Alternative Investments Analysis KASNEB Notes

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This paper is intended to equip the candidate with the knowledge, skills and attitudes that will enable him/her to value and analyse alternative investments.


A candidate who passes this paper should be able to:

  • Identify the principal classes of alternative investments
  • Identify various players in the alternative investment market
  • Apply valuation techniques to price alternative investments
  • Advise a client on how to incorporate alternative investment in his/her portfolio according to his or her investment objectives and risk tolerance
  • Evaluate the importance of asset backed securities and mortgage backed securities as asset classes


Overview of alternative investments

  • Distinction between alternative investments from traditional investments
  • Categories of alternative investment (real assets, hedge funds, commodities, private equity and structured products)
  • Types of alternative investment structures: regulatory, securities, trading, compensation, institutional
  • Distinction of alternative and traditional investments based on return characteristics and methods of analysis
  • Goals of alternative investing

The environment of alternative investments

  • Participants in the alternative investing environment: buy side participants (plan sponsors; foundations and endowments; private wealth institutions; hedge funds; funds of funds; private equity funds; commodity trading advisors; separately managed accounts) and their roles
  • Sell side participants (large dealer banks, brokers) and their roles in the alternative investing environment
  • Outside service providers (prime brokers, accountants and auditors, advocates, fund administrators, hedge fund infrastructure, consultants, depositories and custodians, commercial banks) and their roles in the alternative investing environment
  • Role of financial markets in alternative investments: primary, secondary, third and fourth markets
  • Regulatory issues related to alternative investments
  • Effect of taxation on alternative investments: income taxes( taxes on capital gains, dividends, interest), non-income tax conventions(real estate taxes, VAT), effect of variation in income tax conventions around the world on investments and investment decisions

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Real assets investments

  • Land as an alternative asset; timber and timberland as alternative assets; farmland as an alternative asset; infrastructure as an alternative asset; intellectual property as an alternative asset
  • Effect of smoothing on the valuation and volatility of real assets investments: smoothing of prices and returns, smoothed returns with market returns
  • Real estate investment trusts (REITs): types of REITs and the potential advantages they offer to investors, net asset value per share (NAVPS) in REIT valuation, estimating NAVPS based on forecasted cash net operating income, use of funds from operations (FFO) and adjusted funds from operations (AFFO) in REIT valuation, comparison of net asset value, relative value (price-to-FFO and price-to-AFFO)and discounted cash flow approaches to REIT valuation; value of a REIT share using net asset value, price-to-FFO and price-to-AFF and discounted cash flow approaches
  • Real Estate Equity Investments: Processes of developing real estate in the context of alternative investments, Valuing of real estate development as a string of real options, decision tree and backward induction to the valuation of a real estate development project, valuation and risks of real estate equity: direct capitalisation and discounted cash flow approach (income approach) to valuing real estate, comparable sale prices for valuing real estate, cost approach, risks of real estate as an investment
  • Alternative real estate investment vehicles: private equity real estate funds, commingled real estate funds, syndications, joint ventures, the concepts of gearing and loan-to-value(LTV) ratios; open-end real estate mutual funds; options and futures on real estate indices; exchange-traded funds based on real estate indices; closed-end real estate mutual funds; equity real estate investment trusts
  • Depreciation of real estate: methods of depreciation of real estate (without income taxation, with depreciation disallowed for tax purposes, with economic depreciation allowed for tax purposes, with accelerated depreciation allowed for tax purposes, and with expensing of capital expenditures for tax purposes) in the analysis of returns

Hedge funds

  • Features of hedge funds; three primary elements of hedge funds; reasons for hedge fund industry growth and concentration
  • Classification of hedge funds; single-manager hedge funds, funds of funds and multi- strategy funds
  • Hedge fund fees: the approach for determining total annual hedge fund fees; the effects of high water marks (HWM) and hurdle rates on hedge fund fees over time; effects of incentive fees on hedge fund manager behaviour; annuity view of hedge funds fees; option view of incentive fees and its implications on manager behaviour
  • Hedge fund strategies: types of hedge fund strategies (Equity based strategies, arbitrage based strategies, opportunistic strategies, multiple strategies)
  • Reasons for incorporating hedge funds into an investment program: return enhancement and diversification potential of hedge funds as additions to portfolios of traditional assets; characteristics and potential benefits of opportunistic hedge fund investing
  • Hedge fund indices: asset-weighted hedge fund indices and equal-weighted hedge fund indices; concepts of representativeness and data biases (survivorship, selection, instant history, liquidation) and their effects on hedge fund returns reported by databases
  • Determinants of investability of hedge fund indices

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Private Equity

  • Structure of private equity funds and investments
  • Roles of various entities involved in private equity investments
  • Major forms of private equity investments that involve direct ownership of equity: leveraged buyouts, management buyouts, venture capital, merchant bankingand their characteristics
  • Major forms of private equity that involve direct ownership of debt securities: mezzanine debt, distressed debt securities, debt covenants, leverage loan securities and factors contributing to their growth
  • Trends and innovations in private equity markets: secondary markets in the context of private equity; private investment in public equity (PIPE) transactions; hedge fund participation in private equity, contrast between private equity funds and hedge funds
  • Venture capital: role of venture capital and leverage buyouts as sources of funding for corporations through their life cycle, role of business plans and exit plans in venture capital investment, structure of venture capital funds, stages of the life cycle of venture capital funds and portfolio companies, compound option embedded in most venture capital investments, the concept of the J-curve in the context of a startup company; risk and return characteristics of venture capital investments, sources of return (risk premiums) to venture capital investments equities
  • Leveraged buyout (LBO) transactions: structure of LBO funds and the role of various entities involved in LBO transactions; fees associated with investments in LBO funds; effects of leverage on the payoffs and returns of LBO transactions; exit strategies of LBOs; risk and return characteristics of LBOs
  • Mezzanine debt: characteristics, typical exit strategy for mezzanine debt investors, how mezzanine debt affects company cost of capital, types of mezzanine debt investors and their motivations
  • Distressed debt: characteristics, supply and demand of distressed debt, typical distressed debt investment strategies, types of corporate bankruptcy processes; risks associated with investments in distressed debt; role of business risk in distressed debt investing

Structured Products

Asset-backed securities

  • Basic structural features of, and parties to a securitisation transaction; the roles they play, and the legal structures involved
  • Prepayment tranching and credit tranching
  • Payment structure and collateral structure of a securitisation backed by amortising assets and non-amortising assets
  • Types of external and internal credit enhancements; cash flow and prepayment characteristics for securities backed by home equity loans, manufactured housing loans, automobile loans, student loans and credit card receivables; financial ratios as used in analysis of commercial mortgages(Loan-to-Value, interest coverage ratio, and debt service coverage ratio); collateralised debt obligations (CDOs): cash and synthetic CDOs; primary motivations for creating a collateralised debt obligation (arbitrage and balance sheet transactions)
  • Credit derivative markets: how a bank can use credit derivatives to transfer credit risk, classification of credit derivatives (single name versus multi-name, funded versus unfunded, sovereign versus non sovereign). four stages of credit derivative activity
  • Credit default swaps: mechanics of credit default swaps, credit options and credit-linked notes, risks of credit derivatives
  • Collateralised debt obligations (CDOs): general structure and life cycle of a CDO, balance sheet CDOs and arbitrage CDOs, cash-funded CDOs and synthetic CDOs, cash flow and market value CDOs, credit risk and enhancement of CDOs, new developments in CDOs(distressed debt CDOs, hedge fund CDOs, single-tranche CDOs)

Mortgage-backed securities

  • Collateralised mortgage obligations (CMOs): characteristics, sequential-pay CMOs, other types of CMO structures and tranches ( Planned Amortisation Class, Targeted Amortisation Class, Principal-only CMO and Floating-rate)
  • Mortgage loans: cash flow characteristics of a fixed-rate mortgage, level payment and fully amortised mortgage
  • Mortgage pass-through securities: investment characteristics, payment characteristics and risks; repayment amount on a mortgage pass-through security for a month, given the single monthly mortality rate; conditional prepayment rate (CPR); Public Securities Association (PSA) prepayment benchmark
  • Relevance of average life of a mortgage-backed with respect to the security’s maturity; factors that affect prepayments and the types of prepayment risks
  • Collateralised mortgage obligation (CMO): creation of a collateralised mortgage obligation and its use in matching of assets and liabilities for institutional investors
  • Mortgage tranches in a CMO: sequential pay tranche; the accrual tranche, the planned amortisation class tranche and the support tranche; risk characteristics and relative performance of each type of CMO tranche, given changes in the interest rate environment; investment characteristics of stripped mortgage-backed securities; agency and non-agency mortgage- backed securities; credit risk analysis of commercial and residential non- agency mortgage-backed securities; basic structure of a commercial mortgage-backed security (CMBS) ;ways in which a CMBS investor may realise call protection at the loan level and by means of the CMBS structure.

Valuing mortgage-backed and asset-backed securities

  • Computation, use and limitations of the cash flow yield, nominal spread and zero- volatility spread for a mortgage-backed security and an asset-backed security
  • Monte Carlo simulation model for valuing a mortgage-backed security
  • Path dependency in pass-through securities and the implications for valuation models
  • Calculation of option-adjusted spread using the Monte Carlo simulation model and its interpretation
  • Evaluation of a mortgage-backed security using option-adjusted spread analysis
  • Reasons for having different effective durations reported by various dealers and vendors; interest rate risk of a security, given the security’s effective duration and effective convexity; cash flow, coupon curve and empirical measures of duration and limitations of each in relation to mortgage-backed securities
  • Use of nominal spread, zero-volatility spread, or option-adjusted spread in evaluating a specific fixed income security


  • Types of market participants in commodity futures markets, ways of participating in commodity markets
  • Overview of forward and futures contracts; marking-to-market of futures positions, initial margin to futures positions, maintenance margins to futures positions
  • Return characteristics of commodity investments
  • Roll process of futures contracts: process of creating and maintaining long-term futures exposures through short-term futures positions; effects of rollover decisions on the returns of long-term futures exposures
  • Term structure of forward prices and the pricing models of futures and forward prices: arbitrage-free pricing models and its application on pricing physical assets, convenience yield
  • The concepts of backwardation, normal backwardation, contango, and normal contango; relationships between forward prices and spot prices under normal backwardation and normal contango; expected returns to spot positions and forward positions (long and short) under normal backwardation and normal contango
  • Potential diversification benefits offered by commodities; commodities in the context of equilibrium diversification; commodities as a diversifier of inflation risk; commodities as potential return enhancers
  • Insurance perspective, the hedging pressure hypothesis and the theory of storage and their implications for futures prices and expected future spot prices
  • Investing in commodities without future
  • (through related equity instruments, exchange-traded funds (ETFs), commodity linked notes)

Emerging issues and trends

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