Discuss distressed securities investing, and compare venture capital investing with distressed securities investing.
Distressed Securities Investing
A typical distressed security investment strategy would involve purchasing the debt of a struggling company, with the goal of ending up with an equity position in the reorganized company.
A typical strategy is to invest in the debt of a company, continue to hold the position throughout the bankruptcy negotiations, and ultimately end up with equity in the new, revitalized operation.
Investing in distressed securities is similar to venture capital investing because both strategies seek an equity position in a company that is eventually successful. Both are illiquid investments with long time horizons.
Investing in distressed securities is most similar to investing in which of the following asset classes?
A. Exchange-traded funds
B. Hedge funds
C. Venture capital
The answer is C. Investing in distressed securities is similar to venture capital investing because both strategies seek an equity position in a company that is eventually successful. Both are illiquid investments with long time horizons.
Discuss the role of commodities as a vehicle for investing in production and consumption.
Investing in commodities gives an investor exposure to an economy’s production and consumption growth.
E.g. when the economy experiences growth, the demand for commodities increases, and price increases are likely.
During recessions, commodity prices are likely to fall with decreased demand.
Overall, swings in commodity prices are likely to be larger than changes in finished goods prices.
While discussing the role of commodities as a vehicle for investment, a commentator makes the following statements:
Statement 1: During economic expansions, increasing supply tends to reduce the price of commodities.
Statement 2: Investing in commodities can give the investor exposure to fluctuations in production and consumption.
Are these two statements CORRECT?
Statement 1 is incorrect. During expansions, increasing demand for finished goods causes an increase in demand for the commodities needed to produce them, resulting in higher prices for commodities. Statement 2 is correct. Commodities can give an investor exposure to the economy’s production and consumption growth, with swings in commodity prices likely to be larger than changes in finished goods prices.
Explain the motivation for investing in commodities, commodities derivatives, and commodity-linked securities.
In a period of rising inflation, the prices of commodities tend to go up, while the prices of stocks and bonds often tend to go down. Thus, the commodities position will act as an inflation hedge for the stock and bond portfolio.
Commodity-linked securities are not derivatives, though their performance is linked to some commodity price. Commodity-linked securities are positively correlated with inflation. Commodity-linked securities are an appropriate investment for those who are prohibited from directly owning real assets such as commodities, but wish to participate in the market.
All of the following are examples of commodity-linked equities EXCEPT:
A. a supermarket operating company.
B. a gold mining company.
C. an oil and gas exploration company.
The answer is A. The stocks of a gold mining company and an oil and gas exploration company are highly correlated with commodities prices, because their values are closely linked to the price of the commodities they produce.
Discuss the sources of return on a collateralized commodity futures position.
Sources of Return
A collateralized commodity futures position involves investing in the futures along with an investment in Treasury securities equal to the value of the futures contract and will have returns from commodity price changes and from the interest income of the Treasury position.
Thus, the total return on the position equals the gain or loss on the futures position plus the interest earned on the Treasury position.
Harold Moore, CFA, wants to establish a collateralized futures position in an investable commodity index. Which of the following actions would correctly implement such a position?
A. Sell index futures contracts with \$30 million in underlying value and buy Treasury securities with an expected future value of \$30 million.
B. Buy index futures contracts with \$30 million in underlying value and buy Treasury securities with a market value of \$30 million.
C. Sell index futures contracts with an expected future value of \$30 million and buy Treasury securities with an expected future value of \$30 million.
⇒ The answer is B. A collateralized commodity futures position is established by going long a futures contract and collateralizing this position by buying Treasury securities with a market value equal to the futures contract value.
A commodities investor establishes a \$10 million collateralized futures position. If the futures are worth \$10.5 million three months later, and Treasuries have an annualized return 4.75% during the period, calculate the total gain on the position.
⇒ The total return on the position equals the gain on the futures position plus the return on the Treasury bills: \$500,000 + (\$10,000,000 × 4.75% × (90 / 360)) = \$618,750