Last Revised: 08/16/2023

2024 Level 2 - Alternative Investments

Learning Modules Page

Introduction to Commodities and Commodity Derivatives 2

Overview of Types of Real Estate Investment 20

Investments in Real Estate through Publicly Traded Securities 30

Hedge Fund Strategies 37

Review 48

M.M138463888.

This document should be used in conjunction with the corresponding learning modules in the 2024 Level 2 CFA® Program
curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2023, CFA Institute. Reproduced and
republished with permission from CFA Institute. All rights reserved.

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 Last Revised: 08/14/2023

Introduction to Commodities and Commodity Derivatives

a. compare characteristics of commodity sectors

b. compare the life cycle of commodity sectors from production through trading
or consumption

c. contrast the valuation of commodities with the valuation of equities and bonds

d. describe types of participants in commodity futures markets

e. analyze the relationship between spot prices and futures prices in markets in
contango and markets in backwardation

f. compare theories of commodity futures returns

g. describe, calculate, and interpret the components of total return for a fully
collateralized commodity futures contract

h. contrast roll return in markets in contango and markets in backwardation

i. describe how commodity swaps are used to obtain or modify exposure to

commodities

j. describe how the construction of commodity indexes affects index returns

M.M138463888.

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Commodities

⇒ Commodity – a physical good attributable to a Page 1

LOS a
natural resource that is tradeable and supplied
- compare
without substantial differentiation by the general public
- trade in physical (spot) & futures/forward markets

- potential for diversification benefits in a Page 2

multi-asset class portfolio due to low (historically) LOS a
- compare
correlation w/ bonds & stocks (some possible inflation
hedging benefits)
from use as a consumable
- derive their value
as inputs to the production process
Sectors/ as per Thompson Reuters/Core Commodity CRB Index
· Energy · Industrial (base) metals · Livestock
· Grains · Precious Metals · Softs (cash crops)
M.M138463888.
1. Energy – most economically valuable sector
1) Crude Oil – must be refined to be useful
Brent – North Sea
- different grades
WTI – US
(trade at
varied prices) Bonny Light – Nigeria
Mayan Crude – Mexico

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Page 3
1. Energy LOS a
1) Crude Oil – low in density & flows freely at - compare
room temperature ⇒ Light
- easier to process, yielding more valuable gasoline & diesel
- low in sulfur content ⇒ Sweet
- weather ➞ temporary impact (e.g. hurricane)
· as economies grow, oil demand increases (availability of
oil at affordable prices also facilitates growth)
extraction
· drivers of supply & demand technology
politics refining
business cycle usage
e.g./ shale oil – supply availability due to extraction technology
electric vehicles, solar – reduce demand for oil products
US & Canada – ban offshore drilling in Artic waters

1. Energy Page 4
LOS a
2) Natural Gas – can be used directly
- compare
(heavier compounds – NGLs – are also extracted

liquids
- categorized as either:
a) associated gas – coming from an oil well (a co-product of oil)
can be: - sold in spot markets
- burned off
- re-injected into the oil field to maintain
pressure (keeps extraction costs low)
b) unassociated gas – on its own (where oil is not present)
- Storage/transportation cost high ➞ need to keep gas under
M.M138463888.
pressure
- liquified natural gas (LNG) – for transport by ships
- must be cooled to -260℉
- primary demand – electric generation
cooling
- also weather dependent
heating

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Page 5
1. Energy LOS a
3) Refined products – heating oil, gasoline, - compare
jet fuel, propane, etc…
- refined products typically have a short shelf life (availability
measured in days)
- refineries typically located on major coastlines & ports
(that is where the oil is delivered)
- planned refinery maintenance ➞ switch over from summer gas
(typically low demand periods) to winter gas

2. Grains/ · Corn · Soybean · Wheat · Rice

- can be stored season over season (sometimes multiple
seasons)
- some crops can be grown multiple times/yr.
- levels of heat & precipitation determine yields & acreage
(droughts kill, floods drown)

Page 6
3. Industrial (base) Metals/ can be stored for years
LOS a
- mined ore that is processed into
- compare
copper, aluminum, nickel, zinc, lead, tin & iron

used in production, construction, infrastructure

- supply is weather insensitive, but demand may be affected

- tied very closely with GDP growth
- political issues ➞ strikes, development approval, environmental
concerns, regulation

feeder
4. Livestock/ · hogs · cattle M.M138463888. · sheep · poultry
live
- depends on low cost inputs (feed) i.e. grains
- high grain costs lead to short-term oversupply
as herds are slaughtered (mid-term price increases)
- tied to GDP growth (especially in emerging/developing
economies)

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Page 7
4. Livestock/ LOS a
Weather – affects health & weight - compare
- winters tough for cattle, heat & humidity tough for hogs
- limits weight gain
avian flu
- disease
mad cow disease
porcine epidemic diarrhea virus (PEDv)

fear of consumption can drive prices down

price effect uncertain
lost supply can increase prices
5. Precious Metals
- straddle monetary & industrial world
gold, silver, platinum ⇒ act as stores of value
- also used in jewelry, auto parts, electronics
(makes up about 50% of demand, other than gold)
- high storability

Page 8
6. Softs (cash crops) · cotton, coffee, sugar, LOS a
cocoa - compare
- called ‘cash crops’ since they are grown to be sold,
not consumed for subsistence

- primary source – countries close to the equator

- weather is an important supply factor, global growth

is an important demand factor

M.M138463888.

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Commodity Production Life Cycle

- will reflect (and amplify) changes in storage, Page 9

LOS b
weather political/economic events that shift demand & supply
- compare
- Short life cycle ⇒ rapid adjustment
- long life cycle ⇒ limits ability of market to react
⇒ Energy/ crude futures
reflect both demand for crude

Extraction Transportation Storage Refining Transportation

50-100 days 1-10 days days to 3-5 days 5-20 days
a few
months
natural gas can be consumption of crude
consumed at this stage oil products begin
- trading in futures will reflect - futures reflect pricing
pricing just prior to this point at this point

Page 10
⇒ Energy/
LOS b
· Refineries – affect demand for crude - compare
& supply of oil products

costly to build - long lead times – built to a specific

oil grade
· Pipelines – affect supply of oil & market reach

costly to build, long lead times

· Exploration – affects supply of crude

- over 120 different grades of oilM.M138463888. - both 1000

Brent barrels
- 2 most traded futures contracts
West Texas Intermediate
(CL)
- contracts for gasoline – RB – 42,000 gallons
nat. gas – NG – 10,000 MBTU
heating oil – HO – 42,000 gallons

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Page 11
⇒ Industrial/Precious Metals
LOS b
- ore & finished products can be stored - compare
for years (but storage costs, risks of ownership, financing
costs)
e.g./ Copper

extracting ➞ grinding ➞ concentrating ➞ roasting ➞ smelting

ore ～ 2% into metal content removes heated to 1200℃

metal content powder reaches 25% sulfur to melt calcine
- powder now - metal content
called calcine reaches 60%

➞ converting ➞ electro-refining ➞ storage/logistics

air blown into purified to typically held in a bonded

the liquid 99.99% warehouse until shipped
- 99% pure copper to end user

Page 12
⇒ Industrial/Precious Metals
LOS b
- smelting/processing relies on economies of scale - compare
- large facilities with high utilization rates
∴ when supply > demand, difficult to cut production
- overproduction continues until smaller players
drop out
- long lead times + large costs to add extraction or processing
capacity
- monthly futures contracts with no seasonality (unlike energy)

⇒ Livestock/ - all year round M.M138463888.

- good weather, high quality pasture & feed accelerate

weight gain
- timing to maturity increases with size

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⇒ Livestock/ poultry – a few weeks Page 13

hogs – a few months LOS b
- compare
cattle – a few years
HE
sow gives birth 6 mos. to get slaughter weight
after summer heat (soymeal & cornmeal)

1-2 years – feeder cattle ⇒ 6-12 months LE

(grass fed) GF (feed lot ➞ corn-based diet)
～ 1200 lbs.
⇒ Grains/
hard
northern winter
hemisphere wheat
(North Am.)

Page 14
⇒ Grains/ - demand for grains is year round
LOS b
- storage facilities supply year round
- compare
⇒ need to understand old crop vs. new crop
(inventory) (coming harvest)
for futures trading
⇒ Softs/ commodities in this sector differ significantly
e.g./ coffee

M.M138463888.

- harvested somewhere all year round (best are from

high-altitude plantations, picked in middle of harvest)

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⇒ Softs/ - newly planted trees take about Page 15

LOS b
3-4 years to produce
- compare
- once picked, laid out in sun for 2-3 weeks to dry
(dry method ～ 50%)

or/ soaked in water to remove pulp, bean then fermented

12-48 hours, then dried 24-36 hours
- then shipped – roasting done by buyer before shipping to sales
points
robusta – lower quality, less flavour
2 main varieties futures traded in London
arabica
futures traded in New York

Valuation

Page 16
estimation of
FV LOS c
future profitability
- contrast
CF CF CF TV and cash flows

PV = DCF Stocks
bonds

financial assets

no cash inflows

future possible ➞ based on

price supply & demand
-CF -CF -CF of the item
PV= M.M138463888.
discounted
potential cash outflows
commodities - transportation
- storage
- physical assets
- tangible items with intrinsic value affects the forward
price curve

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Participants
Page 17
1) Hedgers – eliminate price risk
LOS d
- may be a registration requirement - describe
(hedgers face different margin requirements
since they make/take delivery)

2) Traders/Investors 1) informed investors

2) liquidity providers
3) arbitrageurs

3) Exchanges – standardized contracts

4) Analysts – perform research, conduct policy

5) Regulators

Spot vs. Futures Price

- spot ➞ current price for immediate delivery Page 18

LOS e
- futures ➞ price today for some future delivery
- analyze
· difference between spot & futures price called the ‘basis’

futures futures
price price
spot - price difference
between one
contract & another
is called the
calendar
spread
M.M138463888.
spot
Backwardation Contango
𝒕 𝒕
- bearish indicator - bullish indicator
- expected future spot - expected future spot price
price = lower = higher
Note: for commodities

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Page 19
Contango LOS e
$ (negative $ - analyze
spot
calendar
spread)
Backwardation
(positive
calendar spread)

spot

𝒕 𝒕
Trading strategy 1. Trading strategy 3.
Buy long-dated contract Sell long-dated contract
Sell short-dated contract Buy short-dated contract

roll over short position roll over long position

each month each month

Trading strategy 2. short long-dated Trading strategy #4 Buy

contract long-dated contract

Theories of Futures Returns

Page 20
⇒ theories to explain the shape of the futures LOS f
curve - compare
1) Insurance Theory (Keynes) – a.k.a. ‘Theory of Normal Backwardation’
- producers will use commodity futures for insurance
by locking-in prices, thereby having more predictable revenue
- this selling forward pushes down prices in the future
⇒ further, prices would have to be lower in the future to
induce a buyer to take price risk (remuneration for the
M.M138463888.

speculator)
∴ such a resulting price curve would be ‘normal’
⇒ not backed by observation however:
i.e. backwardation does not generate positive returns
contango does not generate negative returns
(statistically significant that is)

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2) Hedging Pressure Hypothesis/ Page 21

LOS f
- producers will want to sell to hedge
- compare
- end users will want to buy to hedge

- if hedging demand from producers & end users is in balance,

then a flat futures curve should develop

- if hedging demand from producers > hedging demand from end users
then futures prices would have to be lower to induce
speculators to fill the gap ⇒ Backwardation

- if hedging demand from producers < hedging demand from end users
then the futures prices will be higher ⇒ Contango
Problem: producers tend to be more persistently exposed to
price risk than end-users/consumers

Page 22
3) Theory of Storage/
LOS f
- compare
Futures price = spot price + direct storage costs – convenience yield

- high when - low when stocks - low when stocks

demand > supply are low are high
- low when - high when stocks - high when stocks
supply > demand are high are low

M.M138463888.

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Components of Futures Returns

- total return with futures is different from Page 23

LOS g
total return on the physical asset
- describe
- futures price return (spot yield) - calculate
roll return (roll yield) - interpret
collateral return (collateral yield)

Price Return/ - change in price in the front month contract

𝐂𝐮𝐫𝐫𝐞𝐧𝐭 𝐩𝐫𝐢𝐜𝐞 − 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞
𝐩𝐫𝐢𝐜𝐞 𝐫𝐞𝐭𝐮𝐫𝐧 =
𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞

Roll/ - as investors move from contract to contract, must sell

the current contract on/near expiration and buy
the next dated contract
- likely a price difference depending on the shape of
the futures curve

Page 24
e.g./
LOS g
- 11 Jan contracts = $110 exposure - describe
10 - rolling forward to Feb, need - calculate
12 contracts = $108 exposure - interpret
(opposite for contango)
9

Jan Feb
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
. 9 %′𝐚𝐠𝐞 𝐨𝐟 𝐭𝐡𝐞
− 𝐟𝐚𝐫𝐭𝐡𝐞𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
𝐑𝐨𝐥𝐥 𝐫𝐞𝐭𝐮𝐫𝐧 = × 𝐩𝐨𝐬𝐢𝐭𝐢𝐨𝐧 𝐛𝐞𝐢𝐧𝐠
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
𝐫𝐨𝐥𝐥𝐞𝐝
e.g./ 𝟏𝟎 − 𝟗
= . 𝟏 𝐨𝐫 𝟏𝟎% M.M138463888.
𝟏𝟎

- the amount of return generated in a backwardated futures

market and profiting from the convergence towards a
higher spot price

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 Last Revised: 08/14/2023

Page 25
3) Collateral Return/ yield from bonds/cash
LOS g
used to maintain the position - describe
- when calculating E(R), most indices will use S.t. T-Bills - calculate
- interpret
Notes/ price return on front month contracts typically different
from the price change of the physical commodity
contract–standardized (quality, delivery)
physical markets – not to the same degree

- roll at T, 𝚫spot at T, 𝚫spot at T, 𝚫spot > 𝚫futures

= 𝚫futures spot < 𝚫futures
futures

spot 𝚫𝐟𝐮𝐭𝐮𝐫𝐞𝐬
− 𝚫𝐬𝐩𝐨𝐭
= 𝐫𝐨𝐥𝐥
futures
futures spot neg. roll
no roll yield pos. roll
T T T

Roll Return – More Detail

- periods of either backwardation or contango Page 26

LOS h
do not persist indefinitely
- contrast
- roll return is also not very indicative of price return
(i.e. pos. roll does not necessarily imply pos. price return)
- roll return is very sector dependent

(statistically strong neg. roll return)

M.M138463888.

longer storage periods

minimal
storage

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Commodity Swaps

- commodity swap – a legal contract involving Page 27

LOS i
the exchange of payments over multiple
- describe
dates as determined by specified reference prices or
indexes relating to commodities
often a series of
futures contracts
e.g./
refiner/
1) may not want to
manage a large # of
futures contracts

2) may want a specific

grade/quality of oil
hedged

3) may want to maintain

flexibility

Page 28
e.g./ oil refiner ➞ long a swap that pays the LOS i
amount exceeding $100/barrel every - describe
month for 9 months
pays $25/barrel
for the 9-month period
· called an ‘excess return swap’

M.M138463888.

overall (-9)
+ 16

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Page 29
- OTC, customizable LOS i
· Total return swap – one party receives payment based - describe
on the change in the level of an index (multiplied
by some notional amount)

· Basis swap – periodic payments are exchanged based on the

values of 2 related commodity reference prices
that are not perfectly correlated
- often used between a highly liquid futures contract
as an illiquid but related material

· variance swaps – for a specific commodity

· volatility swaps – relative to the volatility of a reference

commodity

Commodity Index
used as a benchmark to evaluate Page 30
⇒ Index LOS j
broader moves in commodity pricing
- describe
for macroeconomic or forecasting purposes
the basis for an investment vehicle

- differ based on:

a) the breadth of coverage - # of commodities & sectors
b) relative weighting – assigned to each component & how
those weights are determined
c) the rolling methodology – has a direct impact on the roll return
d) methodology & frequency of rebalancing the weights
of the individual commodities,M.M138463888.
sectors & contracts - potential
for positive rebalancing return (assuming mean reversion
of prices)

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 Last Revised: 08/14/2023

- differ based on: Page 31

LOS j
e) governance – rules-based ⇒ quantitative
- describe
methodology for a-d above
- selection-based – an index committee selects
the commodities

- the Index should be replicable to be useful – must be

investable (i.e. translated into a representation of the
asset class)
- use of exchanges vs. physical trading
- contracts/markets with liquidity
- care used in selecting long-dated contracts
⇒ S&P GSCI – based on 24 commodities
- uses only contracts with a minimum level of
trading volume

⇒ S&P GSCI/ Page 32

LOS j
- uses a world-production weighting scheme
- describe
- largest weight to the most valuable commodity
of the basis of physical trade value
(crude oil highest single weight, energy highest sector
weight)
- rolling methodology ⇒ owning the front contracts
- highest liquidity
- supply/demand shocks have most impact

⇒ Bloomberg Commodity Index/ (BCOM – formerly DJ–USB)

- 22 commodities, selection-based
- 33% cap on size of sectors,
M.M138463888.
2% minimum floor
- results in very different index composition &
weights
- same rolling methodology as S&P GSCI

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Page 33
⇒ Deutsche Bank Liquid Commodity Index/
LOS j
- uses a fixed weighting scheme - describe
- rolling a bit complicated ⇒ attempts to maximize
backwardation & minimize contango

more e.g./ June contract 1% backwardated to May

active July contract 3% 3%/2 months = 1.5%/month
roll
mgmt. ∴ roll May into July

⇒ Thompson Reuters/Core Commodity CRB Index

- 19 commodities, fixed weights, selection committee
- rolling ⇒ own front or second front month

Page 34
⇒ Rogers International Commodity Index (RICI)/ LOS j
- 37 commodities, fixed weights, selection committee - describe
- not all components are denominated in USD

- Rebalancing Frequency/
- rebalancing is more important if a market is
frequently mean reverting (more peaks to sell, more
valleys to buy)
- can lead to underperformance in a trending market

- TR/CC CRB & RICI – monthly rebalancing

- Other – annual
- S&P GSCI & BCOM ➞ typically have lower rebalancing costs
(production weights) M.M138463888.

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Overview of Types of Real Estate Investment

a. compare the characteristics, classifications, principal risks, and basic forms of

public and private real estate investments

b. explain portfolio roles and economic value determinants of real estate

investments

c. discuss commercial property types, including their distinctive investment

characteristics

d. explain the due diligence process for both private and public equity real estate
investment

e. discuss real estate investment indexes, including their construction and

potential biases

M.M138463888.

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Real Estate Investments

Page 1/
➞ Basic Forms/ owner occupied
single family rental
Residential urban
multi-family* rental
suburban
high rise garden or
low-rise
townhouse
Non-residential Office*
Industrial/Warehouse*- light/heavy manufacturing
Shopping Centers*- covered malls/strip malls
Multi-use (combinations of commercial types)

Farmland each produce a saleable commodity

Timberland + price appreciation

* Core property types

- core real estate investment style ➞ investing in high-quality,
well leased core property types with low leverage (< 30% of
in the largest markets with strong diversified asset value)
economies

Page 2
➞ Basic Forms/ LOS a
non-core properties - hotels, senior housing, hospitals, - compare

MHC (manufactured home communities), cell towers,

data centers, etc…

Public Private
shares of REOCs direct investment higher required
Equity shares of REITs, ETFs, as a LP to an rate of return
index funds investment fund income + price
private REITs/REOCs
M.M138463888. appreciation

mREITS mortgages interest plus

Debt MBS private debt principal
unsecured REIT debt band debt

divisibility & diversification requires management expertise

liquidity longer investment horizons

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Page 3
➞ Characteristics/ LOS a
a) unique asset & fixed location - compare
- no 2 properties are the same
(use, age, size, location, type of construction, quality of tenant
and leasing arrangement)
b) high unit value - indivisibility

c) management intensive - maintaining the property

- negotiating leases
creates additional
costs - collecting rents

d) high transaction costs - appraisers, lawyers, agents/brokers

e) Depreciation - or appreciation

f) Need for debt capital - ability to access funds, cost of funds

- values are sensitive to the cost and
availability of funds
(high rates + low credit availability = low property values)

Page 4
➞ Characteristics/ LOS a
g) Illiquidity - compare

h) price determination - often requires estimates or appraisals

➞ Risk Factors/ 1. Valuation/

a) Business conditions - affects both current income and property
values
b) Demographics - size and age dist. of population, new
household formation

c) Excess supply - tight markets ➞ rising rents

- encourages
M.M138463888.supply

- new development requires long lead times

- supply usually comes to market late in the
business cycle
- a contraction will create significant oversupply

d) Cost and availability of capital

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Page 5
➞ Risk Factors/ LOS a
e) Availability of Information - improving - compare

f) Lack of Liquidity

g) Rising Interest rates - raises costs of financing

2. Property Operations/
a) Management - property + asset management
(day-to-day ops.) (monitoring performance)

b) Lease provisions - rent reviews, step-ups/escalators

- more important for longer-term leases

c) Leverage - affects returns but not the value of the property

- loan-to-loan ratio (LTV: higher = more leverage)

d) Environmental - contaminants of previous owner or adjacent

property

Page 6
➞ Risk Factors/ LOS a
2. Property Operations/ - compare
e) Obsolescence - changes in tenant preferences, regulations, and
technology
- may not be economically viable to upgrade

f) recent and ongoing market disruption - online shopping,

growth of data and fulfillment centers, carbon
footprint
g) Others - unobserved physical defects, natural
disasters, pandemics, acts of terrorism, unknown risks

➞ Economic drivers/ age LOS b

- explain
M.M138463888.

cash flow = f(rental income, op. exp., leverage, CAPEX)

supply inflation credit availability
demand interest rates
economy credit risk

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Page 7
➞ Economic drivers/
LOS b
GDP growth - most - explain
important single economic factor

largest driver of apartment demand

consumer discretionary
- demand ↑ as incomes ↑

Demographic trends - long-term

others listed - short to medium
term
college graduation rates

age ➞ 65+, esp. 75+

Page 8
➞ Role in an investment portfolio/ LOS b
1/ Current income - lease/rent income - explain
- typically largest component of return
2/ Price appreciation - capital gain component
3/ Inflation hedge - rents and property values typically rise with inflation
4/ Diversification - low correlation with the performance of traditional
asset classes

M.M138463888.
returns

correlations
- publicly traded
RE appears to
behave more like
stocks.

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Page 9
➞ Role in an investment portfolio/ LOS b
5/ Tax Benefits - depreciation tax shield for direct - explain
investments
- elimination of corporate tax for REITs as long as
a min. amount of taxable income is paid as a div.

➞ Risk and Return/

E(R) better yield than bonds ➞ higher current income
with the possibility for income growth
non-core Equities
leasing rates, terms, renewals affected by overall
Real Estate (core)
economy, as are equities
Bonds - real estate risk thus has an equity
𝛔 characteristic

Page 10
➞ Classifications/ LOS c
1/ Office - single tenant to multi-tenant - discuss
(build-to-suit) (typically has an anchor tenant)

- pre-leased buildings for development are easier to finance

- speculative development increases as the property cycle heats
- net lease - tenant pays op. exp. up.
- lease structures differ by country and property

2/ Industrial/Warehouse - wholesale/retail distribution centers

- light to heavy manufacturing
- warehouse/showroom
M.M138463888.

- net leases usually

3/ Retail - covered malls, strip malls, community shopping centers (big-box

stand-alone properties pad locations)
- office with ground floor retail common
- net leases, fixed or variable rent (base + % of sales)

25
 Last Revised: 08/14/2023

Page 11
➞ Classifications/
LOS c
4/ Hospitality - motels, small hotels, hotels at destinations - discuss
(airports, tourist resorts)

5/ Other specialty - hospitals, labs, self-storage, student housing,

cell towers, data centers, parking facilities,
restaurants

- some types are more mgmt. intensive (i.e. hotels, recreational facilities)
- often property ownership is separated from operating the
business

➞ Investment characteristics by property type/ - location is key

Types of leases:
net lease - tenant pays operating expenses of building + unit
gross lease - owner pays operating expenses
triple net lease (TN or NNN)
common area/repairs, property taxes, insurance

Page 12
➞ Investment characteristics by property type/ LOS c
Types of leases: - discuss
sale and leaseback - company sells the building to a real
estate investor and agrees to a long-term net lease
- medium/long-term leases include rent escalators (rent bumps or
rent step-ups)
- low vacancy rates + rising rents
➞ owner benefits more from short-term leases
(marking-to-market effects)
a) Office: depends heavily on employment growth
lease duration ~ 3-5-10 years
- typically net leases
M.M138463888.

b) Industrial/warehouse: heavily dependent on strength of economy & growth

warehouse demand also depends on M/X activity
Industrial - long-term net leases usually

26
 Last Revised: 08/14/2023

Page 13
➞ Investment characteristics by property type/ LOS c
c) Retail: depends on trends in consumer spending - discuss
- leases vary considerably anchors ➞ 10-20 yrs. favourable rents
attract other tenants
- triple net for strip malls, community sh. centers
- percentage lease for covered malls typically

- base rent + % of sales 𝟐𝟓𝟎, 𝟎𝟎𝟎 $4.16M

=
. 𝟎𝟔
e.g. $50/ft2 5000 ft2 or 6% sales if larger
natural
d) Multi-family - depends on population growth, esp. for the age breakpoint
segment most likely to rent
- also depends on cost of renting vs. owning (HP ↑, renting ↑)
- as rates rise, mortgage costs rise + opportunity cost of
home equity rises ➞ shift towards renting

- typically 1 yr. leases (gross) + unit costs (util., phone, internet)

Page 14
➞ Considerations in due diligence/ LOS d
market review - trends, local market pop., job, and - explain

income growth, expected supply, vacancy rates, rents, etc…

lease and rent review - in-place rents vs. market rents
short leases ➞ mark-to-market potential impact
- history of payments/defaults
costs of releasing space - brokerage, leasehold improvements, grace periods,
seek underlying documentation - bills for op. exp. vacancy periods
several years of audited financial statements
environmental inspection
physical/engineering inspectionM.M138463888.
title search/property survey (easements)
service/maintenance records
verify compliance with zoning, regulations, parking ratios
verify taxes, assessments have been paid

27
 Last Revised: 08/14/2023

Page 15
➞ Considerations in due diligence/
LOS d
- for a real estate company (REIT) - explain

tenant concentration
balance sheet/leverage analysis
mgmt. ➞ backgrounds, skill sets, experience, track records
- completion and stabilization of developed properties
- unit upgrades
- financial statements + notes
- compare stock price with NAVPS
- compare cash flow multiples or div. yields with comparables

LOS e
➞ Appraisal-based indexes/
- discuss
NCREIF Property Index (NPI) - common U.S. Index

- members contribute information on the appraised value,

NOI, CAPEX, occupancy rate, etc. every quarter

Page 16
➞ Appraisal-based indexes/ LOS e
𝐍𝐎𝐈 − 𝐂𝐀𝐏𝐄𝐗 + (𝐄𝐧𝐝𝐢𝐧𝐠 𝐌𝐕 − 𝐁𝐞𝐠. 𝐌𝐕) - discuss
Return =
𝐁𝐞𝐠. 𝐌𝐕
HPR Ending MV
appraisals
(a single period IRR) Beg. MV

𝐍𝐎𝐈 (𝐄𝐧𝐝𝐢𝐧𝐠 𝐌𝐕 − 𝐁𝐞𝐠. 𝐌𝐕) − 𝐂𝐀𝐏𝐄𝐗

= income return = capital return
𝐁𝐞𝐠. 𝐌𝐕 𝐁𝐞𝐠. 𝐌𝐕

𝐍𝐎𝐈 − 𝐂𝐀𝐏𝐄𝐗
= cash return
𝐁𝐞𝐠. 𝐌𝐕
M.M138463888.
- a return measure is first calculated for each reported property and then
value-weighted to get the return for all properties in the index
- allows for the comparison of real estate performance with other
asset classes
- quarterly returns help measure risk (volatility or s.d. of returns)
- index also acts as a benchmark

28
 Last Revised: 08/14/2023

Page 17
➞ Transaction-based indexes/ LOS e
- requires observations of enough transactions - discuss
- both NCREIF and MSCI

1) repeat-sales index - relies on repeat sales of the same property

change in value since last sale

every quarter ➞ observed
indicates how market conditions
sales & prices
have changed

a regression methodology allocates this

change to each time period

2) Hedonic Index - requires only one sale of the property

- uses a regression with IVs that control for age,
size, location, etc…

Page 18
➞ Advantages/Disadvantages/ LOS e
lags market prices - discuss
- appraisal lag
smooths the index - understates volatility
(thus appearing to have lower correlations with other
asset classes)
also overstates Sharpe ratio

- can unsmooth returns

- can use a transaction-based index for measure of correlation for
asset allocation or for comparisons with other asset classes

- transaction-based index - leads appraisal-based index

- includes a random element (noise) due to statistical
M.M138463888.

technique used
- the more transaction, the less noisy the series

29
 Last Revised: 08/14/2023

Investments in Real Estate through Publicly Traded Securities

a. discuss types of publicly traded real estate securities

b. justify the use of net asset value per share (NAVPS) in valuation of publicly
traded real estate securities and estimate NAVPS based on forecasted cash net
operating income

c. describe the use of funds from operations (FFO) and adjusted funds from
operations (AFFO) in REIT valuation

d. calculate and interpret the value of a REIT share using the net asset value,
relative value (price-to-FFO and price-to-AFFO), and discounted cash flow
approaches

e. explain advantages and disadvantages of investing in real estate through

publicly traded securities compared to private vehicles

M.M138463888.

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Real Estate Investments

Page 1/
➞ Types of Publicly Traded Real Estate Securities/

a) Real Estate Investment Trusts (REITs)

a) equity REIT - own, operate (maybe develop)

income-producing real estate
b) mortgage REITs - make loans, or hold mortgage securities,
backed by real estate

b) Real Estate Operating Companies (REOCs)

- taxable
- REOC structure used when a jurisdiction does not have a
tax advantaged REIT regime in place
or/ engage to a large extent in the development of properties
(with the intent to sell)
or/ if they offer other non-qualifying services ➞ brokerage, 3rd party
property management

Page 2/
➞ Types of Publicly Traded Real Estate Securities/

b) Real Estate Operating Companies (REOCs)

- primary cash flows from the sale of properties
- reinvest cash flow rather than distribute large dividends

c) Mortgage-back securities (debt) - covered in fixed income

➞ REIT structures/ corporations or trusts

- tax-advantaged, required to distribute 90%-100% of taxable
earnings
> 75% of assetsM.M138463888.
in real estate
> 75% of income from rental or interest income

- may have min. number of shareholders, max. share ownership,

min. number of properties, maximum asset concentration,
maximum level of non-rental income
- most US REITs are self-managed and self-advised
- externally managed relies on property management companies

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 Last Revised: 08/14/2023

Page 3/
➞ Advantages/

1/ greater liquidity - publicly traded

2/ transparency - share price, quarterly financials, annual audit
3/ diversification - geography, property type
4/ high-quality portfolios
5/ active professional management
6/ high, stable income - predictable, recurring, contractual revenue
7/ tax efficiency - at corporate/trust level

➞ Disadvantages/
- lack of retained earnings - more frequent secondary offerings
- constrained in the types of assets the own

- will own taxable REIT subsidiaries (TRS)

- concentrate non-qualifying revenue there

Page 4/
+ premium = potential overvaluation
➞ Net Asset Value per share
- discount = potential undervaluation
(NAVPS)
key word - over/under valuation may
largest component of be justified
intrinsic value

IFRS - Investment Property - owned for the purpose of earning either

rental income or price appreciation
- valued with cost model or fair value model
- method must be disclosed all changes affect net income
cost ➞ dep. method, useful life, + FV - must be able to reliably determine
M.M138463888.
FV on a continuing basis
FV ➞ how determined, reconcile
beg. + end. FV balances

U.S. GAAP - cost model only tends to - overstate dep.

- understate carrying values

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 Last Revised: 08/14/2023

Page 5/
NAVPS - difference between assets and liabilities all
taken at market value, divided by the number of
shares outstanding

MV assets ➞ appraised value of properties (if available)

or 𝐍𝐎𝐈T𝐜𝐚𝐩 − 𝐫𝐚𝐭𝐞 (comparables)

(- goodwill, DTA,
deferred financing exp.) + other assets
- MV liabilities
(-DTL)

# of shares outstanding

Page 6/

result of straight-lining rent

(may be pos. or neg.)

reflect a full year’s impact of

acquisitions

value of other tangible assets

M.M138463888.
$𝟐, 𝟗𝟏𝟒, 𝟏𝟗𝟖
= $𝟓𝟐. 𝟑𝟑 𝐍𝐀𝐕𝐏𝐒
𝟓𝟓, 𝟔𝟖𝟗

33
 Last Revised: 08/14/2023

Page 7/
- since comparables are from the private market,
so are cap-rates and values per square foot
- NAV reflects the value of a REITs/REOCs assets
to a private market buyer

- may or may not be the same as the value that a

REIT/REOC investor may use
- helps account for some of the discount/premium range
- NAV also does not reflect value that a mgmt. team can add
(or subtract) from NAV
- other NAV issues
NAV can become subjective in illiquid markets
undeveloped land, very large properties with few/no comparables,
specific use properties ➞ all complicate NAV
- since REITs/REOCs offer liquidity, r should be lower, ∴ should trade
at a premium (can also attract better mgmt.)

Page 8/
➞ FFO/AFFO: widely accepted and reported measure of
the operating performance of a REIT

FFO = Net Income

+ Dep. ➞ since RE often appreciates over the long-term, Dep.

does not reflect economic reality
+ Amort. ➞ leasing commissions, tenant
improvements/allowances

+ losses
➞ on sale of properties - do not represent sustainable
- gains
normal income
+ impairments
+ writedowns M.M138463888.

AFFO (FAD - funds available for distribution)

= FFO
+/- non-cash rent
- maintenance-related CAPEX and leasing commissions

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 Last Revised: 08/14/2023

Page 9/
➞ FFO/AFFO: AFFO is superior to FFO as a measure of
economic income since it takes into consideration
the CAPEX needed to maintain the economic
income of the property
- also more reflective of dividend-paying ability ex. # 30/31

- open to more variation and error in estimation than FFO

Relative valuation measures

h versus historical multiples
versus other REITs or
𝐏7
𝐅𝐅𝐎
𝐏7 - based on net income available to equity, thus
𝐀𝐅𝐅𝐎 represent levered income
𝐄𝐕7
𝐄𝐁𝐈𝐓𝐃𝐀 - measures income before the leveraging effects of debt
- facilitates like-for-like valuation comparisons

drivers of multiples 1/ expectations for growth of FFO/AFFO

- higher expectations, higher multiple

Page 10/
drivers of multiples
2/ risk associated with the underlying real estate
- cash flow volatility associated with asset type,
quality, age, market conditions, etc…

e.g. apartments less risky CF vs. hotels

higher multiples

3/ risks associated with the company’s capital structure and access

h to capital
- as leverage ↑, multiples ↓ since r ↑ as risk ↑
- investors anticipate equity offering

+/ widely accepted P/FFO ➞ most frequently used multiple

M.M138463888.

readily available through market data providers (FF0)

-/ may not capture the intrinsic value of all real estate assets
(esp. non-income producing assets, e.g. undeveloped land)
P/FFO ignores cap. reinvestment necessary to maintain income levels
- P/AFFO does, wide variations in assumptions exist

35
 Last Revised: 08/14/2023

Page 11/
LOS n - calculate/interpret - mini case study
LOS o - explain

M.M138463888.

36
 Last Revised: 08/14/2023

Hedge Fund Strategies

a. discuss how hedge fund strategies may be classified

b. discuss investment characteristics, strategy implementation, and role in a

portfolio of equity-related hedge fund strategies

c. discuss investment characteristics, strategy implementation, and role in a

portfolio of event-driven hedge fund strategies

d. discuss investment characteristics, strategy implementation, and role in a

portfolio of relative value hedge fund strategies

e. discuss investment characteristics, strategy implementation, and role in a

portfolio of opportunistic hedge fund strategies

f. discuss investment characteristics, strategy implementation, and role in a

portfolio of specialist hedge fund strategies

g. discuss investment characteristics, strategy implementation, and role in a

portfolio of multi-manager hedge fund strategies

h. describe how factor models may be used to understand hedge fund risk
exposures

i. evaluate the impact of an allocation to a hedge fund strategy in a traditional

investment portfolio

M.M138463888.

37
 Last Revised: 08/14/2023

Hedge Fund Strategies

Page 1
- The Investment Thesis: additional alpha + diversification LOS a
benefits - discuss
Common Characteristics
1/ Legal/Regulatory – accredited investors only (min. income/net worth)
- liquid alts. ➞ MF/ETF structures for the more liquid HF
strategies, retail investors
2/ Flexible mandates – Few Investment constraints
3/ Large Investment Universe – traditional assets + private securities, HY debt,
distressed securities, derivatives
4/ Aggressive Investment Style – shorting, concentration, leverage
5/ Liberal use of Leverage – loans and derivatives
6/ Liquidity Constraints – lock-up periods, liquidity gates, exit windows
7/ Relatively high fee structure – mgmt. + incentive fees
1-2% 10-30%

Page 2
➞ Classification/ LOS a
- discuss

single manager funds (i.e. one strategy or style)

Equity - equity market return and risk characteristics
Event-Driven – corporate events (governance, M&A, bankruptcy)
Relative-Value – relative valuation between two or more securities,
exposed to credit & liquidity risk
Opportunistic – top-down approach, multi-asset opportunity set
M.M138463888.

Specialist - strategies that require specialized skill or knowledge of

a specific market

38
 Last Revised: 08/14/2023

Page 3
➞ Equity Strategies/ Long-Short Equity LOS b
- discuss
- reliance on fundamental
research
- most managers specialize in a
specific geography, sector or style
- some are more generalist
and avoid complex sectors

➞ strategy is a mix of extracting alpha

on long and short side from single-
name stock selection combined with
some net long embedded beta

the less risk factor exposure, the

more leverage risk exposure

Page 4
➞ Equity Strategies/ Dedicated Short/Bias LOS b
- discuss
+ activist short
selling
➞ take a short position then
present research publicly
➞ reputation effect may help

increasing returns when the

market declines, 𝐫𝐟 or decreasing
returns when the market rises
- bottom-up approach (deep-dive)
- difficult to get mgmt. cooperation
M.M138463888.
- flawed business models, high &
unsustainable debt levels, poor
governance, questionable actg.
etc.

39
 Last Revised: 08/14/2023

Page 5
➞ Equity Strategies/ Equity Market Neutral LOS b
- discuss
➞ 𝐄(𝛃𝐏 ) = 𝟎
➞ typically try to be sector and
industry neutral as well
(pairs trading, stub trading, multi-class
➞ more diverse holdings trading)
- adjusted often (daily, hourly)
must balance
neutrality with the costs
of rebalancing
often seen as preferred
replacements for FI during
low return periods or YC is
flat
➞ since 𝛃 = 𝟎, require leverage to
generate meaningful returns

Equity Strategies
Page 6
Short bias L/S
LOS b
Dedicated Market long-only - discuss
Short neutral (100% +)
(60%-120%)
Leverage low high low
Volatility high low high
𝛃 exposure negative neutral positive
Return Correlation negative zero positive
Orientation deep. fund. quantitative fundamental
Valuation approach absolute relative absolute
Position sizing concentrated diverse concentrated
M.M138463888.

Long/Short ➞ 𝛂 – stock picking, market timing (factor tilts)

➞ return – equivalent to long only
➞ risk – ½ of long only

40
 Last Revised: 08/14/2023

Page 7
Dedicated Short/Short Bias LOS b
𝛂 – stock picking, some market timing - discuss
return – lower than other HFs, but negative correlation
risk – more volatile than typical L/S benefit

Market Neutral
𝛂 – security selection, market timing
return – steadier than other equity hedge strategies
risk – less volatility, but leverage risk creates tail
risk

Page 8
Event-Driven Strategies/ Merger Arbitrage LOS c
- discuss
- soft-catalyst ED approach
- trade in anticipation of an
event
- hard-catalyst ED approach - trade
in reaction to an event
(less volatile/risky)
- cash-for-stock deal, buy target
stock
- Stock-for-stock deal, buy T and sell
A in same ratio as the offer
(contrarian approach - sell T, buy A)
uncorrelated source of alpha
- trades typically done using common
stock, but may include preferred,
M.M138463888.

or junior/senior debt

41
 Last Revised: 08/14/2023

Page 9
Event-Driven Strategies/ Distressed Securities LOS c
- in bankruptcy, potential bankruptcy, - discuss
or financial distress

may take several years

to resolve

➞ long lock-up periods

➞ liquidation - assets are

sold and paid out
based on capital structure
priority
best context for
or/ reorganization
reorganization
(capital structure arb.)
i.e. buy senior debt
may be
sell junior debt
a fulcrum
or equity
security

Event-Driven Strategies
Page 10
Merger Arbitrage: LOS c
𝛂 – specific deal selection - discuss
return – 7 - 12% range, low correlation to market return
risk – low, single digit s.d.
- market sensitivity in times of market stress
∴ left-tail risk
Distressed Securities
𝛂 – deal selection, capital structure decisions
return – higher end of event-driven strategies
risk – higher volatility M.M138463888.
than other event-driven strategies

42
 Last Revised: 08/14/2023

Page 11
Relative Value Strategies/ Fixed-Income Arbitrage LOS d
- discuss

- valuation differences
between securities due to
credit quality, and/or implied
volatility spreads

- pricing inefficiencies are

quite small, but high
correlations between securities
∴ high levels of
leverage

Page 12
Relative Value Strategies/ Convertible Bond Arbitrage LOS d
- discuss

➞ embedded option trades at

relatively low implied vol.
levels compared to the
underlying - makes the call
cheap
- must accept or hedge away
interest rate, credit and
market risk
- if realized equity vol. is
M.M138463888.
greater than the IV of
the convertible’s option - overall
gain is achieved

43
 Last Revised: 08/14/2023

Opportunistic Strategies
Page 13
- wide range of markets and securities LOS e
- discuss
region and asset-class level (vs. individual securities)
- broad themes, global relationships, market trends, cycles
- generally divided by:
technical fundamental
relies on mgr. skill, subject
discretionary to behavioral biases
rules-based algorithms, may
systematic fail in new contexts
(subject to herding effects)
use statistical methods use economic data and focus
to predict relative price on fair valuation of securities,
movements based on past sectors, markets
price trends

Page 14
➞ Global Macro ➞ wide range of asset classes LOS e
➞ focus on themes or regions - discuss
➞ top-down, typically fundamental

- tend to be anticipatory, often contrarian, but some follow momentum

- fairly heterogeneous as a group
∴ not as consistent a source of alpha compared
to systematic, trend-following managed futures
- common theme ➞ use of leverage (6 - 7x)
- mean-reverting, low volatility markets offer few opportunities
𝛂 – correctly discerning and capitalizing on trends in global markets
return – produce lumpier and more uneven return streams than other
hedge fund strategies
M.M138463888.

risk – higher levels of volatility

44
 Last Revised: 08/14/2023

Page 15
➞ Managed Futures LOS e
uncorrelated with stocks and bonds - discuss
returns tend to be positively skewed
- since funds only acquire asset exposure (not assets), the
majority of capital (85% - 90%) is invested in short-term
government debt
- tend more towards systematic trading with a quantitative
driven approach to trend identification

① TSM – time series momentum trend following

(long assets that are rising in price, short
assets that are falling in price)
② CSM – cross-sectional momentum
- same as TSM, but a group of long
positions against a group of short positions

Page 16
Opportunistic Strategies/ Global Macro LOS e
Managed Futures - discuss

M.M138463888.

45
 Last Revised: 08/14/2023

Page 17
Specialist Strategies/ Volatility Trading LOS f
- discuss

Relative Value
volatility arbitrage
- buy cheap vol. and
sell more expensive vol.
Long/Short vol.
- VIX futures
- options
- swaps
(watch term structure
of vol., skew & smile)

Specialist Strategies Page 18

LOS f
- Reinsurance/Life Settlement: - discuss

catastrophe rather than policyholders surrendering their

insurance policies to the insurer when no longer wanted,
uncorrelated they often realize more by selling the policy
with other to a fund
asset classes - fund continues to pay the premiums, collects
payout upon death
catastrophe bonds
catastrophe risk futures uncorrelated with other HF strategies
and with other asset classes

M.M138463888.

46
 Last Revised: 08/14/2023

Page 19
Multi-Manager Strategies/ FoF, Multi-Strategy HF
LOS g
- discuss
FoF ➞ fees
fees

fund 1 … … … fund n
FoF manager allocates to
uncorrelated strategies
- more diversification
- less extreme risk exposure
- lower realized volatility
fees
Multi-strategy

strategy 1 … … … strategy n

fee netting at fund level

Hedge Fund Strategies

Page 20
Conditional Factor Risk Model LOS h, i
One factor ➞ CAPM dummy variable = 1 in - describe
b𝐑 𝐇𝐅𝐢 c𝐭 = 𝛂𝐢 + 𝛃𝐢 (𝐄𝐑𝐏)𝐭 + 𝐃𝐭 𝛃𝐢 (𝐄𝐑𝐏)𝐭 period 𝐭 - evaluate

factor risk model conditional

Multi-factor: exposure to 𝐅𝟏 for 𝐇𝐅𝐢 in period 𝐭 (normal times)

b𝐑 𝐇𝐅𝐢 c𝐭 = 𝛂𝐢 + 𝛃𝐢,𝟏 (𝐅𝟏 )𝐭 + 𝛃𝐢,𝟐 (𝐅𝟐 )𝐭 + ⋯ + 𝛃𝐢,𝐤 (𝐅𝐤 )𝐭

+ 𝐃𝐭 𝛃𝐢,𝟏 (𝐅𝟏 )𝐭 + 𝐃𝐭 𝛃𝐢,𝟐 (𝐅𝟐 )𝐭 + ⋯ + 𝐃𝐭 𝛃𝐢,𝐤 (𝐅𝐤 )𝐭

+ (𝐞𝐫𝐫𝐨𝐫)𝐢,𝐭 incremental exposure to 𝐅𝐤 for 𝐇𝐅𝐢
in period 𝐭 (financial crisis period)
M.M138463888.
factors: SNP500 - monthly return to index USD - monthly return on USD index
CREDIT - (Baa - Aaa) bond yields VIX - (𝐕𝐈𝐗 𝐭 − 𝐕𝐈𝐗 𝐭$𝟏 )𝐄𝐎𝐌

47
 Last Revised: 08/14/2023

REVIEW

M.M138463888.

48
 Last Revised: 08/14/2023

Commodities
Review - 1
⇒ commodity – a physical good that is tradable and supplied
without substantial differentiation (spot & future/forward
markets)
- potential for diversification – low 𝐫 with stocks
and bonds
- possible inflation hedging benefits
⇒ Energy/ – most economically valuable sector
1) Crude Oil - different grades (Brent, WTI)
– low in density ⇒ Light - low sulfur content ⇒ Sweet
- drivers of supply & demand technology extraction
politics refining
usage
2) Natural Gas business cycle
· associated gas – coming from an oil well
· unassociated gas – no oil present
- storage/transportation costs high - markets tend to be
- primary demand – electric generation regional
(heating/cooling)

⇒ Energy/ Review - 2
3) Refined products – heating oil, gasoline, jet fuel etc…
- shut down for planned maintenance 2x/yr. during low
demand periods
⇒ Grains/ · Corn · Soybean · Wheat · Rice - can be stored season
- heat/precipitation determine yield over season
⇒ Industrial (base) Metals/ - copper, aluminum, zinc, lead, tin, iron etc…
· demand tied very closely to GDP
feeder
⇒ Livestock/ · hogs · cattle · sheep · poultry
live
- depend on price of grains (input)
M.M138463888.

- tied to GDP growth (esp. in emerging/developing markets)

- weather – can affect health & weight
- disease
⇒ Precious Metals/ · gold · silver · platinum · palladium
- act as stores of value
- also used as an input in other items

49
 Last Revised: 08/14/2023

Review - 3
⇒ Softs/ cash crops · cotton, coffee, sugar, cocoa
- weather affects supply, GDP growth affects demand

⇒ Commodity Production Life Cycle/

Extraction Transport. Storage Refining Transport.
➀ Energy
50-100d. 1-10d. days to a 3-5d. 5-20d.
few months
nat. gas can be consumed here oil products
futures reflect
Refineries – affect demand for crude pricing here
- costly to build - long lead times
Pipelines
affect supply of oil
Exploration
➁ Industrial/Precious Metals - can be stored for yrs.
- requires storage, risks of ownership, financing costs
· smelting/processing relies of economies of scale
· long lead times + large costs to add extraction/processing
· monthly futures contracts w/ no seasonality capacity

⇒ Commodity Production Life Cycle/ Review - 4

poultry – a few weeks
4) Livestock – all yr./
hogs – a few months
cattle – a few years
5) Grains ➞ 5-6 mos. (Planting to Harvest)
- demand year round, storage facilities supply yr. round
6) Softs - each commodity differs significantly
⇒ Participants/
· Hedgers – eliminate price risk · Exchanges – standardized
· Traders/Investors informed investors · Analysts contracts
liquidity providers · Regulators
arbitrageurs
M.M138463888.
⇒ Spot vs. Futures Price/ - difference between spot & futures price
negative Contango called ‘basis’
Backwardation
calendar limited by positive spot
spread arbitrage calendar
bullish
spread
spot indicator
bearish indicator
𝐭 𝐭

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 Last Revised: 08/14/2023

⇒ Spot vs. Futures Price/ Review - 5

Contango - buy long dated contracts

sell short dated contracts

roll over short pos. each

Backwardation – opposite month

⇒ Theories of Futures Returns/

1) Insurance Theory (Keynes) (Theory of Normal Backwardation)
- produces reduce risk by selling futures, prices ↓
2) Hedging Pressure Hypothesis - producers sell to hedge
but users buy to hedge
producers = users - flat curve
producers > users - backwardation, else Contango
3) Theory of Storage
direct storage convenience
Futures price = spot price + -
costs yield
low is stocks - low when
D > S, then
low stocks
high
high

⇒ Components of Futures Returns/ Review - 6

· Price return (spot yield) price 𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐩𝐫𝐢𝐜𝐞 − 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞

=
· change in price in the return 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞
front month contract
· Roll – depends on the shape of the futures curve (p. 24)
roll return = "𝐧𝐞𝐚𝐫 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞 − 𝐟𝐚𝐫𝐭𝐡𝐞𝐫4 %’age of the
𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
× position
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
being rolled

long ⇒ amt. of return in a short ⇒ the amt. of return in a

backwardated market contango market profiting from
profiting from convergenceM.M138463888.
to a convergence to a higher spot price
higher spot price
Note: 𝚫futures - 𝚫spot = roll
· Collateral Return - yield from collateral used (bonds/cash)

⇒ Commodity Swaps/ (pg. 27-28)

· Total return swap · Basis swap · Variance swap · Volatility Swap

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 Last Revised: 08/14/2023

Components of Futures Returns

e.g./ Page 24
- 11 Jan. contracts = $110 exposure LOS g
10 - rolling forward to Feb., need - describe
12 contracts = $108 exposure - calculate
- interpret
(opposite for contango)
9

Jan. Feb.

Roll return = C 𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞

K %’age of the
− 𝐟𝐚𝐫𝐭𝐡𝐞𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
× position being
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
𝟏𝟎 − 𝟗 rolled
e.g./ = . 𝟏 𝐨𝐫 𝟏𝟎%
𝟏𝟎
- the amount of return generated in a backwardated futures
market and profiting from the convergence towards a
higher spot price

Commodities
Review - 6
⇒ Components of Futures Returns/
· Price return (spot yield) price 𝐜𝐮𝐫𝐫𝐞𝐧𝐭 𝐩𝐫𝐢𝐜𝐞 − 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞
=
· change in price in the return 𝐩𝐫𝐞𝐯𝐢𝐨𝐮𝐬 𝐩𝐫𝐢𝐜𝐞
front month contract
· Roll – depends on the shape of the futures curve (p. 24)
roll return = "𝐧𝐞𝐚𝐫 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞 − 𝐟𝐚𝐫𝐭𝐡𝐞𝐫4 %’age of the
𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
× position
𝐧𝐞𝐚𝐫 − 𝐭𝐞𝐫𝐦 𝐟𝐮𝐭𝐮𝐫𝐞𝐬 𝐜𝐥𝐨𝐬𝐢𝐧𝐠 𝐩𝐫𝐢𝐜𝐞
being rolled

long ⇒ amt. of return in a short ⇒ the amt. of return in a

backwardated market contango market profiting from
profiting from convergence to a
M.M138463888.

convergence to a higher spot price

higher spot price
Note: 𝚫futures - 𝚫spot = roll
· Collateral Return - yield from collateral used (bonds/cash)

⇒ Commodity Swaps/ (pg. 27-28)

· Total return swap · Basis swap · Variance swap · Volatility Swap

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 Last Revised: 08/14/2023

Commodity Swaps

- commodity swap – a legal contract involving Page 27

the exchange of payments over multiple LOS i
- describe
dates as determined by specified reference prices or
indexes relating to commodities often a series of
futures contracts
e.g./
refiner/
1) may not want to
manage a large # of
futures contracts
2) may want a specific
grade/quality of oil
hedged
3) may want to maintain
flexibility

Page 28
e.g./ oil refiner ➞ long a swap that pays the LOS i
amount exceeding $100/barrel every - describe
month for 9 months
pays $25/barrel
for the 9-month period called an ‘excess return swap’

M.M138463888.

overall (-9) +16

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 Last Revised: 08/14/2023

Commodities

⇒ Commodity Index/ a benchmark Review - 7

macro forecasting purposes
investment vehicle
Differ based on:
· breadth of coverage - # of commodities/sectors
· relative weighting
· rolling methodology
· rebalancing methodology/frequency
· governance – rules based quantitative methodology
- selection based – index committee selects

M.M138463888.

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 Last Revised: 08/14/2023

Investment Characteristics
Review - 1
Equity:
1/ Long/short: specialize by region/sector/style (some generalists)
typically net long (pos. market factor exposures) (40 - 60%)
heterogeneity in exposures to various equity factors
alpha through stock picking (market timing poor)
𝐄(𝐑) ~ long only, 𝐄(𝛔) = 𝟏T𝟐 long only
liquid, average leverage
df
2/ Dedicated Short:
negatively correlated returns vs. equities and other HF
alpha through stock picking (market timing poor) strategies
60% - 120% short
𝛔𝐒 > 𝛔𝐋#
𝐒
liquid, low leverage

Review - 2
Equity:
3/ Equity Market Neutral:
high leverage, quantitative approach
steadier returns, less volatile
highly diversified, high liquidity
short IH, mean-reverting trades, higher turnover, tax
no/low beta risk issues

Event Driven:
df
4/ Merger-Arb.:
cash-for-stock ➞ long target
stock-for-stock ➞ long target, short acquirer (𝟕+ %)
cross-border M/A, vertical M/A ➞ wider spreads, more risk
friendly M/A, horizontal M/A, domestic deals ➞ smaller spreads
M.M138463888.

(3-7%)
left-tail risk due to M/A failures, market sensitivity (more deals
alpha from deal selection fail with
high leverage, 𝐄(𝐑) ~ low double digits, 𝐄(𝛔) < 𝟏𝟎% market stress)

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 Last Revised: 08/14/2023

Review - 3
Event Driven:
5/ Distressed Securities:
very illiquid, long IH, longer lock-up periods
𝐄(𝐑) highest for event driven strategies, but higher 𝛔
typically long-biased (returns are
low diversification, concentrated positions lumpy and
best in early recovery period cyclical)
df
moderate to low leverage (1.2x – 1.7x NAV)

Relative Value:
6/ Fixed Income Arbitrage: - credit quality, liquidity, volatility premiums
reversion to the mean
net positive carry (as well)
high levels of leverage (4x – 5x)
liquidity varies by security type

Review - 4
Relative Value:
7/ Convertible Bond Arbitrage
tend to be volatility related trades
more illiquid (small issues sizes) ➞ low investment
high levels of leverage (3x) capacity
may/may not hedge credit, interest rate risk
diversification benefit, small return, risk reduction effect
df
Opportunistic:
8/ Global Macro
fundamental/technical, discretionary, some systematic
strong trends or themes (mean reverting, low vol. markets
risk factor exposure very heterogeneous, dynamic poor)
high leverage, 6x – 7x
M.M138463888.

lumpier return series, higher vol.

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 Last Revised: 08/14/2023

Review - 5
Opportunistic:
9/ Managed Futures:
uncorrelated with stocks/bonds
cyclical return profile, range-bound, mean-reverting
markets poor
highly liquid, systematic, trend following, wide range
of risk factor exp.
positively skewed returns in stressed markets
higher volatility than most
df HFs
high leverage

Specialist:
10/ Volatility Trading - long vol. ➞ positive convexity, short equity bet
- short vol. ➞ premium income, long equity bet
- low leverage
11/ Reinsurance/Life Settlement – no asset class correlation
- very specialized skills
- low investment capacity

Review - 6
Multi-Strategy:
F-o-F: - diversification, investment access
- liquidity, manager selection expertise
- strategic, tactical, style allocation
- lower realized 𝛔, less single mgr. risk
- netting risk, added layer of fees, less transparency
- steady, low vol. returns
df
Multi-Strategy – faster tactical allocations
- GP absorbs netting risk, one layer of fees
- concentration of M.M138463888.
operational risks
- steady, low vol. returns > FoF, but more variance
- less investor liquidity than FoF
- more leverage than FoF

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 Last Revised: 08/14/2023

Hedge Funds
Review - 7
LOS h/
Conditional Factor Risk Model
𝐑 𝐇𝐅𝐢 = 𝛂𝐢 + 𝛃𝐢,𝟏 𝐅𝟏 + ⋯ + 𝛃𝐢,𝐧 𝐅𝐧
+ 𝐃𝐭 𝛃𝐢,𝟏 𝐅𝟏 + ⋯ + 𝐃𝐭 𝛃𝐢,𝐧 𝐅𝐧
df
dummy var. ➞ incremental exposure

e.g. 𝛃𝟏 = . 𝟕𝟏 or 𝛃𝟐 = . 𝟔𝟒
𝐃𝛃𝟏 = . 𝟎𝟑 𝐃𝛃𝟐 = −. 𝟎𝟖
. 𝟕𝟒 . 𝟓𝟔

Review - 8
LOS i/
- when added to a 60/40 eq./fx-inc. port.

df

vs. 6.96 8.66 .62 1.13 14.42

M.M138463888.

58