CAIA Level 1 Questions & Answers Correct 100%

Define investment - Answer Investment is deferred consumption List the four major types of real assets other than land and other types of real estate. - Answer Natural resources, commodities, infrastructure, and intellectual property. List the three major types of alternative investments other than real assets in the CAIA curriculum. - Answer Hedge funds, Private Equity, and Structured Products Name the five structures that differentiate traditional and alternative investments - Answer Regulatory Structures, Securities Structures, Trading Structures, Compensation Structures, and Institutional Structures. Which of the five structures that differentiate traditional and alternative investments relates to the taxation of an instrument? - Answer Regulatory Structures Name the four return characteristics that differentiate traditional and alternative investments. - Answer Diversification, Illiquidity, Inefficiency, and Nonnormality. Name four major methods of analysis that distinguish the analysis of alternative investments from the analysis of traditional investments. - Answer Return Computation Methods, Statistical Methods, Valuation Methods, Portfolio Management Methods. Describe an incomplete market. - Answer An incomplete market refers to the lack of investment opportunities that causes market participants to be unable to implement an investment strategy that satisfies their exact preferences such as risk preferences. Define active management. - Answer Active management refers to efforts of buying and selling securities in pursuit of superior combinations of risk and return. What distinguishes use of the term pure arbitrage from the more general usage of the term arbitrage? - Answer Pure arbitrage is risk free, while arbitrage, as a more general term is not risk free. Pure arbitrage is an attempt to earn risk-free profits through the simultaneous purchase and sale of identical positions trading at different prices in different markets. Whereas, arbitrage is used to represent efforts to earn superior returns even when risk is present because the long and short positions are not identical assets or are not held over the same time period. What is the term for a private management advisory firm that serves a group of related and ultra-high net worth investors? - Answer Family office In a large financial services organization, what is the name used to denote the people and processes that play a supportive role in the maintenance of accounts and information systems as well as in the clearance and settlement of trades? - Answer Back office operations Are dealer banks described as buy-side or sell-side market participants? - Answer Sell-side market participants List several advantages of Separately Managed Accounts relative to funds. - Answer 1) A fund investor owns shares of a company (the fund) that in turn owns other investments, whereas an SMA investor actually owns the invested assets as the owner on record. 2) A fund invests for the common purposes of multiple investors, while an SMA may have objectives tailored to suit the specific needs of the investor, such as tax efficiency. 3) A fund is often opaque to its investors to promote confidentiality; an SMA offers transparency to its investors. 4) Fund investors may suffer adverse consequences from redemptions (withdrawals) and subscriptions (deposits) by other investors, but an SMA provides protection from these liquidity issues for its investors. Which of the following participants is LEAST LIKELY to be classified as an outside service provider to a fund: Arbitrageurs, accountants, auditors, or attorneys? - Answer Arbitrageurs List four major legal documents necessary for establishing and managing a hedge fund? - Answer Private-placement memorandum, partnership agreement, subscription agreement, management company operating agreement What is systemic risk? - Answer Systemic risk is the potential for economy-wide losses attributable to failures or concerns over potential failures in financial markets, financial institutions, or major participants. What is the acronym for fund vehicles that are regulated and allow retail access of hedge-fund-like investment pools in the European Union? - Answer UCITS In terms of financial regulation, what is the FCA? - Answer Financial Conduct Authority - the primary regulator of financial services in the UK. What is progressive taxation of income? - Answer Progressive taxation places higher percentage taxation on individuals and corporations with higher incomes. What is the general term denoting compound interest when the interest is not continuously compounding? - Answer Discrete compounding What is the primary challenge that causes difficulty in calculating the return performance of a forward contract or other position that requires no net investment? How is that challenge addressed? - Answer If the forward contract has a starting value of zero, it would cause division by zero. One solution to the problem of computing return for derivatives is to base the return on notional principal. Another is to include collateral. Consider a position in a single forward contract. What distinguishes a fully collateralized position in this forward contract from a partially collateralized position? - Answer A fully collateralized position is paired with a quantity of capital equal in value to the notional principal of the contract whereas a partially collateralized position is paired with a collateral lower in value than the notional value. An IRR is estimated for a fund based on initial investment when the fund was created, several annual distributions and an annual estimate of the fund's value prior to termination. What type of IRR is this? - Answer Since Inception IRR An investment has two solutions for its IRR. What can be said about the investment and the usefulness of the two solutions? - Answer There are two sign changes in the cash flow stream. None of the IRRs should be used. Two investments are being compared to ascertain which investment would add the most value to a portfolio. Both investments have simplified cash flow patterns of an initial cost followed by positive cash flows. Why might the IRRs of the investment provide an unreliable indication of which investment adds more value? - Answer The major challenge with comparing IRRs across investments is when investments have scale differences. Scale differences are when investments have unequal sizes and/or timing of their cash flows. An analyst computes the IRR of an alternative to be 20% and another to be 30%. When the analyst combines the cash flows of the two alternatives into a single investment, must the IRR of the combination be greater than 20% and less than 30%? - Answer No. The answer is not immediately apparent because the IRR of a portfolio of two investments is not generally equal to a value-weighted average of the IRRs of the constituent investments. If the cash flows from two investments are combined to form a portfolio, the IRR of the portfolio can vary substantially from an average of the IRRs of the two investments. Is an IRR a dollar-weighted return or a time-weighted return? Why? - Answer The IRR is the primary way of computing a dollar-weighted return. In which scenario will a clawback lead to payments? - Answer A clawback clause, clawback provision or clawback option is designed to return incentive fees to LPs when early profits are followed by subsequent losses. What is the difference between a hard hurdle rate and a soft hurdle rate? - Answer A hard hurdle rate limits incentive fees to profits in excess of the hurdle rate. A soft hurdle rate allows fund managers to earn an incentive fee on all profits, given that the hurdle rate has been achieved. " Name the assets that are often characterized as traditional by some and as alternatives by others of the following categories: hedge funds, private equity, and real assets. - Answer Hedge Funds - liquid alternative mutual funds Private Equity - close-end funds with illiquid holdings Real Assets - public real estate and public equities of corporations with performance dominated by stable positions in real assets. Approximately when did average-quality corporate bonds and international equities become commonly viewed as institutional-quality investments in the United States? - Answer Between 1950 to 1980 Name the four major methods of analysis that distinguish the analysis of alternative investments from the analysis of traditional investments. - Answer Return Computation Methods, Statistical Methods, Valuation Methods, Portfolio Management Methods. Define active management. - Answer Active management refers to efforts of buying and selling securities in pursuit of superior combinations of risk and return. In a large financial services organization, what is the name used to denote the people an processes that play a supportive role in the maintenance of accounts and information systems as well as in the clearance and settlement of trades? - Answer Back office operations List several advantages of Separately Managed Accounts (SMAs) relative to funds. - Answer 1) A fund investor owns shares of a company (the fund) that in turn owns other investments, whereas an SMA investor actually owns the invested assets as the owner on record. 2) A fund invests for the common purposes of multiple investors, while an SMA may have objectives tailored to suite the specific needs of the investor, such as tax efficiency. 3) A fund is often opaque to its investors to promote confidentiality; an SMA offers transparency to its investors. 4) Fund investors may suffer adverse consequences from redemptions (withdrawals) and subscriptions (deposits) by other investors, but an SMA provides protection from these liquidity issues for its only investor. Which of the following participants is LEAST Likely to be classified as an outside service provider to a fund: Arbitrageurs, accountants, auditors, or attorneys? - Answer Arbitrageurs List four major legal documents necessary for establishing and managing a hedge fund. - Answer Private-placement memoranda, partnership agreement, subscription agreement, management company operating agreement. What is a qualified majority? - Answer More than 75% of LPs voting to make a decision (e.g., the decision to extend the investment period or the fund's distribution. Is the New York Stock Exchange a secondary or third market? - Answer Secondary market What are the three constraints against achieving alternative investment benefits through liquid products? - Answer 1) Leverage: there is a 300% asset coverage rule that requires a mutual fund to have assets totaling at least three times the total borrowings of the fund, thus limiting borrowing to 33% of assets. UCITS restrictions are even tighter. 2) Regulatory constraints on concentration 3) Illiquidity constraints What is the general term denoting compound interest when the interest is not continuously compounded? - Answer Discrete compounding An IRR is estimated for a fund based on an initial investment when the fund was created, several annual distributions and an estimate of the fund's value prior to its termination. What type of IRR is this? - Answer Since Inception IRR An analyst computes the IRR of one alternative to be 20% and another to be 30%. When the analyst combines the cash flows of the two alternatives into a single investment, must the IRR of the combination be greater than 20% and less than 30%? - Answer No. THe answer is not immediately apparent because the IRR of a portfolio of two investments is not generally equal to a value-weighted average of the IRRs of the constituent investments. If the cash flows from two investments are combined to form a portfolio, the IRR of the portfolio can vary substantially from an average of the IRRs of the two investments. Is an IRR a dollar-weighted return or a time-weighted return? Why? - Answer The IRR is the primary method of computing a dollar weighted return. What is the primary cause of the shape of teh J-curve of interim private equity fund returns? - Answer It is caused by a combination of early expense recognition, early loss recognition, and deferred gain recognition. In which scenario will a clawback clause lead to payments? - Answer A clawback clause, clawback provision or clawback option is designed to return incentive fees to LPs when early profits are followed by subsequent losses. Describe the difference between an ex ante return and an ex post return in the case of a financial asset. - Answer Ex post returns are realized outcomes rather tan anticipated outcomes. Future possible returns and their probabilities are referred to as expectational or ex ante returns. Contrast the kurtosis and the excess kurtosis of the normal distribution. - Answer Kurtosis serves as an indicator of the peaks and tails of a distribution. In the case of a normally-distributed variable the kurtosis is 3. Excess kurtosis is equal to kurtosis minus 3. Thus a normally distributed variable has an excess kurtosis of 0. Excess kurtosis provides a more intuitive measure of kurtosis relative to the normal distribution since it varies around zero to indicate kurtosis that is larger (positive) or smaller (negative) than the case of the normal distribution. How would a large increase in the kurtosis of a return distribution affect its shape? - Answer Kurtosis is typically viewed as capturing the fatness of the tails of a distribution, with high values of kurtosis, or positive values of excess kurtosis, indicating fatter tails (i.e. higher probabilities of extreme outcomes) than is found in the case of a normally distributed variable. Kurtosis can also be viewed as indicating the peakedness of a distribution, with a sharp narrow peak in teh center being associated with high values of kurtosis, or positive values of excess kurtosis. Using statistical termniology, what does the volatility of a return mean? - Answer Volatility is often used synonymously with standard deviation in investments. The covariance between the returns of two financial assets is equal to the product of the standard deviations of the returns of the two assets. What is the primary statistical terminology for this relationship? - Answer The covariance will equal the product of the standard deviations when correlation coefficient is equal to one. What is the value of the beta of the following three investments: a fund that tracks the overall market index, a riskless asset, and a bet at a casino table? - Answer +1, 0, 0 (assuming the casino bet is a traditional bet not based on market outcomes) In the case of a financial asset with returns that have zero autocorrelation, what is the relationship between the variance of the assets daily returns and the variance of the asset's monthly returns? - Answer The variance of the monthly returns are T times the variance of the daily returns where T is the number of trading days in the month. In the case of a financial asset with returns that have autocorrelation approaching +1, what is the relationship between the standard deviation of the asset's monthly returns and the standard deviation of the asset's annual return? - Answer In the perfectly correlated case the standard deviation of a multiperiod return is proportional to T. In the case the annual vol is 12 times the monthly vol. What is the general statistical issue addressed when the GARCH method is used in a time series analysis of returns? - Answer The tendency of an asset's variance to change through time. Jane studies past prices and volume of trading in major public equities and establishes equity market neutral positions based on her forecasts of prices. Jane consistently outperforms market indices of comparable risk. Does the performance indicate that the equity market is informationally inefficient at the semistrong level? - Answer The underlyin equity market is informationally inefficient at both the weak level and the semi-strong level since an inefficiency at a "lower" level indicates inefficiency at a "higher" level because the underlying information sets are cumulative moving from weak to strong. List two major factors that drive informational market efficiency through facilitating better investment analysis. - Answer 1) Assets will also tend to trade at prices closer to their informationally efficient values when there is easier access to better information. 2) Assets will also tend to trade at prices closer to their informationally efficient values when there is less uncertainty about their valuation. In other words, when there are better valuation methods. What does the modified Fisher equation express regarding minimal interest rate determinants? - Answer It expresses the nominal interest rate as the combination of the after-tax real interest rate, r, and the anticipated rate of inflation, with an adjustment for income tax. What does it mean to bootstrap a yield curve? - Answer It is the process of recursively estimating spot rates using one or more zero-coupon bonds on the short end and coupon bonds on the medium- and long-term regions of the term structure. In which theory of the term structure of interest rates do all bonds have the same expected return? - Answer Unbiased expectations theory. What differentiates a relative pricing model from an absolute pricing model? - Answer A relative pricing model prescribes the relationship between two prices. An absolute pricing model attempts to describe a value, or a price level, based on its underlying economic factors. What makes a binomial tree a recombining tree? - Answer A binomial tree with an upward movement followed by a downward movement that recombines with a pathway with a downward movement and an upward movement. A recombining binomial tree has n+l possible final outcomes for an n period tree, rather than 2^n outcomes. What is the term used to describe a framework for specifying the return or price of an asset based on its risk, as well as future cash flows and payoffs? - Answer Asset pricing model. What is the market portfolio and what is a market-weight? - Answer 1) The market portfolio is a hypothetical portfolio containing all tradable assets in the world. 2) The market weight of an asset is the proportion of the total value of that asset to the total value of all asset in the market portfolio. What is an ex post excess return? - Answer A realized return (an observed historical return) expressed as an excess return by subtracting the riskless return from the asset's total return. What two spot interest rates imply the value of a six-month forward contract from a six-month Treasury bill? - Answer The current six-month and 12-month spot rates are needed to find the six-month forward contract for a six-month Treasury bill. What is the relationship between a forward interest rate and its expected value at settlement under the unbiased expectations hypothesis and the liquidity premium hypothesis? - Answer Under the unbiased expectations hypothesis, forward bond prices (whether implied by spot rates or observed in the forward price of forward contracts) are unbiased predictors of subsequent spot or cash market prices. What are the carrying costs (and benefits) of physical inventory such as a commodity? - Answer The carrying costs of physical inventory include interest (r) and storage (c), the benefit of physical inventory is the convenient yield. Which is more likely to be more liquid, a forward contract or a futures contract? - Answer A futures contract is more likely to be more liquid. What does it mean when a future is marked-to-market? - Answer When a future is marked-to-market, it means that the side of a futures contract that benefits from a price change receives cash from the other side of the contract (and vice versa) throughout the contract's life. What is maintenance margin? - Answer A maintenance margin is collateral put up by the investor on an ongoing basis until the position is closed out. What two asset form a long straddle? - Answer A long call and a long put with the same strike price. What is the equation for put-call parity? - Answer Call + bond - Put = Underlying Asset What are the five variables that determine the price of an option on a non-dividend stock according to the Black-Scholes option pricing model? - Answer 1) The price of the underlying asset 2) The strike price 3) the return volatility of the underlying asset 4) The time to the option's expiration 5) The riskless rate What are the names of the first and second derivatives of an option price with respect to the price of the option's underlying asset? - Answer Delta and gamma What are the two main differences between the formula for variance and the formula for semivariance? - Answer The semivariance uses a formula otherwise identical to the variance formula except that it only includes the negative deviations in the numerator and a smaller number of observations in the denominator. What are the main differences between the formula for semistandard deviation and target semistandard deviation? - Answer Target semivariance is similar to semivariance except that target semivariance substitutes the investors' target rate of return in place of the asset's mean return. Define tracking error and average tracking error? - Answer 1) Tracking error indicates the dispersion of the returns of an investment relative to a benchmark return, where a benchmark return is the contemporaneous realized return on an index or peer group of comparable risk. 2) Average tracking errors imply refers to the average difference between an investment's return relative to its benchmark. In other words, it is the numerator of the information ratio. What is the difference bewteen value at risk and conditional value-at-risk? - Answer 1) Value at risk (VaR or VAR) is the loss figure associated with a particular percentile of a cumulative loss funtion. In other words, VaR is the maximum loss over a specified time period within a specified probability. 2) Conditiona value-at-risk (CVaR), also known as expected tail loss, is the expected loss of the investor given that the VaR has been equaled or exceeded. CVaR will exceed VaR (if the overall maximum potential loss exceeds VaR). Name the two primary approaches for estimating the voaltility used in computing value-at-risk. - Answer 1) Estimate the standard deviation (volatility) as being equal to the asset's historical standard deviation of returns. 2) Estimate volatility based on the implied volatilities from option prices. What are the steps invovled in directly estimate VaR from historical data rather than through a parametric technique? - Answer 1) Collect the perecentage price changes 2) Rank the gains/losses from the highest to the lowest 3) Select the outcome (loss) reflecting the quantile specified by the VaR (e.g., for a VaR based on 95% confidence pick the observation with a loss larger than 95% of the other outcomes). When is Monte Carlo analysis most appropriate as an estimation technique? - Answer It is best used in difficult problems where it is not practical to find expected values and standard deviations using mathematical solutions. What is the difference between the formulas for the Sharpe and Treynor ratios? - Answer The Treynor ratio differs from the Sharpe ratio by the use of systematic risk rather than total risk in the denominator. Define return on VaR - Answer Return on VaR (RoVaR) is simply the expected or average return of an asset divided by a specified VaR (expressing VaR as a positive number) Describe the intuition of Jensen's alpha. - Answer Jensen's alpha is a direct measure of the absolute amount by which an asset is estimated to outperform, if positive, the return on efficiently priced assets of equal systematic risk in a single- factor market model. Provide two common interpretations of the investment term alpha. - Answer 1) Alpha refers to an excess or deficient investment return after the return has been adjusted for the time value of money (the risk-free rate) and for the effects of baring systematic risk (beta). 2) Alpha can also refer to the extent to which the skill, information, and knowledge of an investment manager generates superior risk-adjusted returns (or inferior risk-adjusted return in the case of negative alpha). 3) Note that the first interpretation can include high returns from luck. Provide two common interpretations of the investment term beta. - Answer 1) Beta is the proportion by which an asset's excess return moves in response to the market portfolio's excess return (the return of the asset minus teh return of the riskless asset). 2) Beta refers to any of a number of measures of risk or the bearing of risk, wherein the underlying risk is systematic (shared by at least some other investments and usually unable to be diversified or fully hedged without cost) and is potentially rewarded with expected return without necessarily specifying that the systematic risk is the risk of the market portfolio. Does ex ante alpha lead to ex post alpha? - Answer Not necessarily. While ex ante alpha may be viewed as expected idiosyncratic return, ex post alpha is realized idiosyncratic return. Simply put, ex post alpha is the extent to which an asset outperformed or underperformed its benchmark in a specified time period. Ex post alpha can be the result of luck and/or skill. To the extent that an investor suffers bad luck, ex ante will not guarantee ex post alpha. What are the two steps to an analysis of ex ante alpha using historical data? - Answer 1) An asset pricing model or benchmark must be used to divide the historical returns ino the portions attributable to systematic risks (and the risk-free rate) and those attributable to idiosyncratic effects. 2) The remaining returns, meaning the idiosyncratic returns (i.e., ex post alpha), should be statistically analyzed to estimate the extent, if any, to which the superior returns may be attributable to skill rather than luck. List the three major types of model misspecification in the context of estimating systematic risk. - Answer 1) Omitted (or misidentified) systematic return factors 2) Misestimated betas 3) Nonlinear risk-return relationships What is the goal of an empirical investigation of abnormal return persistence? - Answer To identify ex ante alpha. What is the term for investment products trying to deliver systematic risk exposure with an emphasis on doing so in a highly cost-effective manner? - Answer Beta drivers (or passive indexers) Does an analyst select a p-value or a significance level in preparation for a test? - Answer The significance level. The p-value is the output of the statistical computations. What is the relationship between selection bias and self-selection bias in hedge fund datasets? - Answer Selection bias is a distortion in relevant sample characteristics from the characteristics of the population, caused by the sampling method of selection or inclusion used by the data manager. If the selection bias originates from the decision of fund managers to report or not to report their returns, then the bias is referred to as a self-selection bias. What are the two methods of detecting outliers in a statistical analysis? - Answer 1) Detection through visual inspection of plots 2) Ordered listings of the variables and regression residuals What is the difference between row cropland and permanent copland? - Answer Row cropland is annual cropland that produces row crops, such as corn, cotton, carrots, or potatoes from annual seeds. Permanent cropland refers to land with long-term vines or trees that produce crops, such as grapes, cocoa, nuts, or fruit.