Derivatives & Alternative Investments Flashcards
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Read the first 7 Derivatives & Alternative Investments flashcards as text
A swaption gives the holder the right but not the obligation to enter into an interest rate swap. A 'payer swaption' grants the holder the right to:
Answer: Pay fixed and receive floating in a swap
A payer swaption gives the holder the right to enter a swap as the fixed-rate payer, which gains value when interest rates rise above the swap's fixed rate.
What is the 'hurdle rate' in a private equity fund structure?
Answer: The minimum return that LPs must receive before the GP earns carried interest
The hurdle rate (preferred return) is the minimum return that must be delivered to LPs before the GP participates in profits through carried interest.
Which of the following statements about delta hedging is correct?
Answer: A delta-neutral portfolio requires frequent rebalancing as the underlying price changes
Delta hedging creates a portfolio with zero net delta, but gamma causes delta to change as the underlying moves, requiring continuous rebalancing.
In distressed debt investing, what is 'loan-to-own' strategy?
Answer: Purchasing debt of a distressed company with the intention of converting it to equity through restructuring
Loan-to-own investors buy distressed debt cheaply expecting to receive equity through a debt-for-equity swap during restructuring, gaining ownership of the reorganized company.
The Black-Scholes model assumes which of the following about the underlying asset's returns?
Answer: Continuously compounded returns are normally distributed with constant volatility
Black-Scholes assumes log-normally distributed asset prices (equivalent to normally distributed log returns) with constant volatility and no jumps.
What is a key risk specific to alternative investments compared to traditional asset classes?
Answer: Illiquidity risk due to lock-up periods and infrequent redemptions
Many alternative investments impose lock-up periods preventing redemptions, creating illiquidity risk not typically found in publicly traded equity or bond funds.
An investor uses an interest rate cap to hedge a floating-rate loan. The cap is essentially a portfolio of:
Answer: Call options on interest rates (caplets) for each reset period
An interest rate cap is a series of caplets, each of which is a call option on the reference rate for a specific reset period, paying when rates exceed the cap strike.