CAIA COMPREHENSIVE HEDGE FUNDS
AND PRIVATE EQUITY REVIEW SHEET
FULL SOLUTIONS
●● List the three major categories of factors that drive asset returns.
Answer: Macroeconomic factors, fundamental/style/investment/dynamic
factors, and statistical factors.
●● What are the three steps of an empirical factor model?
Answer: First, the risk-free rate is subtracted from the returns of each
security to form an excess return, which is used as the dependent
variable; Second, the researcher selects a set of potential factors that
serve as independent variables; Third, statistical analysis is used to
identify those factors that are significantly correlated with returns.
●● What factor is contained in the Fama-French-Carhart model that is
not contained in the Fama-French model?
Answer: Momentum
●● What are the three challenges associated with empirical multi-factor
models?
Answer: False identification of factors, factor return correlation vs.
causation, and justifying why the CAPM may not be sufficient.
,●● Regarding factor investing, list the three important observations as
described by Ang (2014).
Answer: Ang (2014) observes that: factors matter, not assets; assets are
bundles of factors; and different investors should focus on different
factors.
●● What are two examples of bond factors? Describe both.
Answer: The credit risk premium and the term premium. The credit risk
strategy takes long positions in bonds with low credit quality and short
positions in bonds with high credit quality. The term strategy takes long
positions in long-term bonds and short positions in short-term bonds.
●● In theory, an investor could passively allocate to several factors that
could produce attractive results, but how might they implement a more
sophisticated approach to multi-factor investing?
Answer: Not all factor premiums are the same, so a sophisticated
strategy would take advantage of these differences by allocating higher
weights to factors that are believed to be offering more attractive risk
premiums.
●● Compare a factor with an arbitrage opportunity.
Answer: A source of return that is a legitimate factor should perform
poorly during "bad" times and "good" during normal times. If a source
of return performs well in both "bad" and "good" times, it's an arbitrage
opportunity.
,●● Describe the four practical implications of an adaptive view on
markets.
Answer: 1)tradeoff between risk and return is not stable over time and
risk premiums can be predicted based on technical and fundamental
variables
2)Market efficiency is a relative concept instead of an absolute one;
market displays varying degrees of efficiency depending on the point in
time and the participant.
3)It is necessary to use adaptable investment approaches to handle
changes in the market environment.
4)With time, alpha becomes beta due to innovation and competition.
●● Why are stochastic discount factors important for a portfolio that
includes alternative investments?
Answer: In a multi-factor portfolio that includes alternative investments,
different pieces of the portfolio will require different types of multi-
factor methods, such as recognizing that cash flows must be valued
differently depending on good vs. bad times and differently based on
time horizons, different liabilities, and illiquidity profiles.
●● Describe a theoretical, normative, time-series model of equity returns
that might be used by a hedge fund to guide a high frequency trading
strategy.
Answer: Theoretical models tend to explain behavior accurately in more
simplified situations where the relationships among variables can be
somewhat clearly understood through logic.
, Normative economic models tend to be most useful in helping explain
underlying forces that might drive rational financial decisions under
idealized circumstances and, to a lesser extent, under more realistic
conditions.
Time-series models analyze behavior of a single subject or a set of
subjects through time.
For example, a model that hypothesized the impact of large orders in an
equity market with risk-averse traders of limited capital in a world of
informational asymmetries in which the large orders were driven by
exogenous shocks to the institutions placing the orders would qualify.
●● Theoretical models
Answer: Theoretical models tend to explain behavior accurately in more
simplified situations where the relationships among variables can be
somewhat clearly understood through logic
●● Normative economic models
Answer: Normative economic models tend to be most useful in helping
explain underlying forces that might drive rational financial decisions
under idealized circumstances and, to a lesser extent, under more
realistic conditions.
●● Time-series models
Answer: Time-series models analyze behavior of a single subject or a set
of subjects through time.
AND PRIVATE EQUITY REVIEW SHEET
FULL SOLUTIONS
●● List the three major categories of factors that drive asset returns.
Answer: Macroeconomic factors, fundamental/style/investment/dynamic
factors, and statistical factors.
●● What are the three steps of an empirical factor model?
Answer: First, the risk-free rate is subtracted from the returns of each
security to form an excess return, which is used as the dependent
variable; Second, the researcher selects a set of potential factors that
serve as independent variables; Third, statistical analysis is used to
identify those factors that are significantly correlated with returns.
●● What factor is contained in the Fama-French-Carhart model that is
not contained in the Fama-French model?
Answer: Momentum
●● What are the three challenges associated with empirical multi-factor
models?
Answer: False identification of factors, factor return correlation vs.
causation, and justifying why the CAPM may not be sufficient.
,●● Regarding factor investing, list the three important observations as
described by Ang (2014).
Answer: Ang (2014) observes that: factors matter, not assets; assets are
bundles of factors; and different investors should focus on different
factors.
●● What are two examples of bond factors? Describe both.
Answer: The credit risk premium and the term premium. The credit risk
strategy takes long positions in bonds with low credit quality and short
positions in bonds with high credit quality. The term strategy takes long
positions in long-term bonds and short positions in short-term bonds.
●● In theory, an investor could passively allocate to several factors that
could produce attractive results, but how might they implement a more
sophisticated approach to multi-factor investing?
Answer: Not all factor premiums are the same, so a sophisticated
strategy would take advantage of these differences by allocating higher
weights to factors that are believed to be offering more attractive risk
premiums.
●● Compare a factor with an arbitrage opportunity.
Answer: A source of return that is a legitimate factor should perform
poorly during "bad" times and "good" during normal times. If a source
of return performs well in both "bad" and "good" times, it's an arbitrage
opportunity.
,●● Describe the four practical implications of an adaptive view on
markets.
Answer: 1)tradeoff between risk and return is not stable over time and
risk premiums can be predicted based on technical and fundamental
variables
2)Market efficiency is a relative concept instead of an absolute one;
market displays varying degrees of efficiency depending on the point in
time and the participant.
3)It is necessary to use adaptable investment approaches to handle
changes in the market environment.
4)With time, alpha becomes beta due to innovation and competition.
●● Why are stochastic discount factors important for a portfolio that
includes alternative investments?
Answer: In a multi-factor portfolio that includes alternative investments,
different pieces of the portfolio will require different types of multi-
factor methods, such as recognizing that cash flows must be valued
differently depending on good vs. bad times and differently based on
time horizons, different liabilities, and illiquidity profiles.
●● Describe a theoretical, normative, time-series model of equity returns
that might be used by a hedge fund to guide a high frequency trading
strategy.
Answer: Theoretical models tend to explain behavior accurately in more
simplified situations where the relationships among variables can be
somewhat clearly understood through logic.
, Normative economic models tend to be most useful in helping explain
underlying forces that might drive rational financial decisions under
idealized circumstances and, to a lesser extent, under more realistic
conditions.
Time-series models analyze behavior of a single subject or a set of
subjects through time.
For example, a model that hypothesized the impact of large orders in an
equity market with risk-averse traders of limited capital in a world of
informational asymmetries in which the large orders were driven by
exogenous shocks to the institutions placing the orders would qualify.
●● Theoretical models
Answer: Theoretical models tend to explain behavior accurately in more
simplified situations where the relationships among variables can be
somewhat clearly understood through logic
●● Normative economic models
Answer: Normative economic models tend to be most useful in helping
explain underlying forces that might drive rational financial decisions
under idealized circumstances and, to a lesser extent, under more
realistic conditions.
●● Time-series models
Answer: Time-series models analyze behavior of a single subject or a set
of subjects through time.
