CAIA UPDATED EXAM COMPREHENSIVE
QUESTIONS AND ANSWERS SURE A+
✔✔Buy and Build LBO Strategy - ✔✔an LBO firm acquires several operating firms or
divisions through additional buyouts and then combines them. The goal is a strategic
alignment and value creation through synergies. This strategy is also known as a
leveraged buildup strategy.
✔✔Targeted amortization class tranches - ✔✔tranches that receive principal payments
in a similar way to planned amortization class tranches, but generally with an even
narrower and more complex set of ranges.
✔✔Principal-only (PO) tranches - ✔✔tranches receive the face value of their investment
through scheduled principal repayments and prepayments received from the
mortgages.
✔✔interest-only (IO) tranches - ✔✔tranches receive interest payments based on a
notional principal amount and the cash flows to the IO tranches decrease as the
principal is paid down.
✔✔Advantages of Credit Derivatives - ✔✔- Isolation of credit risk.
- Efficient shorting of credit risk.
- Ease of establishing synthetic positions.
- Linking of markets.
, - Liquidity during periods of market stress.
✔✔Terms negotiated between the CDS buyer and seller - ✔✔- CDS spread- the
premium paid by the buyer to the seller.
- Contract size and maturity- size and maturity are determined by the buyer and seller
with no ISDA constraints.
- Trigger events- scope of the trigger events the CDS covers is negotiated by the buyer
and seller.
- Method of settlement- If a credit event occurs, either cash or physical settlement is
allowed by the ISDA. In a physical settlement, the CDS seller buys the reference asset
from the CDS buyer at par value.
- Choice of assets to deliver. If physical settlement is selected, the CDS buyer chooses
which asset to deliver to the CDS seller.
✔✔total return swap (TRS) - ✔✔a 2-party agreement whereby the total return on an
underlying credit risky asset is exchanged for a fixed return.
the total return of the reference asset is passed through to the swap buyer regardless of
a credit event. Thus, the TRS protection buyer will forgo any upside potential of the
credit-risky asset.
✔✔credit default swap (CDS) - ✔✔protection or insurance against default on an
underlying credit instrument. The party that sells the protection receives a periodic fee in
exchange for a commitment to stand behind the underlying bond or loan should the
issuer default.
✔✔Credit Spread Compression - ✔✔occurs when credit spreads decline over time and
is particularly a problem for arbitrage CDOs.
✔✔six key assumptions required for alpha to be a zero-sum game - ✔✔- Identical
investment horizons for all investors.
- Identical risk tolerances for all investors.
- No market segmentation (i.e., all investors can invest in all assets).
- Homogeneous investor expectations about risk and return.
- Zero or equal taxes for all investors.
- Zero transaction costs.
✔✔information asymmetry - ✔✔describes markets where participants have different
levels of knowledge about the investment.
✔✔Incomplete Market - ✔✔describes a market where an investor cannot satisfy her
exact investment options due to the existence of some restriction or limitation.
✔✔Cross Sectional Models - ✔✔Attempt to explain difference in performance between
assets over a period
QUESTIONS AND ANSWERS SURE A+
✔✔Buy and Build LBO Strategy - ✔✔an LBO firm acquires several operating firms or
divisions through additional buyouts and then combines them. The goal is a strategic
alignment and value creation through synergies. This strategy is also known as a
leveraged buildup strategy.
✔✔Targeted amortization class tranches - ✔✔tranches that receive principal payments
in a similar way to planned amortization class tranches, but generally with an even
narrower and more complex set of ranges.
✔✔Principal-only (PO) tranches - ✔✔tranches receive the face value of their investment
through scheduled principal repayments and prepayments received from the
mortgages.
✔✔interest-only (IO) tranches - ✔✔tranches receive interest payments based on a
notional principal amount and the cash flows to the IO tranches decrease as the
principal is paid down.
✔✔Advantages of Credit Derivatives - ✔✔- Isolation of credit risk.
- Efficient shorting of credit risk.
- Ease of establishing synthetic positions.
- Linking of markets.
, - Liquidity during periods of market stress.
✔✔Terms negotiated between the CDS buyer and seller - ✔✔- CDS spread- the
premium paid by the buyer to the seller.
- Contract size and maturity- size and maturity are determined by the buyer and seller
with no ISDA constraints.
- Trigger events- scope of the trigger events the CDS covers is negotiated by the buyer
and seller.
- Method of settlement- If a credit event occurs, either cash or physical settlement is
allowed by the ISDA. In a physical settlement, the CDS seller buys the reference asset
from the CDS buyer at par value.
- Choice of assets to deliver. If physical settlement is selected, the CDS buyer chooses
which asset to deliver to the CDS seller.
✔✔total return swap (TRS) - ✔✔a 2-party agreement whereby the total return on an
underlying credit risky asset is exchanged for a fixed return.
the total return of the reference asset is passed through to the swap buyer regardless of
a credit event. Thus, the TRS protection buyer will forgo any upside potential of the
credit-risky asset.
✔✔credit default swap (CDS) - ✔✔protection or insurance against default on an
underlying credit instrument. The party that sells the protection receives a periodic fee in
exchange for a commitment to stand behind the underlying bond or loan should the
issuer default.
✔✔Credit Spread Compression - ✔✔occurs when credit spreads decline over time and
is particularly a problem for arbitrage CDOs.
✔✔six key assumptions required for alpha to be a zero-sum game - ✔✔- Identical
investment horizons for all investors.
- Identical risk tolerances for all investors.
- No market segmentation (i.e., all investors can invest in all assets).
- Homogeneous investor expectations about risk and return.
- Zero or equal taxes for all investors.
- Zero transaction costs.
✔✔information asymmetry - ✔✔describes markets where participants have different
levels of knowledge about the investment.
✔✔Incomplete Market - ✔✔describes a market where an investor cannot satisfy her
exact investment options due to the existence of some restriction or limitation.
✔✔Cross Sectional Models - ✔✔Attempt to explain difference in performance between
assets over a period
