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    Diana Muriuki

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UNIT DESCRIPTION This paper is intended to equip the candidate with the knowledge, skills, and attitudes that will enable him/her to value and analyze alternative investments. LEARNING OUTCOMES A candidate who passes this paper should be able to: • Identify the principal classes of alternative investments • Demonstrate knowledge of the environment and various players in the alternative investment market. • Apply valuation techniques to price and value alternative investments • Advise clients on how to incorporate alternative investments to their portfolio according to stated investment objectives and risk tolerance • Evaluate the importance of alternative investments as asset classes for portfolio management

Paper No. 14 Alternative Investments Analysis

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

A candidate who passes this paper should be able to:
• Identify the principal classes of alternative investments
• Demonstrate knowledge of the environment and various players in the alternative
investment market.
• Apply valuation techniques to price and value alternative investments
• Advise clients on how to incorporate alternative investments to their portfolio according
to stated investment objectives and risk tolerance
• Evaluate the importance of alternative investments as asset classes for portfolio

1. Introduction to alternative investments
1.1 Distinction between alternative investments and conventional investments
1.2 Historical evolution of alternative investments
1.3 Features of alternative investments
1.4 Types of alternative investment structures: regulatory, securities, trading,
compensation, institutional
1.5 Goals of alternative investing

2. The environment of alternative investments
2.1 Participants in the alternative investing environment:
2.2 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 in the alternative
investing environment
2.3 Sell side participants (large dealer banks, brokers) and their roles in the
alternative investing environment
2.4 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
2.5 Features of fund structures
2.6 Documents used in establishing and maintaining hedge fund, private equity fund
and other private partnerships (private-placement memoranda, partnership
agreement, subscription agreement, management company operating
2.7 Moral hazard and adverse selection in alternative investments
2.8 Components of investments objectives, fund size, and fund terms within a limited
partnership agreement
2.9 Regulatory issues related to alternative investments: Global regulations (markets
in financial instruments directive (MiFID), MiFID II, alternative investment fund
managers directive (AIFMD) and their impact on asset allocation
2.10 Role of financial markets in alternative investments: primary, secondary, third
and fourth markets
2.11 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.

3. Real assets investment
3.1 Characteristics of real assets
3.2 Land as an alternative asset; land banking, types of land lots (paper lots, blue top
lots, and finished lots); investment in undeveloped land as a call option; binomial
option pricing technique for valuing land as a call option risks and returns of
investing in land; expected return of land investments
3.3 Timber and timberland as alternative assets; characteristics of timber and
timberland, risks and returns of timberland investments; methods of gaining
exposure to timberland, benefits and disadvantages of timber investment
3.4 Farmland as an alternative asset; characteristics of farmland investments,
reasons for preserving farmland, value of farmland based on annual operating
income and the cap rate, benefits and disadvantages of farmland investment
3.5 Infrastructure as an alternative asset; elements that help identify investable
infrastructure, role of public-private partnerships in infrastructure investing, risks
and government regulation of infrastructure investing, stages of infrastructure
investing, infrastructure investment vehicles
3.6 Intellectual property; characteristics of intellectual property, models of intellectual
3.7 Effect of smoothing on the valuation and volatility of real assets investments:
smoothing of prices and returns, smoothed returns with market returns
3.8 Real estate assets and debt; categories of real estate, equity versus debt,
advantages, disadvantages, and styles of real estate investments as well as
advantages and disadvantages of investing in real estate, challenges of
international real estate investments, residential vs. commercial real estate,
private vs. public real estate, real estate categorization based on market size,
styles of real estate investing, attributes of differentiating real estate styles,
purposes of real estate style analysis and real estate style boxes, analysis of
default risk of commercial mortgages, financial ratios employed in the analysis of
commercial mortgage. Role of real estate in an investment portfolio, types of
real estate investment trusts (REITs), advantages and disadvantages of REITs
as an alternative investment.
3.9 Residential Mortgages-variable rate, gradual payment, option-adjusted rate and
balloon payments
3.10 Real estate equity investments; real estate development in the context of
alternative investments, development phase of real estate, importance of
commercial real estate equity exposures,
3.11 Commercial real estate valuation : comparable sale prices approach, profit and
cost approaches to real estate valuation, cap rates and perpetuity valuation
approach to a real estate project, income approach as a major real estate
valuation approach and transaction-based methods to real estate valuation,
advantages and disadvantages of appraisal-based models over transactionbased models, discounted cash flow approach (income approach) to the
calculation of net operating income, real estate project’s discount rate and the
risk premium approach, role of taxes in estimating discount rates and the cash
flows of a real estate project, appraised value of an office building using the
income approach, private equity real estate funds, commingled real estate funds,
syndications and joint ventures, limited partnerships, and concepts of gearing
and loan-to-value (LTV) ratios, open-end real estate mutual funds, exchange-traded funds and closed-end real estate mutual funds, equity real estate
investment trusts, knowledge of equity REIT returns, private and public REITs
and illiquidity premiums in public REITs , REIT valuation (net asset value per
share (NAVPS), funds from operations (FFO) and adjusted funds from operations
(AFFO)) , comparison of net asset value, relative value (price-to-FFO and priceto-AFFO) and discounted cash flow approaches.

4. Hedge funds
4.1 Features of hedge funds; three primary elements of hedge funds; reasons for
hedge fund industry growth and concentration
4.2 Classification of hedge funds; single-manager hedge funds, funds of funds and
multi-strategy funds
4.3 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
4.4 Hedge fund strategies: types of hedge fund strategies (Equity based strategies,
arbitrage-based strategies, opportunistic strategies, multiple strategies)
4.5 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
4.6 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
4.7 Determinants of investability of hedge fund indices
4.8 Funds of hedge funds; multi-strategy funds; process of investing in funds of
hedge funds, building a portfolio of single hedge funds, multi-alternatives and
other hedge fund liquid alternatives

5. Private equity
5.1 Background of private equity
5.2 Structure of private equity funds and investments
5.3 Roles of various entities involved in private equity investments
5.4 Major forms of private equity investments that involve direct ownership of equity:
leveraged buyouts(LBOs), management buyouts(MBOs), venture capital,
merchant banking and their characteristics
5.5 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
5.6 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
5.7 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 start-up company; risk and return characteristics of venture capital
investments, sources of return (risk premiums) to venture capital investments
5.8 Growth equity: growth equity investments and protective provisions as a key deal
characteristic in growth equity investment, characteristics of growth equity
investment, valuation of growth equity based on revenue
5.9 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
5.10 Private investments in public equity (PIPEs); characteristics and types of
securities issues through PIPEs, motivations of buyers and sellers in PIPEs.
5.11 Private credit and distressed debt; types of fund private credit vehicles; private
credit and distressed debt investments, interval funds, drawdown funds, Funds
with a loan-to-own objective, fulcrum securities and reorganization; credit risk
analysis and the bankruptcy process, basic credit ratings, yields, and financial
ratios, interpret credit spreads and credit risk, credit risk and its relationship to
risk of default, covenants on debt, ways that covenants can control risk,
distressed debt and the bankruptcy process, leveraged loans; basics of
leveraged loans, growth in leveraged loans, liquidity and demand for leveraged
loans, mezzanine debt, structures of mezzanine debt and lowering the weighted
average cost of capital, mezzanine debt financing vs. other forms of financing,
major types of investors in mezzanine debt, characteristics of mezzanine debt.
5.12 Corporate governance structures in private funds.

6. Structured Products
6.1 Introduction
6.1.1 Overview of structuring; major types/forms of structuring, key elements of
a structured products, reasons for structuring, advantages and
disadvantages of structuring, structuring with tranches and how structured
products are created, the primary economic role of structuring, economic
role of structured products
6.1.2 Motivations of structured products; investor related and tax-related
motivations for investors
6.1.3 Structured investment products in the structured products market; capital
protected, yield enhancement and leverage structured products.

6.2 Asset-backed securities
6.2.1 Basic structural features of, and parties to a structuring transaction; the
roles they play, and the legal structures involved
6.2.2 Types of tranching; prepayment tranching and credit tranching
6.2.3 Payment structure and collateral structure of structuring backed by
amortising assets and non-amortising assets
6.2.4 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)
6.2.5 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
6.2.6 Credit default swaps: mechanics of credit default swaps, credit options
and credit-linked notes, risks of credit derivatives
6.2.7 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).

6.3 Mortgage-backed securities
6.3.1 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)
6.3.2 Mortgage loans: cash flow characteristics of a fixed-rate mortgage, level payment
and fully amortised mortgage
6.3.3 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
6.3.4 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
6.3.5 Collateralised mortgage obligation (CMO): creation of a collateralised mortgage
obligation and its use in matching of assets and liabilities for institutional investors
6.3.6 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.

7. Valuing mortgage-backed and asset-backed securities
7.1 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
7.2 Monte Carlo simulation model for valuing a mortgage-backed security
7.3 Path dependency in pass-through securities and the implications for valuation
7.4 Calculation of option-adjusted spread using the Monte Carlo simulation model
and its interpretation
7.5 Evaluation of a mortgage-backed security using option-adjusted spread analysis
7.6 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

8. Commodities
8.1 Types of market participants in commodity futures markets, ways of participating
in commodity markets
8.2 Advantages and disadvantages of direct investment in physical commodities,
Hotelling’s theory, Julian Simon’s argument related to direct commodity returns
8.3 Overview of forward and futures contracts; marking-to-market of futures
positions, initial margin to futures positions, maintenance margins to futures
8.4 Return characteristics of commodity investments
8.5 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
8.6 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
8.7 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
8.8 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
8.9 Insurance perspective, the hedging pressure hypothesis and the theory of
storage and their implications for futures prices and expected future spot prices
8.10 Investing in commodities without futures (through related equity instruments,
exchange-traded funds (ETFs), commodity-linked notes)
8.11 Commodity indices; the process of construction of commodity futures indices,
characteristics of commodity indices, production-weighted long-only commodity
indexes, market liquidity-weighted long-only commodity indexes
8.12 Commodity risk attributes; characteristics of commodities with respect to event
risks, commodities as a defensive investment, institutional investing demand and
its effect on commodity prices.

9. Crowd funding
9.1 Introduction to crowd funding and prediction markets
9.2 Structure, benefits and weakness
9.3 Reward crowdfunding
9.4 Equity crowdfunding
9.5 Peer 2 Peer lending

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