Category: Essential Concepts for Level II

10-12-19 Essential Concept 81: Delta Hedging and Gamma Risk

Delta hedging refers to managing the portfolio delta by entering additional positions into the portfolio. If DeltaH is the delta of the hedging instrument, the optimal number of units of the hedging instruments, NH, is given by the formula below: Example: Suppose we know S = 100, X = 100, r = 5%, T = 1.0, σ = 30%, and δ = 5%. We have a short position in put options on 10,000 shares of stock. Based on this information, we note Deltac = 0.532, and Deltap = –0.419. Assume each stock option contract is for one share of stock…. Read More

101 concepts level II

10-12-19 Essential Concept 82: Income Approach to Value Real Estate

The income approach focuses on net operating income generated from a property. NOI is roughly analogous to EBITDA. We can calculate NOI as shown below: Rental income at full occupancy + Other income = Potential gross income – Vacancy and collection loss = Effective gross income – Operating expenses = Net operating income The income approach includes two different valuation methods: direct capitalization method and discounted cash flow method. Direct capitalization method: Value is based on capitalizing the first year NOI of the property using a cap rate. If the NOI and value of a property are expected to grow… Read More

101 concepts level II

10-12-19 Essential Concept 83: Cost Approach to Value Real Estate

Under the cost approach, value is derived by adding the value of the land to the current replacement cost of a new building less adjustments for estimated depreciation and obsolesce. The steps involved are: Estimate the market value of the land Estimate the building’s replacement cost Adjust for depreciation including. a. Physical deterioration b. Functional obsolescence c. Locational obsolescence d. Economic obsolescence Advantages and disadvantages of the cost approach Advantage: It is most reliable for new properties with relatively modern design in a stable market. Disadvantage: It is less reliable for old properties as it is difficult to estimate the… Read More

101 concepts level II

10-12-19 Essential Concept 84: Net Asset Value Approach – REITs

Net asset value per share (NAVPS) is the difference between a REIT’s assets and its liabilities (all taken at current market values rather than accounting book values), divided by the number of shares outstanding. NAVPS = (Value of assets – Value of liabilities) / number of shares outstanding The actual share price can be different from NAVPS. Shares can trade either at a discount or a premium to NAVPS. NAVPS is the largest component of the intrinsic value of the stock. NAVPS calculation The current market value of real estate assets is calculated by capitalizing NOI. The market values of… Read More

101 concepts level II

10-12-19 Essential Concept 85: Relative Value Approach – REITs

Funds from operation (FFO) is accounting net earnings excluding: Depreciation charges on real estate Deferred tax charges (deferred portion of tax expenses) Gains/losses from sale of property and debt restructuring Adjusted funds from operation (AFFO) is a refinement to FFO and is designed to be a more accurate measure of current economic income. AFFO = FFO -straight line adjustment – recurring maintenance type capital expenditures and leasing commissions In relative value approach, we use the P/FFO, P/AFFO, EV/EBITDA multiples to value REITs. The main drivers behind these multiples are: Expectations for growth in FFO Risk associated with underlying real… Read More

101 concepts level II

10-12-19 Essential Concept 86: Private Equity Fund Structures, Terms, Valuation and due Diligence

Fund structure: Most PE firms are structured as limited partnerships, where the fund manager is the general partner (GP) and the fund’s investors are limited partners (LP). The GP has management control over the fund and is jointly liable for all debts. The LPs have limited liability; they do not risk more than the amount of their investment in the fund. Two core functions of the GP are: (1) to raise funds and (2) To manage investments The following figure shows the funding stages for a private equity firm. Terms: The most significant economic terms are: Management fees: represent a… Read More

101 concepts level II

10-12-19 Essential Concept 87: Evaluating a PE Fund’s Performance

Analysis of private equity fund’s financial performance includes the following: Gross IRR: Relates to cash flows between the fund and its portfolio companies. It is considered a good measure of the investment management team’s track record in creating value. Net IRR: Relates to cash flows between the fund and LP’s. It measures the returns to investors. PIC (paid in capital): The ratio of paid in capital to date divided by committed capital. DPI (distributed to paid in): Cumulative distributions paid out to LPs as a proportion of the cumulative invested capital. DPI is presented net of management fees and carried… Read More

101 concepts level II

10-12-19 Essential Concept 88: Theories Explaining Futures Returns

There are three theories of commodity futures returns: Insurance theory: Commodity producers sell the commodity in futures market in order to make their revenues predictable. This implies that the futures price must be less than the spot price as a payment to the speculator for providing insurance to the producer. Hedging pressure hypothesis: Producers and consumers sell and buy (respectively) in the futures market in order to remove price uncertainty. The number of sellers as against the number of buyers would determine whether the futures market would be in contango or backwardation. Theory of storage: Commodity futures prices are affected… Read More

101 concepts level II

10-12-19 Essential Concept 89: Components of Futures Returns

The total return of a fully collateralized commodity futures contract is made up of: Price return is produced by a change in spot prices. Price return = (Current spot price – Previous spot price)/Previous spot price Roll return is produced by closing expiring contracts and reestablishing the position in far-dated contracts. Roll return is sector dependent, it is positive when futures markets are in backwardation and negative when futures markets are in contango. Roll return can be significant for a single period but is a small percentage of total return over multiple periods. Gross roll return = (Near-term contract closing… Read More

101 concepts level II

10-12-19 Essential Concept 90: The Creation/Redemption Process – ETFs

ETFs rely on a creation/redemption process that is carried out in an OTC primary market between the ETF issuer and authorized participants (a special group of institutional investors). The AP creates new ETF shares by transacting in-kind with the ETF issuer: A pre-specified basket of securities is exchanged for a certain number of shares in the ETF. At the start of every business day, the ETF manager publishes a list of required in-kind securities. This list is called the creation basket. The process also works in reverse: The AP can present the ETF shares to the ETF issuer for redemption… Read More

101 concepts level II