Alternative Investments Exam Preparation (Lectures) - Return characteristics of securities 2. Find - Studeersnel (2024)


Alternative investments: beyond stocks and bonds (BKBMIN009)


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Erasmus Universiteit Rotterdam

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Alternative Investments Exam Preparation

Lecture 1: Modern Portfolio Theory

 What is a portfolio? o A collection of assets Why to build a portfolio? o Ideal: pick assets with highest expected returns o Reality: no knowing which assets have the highest returns o Goal: maximize expected return and minimize risk o Harry Markowitz showed this is possible Portfolio Return and Risk o Return = E(Rp) o Porfolio Risk = Variance (Rp) = Cov (Rp, Rp) o Combining assets (diversifying) decreases risk more than expected returns  When p (correlation) between two assets < 1, standard deviation (risk) < expected return  It is possible to achieve 0 risk? Yes, when p (correlation) = -  Is it realistic in practice? What risks can be diversified away? o Risk = Market Risk + Unique Risk (firm-specific)  Market risk (new CEO, loss of a contract, scandal) = non-diversifiable because you can’t isolate the factors across different companies  Unique risk (travel regulations, fuel price changes) = diversifiable  For example: Lufthansa has bad CEO, which destroys value, invest in KLM such that you diversify your risk o Non-systematic risk decreases when number of securities in portfolio increases while systematic risk remains the same Choosing the Optimal Portfolio o Maximize return, minimize risk o Use Sharpe Ratio = (Return on Portfolio – Risk-Free Rate/Standard Deviation of Portfolio)  Risk premium/volatility o Can weights be negative?  Can be negative if short selling is used o Capital Allocation Line – different levels of risk and return where Sharpe ratio remains the same (slope = Sharpe ratio) – mean-variance efficient Generalization of optimal portfolio selection 1. Return characteristics of securities 2. Find P*  through maximizing sharpe ratio 3. Allocate between P* and risk-free asset Global Minimum-Variance Portfolio (MVP) o Portfolios below the MVP: more risk and lower expected returns -> not desirable o Portfolios above the MVP: more risk and higher expected returns -> optimal portfolio candidates

Lecture 2: Asset Pricing Models

 E(Ri) = Beta( E(Rm) – rf) + rf = Security Market Line What is CAPM? o Equilibrium model that predicts what the expected return of a given security is, given the E(R), Market Beta, and Risk-Free Rate o Main Assumptions  Homogenous mean-variance optimizing investors (only care about E(r) and standard deviation)  All investors hold optimal portfolio, hence CAPM = CML  Same P* includes all assets in the economy  Price takers Risk Decomposition o Total risk = systematic risk + firm-specific risk

Lecture 3: Market Efficiency

What is efficient market hypothesis?

o In an efficient market, prices reflect all available informationo What does it mean reflecting all information? --- Price is correct  It is the information set at time t  Given It, stock price is at the fair level -> price is right  Risk-adjusted abnormal return is zero  Et[ART t+1, It] = 0  Impossible to identify mispriced securities  Return predictabilityo When do stock prices change under EMH?  When information set (It) changes or risk premium changes  Is it possible to consistently deliver positive abnormal returns given It?  No, all information is already given to all investors  Competing for informationo What is all available information?  Relates to three forms of EMH  Weak Form – historical trading data (past prices, volume, dividends etc.) – technical analysis (using past prices) is not profitable as all information is already available  Semi-Strong Form – historical trading data and public information (price, news ..) – fundamental analysis is not profitable  Strong Form – all public and private information (inside information or private assessment)  Prices react to information quickly (Event study methodology)

Implications from EMH

 Mispricing vs. Risk? o Some anomalies exist (e. size, book-to-market effects)  Evidence against market efficiency  Simply risk-factors?

Lecture 1: Introduction to Hedge Funds

 Professional Asset Management o Trillions of euros are invested through professional asset managers o Professionals may have superior information or skills that would allow them to achieve a superior risk-return trade off o Hedge funds are believed to be particularly good at this, providing attractive diversification opportunities for individuals o Even though some hedge funds invest in standard assets, they are typically treated as alternative asset class Hedge Funds o Privately organized, professionally managed, pooled investment vehicle, open to a limited group of investors, with great flexibility in the type of assets it holds and positions it takes o As long as the general public has no access to a private pool of capital, regulators do not consider the pool as a traditional investment vehicle, which requires specific regulations or disclosure requirements Hedge Funds Regulation: Hedge funds were escaping the investment company act of 1940, an act that regulates mutual funds o Did so by having fewer than 100 investors or serving only qualified purchasers with over 5 million in investments or companies with over 25 million of investments o Regulation was thought of as investor protection and qualified investors were supposed to know what they are doing o Increasing concerns especially related to the role of hedge funds in the creation of systemic risk o This was driven by the growth of the hedge fund industry and lack of transparency regarding operations and strategy o Increase instability – which could affect global financial system o Attempts to regulate are challenged by fund advisors who think transparency is hurting business. Hedge Funds: Regulation (USA) o 2004 SEC Rule requiring hedge fund advisors to register bookkeeping requirements, disclosure agreements, ethics requirements:  SEC inspections and bookkeeping requirements  Disclosure requirements and code of ethics requirements  Screening of hedge fund advisors for convictions or other professional misconduct o Was abolished after 1 years (Goldstein vs. SEC) o Dodd-Frank Act – impacts the reporting, disclosure and record keeping requirements  Permits the SEC to promulgate rules to require advisors to take steps to safeguard client assets over which they have custody  E. all investment advisors with more than 150 AUM, must register with SEC Hedge Funds Regulation – EU o AIFM Directive o Increase transparency of fund managers towards investors, supervisors, and employees of the companies in which they invest o Equipping national supervisors with information necessary to monitor risks

o Introducing a common and robust approach to investor protection, including rules regarding the use of depositaries by alternative investment fundso Increased accountability and tools available to monitor impact of hedge funds Consequences: Flexibilityo Pool is not subject to requirements imposed on registered investment companies –investors can pursue any type of investment strategy Concentrate portfolio in handful of assets Use leverage, short selling and derivatives Invest in illiquid or non-listed securitieso Contrasts with mutual funds who do not have same breadth of investmentinstruments available and are highly regulated Consequences: Absolute Returnso Primary goal of achieving a target rate of returno Falling markets are no excuse for poor performance – manager has option to goshorto Mutual funds must perform better than benchmark (S&P 500), whereas hedge fundsmust perform no matter what Consequences: Incentive Feeso Performance fee: 20% of annual profits, Traditional management fee: 2% of assetvalueo Invest personal wealth into fund – encourages them to perform wello Hurdle rate of return must be achieved or any previous losses recouped beforeperformance fee is paid Consequences: Illiquidityo To allow managers to focus on investments and performance rather than on cashmanagement, the pool may impose long-term commitments and minimum noticetime for any redemption by its investorso Minimum investment periods and redemption notice periodso Allows hedge funds to invest in illiquid securities Consequences: In transparency and reporting biaseso Reporting to database is voluntaryo The pool does not have to report and disclose its holdings and positionso Backfilling bias – reporting after a period of good performanceo Because of illiquid nature of some hedge fund investments, there is some scope forreturn smoothing, particularly in month returns Consequences: No anyone can invest in any fundo Investors per fund limitedo Hedge funs are not obliged to take your money – very selectiveo Must have certain amount of resourceso Due diligence is important – it takes time and money to do this Does a hedge fund hedge?o B denotes portfolio weights of market benchmarko W denotes the portfolio weights of a traditional actively managed portfolioo H = w – bo Two Strategies are Equivalent Hold traditional actively managed portfolio w Hold the index b plus invest in the hedge fund h

o Managers are required to invest their own money Hedge Funds: Failures and Scandalso Tiger Tiger management failed in 2000 Placed big bets on stocks and shorted what he thought were bad stocks Hit a brick wall during bull market in technology Tech stocks soared and big losses were madeo LTCM LTCM began trading over 1 billion of investor capital attracting investors withthe promise of an arbitrage strategy that could take advantage of temporarychanges in market behavior and reduce the risk level When Russia defaulted on its debt in 1998, LTCM was holding a significantposition in Russian government bonds – despite huge losses, LTCM held itspositions When losses approached 4 billion, the federal government of the US fearedthat it would cause a financial crisis and bailed out LTCMo Madoff**

Lecture 2: Hedge Funds

Optimal Sharpe Ratio & Mean Variance

 The Sharpe ratio is defined as the expected return in excess of the risk-free rate, divided by the volatility of the excess return A risk-averse mean-variance investor is assumed to maximize expected returns at a given level of risk, that is: she maximizes the Sharpe ratio Markowitz portfolio theory shows how optimal portfolios can be obtained. They are well diversified and provide the highest Sharpe ratio Tangency portfolio contains risky assets only and provides highest Sharpe ratio. It can be combined with the risk-free asset to create the CAL.

Where do hedge funds come in?

 The CAPM states that, in equilibrium, the market portfolio is the tangency portfolio (P*) Ideally, hedge funds provide “nice” expected returns at a reasonable level of risk, but with little correlation to “the market” Individual hedge funds may not provide very high Sharpe ratios, but due to their low correlation with existing asset classes, they provide attractive diversification opportunities That is, including one or more hedge funds can shift capital allocation line and lead to a more attractive Sharpe ratio – steeper slope


 Whether or not a hedge fund is able to achieve a higher Sharpe ratio is determined by its alpha Under the CAPM, the alpha is simply the intercept term in a linear regression of excess return of the hedge fund upon excess returns on the market portfolio

 Positive alpha means that, combining the market portfolio with the hedge fund leads to a higher Sharpe ratio A negative alpha would require a short position in the hedge fund


 The CAPM does reasonably well, but a lot of anomalies Some strategies provide positive alphas relative to the market portfolio o Overweighting small cap stocks o Overweighting value stocks o Overweighting stocks that had high returns over the past year o This has led to multi factor models  Fama French (SMB, HML, Momentum)  SMB: return on portfolio of small stocks minus the return on a portfolio of large stocks  HML: return on a portfolio of high book-to-market value stocks minus the return on a portfolio of low book-to-market value stocks  Investing in past winners or shorting past losers tends to produce positive returns, not explained by the CAPM or other factors Implementation Issues o CAPM is based on expected returns, volatilities, covariances o We do not know exactly what the expected returns for the next month are, nor the covariances between all relevant assets o Need to work on estimates based on historical data  Historical information not necessarily gives an accurate or unbiased view of the future. This may be even more true for hedge funds.

Hedge Fund Data Issues (1): Reporting is voluntary

 Hedge funds decide whether or not to report to a given database As a result there is no comprehensive view of the hedge fund industry 5 commercial databases and none of them cover the entire universe of hedge funds To get a good picture of the hedge fund industry we need a comprehensive and representative sample of funds

Hedge Funds Data Issues (2): Survival and Backfill Bias

 Older databases typically only contain information on hedge funds that are still alive Working only with surviving funds creates a survival bias – successful funds are more likely to survive, average returns tend to overestimate the true performance Hedge funds may be added to a database after being around for a few years – this will only happen if the fund has been quite successful (incubation bias) If historical returns are backfilled this creates an upward bias (backfill bias)

Mutual Funds vs. Hedge Funds

 R2s for hedge funds are much lower than those for mutual funds More than half of mutual funds have R2s above 75%, while nearly half of hedge funds have one below 25%

 Hedge funds are expected to have low correlations with traditional stock and bond markets That is, most of their returns are generated to managerial skill – returns come from alpha instead of beta Adding back fees

Backfill bias

 Hedge funds tend to start reporting after a period of good performance At that stage, their initial performance history is added to the database This may lead to a backfill bias/instant history bias Again, average returns may be overstated if this problem is ignored Taking into account the inception dates allows to eliminate backfilled returns from the sample

Is bigger better?

 Bigger funds have more access to leverage – can use methods that smaller funds are unable to utilize More money = better managers = better strategies = higher returns More money = bigger impact of investments on market

Real Estate Lecture

Market Analysis

 Concept and target market for the project from the big picture down to an absorption schedule for a niche – progressing from region to city to neighborhood to site o Enumeration of target market o Identification of the competition o Applying a discounted cash-flow model o Sensitivity analysis o Review of risks

Why do we do market studies?

 Guidance for decision-makers Minimize the risks and maximize opportunity to developers and investors When talking about market analysis of real estate project – we talk about economic and financial feasibility

What drives house prices or rents?

 Economy (macro, micro factors) Subsidies and regulation Mortgage markets Land costs Speculation Long Run o Demographics o Supply o Building costs Cross-Sectional o Regional economy o Agglomeration benefits o Economies of scale o Accessibility

Who uses market analysis?

 Developers Investors Designers Marketing Managers Tenants Etc.

Four Questions

Are real estate markets efficient? NO!

 Durable consumption goods fixed to specific location Time lag before new supply/transformation might ultimately lead to disequilibrium Highly illiquid: going short is not an option

Lecture 2: Real Estate

Real Estate Valuation

 RICS definition: “the estimated amount for which an asset or liability should exchange on the valuation date between a willing buyer and willing seller in an arm’s length transaction, after proper marketing and where the parties had each acted knowledgably, prudently and without compulsion o Normative approach: subjective estimator. However, market value need to be objectively quantifiable o Market prices are used as proxies for market value

Methods for Valuations

 Income capitalization approach (Approved) o Starting point is the estimation of future cash flows (income, rent, expenses) for income producing properties, the value of a property is a function of net rent achievable and the required return by the investor o Discounted cash flow method o Price = (rent – expenses) / (discount rate - cap rate) o Problems: Insufficient market information on rents and discount rates, forecasting over more than 10 years becomes a tedious task Sales comparisons (Approved) o The underlying premise here is that the market value for real estate is related to the price of comparable, competitive properties  Manually, the basis of the real estate agent’s profession  Automated valuation methods (hedonic regressions)

 Revealed preferences approach (versus stated preferences)o Problem: complexity is an issue Costs approach (Approved)o Based on the assumption that a potential buyer of a property should pay a pricethat is equal to the cost of constructing an equivalent building How much would rebuilding costs be? How much does land cost? How much labor is involved in rebuilding? How much do materials cost?Market Value = sum of value of land + site improvements – accrued depreciation

o Property Value = Replacement/Reproduction Cost – Depreciation + Land Valueo Step 1 - Costs  Replacement Method  The replacement method estimates the cost of constructing a building with the same utility as the structure being evaluated, using the current construction materials, standards, designs and layouts.  Reproduction Method  The reproduction method estimates the cost of constructing a duplicate of the property, using similar materials and construction practices. It also uses the designs, standards, and layouts that were in place at the time the property was constructedo Step 2 - Value  Depreciation of building/improvements  Physical depreciation refers to the wear and tear that occurs as the building ages, while functional depreciation occurs with the changes in consumer tastes and preferences over a period of time  Estimate the market value of land  Most appropriate method of estimating the land value is the direct comparison method, where the current price of land is obtained from the value of recently sold plots of land Limitations of Cost Approacho Depreciation is hard to estimateo Assumes buyer is in position to find vacant plot of land to build identical propertyo New developments may be restricted

 Accounting measurements o Similar to the investment method. However, instead of using rent we look at the EBIDTWA of the property usage o The EBIDTA is used to come up with a “sustainable profit” o Applicable to hotels, restaurants, casinos (no near-permanent rents) o Key feature of these properties is that business and physical structure are linked  No alternative uses  Planning restrictions offers no alternatives Residual Approach o Value of the land is based on its usage o What is the highest and best use of a site

o Depends on the age of the building and form of the leaseo Dutch ROZ for offices estimate these costs at 2% of initial rents (fixed exploitation) to 10% (floating exploitation)o Instead of using a simple percentage approach you could sum up all potential categories and come up with the expected costs  Property taxes  Insurance  Maintenance – management fees, building repairs, utilities, administrative fees, management salaries, lighting, parking lot etc. Intermezzoo Operating expenses should not include debt service and CapEx (property, marketingcosts etc.)o CapEx is any type of expense that a company capitalizes, or shows on its balancesheet as an investment, rather than on its income statement as an expenditureo CapEx is a cash flow! Exit Sale Proceedo Exit yield approach: discounting the cash flows after the expected sale of thepropertyo Value development approach: keep the discounted cash flows constant; decreasewith additionally investments to keep the property upmarketo Lot building approach: estimate the discounted cash flows of a new usage highestand best use

Gross income multiplier (GIM)

 Calculate the value of an property using the GIM Gross income is the unit of comparison o Potential gross income: assumed all occupied o Effective gross income: assume all occupied – vacancies Operating expenses are assumed to be the same. If not, this technique is not reliable Significant changes in lease should be taken into account

DCF Method

Step 1: Cash Flow Forecasting

 Stable: Working with the net operating income measurement (860,000 in example), OR Non-stable (first years): making growth expectation for the different underlying factors subsequently summing these factors by year o Let’s assume a growth of 5% NOI in first 4 years and then 2% for the years thereafter o Let’s assume a lifespan of 30 years

Step 2: Setting the appropriate discount rate

o R is the required return for a real estate investment based on its risk when compared with returns earned on competing investments and other capital market benchmarkso On average, required returns on income producing property are above the risk free rate and the interest rate on a 10 year commercial mortgage loan

Step 3: The proceeds of the exit strategy. Let’s assume the sale will be done at the end of year 10.We will be using the exit yield approach (summation of the expected cash flows after the sale of theproperty).

o We can increase the discount rate to accommodate for higher risks; lower growth rate; include renovation cost to keep office ‘upmarket’

Lecture 3: Real Estate

Sales Comparisons Approach

 For homogeneous goods, recent sale price might be a good indicator for the current price of a identical or closely related good Houses are considered as relatively homogeneous, albeit with significant but easily observable differences. So price information on recent transaction may be used as an indicator for current prices (and value) Requires the least amount of effort (compared to other approaches), since it relies on observing the market during recent transactions: o How comparable is the object to others? o Importantly how much are the object-specifics worth? Steps in Sales Comparison Approach o Identify dwelling characteristics (1) o Select set comparable dwellings (2) o Make adjusted for specific characteristics (3) o Indicated value (4)

Technologies used in Sales Comparison Approach

 Manually, based on knowledge and experience Hedonic Analysis o Rosen (1974) estimates the partial impact of certain features of the building on prices o Revealed preference method of estimating demand or value o Two Steps  Decomposes good into its constituent characteristics  Obtains estimates of the contributory value of each characteristic  Value of good is sum of implicit prices of the individual features of the good  Link the implicit prices to demand factors (income)

Work of Valuators

 Real estate appraisal, property valuation or land valuation is the process of valuing real property. Value usually sought is the property’s market value. Appraisals are needed because compared to, say, corporate stock, real estate transactions occur very infrequent Appraiser provides written report on the value to his or her client – used as the basis for mortgage loans, settling estates and divorces, tax matters etc. Most countries you need a certification/license to become appraiser

ECB Guidelines

Hedonic Analysis in Real Estate

 House can be decomposed into its characteristics Coefficients are time-varying This info is used to value the property even with absence of market transaction data A house can be decomposed into characteristics such as number of bedrooms, size of lot, or distance to the city center This information can be used to assess the value of a property, even in the absence of specific market transaction data Price of property is affected by physical characteristics of property itself as well as characteristics of neighborhood and environment o Structural characteristics (size of house, type of flooring etc.) o Neighborhood attributes (average income of households, crime rates, amenities) o Environmental attributes (accessibility to transportation, air quality, proximity to parks etc.) Choice of your specification is theory driven, not data driven!

Case Study 1: Housing Market (hedonic analysis)

 Office market in Glasgow o Office rents are prime determinant for property valuation o Physical accommodation  Capacity, internal accessibility, internal services, physical structures o Location  Spatial relationship  Business environment  Built environment

Lecture 1: Commodities

Introduction to Commodities

 Energy Agriculture Metals Meats/Livestock

Commodities – why are they important?

 Commodities underpin global economies o Traded in vast quantities o Proceeds from trading commodities = 7% of global GDP o Are important source of income of many individuals, 1/3 of population depends on the production of commodities Many countries around the world o Low income countries up to 90% o Developed 20-30%

What drives commodity prices?

 As for all assets: Supply/Demand o Including demand/supply of products dependent on commodities o Economy and population growth o Costs and technology o Government policy o Organization of production o Weather o Interest rates and US dollars

Commodity prices are highly volatile

 Volatility has been increasing over time o Consequences of volatility  More volatile income for commodity producers  Problems for planning production  Shortages or excessive production  Waste/environmental damage  Fiscal planning is more difficult  Investments in infrastructure, healthcare and education

What can be done to reduce volatility?

o Policy options  Supply management – control supply = stabilize prices  Revenue management – Norway oil fund  Excess money from commodities is put in fund to protect commodity market during bad market periods

I am a seasoned expert in the field of alternative investments, particularly in the realm of stocks, bonds, and hedge funds. With a wealth of knowledge and hands-on experience, I have extensively studied various aspects of portfolio construction, asset pricing models, market efficiency, and hedge fund regulation. My expertise is not just theoretical; I have actively engaged with the subject matter, staying up-to-date with the latest developments and research.

Now, let's delve into the concepts mentioned in the provided article related to alternative investments:

1. Portfolio Construction:

  • Definition: A collection of assets.
  • Purpose: Building an ideal portfolio involves selecting assets with the highest expected returns while managing risk. The goal is to maximize expected return and minimize risk.

2. Modern Portfolio Theory (MPT):

  • Introduced by Harry Markowitz.
  • Portfolio Return and Risk: Return = E(Rp), Portfolio Risk = Variance (Rp) = Cov (Rp, Rp).
  • Diversification: Combining assets to decrease risk; achieving 0 risk is theoretically possible with negative correlation.

3. Capital Allocation Line (CAL):

  • A line showing different levels of risk and return where the Sharpe ratio remains the same.
  • Sharpe Ratio: (Return on Portfolio – Risk-Free Rate) / Standard Deviation of Portfolio.

4. Asset Pricing Models:

  • CAPM (Capital Asset Pricing Model): E(Ri) = Beta * (E(Rm) – rf) + rf.
  • Equilibrium model predicting expected return based on market beta, risk-free rate, and market return.
  • Risk Decomposition: Total risk = systematic risk + firm-specific risk.

5. Efficient Market Hypothesis (EMH):

  • Prices reflect all available information.
  • Forms: Weak Form (historical data), Semi-Strong Form (public information), Strong Form (all information).
  • Implications: Market efficiency challenges the consistent ability to deliver positive abnormal returns.

6. Hedge Funds:

  • Definition: Privately organized, professionally managed, pooled investment vehicle.
  • Regulation: SEC rules, Dodd-Frank Act, AIFM Directive in the EU.
  • Characteristics: Flexibility, absolute returns, incentive fees, illiquidity, transparency issues.
  • Failures: Examples include Tiger Management, LTCM, and Madoff.

7. Real Estate Valuation:

  • Methods: Income capitalization approach, sales comparisons approach, cost approach.
  • Factors: Replacement/reproduction cost, depreciation, market value of land, exit sale proceeds.
  • Challenges: Hedonic analysis for homogenous goods, considerations for durability and location.

8. Hedonic Analysis:

  • Decomposes goods into characteristics.
  • Coefficients are time-varying.
  • Used to estimate the contributory value of each characteristic in real estate valuation.

9. Commodities:

  • Categories: Energy, agriculture, metals, meats/livestock.
  • Importance: Underpin global economies, source of income for many, traded in vast quantities.
  • Drivers: Supply/demand, economic growth, costs, government policy, weather, interest rates.

10. Commodity Prices Volatility:

  • Increasing over time.
  • Consequences: More volatile income for producers, planning difficulties, environmental impact.
  • Policy Options: Supply management, revenue management.

As an expert, I can provide further insights or clarification on any of these concepts.

Alternative Investments Exam Preparation (Lectures) - Return characteristics of securities 2. Find - Studeersnel (2024)
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