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Alternative Investments: CAIA Level I, 4th Edition is the curriculum book for the Chartered Alternative Investment Analyst (CAIA) Level I professional examination. Covering the fundamentals of the alternative investment space, this book helps you build a foundation in alternative investment markets. You'll look closely at the different types of hedge fund strategies and the range of statistics used to define investment performance as you gain a deep familiarity with alternative investment terms and develop the computational ability to solve investment problems. From strategy characteristics to portfolio management strategies, this book contains the core material you will need to succeed on the CAIA Level I exam. This updated fourth edition tracks to the latest version of the exam and is accompanied by the following ancillaries: a workbook, study guide, learning objectives, and an ethics handbook.

Alternative Investments - CAIA Level I, Fourth Edition

Preface xxxiii





Acknowledgments xxxvii





About the Authors xli





Part 1 Introduction to Alternative Investments





Chapter 1 What is an Alternative Investment? 3





1.1 Alternative Investments by Exclusion 3





1.2 Alternative Investments by Inclusion 4





1.3 The Blurred Lines between Traditional and Alternative Investments 8





1.4 A History of Alternative Investing: The U.S. Case 10





1.5 Investments are Distinguished by Return Characteristics 11





1.6 Investments are Distinguished by Methods of Analysis 14





1.7 Eight Other Characteristics that Distinguish Alternative and Traditional Investments 16





1.8 Five Goals of Alternative Investing 18





1.9 Two Pillars of Alternative Investment Management 20





1.10 Overview of This Book 22





Review Questions 23





Chapter 2 The Environment of Alternative Investments 25





2.1 The Participants 25





2.2 Alternative Investment Structures 33





2.3 Key Features of Fund Structures 36





2.4 Financial Markets 40





2.5 Regulatory Environment 42





2.6 Liquid Alternative Investments 43





2.7 Taxation 47





2.8 Short Selling 49





Review Questions 52





Notes 53





Chapter 3 Quantitative Foundations 55





3.1 Return and Rate Mathematics 55





3.2 Returns Based on Notional Principal 57





3.3 Internal Rate of Return 60





3.4 Problems with Internal Rate of Return 64





3.5 Other Performance Measures 73





3.6 Illiquidity, Accounting Conservatism, IRR, and the J-Curve 75





3.7 Distribution of Cash Waterfall 77





Review Questions 85





Note 86





Chapter 4 Statistical Foundations 87





4.1 Return Distributions 87





4.2 Moments of the Distribution: Mean, Variance, Skewness, and Kurtosis 90





4.3 Covariance, Correlation, Beta, and Autocorrelation 94





4.4 Interpreting Standard Deviation and Variance 104





4.5 Testing for Normality 111





4.6 Time-Series Return Volatility Models 114





Review Questions 116





Chapter 5 Foundations of Financial Economics 117





5.1 Informational Market Efficiency 117





5.2 The Time Value of Money, Prices, and Rates 122





5.3 The Three Primary Theories of the Term Structure of Interest Rates 127





5.4 Forward Interest Rates 129





5.5 Arbitrage-Free Models 131





5.6 Binomial Tree Models 134





5.7 Single-Factor Default-Free Bond Models 137





5.8 Single-Factor Equity Pricing Models 143





Review Questions 148





Note 149





Chapter 6 Derivatives and Risk-Neutral Valuation 151





6.1 Foundations of Forward Contracts 151





6.2 Forward Contracts on Rates 155





6.3 Forward Contracts on Equities 157





6.4 Forward Contracts on Assets with Benefits and Costs of Carry 165





6.5 Forward Contracts Versus Futures Contracts 171





6.6 Managing Long-Term Futures Exposures 178





6.7 Option Exposures 180





6.8 Option Pricing Models 186





6.9 Option Sensitivities 188





Review Questions 190





Notes 191





Chapter 7 Measures of Risk and Performance 193





7.1 Measures of Risk 193





7.2 Estimating Value at Risk (VaR) 198





7.3 Benchmarking and Performance Attribution 203





7.4 Ratio-Based Performance Measures 204





7.5 Risk-Adjusted Return Measures 210





Review Questions 214





Notes 214





Chapter 8 Alpha, Beta, and Hypothesis Testing 215





8.1 Overview of Beta and Alpha 215





8.2 Ex Ante Versus Ex Post Alpha 217





8.3 Single-Factor Models and Regression 220





8.4 Inferring Ex Ante Alpha From Ex Post Alpha 225





8.5 Return Attribution, Alpha, and Beta 226





8.6 Ex Ante Alpha Estimation and Return Persistence 230





8.7 Return Drivers 231





8.8 Using Statistical Methods to Locate Alpha 234





8.9 Sampling and Testing Problems 239





8.10 Statistical Issues in Analyzing Alpha and Beta 242





Review Questions 246





Notes 247





Part 2 Real Assets





Chapter 9 Natural Resources and Land 251





9.1 Natural Resources Other Than Land 251





9.2 Land 256





9.3 Timber and Timberland 261





9.4 Farmland 263





9.5 Valuation and Volatility of Real Assets 268





9.6 Pricing and Historic Data Analysis 272





9.7 Contagion, Price Indices, and Biases 275





9.8 Key Observations Regarding Historical Returns of Timberland 278





9.9 Key Observations Regarding Historical Returns of Farmland 278





Review Questions 279





Notes 279





Chapter 10 Commodities 281





10.1 Investing in Commodities Without Futures 281





10.2 The Term Structure of Forward Prices on Commodities 288





10.3 Rolling of Forward and Futures Contracts 296





10.4 Normal Backwardation and Normal Contango 302





10.5 Commodity Exposure and Diversification 307





10.6 Expected Returns on Commodities 310





10.7 Commodity Futures Indices 312





10.8 Commodity Risk Attributes 314





10.9 Observations Based on Historical Returns 318





Review Questions 318





Notes 318





Chapter 11 Other Real Assets 319





11.1 Commodity Producers 319





11.2 Liquid Alternative Real Assets 322





11.3 Infrastructure 325





11.4 Intellectual Property Overview 336





11.5 Cash Flows of Intellectual Property 341





11.6 Visual Works of Art and Historical Performance Data 344





11.7 R&D and Patents as Unbundled Intellectual Property 346





11.8 Intellectual Property Conclusions 349





Review Questions 350





Notes 350





References 350





Chapter 12 Real Estate Assets and Debt 353





12.1 Categories of Real Estate 353





12.2 Advantages, Disadvantages, and Styles of Real Estate Investments 355





12.3 Real Estate Style Boxes 361





12.4 Residential Mortgages 363





12.5 Commercial Mortgages 372





12.6 Mortgage-Backed Securities Market 375





12.7 Liquid Alternatives: Real Estate Investment Trusts 380





12.8 Key Observations Regarding Historical Returns of Mortgage REITs 382





Review Questions 384





Notes 384





Chapter 13 Real Estate Equity 385





13.1 Real Estate Development 385





13.2 Commercial Real Estate Valuation 389





13.3 Details of the Income Approach to Real Estate Valuation 397





13.4 Illustration of the Income Method of Real Estate Valuation 402





13.5 Alternative Real Estate Investment Vehicles 403





13.6 Equity REIT Returns 409





13.7 Key Observations Regarding Historical Risks and Returns of Equity REITs 410





Review Questions 412





Part 3 Hedge Funds





Chapter 14 Structure of the Hedge Fund Industry 415





14.1 Distinguishing Hedge Funds 415





14.2 Hedge Fund Fees 419





14.3 Hedge Fund Classification 431





14.4 Hedge Fund Returns and Asset Allocation 433





14.5 Evaluating a Hedge Fund Investment Program 438





14.6 Three Research Studies on Whether Hedge Funds Adversely Affect the Financial Markets 441





14.7 Hedge Fund Indices 442





14.8 Conclusion 451





Review Questions 451





Notes 451





Chapter 15 Macro and Managed Futures Funds 453





15.1 Macro and Managed Futures Strategies 453





15.2 Global Macro 455





15.3 Managed Futures 459





15.4 Systematic Trading 464





15.5 Four Core Dimensions of Managed Futures Investment Strategies 476





15.6 Systematic Futures Portfolio Construction 479





15.7 Eight Core Benefits of Managed Futures for Investors 483





15.8 Evidence on Managed Futures Returns 485





15.9 Benefits of Managed Futures Funds 493





15.10 Key Observations Regarding Historical Returns of Macro and Systematic Diversified Funds 499





Review Questions 499





Notes 499





Chapter 16 Event-Driven Hedge Funds 501





16.1 The Sources of Most Event Strategy Returns 501





16.2 Activist Investing 505





16.3 Merger Arbitrage 517





16.4 Distressed Securities Funds 524





16.5 Event-Driven Multistrategy Funds 532





Review Questions 534





Notes 534





Chapter 17 Relative Value Hedge Funds 535





17.1 Overview of Relative Value Strategies 535





17.2 Convertible Bond Arbitrage 536





17.3 Volatility Arbitrage 551





17.4 Fixed-Income Arbitrage 565





17.5 Relative Value Multistrategy Funds 575





Review Questions 578





Notes 578





Chapter 18 Equity Hedge Funds 579





18.1 Commonalities of Equity Hedge Funds 579





18.2 Sources of Return 580





18.3 Market Anomalies 584





18.4 Implementing Anomaly Strategies 590





18.5 The Three Equity Strategies 594





18.6 Equity Hedge Fund Risks 605





Review Questions 605





Notes 606





Chapter 19 Funds of Hedge Funds 607





19.1 Overview of Funds of Hedge Funds 607





19.2 Investing in Multistrategy Funds 616





19.3 Investing in Funds of Hedge Funds 619





19.4 Investing in Portfolios of Single Hedge Funds 622





19.5 Multialternatives and Other Hedge Fund Liquid Alternatives 624





19.6 Key Observations Regarding Historical Returns of Funds of Funds 628





Review Questions 631





Notes 631





Part 4 Private Securities





Chapter 20 Private Equity Assets 635





20.1 Introduction to Private Equity Terms and Background 635





20.2 Overview of Three Forms of Pre-IPO Private Equity Investing 637





20.3 Venture Capital 639





20.4 Venture Capital as a Compound Option 647





20.5 Growth Equity 648





20.6 Buyouts and Leveraged Buyouts 651





20.7 Buyouts of Private Companies 653





20.8 Leveraged Buyouts (LBOs) 655





20.9 Merchant Banking 663





20.10 Dynamics of Private Equity Opportunities 663





Review Questions 665





Notes 666





Chapter 21 Private Equity Funds 667





21.1 Overview of Private Equity Funds 667





21.2 Private Equity Funds as Intermediaries 671





21.3 The LP and GP Relationship Life Cycle 677





21.4 Private Equity Fund Fees and Terms 680





21.5 Key Determinants of Venture Capital Fund Risks and Returns 687





21.6 Roles and Three Key Distinctions of Venture Capital and Buyout Managers 689





21.7 Leveraged Buyout Funds 689





21.8 Private Equity Liquid Alternatives 693





21.9 Private Equity Funds of Funds 698





21.10 Private Investments in Public Equity 699





21.11 Private Equity Secondary Markets and Structures 703





Review Questions 706





Notes 707





Chapter 22 Private Credit and Distressed Debt 709





22.1 Types of Fund Private Credit Vehicles 709





22.2 Fixed-Income Analysis 711





22.3 Credit Risk Analysis and the Bankruptcy Process 715





22.4 Leveraged Loans 725





22.5 Direct Lending 727





22.6 Mezzanine Debt 728





22.7 Distressed Debt 737





22.8 Private Credit Performance and Diversification 743





Review Questions 744





Note 744





References 745





Part 5 Structured Products





Chapter 23 Introduction to Structuring 749





23.1 Overview of Financial Structuring 749





23.2 Major Types of Structuring 750





23.3 The Primary Economic Role of Structuring 751





23.4 Collateralized Mortgage Obligations 753





23.5 Structural Model Approach to Credit Risk 761





23.6 Interest Rate Options 766





23.7 Introduction to Collateralized Debt Obligations 768





Review Questions 773





Note 773





Chapter 24 Credit Risk and Credit Derivatives 775





24.1 An Overview of Credit Risk 775





24.2 Reduced-Form Modeling of Credit Risk 776





24.3 Credit Derivatives Markets 783





24.4 Interest Rate Swaps 786





24.5 Credit Default Swaps 793





24.6 Other Credit Derivatives 801





24.7 CDS Index Products 804





24.8 Five Key Risks of Credit Derivatives 805





Review Questions 807





Notes 807





Chapter 25 CDO Structuring of Credit Risk 809





25.1 Overview of CDO Variations 809





25.2 Balance Sheet CDOs and Arbitrage CDOs 812





25.3 Mechanics of and Motivations for An Arbitrage CDO 814





25.4 Cash-Funded CDOs Versus Synthetic CDOs 816





25.5 Cash Flow CDOs Versus Market Value CDOs 820





25.6 Credit Enhancements 821





25.7 Other Types of CDOs 823





25.8 Risks of CDOs 824





Review Questions 829





Chapter 26 Equity-Linked Structured Products 831





26.1 Structured Products and Six Types of Wrappers 831





26.2 Four Potential Tax Effects of Wrappers 832





26.3 Structured Products with Exotic Option Features 835





26.4 Popular Structured Product Types 843





26.5 The EUSIPA Classification 844





26.6 Global Structured Product Cases 848





26.7 Structured Product Valuation 850





26.8 Motivations of Structured Products 854





Review Questions 855





Notes 856





Index 857