CAIA LEVEL 1 PRACTICE EXAM
QUESTIONS AND ANSWERS
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. "http://hedgefundlawblog.com/hedge-fund-hurdle-rate.html"
, 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.
QUESTIONS AND ANSWERS
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. "http://hedgefundlawblog.com/hedge-fund-hurdle-rate.html"
, 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.
