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? - ANSWER-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. - ANSWER-Macroeconomic factors, fundamental/style/investment/dynamic factors, and statistical factors. What are the three steps of an empirical factor model? - ANSWER-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? - ANSWER-Momentum What are the three challenges associated with empirical multi-factor models? - ANSWER-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). - ANSWER-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. - ANSWER-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? - ANSWER-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. - ANSWER-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. - ANSWER-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 ma