Alternative Investments

Fundamental analysis of commodities

• Announcements. Government or private agencies produce forecasts, which can be useful for analysts in their models.

• Component analysis. Different products that make up the commodity class are the components of that commodity (e.g., jet fuel, diesel, gasoline, and lubricants are components of crude oil). Analysis of demand and supply forecasts of components can fine-tune the forecasts for the aggregate.

• Timing issues. Incorporating any seasonality and previously observed logistical issues can refine estimates of demand/supply.

• Macro. Macroeconomic factors such as inflation may trigger an increase in demand for commodities. Low interest rates may increase capital spending and, therefore, the demand for commodities in the intermediate term.

Define contango and backwardation, and state the sign of the calendar spread/basis in each.

Contango: futures prices rise with maturity; spread/basis negative. Backwardation: futures prices fall with maturity; spread/basis positive.

Contango = futures prices increase further out (upward-sloping curve), giving a negative calendar spread and negative basis. Backwardation = futures prices decrease further out (downward-sloping curve), giving a positive calendar spread and positive basis.

How does roll return affect a long futures position in backwardation versus contango, and why?

Backwardation gives a positive roll return for long positions, because futures prices are below spot and converge upward toward spot over time. Contango gives a negative roll return, because futures prices are above spot and converge downward toward spot over time.

As time passes, futures prices converge to spot prices. In backwardation, futures start below spot, so convergence pushes the futures price up — a positive return component for longs. In contango, futures start above spot, so convergence pushes the futures price down — a negative return component for longs.

Insurance Theory (Keynes) — core idea and key weakness?

Producers sell futures to hedge price risk, pushing futures prices below expected future spot; speculators who buy futures earn a return for bearing that risk — predicts backwardation. Weak: buyers haven't earned the predicted premium, and contango is common.

Keynes argued producers sell futures to hedge, pushing futures below expected future spot price; the discount is a return paid to speculators for absorbing price risk. Predicts normal backwardation. Weakness: backwardation buyers haven't consistently earned that extra return, and many markets show contango instead.

Hedging Pressure Hypothesis — core idea and key weakness?

Extends Insurance Theory to include consumer hedging (e.g., buyers going long futures). Backwardation when producer hedging dominates; contango when consumer hedging dominates. Weak: hedging pressure isn't observable, hard to test.

This theory adds consumer hedging (e.g., a bakery going long wheat futures) to producer hedging. Whichever side's hedging dominates determines the curve shape. Weakness: hedging pressure isn't directly observable, so it's hard to test, and both sides may also speculate.

Theory of Storage — core idea and formula?

Futures price = spot price + storage costs − convenience yield. High storage costs relative to convenience yield → contango; high convenience yield (e.g., low inventory/scarcity risk) → backwardation.

Formula: futures price = spot price + storage costs − convenience yield. High storage costs relative to convenience yield → contango; high convenience yield (e.g., low inventories, supply risk) relative to storage costs → backwardation.

What is collateral return (collateral yield) in a fully collateralized futures position?

The yield earned on the collateral (e.g., T-bills) posted to fully collateralize a futures position — equal to the holding period yield on those T-bills.

In a fully collateralized futures position, the investor posts cash or securities (e.g., T-bills) equal to the notional value of the futures (price × contract size). If T-bills are used, the collateral return is simply the holding period yield earned on those T-bills — a return component separate from the futures price return itself.

Excess return swap — how does it work?

Buyer may pay upfront at initiation, then gets periodic payments = (% by which commodity price exceeds a fixed/benchmark value) × notional value; no payment in months price doesn't exceed the benchmark.

The buyer may pay an upfront amount at initiation, then receives periodic payments equal to the percentage by which the commodity price exceeds a fixed/benchmark value, times notional value. If price doesn't exceed the benchmark in a given month, no payment is made that month.

Basis swap — how does it work?

Variable payments based on the price difference (basis) between two commodities, often one with liquid futures and one without; combined with a futures hedge, lets a buyer hedge an input lacking a liquid futures market.

Basis swaps pay based on the price difference (basis) between two related commodities — typically one with liquid futures and one without. Since the two prices aren't perfectly correlated, the basis fluctuates. Combining a futures hedge on the liquid commodity with a basis swap lets a buyer hedge exposure to the illiquid commodity they actually use.

Commodity volatility swap (and variance swap) — how does it work?

Underlying factor is price volatility (or variance). Buyer is paid if actual volatility/variance exceeds the specified level; seller is paid if actual is lower.

In a volatility swap, the volatility buyer is paid if actual volatility exceeds the level specified in the swap; the volatility seller is paid if actual volatility is lower. A variance swap works the same way but based on variance instead of volatility — buyer paid if actual variance exceeds the fixed variance, seller paid if it's lower.

Real Estate Investment Types

• Senior debt. First mortgages, and investment-grade commercial mortgage-backed securities (CMBS).

• Core. Stable income-producing properties, diversified public REITs, and sale and leaseback arrangements.

• Core plus. A property that is functional and generating income, but has the potential to be improved through minimal refurbishment, cash flow stabilizing, and tenant repositioning.

• Value add. e.g., A property that could be improved through upgrades or repositioning. This category also includes sub-investment-grade CMBS.

• Opportunistic. New development/redevelopment, and distressed debt.

Class A - Class D Multifamiliar properties

Class A	Class B	Class C	Class D
Built within the past 10 years or substantially renovated Top exterior and interior amenities relative to the market High-quality construction using highest-quality materials	Built within past 20 years, or older property renovated Dated interior and exterior amenities relative to market Good-quality construction and only limited deferred maintenance	Built within past 30 years, or older property renovated Dated exterior and limited interior amenities relative to market Deferred maintenance on aging construction	Built over 30 years ago, and located in a less desirable location Minimal exterior or interior amenities Low-quality construction, poor condition, and limited remaining usability

DSCR and LTV — what do lenders use them for, and what is debt service?

DSCR = NOI ÷ debt service (income coverage of loan payments); LTV = loan amount ÷ appraised value (leverage); debt service = interest + principal (unless interest-only), and loan rates can be fixed, variable, or adjustable.

DSCR = NOI / debt service, measuring a property's income coverage of loan payments. LTV = loan amount / appraised value, measuring leverage relative to property value. Debt service includes interest and principal (except interest-only loans, where the balance isn't reduced), and loan rates can be fixed, variable, or adjustable (fixed then variable).

Equity dividend rate (cash-on-cash return) — formula and how it differs from IRR and after-tax return?

Equity dividend rate = (NOI − debt service) / equity, a single-period pretax return (a.k.a. cash-on-cash return), distinct from IRR (multi-period, includes appreciation). After-tax return adjusts for taxes net of depreciation shield; land isn't depreciated.

Equity dividend rate (cash-on-cash return) = first-year cash flow / equity, where first-year cash flow = NOI − debt service. It's a single-period, pretax metric — unlike IRR, which spans the whole holding period and includes capital appreciation. After-tax return (analogous to ROE) accounts for taxes net of the depreciation tax shield; land is excluded from the depreciable base.

two primary categories of risks affecting real estate investments

1. Economic and competitive factors. These influence the broad real estate asset class. Such risks include changes in economic activity, changes in demographics, and the cost and availability of capital.

2. Property-level risks. These are unique to individual properties. They include obsolescence (requiring extensive remodeling), rezoning, environmental factors (such as earthquakes, floods, wildfires, and energy efficiency mandates), and issues related to managing the property such as maintaining and leasing it.

What are the key portfolio characteristics of real estate investment?

• Current income – rent from leases that may step up, float with an index (e.g., CPI), include overage clauses, or pass operating costs to tenants; rollover risk arises if the holding period exceeds the lease term

• Capital appreciation – property values tend to rise, but precise gains are hard to measure until sale due to illiquidity and heterogeneity

• Inflation hedge – via rising rents and property appreciation, especially with inflation-indexed leases

• Diversification – low historical correlation with stocks and bonds

• Tax benefits – depreciation deductions and, for REITs, exemption from double taxation

What is an appraisal, in the context of real estate indexes?: Why does appraisal lag cause real estate indexes to show lower correlations with other asset classes than actually exist?

An appraisal is a professional's estimate of a property's current market value, based largely on past comparable transactions, used in place of an actual sale price when the property itself hasn't recently traded.

Appraisal lag smooths the index (like a moving average), dampening its measured volatility and price movements, which artificially reduces the calculated correlation with more responsive assets like stocks and bonds.

What is an transaction-based index, a repeat-sales index, a hedonic index, and a public security index?

• Transaction-based indexes measure price changes based on actual sales of real estate. Two categories of statistical transaction-based indexes have been developed to address the issue of property sales occurring only infrequently: repeat-sales indexes and hedonic indexes.

• Repeat-sales index – a transaction-based index tracking the same property sold multiple times; needs two sales to measure a market change

• Hedonic index – a transaction-based index using regression to control for property characteristics (size, age, location); needs only one sale per property

• Public security index – tracks publicly traded real estate securities (e.g., equity REITs, REOCs, debt securities like CMBX), produced by providers like Bloomberg, FTSE Russell, MSCI, and Nareit