subject to general credit market events or other
market wide events. Anson reports the correlation of fund of funds returns with leveraged
loans and high yield returns of only .35 and .43. Thus, investors can receive the benefits
of somewhat diversified risk exposures that contain less systematic risk (and perhaps
more idiosyncratic risk related to funds manager skill).
Risks of CFO investing are generated from the risks of the assets (hedge funds) that
comprise the portfolio. Anson analyzes historic returns to funds of funds and compares
the return distributions to the distributions of high yield portfolios and leveraged loan
portfolios. Anson concludes that the past return distributions have been roughly similar.
The hedge fund of fund returns have moderate volatility and a good Sharpe ratio but have
a slight negative skew and slightly high kurtosis. Therefore, CFO investors are exposed
to a relatively substantial risk of large negative returns. However, as noted in the previous
paragraph, the correlations of the returns with large credit market events may be
reasonably low and therefore CFOs provide diversification benefits.
4.

Describe the structure of a collateralized commodity obligation (CCO).
The concept of collateralized obligations (COs) has been extended into commodities with
a collateralized commodity obligation (CCO) being issued with rated tranches in 2005.
The idea is to utilize a CO structure to facilitate exposure to commodity price risk.
The commodity price risk is accomplished in the CCO using commodity trigger swaps
(CTSs). A commodity trigger swap is similar to a credit default swap except that the risk
to the principal is generated by falling commodity prices (rather than a credit event). The
CCO receives fixed coupons (much like insurance premiums) up to the maturity of the
CTS at which time the CCO either receives the full principal of the CTS (if the
triggering event has not occurred) or nothing from that CTS if the triggering event has

occurred. The triggering event is prespecified. For example, a triggering event might be if
a ten day average of a particular commodity price has declined more than 35% from the
commodity price when the swap is set.
The CCO contains a diversified portfolio of CTSs and must adhere to prespecified
diversification standards. The result is a set of tranches that offer a spectrum of
probabilities for full payment and an exposure to various commodity prices such that
severe declines in one or more commodity prices could cause tranches to lose principal
(starting with the least senior tranches).

5.

Describe the conceptual characteristics of infrastructure sectors.
Mansour and Nadji describe six conceptual characteristics of infrastructure sectors. Note
that the set of characteristics of infrastructure investments is a main point of CAIA’s
Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

3


Topic 7: Structured Products, New Products and New Strategies

curriculum. Of particular interest here is the fact that infrastructure assets are highly
heterogeneous, with no two infrastructure assets having identical attributes. Another
crucial aspect is that the lifecycle of the infrastructure asset is a key determinant of the
asset’s performance.
1. Monopoly: Infrastructure assets generally have very high initial fixed costs. As a
result, they are typically large-scale investments that can act as a barrier to entry for
new entrants. A consequence of this is that infrastructure assets have monopolistic or
“quasi-monopolistic” characteristics. The article also notes that these assets have
traditionally been funded by the government through general taxes or the municipal

bond market that also indicates a barrier to entry for new entrants.
2. Inelastic demand: Infrastructure assets provide essential services to the community and
demand does not fluctuate with price movements or the business cycle. Since
infrastructure assets have few substitutes, they contribute to the inelastic nature of
demand.
3. Stable cash returns: The previous two characteristics – monopoly and the inelastic
nature of demand – ensure that infrastructure assets have stable cash returns. This is
generally because infrastructure assets render essential services, the demand for which
does not change with consumer sentiment.
4. Long duration: As is the case with real estate, infrastructure assets last for a long time,
often over 50 years. The long lasting nature of infrastructure asset returns makes these
assets very attractive to institutional investors. Most public and corporate pension
plans face long-term liabilities and the long lasting nature of these assets makes them
very attractive to plan sponsors.
5. Inflation hedge: Infrastructure assets can be classified as tangible, real assets and
provide an inflation hedge. The replacement costs of real assets increase in an
inflationary environment, which preserves the value of existing infrastructure assets.
Rent escalations on infrastructure assets that are usually CPI-linked are permitted.
6. Hybrid asset: Infrastructure assets share many common features with a variety of other
assets such as real estate, fixed income, and private equity. If the infrastructure asset is
government regulated, the income streams are analogous to fixed income investments
with the additional advantage of having inflation protection. Developing infrastructure
assets in India share common risk and return characteristics with opportunistic real
estate development. An infrastructure investment in an operating company that runs an
airport is a common private equity strategy.
6.

Compare infrastructure with other traditional and alternative assets.
Many institutional investors new to this asset class view it as a subset of commercial real
estate – with physical, real, tangible assets generating cash flows. But others view it as a

substitute for long duration bonds with an embedded inflation hedge. More generally,
infrastructure is a hybrid asset class and shares common features with many traditional
and alternative assets. However, the bond-like, equity-like, and real estate-like features of

Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

4


Topic 7: Structured Products, New Products and New Strategies

any infrastructure investment depends on the individual asset and the stage of the asset’s
maturity. See the exhibit below.

Expected Return

Opportunistic/Private
Equity

Value-Added

Core Real Estate/Fixed
Income

Risk
Core Real Estate/Fixed Income

Value-Added

Opportunistic/Private Equity

Gas/Electricity/Transmission (Mature)
Mature Toll Roads
Mature Telecom
Water

Airports
Seaports
Mature Toll Roads (with Expansion)

Greenfield Toll Roads
New Telecommunications
Power Generation/Transmission

Source: Mansour and Nadji (2007)

7.

Critique the evidence on the performance history for infrastructure
investments.
The performance history for infrastructure investments has several limitations. These
limitations include:
1. Limited Performance History.
2. Expensive and often proprietary data collection.
3. Lack of Appropriate Benchmarks.
4. Significant variation within infrastructure investments given its hybrid nature.

8.

Explain how the composition and construction of the following indices

impact their relative performance:
Note that the bulk of the material focuses on the UBS Index and Moody’s
Economy.com Infrastructure Index. Also note that benchmarking infrastructure
investments is listed as a main point for this Learning Objective, and such investments
can be: listed infrastructure investments and unlisted infrastructure investments.
The major indexes use listed companies in their construction. The article also notes a
study by Peng and Graeme (2007) that examined the performance of 19 major unlisted
Australian funds.

Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

5


Topic 7: Structured Products, New Products and New Strategies

a.

RREEF Hypothetical Infrastructure Index

The RREEF was constructed based on the UBS index because the UBS index was not
widely available on a global or U.S.-basis. RREEF used the UBS-Europe Index as the
base, stripping out companies that did not focus on direct infrastructure such as airlines
and logistics. Hence, the RREEF index has focused primarily on pure infrastructure plays
or “infrastructure operating companies.”
Since only listed companies were used, the volatility of this series was increased but
could be directly compared to publicly-traded assets such as equities and securitized real
estate. It returned 12.5% per year with a 13.2% volatility, placing it between European
bonds and equities.
b.

UBS Global Infrastructure & Utilities Index

The UBS indices exist for the global and major regions of the world, including the U.S.
The Global series is based on a group of 85 companies.
The UBS index is about 4.6% of the S&P Global Universe. Integrated Utilities make up
52% of the index, Integrated Regulated Utilities make up 25% and Energy Transmission
and Distribution make up 13%. The remaining subsets are Power Generation (5%), Water
(1%) and Other Infrastructure (including communication and transport) that make up 4%.
On a 10-year basis, the UBS index averaged 12.7% less than private equity and public
real estate but more than hedge funds, public equity, and fixed income returns. The
volatility at 18.3% has exceeded fixed income and hedge funds but trails public real
estate and public equity.
The index has showed low correlations with traditional and alternative assets.
c.

Moody’s Economy.com Infrastructure Index

Five infrastructure sectors are included: Electricity (Distribution and Generation), Water
(Treatment and Distribution), Communications, Transport, and Gas (storage and
distribution).
The Electricity, Water, and Gas sectors are under Energy and Utility.
Companies are market-cap weighted. The Economy.com Index has a lower return than
the UBS Index since its inception (5.3% for Economy.com versus 9.4% for UBS). It also
has a lower volatility than the UBS Index (13.1% for Economy.com versus 19.3% for
UBS).
9.

Identify risks involved with infrastructure investments.
Mansour and Nadji find six types of risks associated with infrastructure projects,

including:
1. Construction Risk: Construction may be delayed or abandoned due to unforeseen risks
related to weather.

Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

6


Topic 7: Structured Products, New Products and New Strategies

2. Operational Risk: Infrastructure projects may fail operationally if a chain of command
does not exist and is not properly supervised.
3. Leverage/Interest Rate Risk: Infrastructure investments may require additional
borrowing of capital which subjects itself to interest rate risk.
4. Regulatory Risk: Infrastructure projects may be exposed to regulatory risk if new laws
inadvertently create new restrictions.
5. Legal Risk: Infrastructure investments may be exposed to legal risk if, for example,
they are to require land not yet acquired.
6. Political Risk: International infrastructure investments may be exposed to the whims
of the government.
Other considerations include liquidity, pricing and benchmarking.
10. Explain the economic implications of climate change in terms of its
impacts on existing assets, future economic activity, increased
regulation, and consumer behavior.
According to the latest Intergovernmental Panel on Climate Change (IPCC), global
warming is a reality, and there will be an increase in the severity of weather around the
globe. Emerging and developing economies will be hit hard. Initially, the human toll will
probably be highest in countries such as India, Bangladesh, South and Central America.
In developed countries, meanwhile, the economic toll will be higher. The changes in

climate will have many impacts: higher cost of capital, higher insurance costs, higher
regulatory costs, and changes in consumer behavior that may have positive or negative
effects.
The increased uncertainty associated with the weather changes will affect the planning of
future economic activity. This will increase the risk premiums from the investments.
Companies that plan to build and invest in an area where the weather effects are higher
can expect a higher cost of capital. Furthermore, people planning to move to such areas
can expect higher insurance premiums for homes and property.
Regulations associated with the weather will increase costs. However, certain industries
are likely to benefit: e.g. construction, renewable energies, and mechanical and electric
engineering as companies attempt to meet the new regulations.
Climate change can also have an economic impact on consumer behavior. Evidence
suggests that consumers are conserving energy and cutting back on climate harming
activities and supporting compensation measures.
11. Describe the role of financial markets in reducing the economic cost of
climate change through:
There are two basic approaches for dealing with climate change: abatement strategies
and adjustment strategies. Abatement strategies attempt to prevent climate change.
Adjustment strategies react rationally to the unavoidable consequences of climate
change.
Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

7


Topic 7: Structured Products, New Products and New Strategies

Financial markets and suitable financial instruments can help finance climate-related
technology and distribute weather risks efficiently. The following list summarizes the
roles of financial markets.

a.

markets for catastrophe and weather risks.

The market for catastrophe risks and weather risks offers adjustment strategies. These
are instruments that provide compensation for certain events. Such instruments include
catastrophe risk transfer instruments such as catastrophe bonds and weather
derivatives, which involve a cash flow when a certain event occurs. There are also risksharing arrangements for unavoidable natural catastrophes and weather risk, which can
reduce the individual cost of coverage.
The effect of these instruments is an efficient sharing of the risks that come from
unavoidable natural catastrophe and weather risks. This lowers the cost of covering
individuals. The markets also provide information such as price signals concerning
environmental threats.
b.

emissions trading.

Emissions trading is part of an abatement strategy. The strategy sets a limit on the
amount of pollution across the economy by issuing a limited supply of emission
certificates. These certificates can be traded, which gives each corporation an incentive to
produce less pollution because it can sell unused emission certificates.
Additional benefits may result from derivatives on those certificates and the existence of
funds and other investment vehicles that invest in emission certificates.
The goal of emission trading is to minimize the costs associated with greenhouse gas
emission reduction. However, there is an ongoing debate concerning the potential
benefits and functioning of the emissions trading market.
c.

climate-related investments.

Climate-related investments are part of both abatement strategies and adjustment
strategies. Climate-related investments include public investment funds and private
equity funds that invest in assets that could profit from climate change. Such investments
would include simply investing in the equity of companies that are developing
environmentally friendly products. Making loans to such companies would also be a part
of this strategy.
There are a wide variety of companies in which to invest, e.g., those in the energy
industry, those that are developing and producing climate protection-relevant
technologies, those that are applying climate protection-relevant technologies, and those
that offer solutions for adapting to climate change. This strategy would be enhanced by a
political and regulatory framework that reduces the cost of debt and equity financing for
the companies. Increased investor awareness would lower perceived risk and the cost of
capital.

Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

8


Topic 7: Structured Products, New Products and New Strategies

12. Explain the economic rationale for using financial instruments to
transfer risk.
The general economic rationale for having financial instruments to transfer risk is that
risk sharing by agents in the economy can reduce shocks to the overall economy. For one
thing, a decline in business for any sector will reduce tax revenues, and there will be a
drain on government funds in repairing the infrastructure. The following list provides
more details.
● Coverage of large volumes: Natural catastrophes and extreme weather events can
cover large areas so that the potential losses are above the levels that a single firm or

even government can afford. The financial instruments would provide payoffs to help
supply capital to cover losses.
● Efficiency and transparency: The market can break down the risk into small pieces
and distribute them among qualified investors. This would reduce the concentration
of risk among a few insurers, and the risk levels would be more transparent. Market
participants would price risk to include all relevant information, which would
increase efficiency.
● Uncorrelated asset class: The new instruments would provide a new tool for
increasing diversification of investment portfolios. This is especially true because
weather-related events typically have a low correlation with market returns.
● Macroeconomic benefits: Firms can hedge risks and increase output, which helps the
overall economy. Market efficiencies should lower the cost of hedging and increase
macroeconomic benefits further.
13. Discuss the criteria that need to be fulfilled by instruments employed
for risk transfer.
There are five basic criteria for instruments to be effective in transferring risk.
1. Measurable and calculable risk: There must be estimates of both losses and
probabilities in order to price the instruments, which would most likely come from
historical data.
2. Affordable risk premium: For the party seeking protection, the risk premium must be
affordable while still covering the potential losses.
3. Reliable payment trigger: To minimize conflicts of interest, there should be a precise
definition of the event that triggers payment. The payment trigger must be transparent,
reliable, and difficult to manipulate.
4. Avoidance of moral hazard and adverse selection: There should be information
symmetry. This would lower the adverse selection problem where high-risk firms seek
coverage at the average market price. Information symmetry would lower the potential
for the moral hazard problem in that the covered firm would want to inflate losses.
5. Development of adequate pricing models: Traditional pricing models would require
modification to price catastrophe risks and weather risks. Weather data is very

different from traditional market data, for e.g., weather data has a seasonal element.
Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

9


Topic 7: Structured Products, New Products and New Strategies

Furthermore, catastrophe data is sparse, and all the outcomes are not known. These
and other considerations would have to be included in the pricing models.
14. Describe existing instruments that can be used to transfer risk and
identify potential investors and sponsors of these instruments.
The following list describes the existing instruments that can be used to transfer
catastrophe and weather risks. Catastrophe bonds and exchange-traded contracts are
fairly liquid, and the other instruments are tailored to meet the needs of certain entities
and are usually held until maturity.
Catastrophe bonds (cat bonds): The coupons are usually based on LIBOR plus an
appropriate risk premium, and when a predefined loss occurs, the investor forfeits the
capital invested. Special purpose vehicles (SPVs) usually issue the bonds and invest the
proceeds in traditional fixed income securities to cover contingent claims by the sponsor.
Cat-risk CDO (Collateralized Debt Obligation): The various catastrophe risks are
bundled and sold in individual risk tranches. One or more events must occur before the
investor suffers a loss.
Capital market-financed quota share reinsurance, known as sidecars: In this contract, the
investors share proportionally in a loss according to a predetermined quota. This uses
tranches as well, and there is at least one debt and equity tranche.
Industry loss warrants (ILW): This market, that has been around for a while, is usually in
the form of private placements. It is a type of capital market-financed loss (re-)insurance,
which is linked to an industry loss index.
Event loss swaps (ELS): These are a variant of conventional ILWs. They are more tradable

because they are more highly standardized.
Catastrophe swaps (cat swaps): These are contracts where two insurers can swap generally
uncorrelated risks, such as those between different regions or industries.
Contingent capital arrangements: This category is composed of types of put options.
The option buyer has the right to raise debt or equity capital or sell assets under specific
terms if a given loss occurs. One use of this would be by a firm that would want to make
sure it has adequate capital in the event of a loss. They were popular in the 1990s, but
because they are difficult to price, they are not used much today.
Exchange-traded contracts in catastrophe risks: Some cat futures and cat options trade
on an exchange. They started in the early 1990s, but turnover was small. There have
been moves to modify the contracts to generate more interest. Since they trade on an
exchange, they offer more liquidity, and they would be used by entities where liquidity is
important.
The investors in these instruments must be knowledgeable, which limits potential
investors to insurers and reinsurers, institutional investors, and hedge funds. Insurers and
reinsurers use the contracts as part of their overall portfolio strategy. Hedge funds make
investments to earn the premiums. Mutual funds using these instruments are being
developed so that more investors can participate.
Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

10


Topic 7: Structured Products, New Products and New Strategies

The “sponsors” are those that issue the contracts for protection. The largest sponsors
are insurers and reinsurers, corporations with a high exposure, and government
insurance and development funds. Insurance companies that have taken on the risks of
companies with insurance contracts are a large group of sponsors that use the
contracts to manage their risk. Corporations with high-risk exposure naturally hedge

risk so they can focus on their business. There are government insurance and
development funds in many countries that are sponsors, e.g., Mexico’s natural
catastrophe fund (FONDEN) recently transferred large amounts of earthquake risks to
the capital markets using catastrophe bonds.
15. Describe both exchange traded as well as over-the-counter weather
derivatives.
The market for weather derivatives is concerned with relatively low-cost high probability
events. This is in contrast to the market for catastrophe risks that covers high-cost low
probability events. Weather derivatives pay off when there are unusually low or high
temperatures. A natural gas company may wish to hedge against a warm winter, for
example, which lowers the quantity demanded of natural gas used for heating.
In the OTC market, the contracts are negotiated individually and with properties specified
by the counterparties. These contracts began in the mid-1990s. Tradable weather-related
futures and options have been on the Chicago Mercantile Exchange (CME) since 1998.
Other exchanges have offered these products, but have discontinued them for now,
through some are planning to introduce new products. As of now, however, the CME is
the only exchange where weather-related futures and options trade, and the exchange
plans to expand its offering. Market participants find that the exchange-traded products
have a lower cost and higher liquidity. There has been an increase in the turnover in
exchange-traded contracts at the CME relative to that of the OTC market.
16. Describe emissions trading, its project-based mechanism, and its
potential market participants.
The biggest market for greenhouse gas emissions is the EU Emission Trading System
(EU-ETS). The EU-ETS uses targets proposed by the Kyoto Protocol, which defines a
number of different emission certificates. There is a distinction, for example, between
emission rights and emission credits. There are a limited number of emission rights for
all companies, and these rights can be traded among companies that emit the greenhouse
gases. This is referred to as cap and trade, in that there is a limit or cap to the emissions
and the right to emit can be traded. The limited number includes the EU Allowances
(EUAs), traded in the EU-ETS, and includes the assigned amount units (AAUs) that

trade internationally.
With respect to emission credits, on the other hand, investors can have credits from
additional climate protection projects that are in other countries credited to their own
reduction target (baseline and credit). Also, with respect to emission credits, there is a
difference when the reductions take place in an industrial country or in an emerging
market. For the industrial country, the resulting certificates are called emission reduction

Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

11


Topic 7: Structured Products, New Products and New Strategies

units (ERUs). For emerging markets, they are called certified emission reductions
(CERs).
The Kyoto Protocol also allows for the realization of carbon-sink projects at home such
as afforestation. This is done with the use of removal units (RMUs). Also, it is possible
to generate tradable project-based credits called verified emission reductions (VERs).
They differ from CERs and ERUs in that VERs can only be used for voluntary CO2
compensation.
The CERs and ERUs are useful for the exceptions the Kyoto Protocol extends to
emerging markets. This is because emerging markets are exempt from greenhouse gases
quantitative reduction commitments. The Kyoto Protocol’s project-based mechanisms
allow the CERs and ERUs from additional climate protection projects in third countries
to be credited to the owner’s reduction target within certain limits, e.g., down to 50% of
the initial target.
The Clean Development Mechanism (CDM) of the Kyoto Protocol allows for
investment to be made in a project that promises to yield future income in the form of
CERs. A wide variety of projects qualify, and the CERs can be generated from a

portfolio of projects. The rights to future CERs are traded at a discount, which is a
function of the project’s stage of progress. A less advanced project would have a higher
discount.
Potential market participants include carbon funds, which include government
purchasing programs and private commercial funds. The Prototype Carbon Fund (PCF),
launched by the World Bank, was one of the earliest funds. It gathered experience with
the new emissions trading instruments and prepared the market for later funds. An
increasing number of investment banks, brokers and institutional investors are buying and
selling certificates for their own or third-party accounts; however, companies that have to
meet reduction commitments within the EU-ETS framework are still the biggest group of
end buyers (compliance buyers).
Investors who have no direct involvement with emissions can attempt to earn a positive
return in the market for these types of instruments. Carbon funds offer advantages over a
direct investment because the funds have an expertise in the area, offer diversification,
and can allow the investors to take on a particular level of risk via the number of shares
purchased in the fund.
There has been increasing product differentiation, and new possibilities are opening up
for investors. Investors can place bets on rising prices through derivative instruments on
emission certificates or participate in the realization of CDM projects.
17. Compare the factor-based approach to hedge fund replication with
the payoff distribution approach to hedge fund replication, in terms of
their:
a.

goals.

The ultimate goal of both the factor-replication approach (or the factor-based
approach) and the payoff distribution approach is to create a portfolio with
Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

12


Topic 7: Structured Products, New Products and New Strategies

characteristics similar to a particular hedge fund, for e.g., to have the same risk
profile, and earn returns similar to those of the hedge fund at a lower cost. To
achieve that ultimate goal, the factor-based approach has the goal of replicating
the hedge fund’s returns using hedge fund risk factors. The payoff distribution
approach attempts to replicate the hedge fund’s returns by matching the
unconditional higher moments, which should then give the same first moment, i.e.,
the same average return.
b.

methodology.

The factor-based approach focuses on the conditional distribution to earn the
conditional mean of a hedge fund, given values of the underlying risk factors. This
requires a two-step approach.
Step 1 requires the calibration of a satisfactory factor model for hedge fund returns. This
is essentially estimating a factor model:
Hedge Fund “k” Returnt = B0 + B1F1,t + B2F2,t + . . . + BNFN,t + et
where each Fi,t is the value of factor “i” at time “t”, and each Bi is the corresponding
factor sensitivity.
A stepwise regression is often used in this process, but it does not allow for the researcher
to make inferences. A stepwise regression is a regression technique that allows for
forward selection of relevant factors or backward elimination of irrelevant factors.
Forward selection starts with no factors and, at each step, the most significant factor is
added to the model. Backward elimination starts with a set of factors and, at each stage,
the least significant factor is removed.

Another approach is to use a conditional factor model which allows the coefficients, Bi,
to be time varying, too. The goal is to capture time varying factor exposures. Another
approach is to use non-linear factor models that may also be able to better capture the
relationship and make better out-of-sample forecasts.
There is also return-based style (RBS) analysis, which examines the exposure of hedge
funds to certain style factors. While this approach allows for lower specification risk, the
key issue is the efficacy of the factors in building mimicking portfolios.
Once having chosen a particular methodology in Step 1, Step 2 requires the identification
of the replicating factor strategy (RFS), which is creating a clone of the hedge fund return
using the estimated coefficients and the out-of-sample values of the factors.
The payoff distribution approach focuses on creating a clone portfolio where, for all x,
Pr(Clone returnThis also requires a two-step process: Step 1 consists of estimating a payoff function that
maps an index return onto a hedge fund return. Step 2 consists of pricing the payoffs and
deriving the replicating factor strategy, which is done using the Merton (1973) replicating
portfolio interpretation of the Black and Scholes (1973) formula.

Copyright © 2009 Institutional Investor, Inc. All Rights Reserved.

13