CAIA Exam Questions With Correct Answers

An asset-pricing model that attempts to explain how investors should behave is a(n): - Answer normative model. Normative models attempt to explain how investors should behave. Positive models attempt to explain how investors do behave. Theoretical models use assumptions and logic, while empirical models are based on historically observed behavior. Henry Thompson examines a sample of returns for a private equity fund and finds that the sample excess kurtosis equals 3. Regarding the private equity fund's returns, which of the following conclusions should Thompson reach? - Answer The fund's returns tend to be leptokurtic. If excess kurtosis is positive, the returns are leptokurtic. The distribution of leptokurtic returns is higher at the peak, and fatter in the tails, versus the normal distribution. Asset-pricing models that describe differences across subjects for a single point in time are most likely known as: - Answer cross-sectional models. Cross-sectional models describe differences across subjects for a single point in time. Normative models attempt to explain how investors should behave. Positive models attempt to explain how investors do behave. Empirical models are based on historically observed behavior. Which of the following is NOT an input into a VaR calculation? - Answer The maximum loss estimate is the output of the VaR calculation, not an input. A simulation recently was performed in which future scenarios are derived from an assumed model. The simulated outcomes were used to indicate what types of losses are possible for a hedge fund. Which type of value at risk (VaR) method would most likely be used in this situation? - Answer Monte Carlo VaR. In a Monte Carlo VaR, a model is developed that simulates values for risk factors (e.g., interest rates) and estimates how changes in risk factors affect the fund's returns. The simulation randomly generates possible outcomes for the fund, and those simulated outcomes measure the amount of losses that are possible for the fund. The Formika Tactical Allocation hedge fund had poor performance for two straight years and stopped reporting performance data to various hedge fund databases. As a result, the Formika Fund was removed from those databases. This is an example of what potential type of database bias? - Answer Survivorship bias. Survivorship bias refers to the fact that hedge funds that stop reporting performance data are removed from the database. Since the most common reason for not reporting is poor performance, the implication is that there tends to be an upside bias in database performance. Survivorship bias is best classified as a form of: - Answer selection bias. Selection bias refers to the exclusion of certain observations from the sample, causing distortions in the relevant characteristics of the populations. Survivorship bias is a type of selection bias, in which funds or companies that are no longer in existence are excluded from the sample Given the following information for Blue Fund, what is the beta of Blue Fund? Standard deviation of Blue Fund = 0.90 Standard deviation of the market portfolio = 0.40 Correlation between Blue Fund and the market portfolio = 0.50 - Answer The correlation of Blue Fund multiplied by the standard deviation of Blue Fund divided by the standard deviation of the market produces the beta for Blue Fund. B blue fund = .50 x (.90/.40) = 1.13 Which of the following statistics is most useful for a manager with a relative return mandate? - Answer Tracking error. Tracking error measures the extent to which the investment returns deviate from the benchmark returns over time, and, therefore, is especially useful for a manager with a relative return mandate. Tracking error quantifies the uncertainty regarding deviations of the investment return from the benchmark return. Over the past several weeks, an advisor mailed various newsletters with different predictions to millions of readers. Which of the following terms best represents the advisor's actions? - Answer Chumming Chumming is the fishing term used to describe the process of luring big fish by scattering pieces of cheap fish as bait. In the world of finance, an unscrupulous advisor chums when scattering investment advice, luring unsuspecting investors. An analyst examines the following data for a private equity fund: Mean return 10% Standard deviation 20% Beta 2 Risk-free rate 5% Target return 8% Target semi-standard deviation 40% Benchmark mean return 9% Tracking error 25% The information ratio and the Sortino ratio for the private equity fund are closest to: - Answer 4% and 5%, respectively. The information ratio equals the portfolio's excess return (defined as the difference between the mean returns for the portfolio and the benchmark) divided by the portfolio's tracking error. (.10 -.09)/.25 = .04 The Sortino ratio equals the portfolio excess return (defined as the difference between the mean return for the portfolio and the target return) divided by the target semi-standard deviation (a downside risk measure): (.10-.08) / .40 = .05 An analyst derives a quarterly return series X, based on discrete compounding, and another quarterly return series Y, based on continuous compounding. Assuming monthly returns are normally distributed, which of the following statements best describes the properties of the two series? - Answer Return series X will not be normally distributed and return series Y will be normally distributed. An advantage of continuous compounding is that continuously compounded returns follow a normal distribution. In contrast, using discrete compounding, simple returns do not follow a normal distribution In hypothesis testing, the component that usually is designed to be rejected is the: - Answer null hypothesis. In hypothesis testing, the null hypothesis is usually designed to be rejected. An asset earned 20% last year. Its beta equals 1.30. The risk-free rate was 2% and the market return was 16%. Using the ex post CAPM, the asset's idiosyncratic return for the last year was closest to: - Answer −0.2% Using the ex post CAPM, the required return for the asset last year was: Rf,t + β(Rm,t - Rf,t) = 0.02 + 1.30(0.16 - 0.02) = 0.2020 = 20.2% The idiosyncratic return equals: εt = Rt - [Rf,t + β (Rm,t - Rf,t)] = 0.20 - 0.2020 = -0.2 = -0.2% The beta of a fund equals 2. Last year, the broad market return was 12%. The risk-free rate is 4%. The return on the fund equaled 18% last year. In the context of the single factor market model, the ex post alpha for the fund equals: - Answer −2%. ex post alpha = RFund,t − [Rf + βFund(Rmt−Rf)] ex post alpha = 0.18 − [0.04 + 2(0.12 − 0.04)] = −0.02 = −2% A security's returns exhibit negative skew. Which of the following is most likely correct regarding the security's distribution? - Answer A security's returns exhibit negative skew. Which of the following is most likely correct regarding the security's distribution? Passive indexing is best described as: - Answer pure play on beta A pure play on beta refers to passive investing such as a buy-and-hold strategy to replicate a benchmark index. Return The risk of moral hazard may occur when: - Answer a bank sells its mortgages to a third party and subsequently no longer closely monitors the risk of the loans. Moral hazard describes a scenario where one party takes actions that disadvantage another party. When a bank has less incentive to closely monitor mortgages sold to a third party, credit and other risks may rise on the mortgages. When managers possess superior information about firm performance, and when alternative investments contain a complexity premium (to compensate an investor's time and expertise in analyzing it), these are examples of information asymmetries. When an investor cannot earn profit due to high costs and fees, this is an example of incomplete markets. Ann Tenner, an analyst with TWJ Securities, is analyzing the return distributions of alternative investments. She has discovered that they are often not normal. Which of the following structures are most likely the source of the non-normal return distributions? - Answer Trading and securities structures