CAIA LEVEL 1 EXAM QUESTIONS WITH
COMPLETE 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)
COMPLETE 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)
