CAIA Level II questions with verified
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What advantage do multi-factor models have over single-factor models, such as the Capital
Asset Pricing Model? - ANS ✔✔Multi-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. - ANS ✔✔Macroeconomic
factors, fundamental/style/investment/dynamic factors, and statistical factors.
What are the three steps of an empirical factor model? - ANS ✔✔First, 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? - ANS ✔✔Momentum
What are the three challenges associated with empirical multi-factor models? - ANS ✔✔False
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). -
ANS ✔✔Ang (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. - ANS ✔✔The 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?
- ANS ✔✔Not 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. - ANS ✔✔A 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. - ANS ✔✔1)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? - ANS ✔✔In 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. - ANS ✔✔Theoretical 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 - ANS ✔✔Theoretical 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 - ANS ✔✔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 - ANS ✔✔Time-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? - ANS ✔✔The 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? - ANS ✔✔A 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. -
ANS ✔✔Sensitivity 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: - ANS ✔✔Working 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 - ANS ✔✔are 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 - ANS ✔✔tend 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.
already passed
What advantage do multi-factor models have over single-factor models, such as the Capital
Asset Pricing Model? - ANS ✔✔Multi-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. - ANS ✔✔Macroeconomic
factors, fundamental/style/investment/dynamic factors, and statistical factors.
What are the three steps of an empirical factor model? - ANS ✔✔First, 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? - ANS ✔✔Momentum
What are the three challenges associated with empirical multi-factor models? - ANS ✔✔False
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). -
ANS ✔✔Ang (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. - ANS ✔✔The 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?
- ANS ✔✔Not 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. - ANS ✔✔A 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. - ANS ✔✔1)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? - ANS ✔✔In 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. - ANS ✔✔Theoretical 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 - ANS ✔✔Theoretical 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 - ANS ✔✔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 - ANS ✔✔Time-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? - ANS ✔✔The 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? - ANS ✔✔A 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. -
ANS ✔✔Sensitivity 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: - ANS ✔✔Working 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 - ANS ✔✔are 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 - ANS ✔✔tend 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.
