Hedge Funds and Mergers Quiz

Risk-Return Trade-offs

• There's a trade-off between risk and expected return.
• Higher risk typically leads to higher expected return, but there's no "free lunch."
• Investors require higher returns to compensate for taking on higher risk in investments like stocks compared to risk-free Treasury bills.

Quantifying Risk

• Investments can be characterized by their expected return and standard deviation of return.
• Examples include equity investments with a 10% expected return and 18.97 standard deviation of return.
• Standard deviation measures return per annum (R).
• Expected return (E(R)) and standard deviation are calculated using formulas involving probabilities and returns.

Quantifying Risk - 2 Asset Portfolio

• Combining two risky investments (R₁, W₁, R₂, W₂) gives an expected portfolio return (μp) calculated as (W₁μ₁ + W₂μ₂).
• Standard deviation of the portfolio (σp) is calculated using a formula involving variances and correlations of the individual investments.

The Efficient Frontier of Risky Investments

• Figure 1.3 (page 6) is a visual representation of the efficient frontier.
• The efficient frontier shows the relationship between expected return and standard deviation of return for various investments.
• The frontier illustrates the best risk-return trade-offs for a range of possible investment portfolios.

The Efficient Frontier of All Investments

• The formula for expected portfolio return is presented (E(R_p) = RF +.). Risk-free rate is designated by RF.
• Figure 1.4 (page 7) is a visual representation of the efficient frontier showing the best mix of investments.

Systematic vs Nonsystematic Risk.

• Using historical data and regression analysis, the relationship between investment returns and market portfolio returns is determined (R =).
• Systematic risk is non-diversifiable (market risk), while nonsystematic is diversifiable.

Capital Asset Pricing Model

• If there is no systematic risk, the return is equal to the risk-free return (R = RF).
• If there is systematic risk, the return is equal to market portfolio return (R = RM).
• Capital asset pricing model (CAPM) formula for determining expected return (E(R)) : E(R) = RF + Equity Risk Premium.

Assumptions

• Investors care only about expected return and standard deviation of the portfolio return (requires a normal distribution of the underlying return).
• Investments have independent returns connected through correlations with the market portfolio.
• Investors focus on returns over a set period, which is constant for all investors.
• Investors can borrow and lend at the risk-free rate.
• Tax rates don't influence investment decisions, and all investors have identical estimates of expected return, standard deviation, and correlations.

Alpha

• Alpha is the excess return earned by a portfolio that surpasses the return predicted by the CAPM.
• Alpha is calculated as excess return (Rp - RF +)
• The weighted average alpha of all investors must equal zero,

Arbitrage Pricing Theory

• The theory extends CAPM by acknowledging that returns depend on various factors, such as domestic interest rates and inflation.
• A portfolio can be structured to eliminate dependence on these factors.
• Investment return is linearly related to these factors after a portfolio is structured.

Risk vs Return for Companies

• Companies must manage risk in the best interests of shareholders.
• Should companies evaluate projects based solely on systematic risk (as shareholders care only about systematic risk)?
• In practice, companies consider total risk (systematic + unsystematic).
• Earnings stability and company survival are crucial for companies.
• Regulators focus on total risk for financial institutions (FIs).

Bankruptcy Costs

• Bankruptcy costs include lost sales, loss of key employees, and significant legal and accounting costs.
• Arguments about bankruptcy costs suggest that managers are concerned with total risk for shareholders, since projects with high total risk are rejected.

Risk Management by FIs

• Two main approaches to risk management for financial institutions (FIs): Risk decomposition and risk aggregation.
• Risk decomposition involves breaking down risks and handling them separately.
• Risk aggregation involves diversification of business/operations to reduce unsystematic risk.

Credit Ratings

• Credit ratings measure the credit quality of a debt instrument. They must be lower than the issuer's creditworthiness itself.
• Agencies like S&P, Moody's, and Fitch assign ratings.
• Ratings indicate credit quality from AAA (highest) to C (lowest), categorized as investment-grade and non-investment-grade.

Chapter 2: Banks

• This provides an overview of the nature of banking activity.

Nature of Banking

• Commercial banks take deposits and give loans, whether wholesale or retail.
• Money center banks work in the wholesale market, often funding loans by borrowing.
• Investment banking involves raising debt/equity for companies, advising on mergers and acquisitions (M&A) and restructurings, as well as initial public offerings (IPOs).

Sample Dutch Auction

• A sample Dutch auction demonstrates how shares are allocated based on bids and prices.

Potential Conflicts of Interest

• Conflicts of interest can arise in banking relationships (e.g., recommendation of securities for sale, sharing of client information).
• Banks may also pass information from one investor to another or recommend an investment to please company management.
• Investment banks may sell securities to give a loan to a commercial bank to improve their liquidity.

History of Bank Regulation in US

• Key legislation impacting US banks includes the McFadden Act (1927, 1933), Douglas Amendment (1956), Bank Holding Companies Act (1970), and Riegel-Neal Interstate Banking and Branching Efficiency Act (1994).

Simplified Banking Balance Sheet

• Assets and liabilities of a simplified balance sheet for a bank are presented.
• Total assets and total liabilities (including shareholder's equity) should be equal in a properly functioning balance sheet.

Simplified Income Statement

• Key income statement line items (net interest income, provision for loan losses, non-interest income, non-interest expense) are shown.
• Operating income and taxes are included in profits or loss figures.

Role of Regulation/External Oversight

• Regulators impose minimum capital requirements for banks in various tiers (Tier 1, Tier 2, Tier 3 capital).
• Equity is an example of Tier 1 capital, subordinated long-term debt is an example of Tier 2 capital.
• The appropriate capital level impacts return on equity (RoE) and the bank's ability to handle losses.

Deposit Insurance

• Many countries implement deposit insurance programs to protect depositors against losses.
• CDIC and FDIC are examples of such programs.
• Deposit insurance levels vary by country.

Accounting

• Accounting practices in banking can differ significantly between banking books and trading books.
• Newer accounting standards (IFRS 9, FASB update) require lenders to estimate expected credit losses, deducting them from amounts owed on loans.

Originate-to-Distribute Model

• This was a common method of mortgage origination in 2000-2007.
• Banks originated loans and then packaged them into mortgage-backed securities that were sold to investors.
• Credit standards for loans stayed important despite the process.

Chapter 3: Insurance Companies & Pension Plans

• This covers different types of insurance and pension plans.

Life Insurance

• Different types of life insurance (term life, whole life, variable life, universal life, endowment life, group life) are discussed.
• Cash flow expectations for insurers are presented visually.
• Early-year investment strategies and annuity contracts are covered.

Mortality Tables & Actuarial Pricing

• Mortality tables are used for actuarial pricing, estimating the likelihood of death at various ages.
• Minimum premiums are close to the present value (PV) of inflows and outflows of financial risks, illustrating the basis for actuarial premiums.
• Data from US Mortality Tables (2019) shows mortality probabilities and life expectancies at different ages for males and females.

Longevity Derivatives

• Companies use derivatives to manage longevity risk.
• The value of life insurance, pension, or bond contracts depends on the number of people who remain in the population.

Non-Life (Property-Casualty) Insurance

• Non-life insurance covers property and legal liability risks.
• Issues such as payout profile (amount and timing of payouts) are analyzed in this segment.
• Biggest risks for insurers in this area are highlighted.

CAT Bonds

• Catastrophe bonds are an alternative to reinsurance.
• They are issued by a subsidiary of an insurance company, and pay higher than normal interest rates.
• They utilize principal payments to handle extreme claims.

Ratios for Non-Life Insurance

• Key ratios for non-life insurance such as loss ratio, expense ratio, combined ratio, dividends paid, and combined ratio after dividends, and investment income.
• The ratios reflect different business performance components.

When do Premiums Change?

• Life insurance premiums typically remain the same throughout the policy's term.
• Property-casualty premiums change with contract renewals as risks are reassessed.
• Health insurance premiums are tied to health care costs.

Moral Hazard and Adverse Selection

• Moral hazard arises when an insurance policy incentivizes riskier behavior.
• Adverse selection occurs when insurers attract the riskier clients because they can't readily distinguish good from bad risks.

Simplified Balance Sheet: Life Insurance

• A balance sheet for a life insurance company showing assets (like investments) and liabilities (policy reserves) is presented to illustrate the financial position of insurers.

Simplified Balance Sheet: P&C Insurance

• A balance sheet for property-casualty insurance companies is presented to illustrate how assets, liabilities, and equity are organized.

Regulation

• Insurance regulation in both US and Canada (mostly at the state/provincial level) and in Europe (mostly at the EU level) is highlighted.

Pension Plans

• Defined benefit and defined contribution plans (types of retirement plans) and their principles are discussed.
• Plan viability, employer and employee contributions, and required contribution amounts are also covered.

Chapter 4: Fund Managers

• Fund managers and the types of funds are under this topic.

Open-End vs Closed-End Mutual Funds

• Open-ended mutual funds are characterized by variable share counts that fluctuate with investor activity..
• Net Asset Value (NAV) is the key metric for these funds.
• There's a distinction between open-end and closed-end funds that are traded on securities exchanges—closed-end fund shares' value relates to the market value of their underlying assets and sometimes differ from the net asset value (NAV).

Exchange-Traded Funds (ETFs)

• ETFs are designed to track an index, acting as a trading vehicle for an index's underlying components.
• Shares are traded on an exchange like company shares.
• There are features to manage ETFs versus open and closed-end mutual funds.

ETFs vs Open- and Closed-End Mutual Funds

• Key features of ETFs, like trading at any time of day and not having to sell holdings to cover redemptions, are discussed.
• The share price of ETFs closely follows NAV.

Performance of Mutual Funds

• Jensen (1969) demonstrated that mutual fund average alpha is close to zero before accounting for investment expenses.
• Data is presented illustrating that mutual funds may not outperform the market over time consistently.

Mutual Fund Scandals

• Late trading, market timing, front running, and directed brokerage are presented as examples of mutual fund scandals.

Hedge Funds (Alternative Investments)

• Hedge funds are alternative investments that are not subject to mutual fund restrictions (e.g., daily NAV calculation, redeemability).
• Characteristics include typical fee structure, lock-up period, and manager incentives.

Other Notable Points

• Fund of funds are portfolios of hedge funds, typically with fees between 1% and 10% depending on what the fund buys.
• Prime brokers handle trades and determine loan and collateral requirements for hedge funds, and they play a critical role in managing and supporting hedge funds.

Hedge Fund Returns

• Historical hedge fund returns, in relation to the S&P 500, are presented illustrating the performance of various funds over time.
• A statistic bias is described as a potential upward bias from hedge funds in performance statistics, in situations where only some funds report performance for a given lookback period.