CAIA Level 1 Exam Questions With Correct Answers

liquid alternatives - Answer Liquid alternatives typically have (1) constraints on permissible investments strategies (for example, liquidity and leverage limits), (2) no incentive fees, (3) less skilled managers as a result of less attractive compensation and limited strategies, and (4) an inability to earn substantial illiquidity premiums. constrained clone - A liquid investment fund that seeks to replicate the strategy of an existing alternative investment but imposes some constraint (e.g., liquidity, leverage, diversification) is categorized as a constrained clone. unconstrained clone - a near-identical strategy that mimics an existing alternative investment strategy that is itself relatively liquid (and therefore doesn't need much modification) liquidity-based replication products - ensures liquidity is present by selecting liquid investments that have similar characteristics to illiquid securities used in alternative funds diversified/absolute return products - focuses on creating returns that have low correlation with traditional assets; does not attempt to mimic an alternative investment strategy fund legal documents - Answer The subscription agreement determines if a potential investor meets the legal requirements to invest in a fund by asking the investor a set of questions. The offering documents explain the potential trading strategies and associated risks of a fund. The partnership agreement describes the legal framework of the partnership and the terms and conditions for all parties in a fund. The management company operating agreement defines the responsibilities of the limited partnership members and of the fund. market types - Answer primary - relate to the sale of newly issued securities (including secondary issues and securitizations) secondary - where securities trade after their initial issuance; consist of both physical exchanges and OTC markets third - a subset of the OTC market where participants make markets in and trade exchange-listed securities fourth - describe the direct exchange of securities between investors without using the services of a broker/intermediary; facilitated by electronic communication network (ECN) Federal Reserve leverage rule - Answer The standard Federal Reserve leverage rule requires a deposit of at least 50% of the purchase cost/short sale proceeds of a trade, or margin transaction. Alternative investment managers that seek higher levels of leverage must avoid falling under this rule by registering as a broker-dealer, using a joint back office account, or relying on a broker-dealer that is located offshore. four categories of institutional-quality alternative assets - Answer real assets, hedge funds, private equity, structured products five structures that describe alternative assets - Answer regulatory, securities, trading, compensation, and institutional alternative investments risk and return characteristics - Answer 1. diversification - seen as diversifiers 2. illiquidity - liquidity risk premia 3. inefficiency - not all information is incorporated into prices 4. non-normal returns primary goals of investing in alternative investments - Answer 1. active management - create better risk and return combinations not found in passive investing 2. generate absolute and relative returns 3. arbitrage, return enhancement, and diversification forms of market efficiency - Answer weak form efficiency - asset prices reflect all available historical data on prices and volumes; cannot earn superior returns using technical analysis semistrong form efficiency - asset prices reflect all publicly available information; cannot earn superior returns with either technical or fundamental analysis strong from efficiency - asset prices reflect all publicly and privately available information; no investor can earn superior returns market efficiency affected by: asset size, trade frequency, trading frictions, regulations, information access, valuation accuracy multifactor asset pricing model - Answer describes the relationship between expected returns of assets and the assets' exposures to multiple risk factors, and therefore better explain systematic risk than single factor models risk factors are derived theoretically (logic that captures behavior) or empirically (historically observed) application to non-equity alternative investments has been limited e.g. CAPM cannot explain alternative asset pricing because alternatives have large idiosyncratic risks that are not easily diversified away Fama French - Answer empirical multifactor model based on three factors: market beta, market capitalization (SMB), and book-to-market ratio (HML) subsequently added the Carhart momentum factor (UMD) cost of carry model of forward contract pricing - Answer cost of carry refers to the cost involved with holding an asset until expiration of the forward contract and includes both the cost of storing the asset and the opportunity costs associated with using capital to purchase the asset any difference between the spot and forward price is due to the cost of carry, which causes the term structure of forward prices to have a slope (arbitrage ensures this) the costs and benefits of direct ownership today versus derivatives ownership (in the future via a forward) determines the arbitrage-free pricing relationships between underlying assets and their associated forward contracts: costs of direct ownership today (opportunity cost of capital and storage costs of a commodity) are added to the spot price (because these are costs not borne by the investor when asset is purchased forward) and benefits of direct ownership (dividends or convenience yield) are subtracted from the spot price (because these are benefits not enjoyed by purchasing asset forward) term structure of forwards - Answer in a simple scenario with no interest costs and dividends (r and d = 0) or if interest costs equal dividends (r = d) forward prices equal spot prices and the term structure is flat when interest rates exceed the dividend rate (r > d, or generally when costs of direct ownership exceed the benefits) forward prices are greater than spot prices and the term structure is upward sloping (referred to as contango) when the dividend rate exceeds the interest rate (r < d, or generally when benefits of direct ownership exceed costs) forward prices are lower than spot prices and the term structure is downward sloping (referred to as backwardation) single option strategy payoffs - Answer long call: unlimited upside, limited downside (premium paid) short call: limited upside (premium earned), unlimited downside long put: limited upside (difference between strike and 0), limited downside (premium paid) short put: limited upside (premium earned), limited downside (difference between strike and 0) covered call: long underlying security, short call option; obligation to deliver covered by long security, limited upside, limited downside --> similar payoff to short put protective put: long underlying security and long put option; unlimited upside, limited downside --> similary payoff to long call strategies with two option positions - Answer option spreads involve both long and short positions in either call or puts (but not both) vertical spreads utilize both long and short positions in either two calls or two puts, with each option differing in strike price: 1) bull spread combines a long position in a lower strike price call option with a short position in a higher strike price call option, creating bullish exposure bounded by the two strike prices; result is a capped gain from underlying increasing in price 2) bearish spread combines a long position in a higher strike price put option with a short position in a lower strike price put option, creating a bearish exposure bounded by the two strike prices; result is capped gain from underlying falling in price option combinations involve positions in both calls and puts; they are known as volatility strategies as the investor anticipates large swings in a security's price but does now know the direction 1) option straddle is a position in a call and a put (either both long or both short) with the same expiration date and strike price (v payoff shape) 2) option strangle is a position in a call and a put (either both long or short) with the same expiration date BUT different strike prices (hitched U payoff shape) 3) an option straddle with different signs e.g long call and short put, creates a synthetic long position in the underlying position with a straight line payoff; long put and short call would result in a synthetic short position 4) a risk reversal is an option strangle with different signs and is similar to a synthetic long position (straddle with different sign options) except the options have different strike prices, creating a break in the payoff line 5) a collar includes a long position in the underlying, a long position in a put, and a short position in a call --> investor expects minimum v put-call parity - Answer a no arbitrage relationship between two sets of positions with identical payoffs: owning a risky underlying asset (e.g. stock) versus being long a call and a risk-free bond and being short a put: call + risk-free bond - put = underlying risky asset the call and put both have identical strike prices and expiration dates the risk-free bond indicates the initial cash investment and the risk-free rate that investment must earn, upside exposure is provided by the long call and downside risk is provided by the short put it is possible to value a firm's capital structure using a structural model based on put-call parity: we assume the assets of the firm are the underlying, the strike price is the face value of debt, and the expiration date of the option is the debt's maturity; the value of equity (residual stake after debt is paid) is the value of the call option on the underlying i.e. the firm's assets: firm's debt = assets - call = risk-free bond - put firm's equity = call = assets + put - risk-free bond i) firm's risky debt valued via call option view of capital structure: risky debt is equivalent to short a call and long the asset i.e. covered call ii) firm's risky debt valued via put option view of capital structure i.e. Merton's structural model: risky debt is equivalent to owning risk-free debt and writing a put option on the firm's assets, the premium of which is based on the riskiness of those assets put-call parity can be used to create a riskless cash flow i.e. a hedge inf the form of a riskless bond: the result is a riskless cash flow equal to the strike price at expiration (option strike prices and expiration dates must be equal) option Greeks - Answer delta - sensitivity of the option price to changes in the price of the underlying security gamma - sensitivity of the option price to changes in the rate of delta (second derivative) vega - measures the sensitivity of the option price to changes in the price volatility of the underlying theta - measures the sensitivity of the option price to changes in the time to expiration (passage of time) rho - measures sensitivity of the option price to changes in the risk-free rate types of asset pricing models - Answer normative models explain how investors should behave e.g. Markowitz, positive models explain how investors actually behave theoretical models are based on logic that captures behavior vs. empirical models which are based on historical observations applied models are designed to address real world problems vs. abstract models are theoretical models designed to describe behavior, often undrealistic circumstances cross-sectional asset pricing models identify risk factors that explain differences in returns across assets vs. time series asset pricing models which are used to identify factors driving returns over time for a single security alpha - Answer the return earned in excess of the risk-adjusted benchmark; can be categorized into two types: 1) ex ante alpha is a forecast of incremental return after adjusting for TMV and systematic effects; the return attributable to manager skill 2) ex post alpha measures the realized (actual) excess return; may be attributable to skill, luck, or both ex post alpha is observable, ex ante alpha is not alpha attributable to manager skill = ex ante alpha - ex post alpha in most cases, performance is attributable to a commingling of alpha and beta abnormal return persistence - Answer refers to the tendency for idiosyncratic performance (alpha) to be positively correlated over time i.e. if the slope coefficient for a regression of current fund returns on past fund returns is positive, then good performance in the past is indicative of good performance in the future; helps dislodge the skill and luck attributes of ex post alpha: hypothesis of performance persistence is supported if the correlation between ex post alpha for period t and for period t+1 is statistically significant i.e. if evidence of serial correlation is present --> we can conclude that returns are attributable mostly to skill if evidence of return persistence is present hypothesis testing - Answer 1. State the hypothesis - the null hypothesis (the statement the analyst attempts to reject) and the alternative hypothesis (the statement the analyst is attempting to prove) are usually mutually exclusive and complements 2. Form an analysis plan - the null hypothesis is examined using a test statistic: large values of the test statistic indicate the sampled data are significantly far from expected, providing evidence against the null hypothesis a significance level (alpha) must be established for the test; denotes the probability that a significant result may be due to random chance i.e. a type 1 error (1%, 5%, 10% typically used); the confidence level is 1 minus the significance level 3. Analyze the sample data - the test statistic is calculated from the data and is compared against the predetermined critical value test statistic = (estimated value - hypothesized value) / standard error of statistic 4. Interpret the results - reject the null hypothesis if the calculated test statistic exceeds its critical value or if the p-value is less than the significance level (identical decisions are reached by both rules) if evidence isn't sufficient to reject the null hypothesis we DON'T accept the null hypothesis we fail to reject the null hypothesis two major errors in hypothesis testing are type 1 and type 2 errors a type 1 error is made when the null hypothesis is rejected when it is in fact true; the probability of making a type 1 error is equivalent to the significance level alpha; a type I error is known as a FALSE POSITIVE