CAIA Level II Exam Questions and Answers 100% Verified

CAIA Level II Exam Questions and Answers 100% Verified What advantage do multi-factor models have over single-factor models, such as the Capital Asset Pricing Model? - answerMulti-factor models tend to explain systematic returns much better than do single-factor models. By doing so, multi-factor models are generally believed to produce better estimates of idiosyncratic returns. List the three major categories of factors that drive asset returns. - answerMacroeconomic factors, fundamental/style/investment/dynamic factors, and statistical factors. What are the three steps of an empirical factor model? - answerFirst, 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? - answerMomentum What are the three challenges associated with empirical multi-factor models? - answerFalse 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). - answerAng (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. - answerThe 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? - answerNot 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. - answerA 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. - answer1)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? - answerIn 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. - answerTheoretical 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 - answerTheoretical 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 - answerNormative 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 - answerTime-series models analyze behavior of a single subject or a set of subjects through time. What are the two main disadvantages of the Ho and Lee model? - answerThe main disadvantages of the Ho and Lee model are that interest rates can be negative and that it assumes a very simple binomial process for bond prices. Between a P-Measure and a Q-measure, which is typically based on an assumption of risk neutrality? - answerA Q-Measure in finance is typically based on an assumption of risk neutrality Describe the relationship between the probability of default and the credit spread with respect to the following four important properties of the Merton model: 1. Sensitivity to maturity, 2. Sensitivity to asset volatility, 3. Sensitivity to leverage, and 4. Sensitivity to the riskless rate. - answerSensitivity to maturity: The probability of default increases, at a decreasing rate, as the time to maturity increases. The credit spread increases with maturity initially but then begins to decline slightly as maturity increases. Sensitivity to asset volatility: The probability of default increases, at a decreasing rate, as the volatility of the asset increases. The credit spread will also increase as the volatility of the asset increases. Sensitivity to leverage: As leverage increases, both the probability of default and the credit spread increase. Sensitivity to the riskless rate: As the riskless rate increases, the mean return on the firm's assets (which under Merton's model is implicitly assumed to be equal to the riskless rate plus a constant risk premium) increases, reducing the probability of default and the credit spread. The five determinants of Altman's Z-Score are: - answerWorking Capital/Total Assets. Retained Earnings/Total Assets. Earnings before Interest and Taxes/Total Assets. Market Value of Equity/Book Value of Total Liabilities. Sales/Total Assets. Positive economic models - answerare often used to try to identify mispricing of securities by recognizing patterns in actual price movement. Technical trading strategies are based on positive economic modeling. For example, a strategy based on point-and-figure charts is a positive strategy. Empirical models - answertend to explain complex behavior relatively well when there are many data points available and when the relative behavior of the variables is fixed or is changing in predictable ways. For example, an empirical model might be better than a theoretical model in the case of a frequently traded but extremely complex security with many overlapping option features. Applied models - answerare designed to address immediate real-world challenges and opportunities. For example, Markowitz's model, which is an applied model, provides useful insights for accomplishing diversification efficiently. Abstract models - answeralso called basic models, tend to have applicability only in solving real-world challenges of the future. Abstract models tend to be theoretical models that explain hypothetical behavior in less realistic scenarios. For example, a model might be constructed that describes how two people with specific utility functions might bargain with regard to prices in a world with only two people and two risk factors. Cross-sectional models - answeranalyze relationships across characteristics or variables observed at a single point in time such as when investment returns are used to explain the differences in risk premiums. Panel data sets - answercombine the two approaches by tracking multiple subjects through time and can also be referred to as longitudinal data sets and cross-sectional time-series data sets. Loyalty to Clients - Managers must - answer-Place client interests before their own. -Preserve the confidentiality of information communicated by clients within the scope of the Manager-client relationship. -Refuse to participate in any business relationship or accept any gift that could reasonably be expected to affect their independence, objectivity, or loyalty to clients. Professional Code B: Investment Process and Actions - managers must - answer-Use reasonable care and prudent judgment when managing client assets. -Not engage in practices designed to distort prices or artificially inflate trading volume with the intent to mislead market participants. -Deal fairly and objectively with all clients when providing investment information, making investment recommendations, or taking investment action. -Have a reasonable and adequate basis for investment decisions. -Take only investment actions that are consistent with the stated objectives and constraints of that portfolio or fund. -for pooled funds, Provide adequate disclosures and information so investors can consider whether any proposed changes in the investment style or strategy meet their investment needs. -before managing separate accounts, evaluate and understand the client's investment objectives, tolerance for risk, time horizon, liquidity needs, financial constraints, ect, that would affect investment policy. and Determine that an investment is suitable to a client's financial situation. Professional Code C: Trading - Managers must: - answer-Not act or cause others to act on material nonpublic information that could affect the value of a publicly traded investment. -Give priority to investments made on behalf of the client over those that benefit the Managers' own interests. -Use commissions generated from client trades to pay for only investment related products or services that directly assist the Manager in its investment decision-making process, and not in the management of the firm. -Maximize client portfolio value by seeking best execution for all client transactions. -Establish policies to ensure fair and equitable trade allocation among client accounts. Professional Code D: Risk Management, Compliance, and Support - Managers must: - answer-Develop and maintain policies and procedures to ensure that their activities comply with the provisions of this C