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Alternative Investments: CAIA Level I, 3rd Edition

ISBN: 978-1-119-00336-6
960 pages
September 2015
Alternative Investments: CAIA Level I, 3rd Edition (1119003369) cover image


The official CAIA Level 1 curriculum book

Alternative Investments: CAIA Level I, 3rd 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 third 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.

Most investment analyst education programs focus primarily on the traditional asset classes, pushing alternative investments to the sidelines. The CAIA designation was developed in response to the tremendous growth of alternative investing, and is the industry's premier educational standard. This book is your official study companion, bringing you fully up to speed on everything you need to know (with the exception of the ethics material covered in a separate handbook).

  • Understand the complexities of each alternative asset class
  • Learn the quantitative techniques professionals use every day
  • Dig into the unique aspects of alternative investments
  • Master the core material covered by the CAIA Level I exam

More than 300 financial institutions and hedge funds have committed key executives to the CAIA exam, and this rapidly growing trend speaks to the designation's rising status as a must-have credential for anyone in the alternative investment sphere. Increase your chances of success by getting your information straight from the source in CAIA Level I.

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Table of Contents

Preface xiii

Acknowledgments xvii

About the Authors xix

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 Structures among Alternative Investments 8

1.4 Investments Are Distinguished by Return Characteristics 12

1.5 Investments Are Distinguished by Methods of Analysis 15

1.6 Investments Are Distinguished by Other Factors 18

1.7 Goals of Alternative Investing 18

1.8 Overview of This Book 20

Review Questions 21

CHAPTER 2 The Environment of Alternative Investments 23

2.1 The Participants 23

2.2 Financial Markets 30

2.3 Regulatory Environment 32

2.4 Liquid Alternative Investments 37

2.5 Taxation 40

Review Questions 43

CHAPTER 3 Quantitative Foundations 45

3.1 Return and Rate Mathematics 45

3.2 Returns Based on Notional Principal 47

3.3 Internal Rate of Return 50

3.4 Problems with Internal Rate of Return 54

3.5 Distribution of Cash Waterfall 60

Review Questions 69

CHAPTER 4 Statistical Foundations 71

4.1 Return Distributions 71

4.2 Moments of the Distribution: Mean, Variance, Skewness, and Kurtosis 74

4.3 Covariance, Correlation, Beta, and Autocorrelation 79

4.4 Interpreting Standard Deviation and Variance 88

4.5 Testing for Normality 95

4.6 Time-Series Return Volatility Models 98

Review Questions 100

CHAPTER 5 Measures of Risk and Performance 101

5.1 Measures of Risk 101

5.2 Estimating Value at Risk (VaR) 105

5.3 Ratio-Based Performance Measures 111

5.4 Risk-Adjusted Return Measures 117

Review Questions 120

CHAPTER 6 Foundations of Financial Economics 121

6.1 Informational Market Efficiency 121

6.2 Single-Factor and Ex Ante Asset Pricing 124

6.3 Multifactor and Empirical Models 129

6.4 Arbitrage-Free Models 135

6.5 The Term Structure of Forward Contracts 142

6.6 Option Exposures 147

6.7 Option Pricing Models 153

6.8 Option Sensitivities 155

Review Questions 157

CHAPTER 7 Benchmarking and Performance Attribution 159

7.1 Benchmarking 159

7.2 Types of Models 162

7.3 Performance Attribution 165

7.4 Distinctions Regarding Alternative Asset Benchmarking 169

Review Questions 172

CHAPTER 8 Alpha, Beta, and Hypothesis Testing 175

8.1 Overview of Beta and Alpha 175

8.2 Ex Ante versus Ex Post Alpha 177

8.3 Inferring Ex Ante Alpha from Ex Post Alpha 180

8.4 Return Attribution, Alpha, and Beta 182

8.5 Ex Ante Alpha Estimation and Return Persistence 185

8.6 Return Drivers 186

8.7 Using Statistical Methods to Locate Alpha 188

8.8 Sampling and Testing Problems 193

8.9 Statistical Issues in Analyzing Alpha and Beta 197

Review Questions 201

CHAPTER 9 Regression, Multivariate, and Nonlinear Methods 203

9.1 Single-Factor Models and Regression 203

9.2 Multifactor Models and Regression 208

9.3 Three Dynamic Risk Exposure Models 210

9.4 Two Approaches to Modeling Changing Correlation 212

9.5 Four Multifactor Approaches to Understanding Hedge Fund Returns 215

9.6 Evidence on Fund Performance Persistence 219

Review Questions 221

PART 2 Real Assets

CHAPTER 10 Natural Resources and Land 225

10.1 Natural Resources Other Than Land 225

10.2 Land 230

10.3 Timber and Timberland 236

10.4 Farmland 238

10.5 Valuation and Volatility of Real Assets 242

10.6 Historical Risks and Returns 246

Review Questions 249

CHAPTER 11 Commodity Forward Pricing 251

11.1 Forward Contracts versus Futures Contracts 251

11.2 Rolling Contracts 259

11.3 The Term Structure of Forward Prices on Commodities 260

11.4 Backwardation and Contango 266

11.5 Returns on Forward Contracts 270

Review Questions 275

CHAPTER 12 Commodities: Applications and Evidence 277

12.1 Commodity Investing for Diversification 277

12.2 Commodity Investing for Return Enhancement 280

12.3 Investing in Commodities without Futures 282

12.4 Commodity Exposure through Futures Contracts 287

12.5 Commodity Futures Indices 294

12.6 Commodity Risks and Returns 296

12.7 Historical Risks and Returns 298

Review Questions 301

CHAPTER 13 Operationally Intensive Real Assets 303

13.1 Commodity Producers 303

13.2 Liquid Alternative Real Assets 306

13.3 Infrastructure 309

13.4 Intellectual Property 315

Review Questions 319

CHAPTER 14 Liquid and Fixed-Income Real Estate 321

14.1 Real Estate as an Investment 321

14.2 Residential Mortgages 323

14.3 Commercial Mortgages 333

14.4 Mortgage-Backed Securities Market 335

14.5 Liquid Alternatives: Real Estate Investment Trusts 341

14.6 Historical Risks and Returns of Mortgage REITs 342

Review Questions 345

CHAPTER 15 Real Estate Equity Investments 347

15.1 Real Estate Development 347

15.2 Valuation and Risks of Real Estate Equity 351

15.3 Alternative Real Estate Investment Vehicles 358

15.4 Real Estate and Depreciation 364

15.5 Real Estate Equity Risks and Returns 370

15.6 Historical Risks and Returns of Equity REITs 374

Review Questions 377

PART 3 Hedge Funds

CHAPTER 16 Structure of the Hedge Fund Industry 381

16.1 Distinguishing Hedge Funds 381

16.2 Hedge Fund Fees 387

16.3 Hedge Fund Classification 400

16.4 Hedge Fund Returns and Asset Allocation 402

16.5 Evaluating a Hedge Fund Investment Program 407

16.6 Do Hedge Funds Adversely Affect the Financial Markets? 410

16.7 Hedge Fund Indices 412

16.8 Conclusion 420

Review Questions 420

CHAPTER 17 Macro and Managed Futures Funds 423

17.1 Major Distinctions between Strategies 423

17.2 Global Macro 425

17.3 Returns of Macro Investing 429

17.4 Managed Futures 431

17.5 Systematic Trading 435

17.6 Systematic Trading Strategies 438

17.7 Evidence on Managed Futures Returns 448

17.8 Analysis of Historical Returns Conclusion 455

Review Questions 457

CHAPTER 18 Event-Driven Hedge Funds 459

18.1 The Sources of Most Event Strategy Returns 459

18.2 Activist Investing 462

18.3 Merger Arbitrage 473

18.4 Distressed Securities Funds 482

18.5 Event-Driven Multistrategy Funds 495

Review Questions 498

CHAPTER 19 Relative Value Hedge Funds 499

19.1 Overview of Relative Value Strategies 499

19.2 Convertible Bond Arbitrage 500

19.3 Volatility Arbitrage 518

19.4 Fixed-Income Arbitrage 532

19.5 Relative Value Multistrategy Funds 543

Review Questions 546

CHAPTER 20 Equity Hedge Funds 547

20.1 Sources of Return 548

20.2 Market Anomalies 552

20.3 The Fundamental Law of Active Management 558

20.4 Implementing Anomaly Strategies 561

20.5 The Three Equity Strategies 565

20.6 Equity Hedge Fund Risks 577

Review Questions 580

CHAPTER 21 Funds of Hedge Funds 583

21.1 Overview of Funds of Hedge Funds 583

21.2 Investing in Multistrategy Funds 592

21.3 Investing in Funds of Hedge Funds 594

21.4 Investing in Portfolios of Single Hedge Funds 598

21.5 Multialternatives and Other Hedge Fund Liquid Alternatives 598

21.6 Historical Returns of Funds of Funds 604

Review Questions 608

PART 4 Private Equity

CHAPTER 22 Introduction to Private Equity 613

22.1 Private Equity Terminology and Background 613

22.2 Private Equity as Equity Securities 616

22.3 Private Equity as Debt Securities 620

22.4 Private Equity Liquid Alternatives 625

22.5 Trends and Innovations in Private Equity 630

Review Questions 635

CHAPTER 23 Equity Types of Private Equity 637

23.1 Contrasts between Venture Capital and Buyouts 637

23.2 The Underlying Businesses of Venture Capital 638

23.3 Venture Capital Funds 639

23.4 The Dynamics of Venture Capital 642

23.5 Venture Capital Risks and Returns 648

23.6 Types of Buyouts 652

23.7 Leveraged Buyout Details 655

Review Questions 665

CHAPTER 24 Debt Types of Private Equity 667

24.1 Mezzanine Debt 667

24.2 Distressed Debt 675

Review Questions 681

PART 5 Structured Products

CHAPTER 25 Introduction to Structuring 685

25.1 Overview of Financial Structuring 685

25.2 Major Types of Structuring 686

25.3 The Primary Economic Role of Structuring 687

25.4 Collateralized Mortgage Obligations 689

25.5 Structural Model Approach to Credit Risk 697

25.6 Introduction to Collateralized Debt Obligations 703

Review Questions 707

CHAPTER 26 Credit Risk and Credit Derivatives 709

26.1 An Overview of Credit Risk 709

26.2 Reduced-Form Modeling of Credit Risk 710

26.3 Credit Derivatives Markets 717

26.4 Credit Default Swaps 720

26.5 Other Credit Derivatives 728

26.6 CDS Index Products 731

26.7 Five Key Risks of Credit Derivatives 732

Review Questions 734

CHAPTER 27 CDO Structuring of Credit Risk 737

27.1 Overview of CDO Variations 737

27.2 Balance Sheet CDOs and Arbitrage CDOs 740

27.3 Mechanics of and Motivations for an Arbitrage CDO 742

27.4 Cash-Funded CDOs versus Synthetic CDOs 744

27.5 Cash Flow CDOs versus Market Value CDOs 748

27.6 Credit Enhancements 749

27.7 Developments in CDOs 751

27.8 Risks of CDOs 752

Review Questions 757

CHAPTER 28 Equity-Linked Structured Products 759

28.1 Structured Products and Six Types of Wrappers 759

28.2 Four Potential Tax Effects of Wrappers 760

28.3 Structured Products with Exotic Option Features 763

28.4 Global Structured Product Cases 770

28.5 Structured Product Pricing 775

28.6 Motivations of Structured Products 778

Review Questions 780

PART 6 Risk Management and Portfolio Management

CHAPTER 29 Cases in Tail Events 783

29.1 Problems Driven by Market Losses 783

29.2 Trading Technology and Financial Crises 790

29.3 Failures Driven by Fraud 792

29.4 Four Major Lessons from Cases in Tail Events 799

Review Questions 799

CHAPTER 30 Investment Process, Operations, and Risk 801

30.1 Investment Strategy and Process 801

30.2 Investment Process and Market Risk 803

30.3 The Three Internal Fund Activities 805

30.4 Operational Risk 806

30.5 Controlling Operational Risk 808

30.6 Controlling Risk of Portfolios with Options 812

Review Questions 814

CHAPTER 31 Due Diligence of Fund Managers 815

31.1 Due Diligence Evidence and Organization 815

31.2 Screening with Three Fundamental Questions 816

31.3 Structural Review 820

31.4 Strategic Review 824

31.5 Administrative Review 827

31.6 Performance Review 829

31.7 Portfolio Risk Review 835

31.8 Legal Review 838

31.9 Reference Review 841

31.10 Evidence on Operational Risk 842

Review Questions 843

CHAPTER 32 Portfolio Management, Alpha, and Beta 845

32.1 Alpha and Smart Beta 845

32.2 The Estimation of Alpha and Beta 846

32.3 The Separation of Alpha and Beta 847

32.4 Portable Alpha 848

32.5 Alpha, Beta, and Portfolio Allocation 853

Review Questions 858


Data Sources 859

Computations and Explanations 867

Index 875

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Author Information

DR. DONALD R. CHAMBERS, CAIA, is the Associate Director of Programs at the CAIA Association, the Walter E. Hanson/KPMG Professor of Finance at Lafayette College in Easton, Pennsylvania, and Chief Investment Officer of Biltmore Capital Advisors. Dr. Chambers previously served as the Director of Alternative Investments at Karpus Investment Management. He is a member of the editorial board of The Journal of Alternative Investments.

DR. MARK J. P. ANSON, CAIA, CFA, CPA, PhD, JD, is a member of the CAIA Board of Directors and the President and Chief Investment Officer of the Bass Family Office—winner of the Family Office of the Year award for 2014–2015. Dr. Anson previously served as President and Executive Director of Investment Services at Nuveen Investments Inc., Chief Executive Officer of both the British Telecom Pension Scheme and its wholly owned asset management company in London, Hermes Pension Management Limited, and Chief Investment Officer at California Public Employees' Retirement System. He has published over 100 research articles in professional journals, has won two Best Paper Awards, is the author of six financial textbooks, and sits on the editorial boards of several financial journals.

DR. KEITH H. BLACK, CAIA, is the Managing Director of Curriculum and Exams at the CAIA Association. He was previously an Associate at Ennis Knupp and, before that, an Assistant Professor at Illinois Institute of Technology. He is a member of the editorial board of The Journal of Alternative Investments.

DR. HOSSEIN KAZEMI, is a senior adviser to the CAIA Association. He is Michael and is Michael and Cheryl Philipp Professor of Finance at the University of Massachusetts Amherst, the Director of the Center for International Securities & Derivatives Markets, a co-founder of the CAIA Association, and the Editor-in-Chief of The Journal of Alternative Investments, the official publication of the CAIA Association.

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Press Release

September 22, 2015
Chartered Alternative Investment Analyst (CAIA) Association Announces Key Changes to its Level I Curriculum

The Chartered Alternative Investment Analyst (CAIA) Association, the global leader in alternative investment education, has made significant revisions to its Level I curriculum text in preparation for the organization’s 2016 exam cycle, it was announced today.  

Changes to the Alternative Investments: CAIA Level I, Third Edition, published by Wiley, include a major focus on the rapidly growing liquid alternatives category, a deeper dive into natural resources as part of the section on real assets, and a new chapter incorporating developments in structured products and fixed income.  The updated text is now available for order.

“While academic rigor will always be a sacred part of our offering, it is essential that we listen to, understand, and incorporate the thinking of the leading minds in the global alternative investment space.” said William J. Kelly, CEO of CAIA. “We are proud that our latest text continues to follow this credo and we remain very fortunate and thankful to a global village of practitioners who truly believe in the importance of education and professionalism within our industry.”

“The CAIA Charter has become the gold standard for alternative investment industry education,” said Keith Black, Ph.D., CAIA, and CAIA’s Managing Director of Curriculum and Exams and an author of the new curriculum. “In recent years, the number of investment strategies that fall under the banner of

‘alternatives’ has exploded, making it important that we stay ahead of the curve in keeping our Members, candidates, the industry, and academics apprised of new developments.”

Also new to this edition, chapters will include specific numerical examples and will end with 10 review questions that will allow Candidates to test their knowledge. Answers will be available on the CAIA website, www.caia.org, itself an important resource for professionals in the alternative investment industry. 

“In updating our curriculum, CAIA had the great luxury of being able to call on some of the brightest minds in academia as well practitioners who are at the very top of their respective alternative investment fields,” said Kelly. “CAIA Members and ‘friends of CAIA’ from the U.S., Canada, Europe, Asia, the Middle East and beyond all played integral roles in helping us shape these updates with our global Membership, and the next generation of Members, in mind.”

As part of this revision, additional ancillary materials will be published for college and university professors who wish to integrate the curriculum into their finance departments and classes “We have already forged more than 30 academic partnerships with leading universities around the globe,” continued Kelly. “We are very excited to begin with others to bring these important lessons to their students.”

The CAIA Association offers the only credential focused on the alternative investment space and has become the global benchmark for alternative investment education. The CAIA Charter, an educational designation uniquely designed for individuals specializing in institutional-quality alternative investments, is granted upon successful completion of two levels of qualifying exams combined with relevant professional experience and joining the Association Membership.

CAIA supports 22 global Chapters in financial centers around the world, including recently launched Chapters in Cayman Islands, China, Australia and Texas, as well as in the form of a Virtual Chapter, that brings together Members from far-flung locations in more than 60 countries. CAIA sponsors more than 120 educational and networking events for its 7,700 Members each year.  

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