Ch7. CFA Study Guide — Alternative Investments & Derivatives

What Are Alternative Investments?

Alternative investments encompass asset classes beyond traditional equities, fixed income, and cash. The CFA curriculum includes hedge funds, private equity, real estate, infrastructure, commodities, and structured products.

Why alternatives matter:

Low correlation to traditional assets → portfolio diversification
Illiquidity premium (extra return for tying up capital)
Inflation hedge (real estate, commodities)
Alpha generation (hedge funds)

Hedge Funds

Major Strategy Categories

Strategy	Description	Characteristic
Long/Short Equity	Buy undervalued + short overvalued	Can be market-neutral
Global Macro	Directional bets on countries, currencies, rates	High volatility/return
Event-Driven	M&A, restructuring, distressed	Illiquidity premium
Relative Value	Exploit mispricing (convert arb, fixed income)	Leverage-dependent
CTA/Managed Futures	Algorithmic trend-following (futures)	Positive in crises

Hedge Fund Performance Metrics

Sharpe Ratio = (Rₚ − Rƒ) / σₚ — risk-adjusted return

Sortino Ratio = (Rₚ − Rƒ) / Downside Deviation — only penalizes downside volatility

Calmar Ratio = Annualized Return / Maximum Drawdown — preferred by hedge fund allocators

Caution: Hedge fund returns may be overstated due to survivorship bias (dead funds excluded from databases) and self-reporting bias (funds only report when performance looks good).

Private Equity

PE Categories

Venture Capital (VC): Early-stage startup investment — high risk / high return
Buyout (LBO): Acquire control of mature companies using leverage
Mezzanine: Hybrid debt/equity instrument (subordinated debt + equity kicker)
Growth Equity: Minority stake in growing companies

LBO (Leveraged Buyout) Mechanics

An LBO uses the target company’s assets and cash flows as collateral to raise debt financing for the acquisition.

Three Sources of LBO Returns:

Leverage effect: As debt is repaid, equity value increases
Operational improvement: Cost reductions and revenue growth
Multiple expansion: Buy cheap, sell expensive (entry vs. exit multiple)

Key metrics: IRR (Internal Rate of Return), MOIC (Multiple on Invested Capital)

Real Estate

Direct vs. Indirect Investment

Feature	Direct	Indirect
Method	Physical property	REITs, RE funds
Liquidity	Low	High (listed REITs)
Entry barrier	High	Low
Transparency	Low	High

Real Estate Valuation

Net Operating Income (NOI) = Gross Rental Income − Operating Expenses

Capitalization Rate (Cap Rate) = NOI / Property Value

→ Rearranging: Value = NOI / Cap Rate

REIT Key Metric: FFO (Funds from Operations) = Net Income + Depreciation − Gains on Sales

Derivatives: Futures and Forwards

Futures vs. Forwards Comparison

Feature	Futures	Forwards
Exchange	Yes	No (OTC)
Daily settlement (MTM)	Yes	No
Credit risk	Exchange guaranteed	Counterparty risk
Standardization	Standardized	Customized
Liquidity	High	Low

Futures Pricing — Cost-of-Carry Model

F₀ = S₀ × e^(r−y)T

S₀: Spot price
r: Risk-free rate
y: Convenience yield (commodities) or dividend yield (equities)
T: Time to maturity

Options: Core Framework

Option Value Components

Option Value = Intrinsic Value + Time Value

Intrinsic value: Call = max(S−X, 0), Put = max(X−S, 0)

Put-Call Parity

C + PV(X) = P + S₀ (European options, no dividends)

Black-Scholes Model

C = S₀·N(d₁) − X·e^(−rT)·N(d₂)

d₁ = [ln(S₀/X) + (r + σ²/2)T] / (σ√T)
d₂ = d₁ − σ√T

The Greeks

Greek	Definition	Direction
Delta (Δ)	∂C/∂S	Call: 0 to +1; Put: −1 to 0
Gamma (Γ)	∂²C/∂S²	Always positive
Theta (Θ)	∂C/∂t	Negative (time decay)
Vega (ν)	∂C/∂σ	Always positive
Rho (ρ)	∂C/∂r	Call: positive; Put: negative

Swaps

Plain Vanilla Interest Rate Swap

Fixed-rate payer ↔ floating-rate payer (reference: SOFR post-LIBOR)
Value = Floating-rate bond − Fixed-rate bond (from fixed-payer’s perspective)

Currency Swap

Exchange principal AND interest in two currencies
Used for simultaneous FX hedging and interest rate exposure management

Credit Default Swap (CDS)

Protection buyer pays periodic premium → receives notional on credit event
Credit events: bankruptcy, failure to pay, restructuring
CFA focus: understand cash flow mechanics and use in credit risk management

CFA Exam Checklist for Chapter 7

Name and describe 5 hedge fund strategy types
Three sources of LBO returns: leverage, operations, multiple expansion
Cap Rate = NOI / Value; Value = NOI / Cap Rate
Put-call parity: C + PV(X) = P + S₀
Black-Scholes: structure of d₁ and d₂
Five Greeks: sign and meaning
Futures vs. forwards: daily settlement and credit risk

Chapter 8 wraps up the CFA series with a 25-question final mock exam and exam-day strategy.