CAIA Level II Sample Exam 2024 Questions and Answers (Graded A+)

Intuition of the Black-Derman-Toy interest rate model - ANSWER-Observed spot rates drive rate levels while implied rate volatilities drive rate spreads Understanding the intuition of imposing these two conditions helps in understanding the essence of the BDT model. The spot rates in the currently observed term structure drive the overall levels of the rates that are projected throughout the binomial tree. The implied volatilities of options trading on short‐term rates (i.e., interest rate caplets) drives the spreads between the "up rates" and the "down rates" corresponding to the expiration dates of the caplets Mitigating Estimation Error Risk in Mean-Variance Optimization - ANSWER-Mitigating Estimation Error Risk in Mean-Variance Optimization returns strives to reduce estimation error and typically is executed by: (1) repeated analysis of hypothetical returns simulated from the statistical parameters estimated from the original sample of returns; or (2) repeated analysis of new samples of returns generated from the original sample using draws with replacement The three major types of credit risk modeling approaches - ANSWER-I. The structural approach II. The reduced-form approach III. The empirical approach The structural approach - ANSWER-In the structural approach, the framework is set around an explicit relationship between capital structure and default. The value of a firm's assets is set equal to the value of its equity plus the value of its debt. Equity of the firm is viewed as a call option on the firm's assets, with the strike price being the face value of the debt due at the time of exercise. In contrast, bondholders are viewed as having a risk-free bond and a short position in a put option on the firm's assets. If the value of assets is less than the face value of the debt, the put option will be exercised on the bondholders, resulting in their giving up the risk-free bond and receiving the firm's assets. Consider a portfolio allocation process in which the following two portfolio allocation strategies are being considered for use: 1. Minimum volatility portfolio weights 2. Risk parity portfolio weights In this particular portfolio allocation process, all the available investment opportunities have the same return volatilities but the return correlations between each pair of assets differ. Which of the following correctly identifies the strategies that will generate equal wei