**CAIA Level II Sample Exam**

What is the correct way to state its claim of compliance with the CFA Institute Asset Manager Code of Conduct?

"[Company name] claims compliance with the CFA Institute Asset Manager Code. This claim has not been verified by CFA Institute."

Three risks of currency carry trades

(1) the funding currency interest rate rises, thereby increasing borrowing costs; (2) the funding currency appreciates against the target currency; and (3) the target currency investment does not yield as much as initially expected

Competitive advantages of family offices

1. Aggressive Asset Allocation. 2. Liquidity Premium Capture. 3. Deal Flow. 4. Speed. 5. Governance and Management of Assets. 6. Alignment of Interests. 7. Higher Returns. 8. Risk Management. 9. Centralization of Services. 10. Lifestyle Assets.

What are three major explanations for the superior performance, within asset sub-classes, generated by large endowments over the last few decades?

1. An aggressive asset allocation. 2. Effective investment manager research. 3. First-mover advantage. 4. Access to a network of talented alumni. 5. Acceptance of liquidity risk. 6. Sophisticated investment staff and board oversight

Conditional correlation

A conditional correlation is a correlation between two variables under specified circumstances. For example, an analyst may estimate the correlation coefficient between a hedge fund's returns and the returns of an equity index during only those months in which the stock market rose by 1% or more. Another example is a hedge fund index has been found to have a different correlation to equity market returns in up markets than it does in down markets.

The top-down approach

A top-down approach analyzes the macroeconomic environment and then determines the weights and the combination of industry sectors, countries, and so on that best meet the program objectives under the likely scenarios.

In the context of investment policy statements, which of the following best describes well-written asset allocation guidelines? A. Discussing broad asset categories using allocation targets and ranges B. Detailing targets of asset classes along with rebalancing methods C. De-risking procedures including procedures for modifying hedge ratios

A. Discussing broad asset categories using allocation targets and ranges Institutional investors should consider establishing targets and ranges by broad asset category or asset role, rather than the more rigid approach of detailing targets by asset classes.

Which factor is a performance driver for insurance-linked securities, such as catastrophe bonds?

Alternative beta They offer a positive expected return that should be considered compensation for the event risk assumed by investors.

Ho and Lee model

An arbitrage-free model that is calibrated to the observed term structure of interest rates Ho and Lee (1986) proposed the first arbitrage‐free model of interest rates. The Ho and Lee model is a single‐factor model that assumes that the short‐term interest rate follows a normally distributed process, with a drift parameter that is chosen so that the modeled term structure of interest rates fits the observed term structure of interest rates.

excess return index

An excess return index provides returns over cash and is linked to the price movements of a basket of commodity futures contracts

Artificial neural network software

Artificial neural network software seeks to identify patterns in data using an approach modeled after the learning process of the human brain with various "nodes" and "layers" forming connections and associations that are modified within the model

Exposure Inertia

Exposure Inertia: How can the appropriate weights of the mimicking portfolio be estimated if the weights of the actively managed product change over time? If managers are dynamically changing the weights of their portfolios, then the true values of the betas are constantly changing and thus can only be estimated with substantial errors. In addition, the estimated betas would reflect what the managers were holding on average over several months, not necessarily what they are holding now

Which of the following hedge fund replication products would be most likely to have returns that are poorly correlated with the hedge fund strategy being replicated? A. An algorithmic replication product B. A bottom-up replication product C. A factor-based replication product D. A payoff-distribution replication product

D. A payoff-distribution replication product On the other hand, the payoff-distribution replicator almost exactly matches the higher moments of the distribution of the Factor-Based Approach to Replication 463 hedge fund's return, but does a poor job of tracking the monthly returns on the hedge fund. It can be seen that monthly return from the payoff replicator has very low correlation to the monthly return on the hedge fund

Dutch disease

De-industrialization due to previously large currency inflows Dutch disease occurs when large currency inflows (such as from the sale of large quantities of commodities) damage the long-run health of a country's other sources of economic prosperity (such as the country's manufacturing sector)

Discretionary directional managers

Discretionary directional managers take fewer bets and larger position sizes because their approach is more labor intensive, and each investment opportunity needs to be analyzed carefully and separately The strategy of bottom-up fundamental analysis is to estimate the value of a company's stock based on firm-level forecasted sales, expenses, earnings, and other data linked economically to the eventual cash distributions of a firm in an attempt to enhance portfolio returns.

Assets for which diversification return is highest

Diversification returns are highest when the individual assets in a portfolio are highly volatile and the correlation among those assets is low

Entry and Establish phase of private equity fund manager-investor relationship

During the entry and establish phase, substantial entry barriers into the PE market exist for both GPs and LPs and, lacking a verifiable track record, new teams find it difficult to raise their first fund. First-time funds note the importance of differentiation or innovation as applied to fundraising and thus often pursue specialized investment strategies.

One type of firm that publishes ESG ratings is major financial rating firms. List the other two types of firms that publish ESG ratings.

ESG ratings are compiled by major financial rating firms (e.g., Moody's and Fitch), major index providers (e.g., FTSE Russell and MSCI) and companies specializing in ESG-related issues (e.g., Sustainalytics and ISS).

Exculpation

Exculpation is a contractual term that relates to freeing someone from blame.

Expectation bias

Expectation bias is synonymous with confirmation bias and is a tendency to overweight those findings that most agree with one's prior beliefs. Thus, a confident manager is more likely to unknowingly accept and report erroneous data if those data portray the fund's performance favorably

Gatekeepers

Gatekeepers are professional advisers operating in the PE market on behalf of their clients: in particular, consultants and account managers, funds of funds, and placement agents. They offer benchmarking services that check and compare the performance of general partners

Some hedge fund replication products are designed to achieve portfolio weights that mimic the returns of a hedge fund index, even though the funds' managers are actively trading the funds' portfolios. What are the conditions under which these replication products can best mimic a hedge fund index?

High view commonality with substantial exposure inertia

In the context of alternative investment risk management, what are the three methods of approximating short-term valuations for illiquid securities?

I. Capital statement valuations II. Discounted cash flow model-based calculations III. Customized index-based calculations While not perfect, three methods for approximating short-term valuations for illiquid securities are capital balance statements, discounted cash flow models, and customized indices

Three challenges of empirical multifactor models

I. False identification of factors II. Potential sufficiency of the CAPM III. Factor return correlation v. causation • p263: First, widespread searches for statistically significant factors run the risk of false identification of useful factors • p264: A second potential difficulty is in differentiating between factors that are correlated with returns and those that cause returns • P264-265: A key challenge in using an empirical multi-factor model lies in justifying why it should perform better than the CAPM in describing the tradeoff between risk and return

From the perspective of the employee saving for retirement, the following are typical advantages of participation in an employer-sponsored defined-benefit pension fund rather than investing directly.

I. Pension plans offer economies of scale for investment management II. Pension plans can use longer time horizons and more safely make less liquid investments III. Pension plans can diversify away individual mortality risk and longevity risk

The three major types of credit risk modeling approaches

I. The structural approach II. The reduced-form approach III. The empirical approach

What four characteristics differentiate warrants from traditional equity options

I. Warrants are generally issued by unlisted firms II. Warrants tend to be dilutive III. Warrants tend to have longer maturities than traditional equity options IV. Warrants are not standardized securities

Describe the purpose of the Global Reporting Initiative Standards.

In 2016, GRI launched the Global Reporting Initiative (GRI) Standards, developed by the Global Sustainability Standards Board (GSSB). The GRI standards (formerly known as the G4 Sustainability reporting Guidelines) are designed to "enable all organizations to report publicly on their economic, environmental and social impacts - and show how they contribute towards sustainable development" and to serve as a "reference for policy makers and regulators" .

The structural approach

In the structural approach, the framework is set around an explicit relationship between capital structure and default. The value of a firm's assets is set equal to the value of its equity plus the value of its debt. Equity of the firm is viewed as a call option on the firm's assets, with the strike price being the face value of the debt due at the time of exercise. In contrast, bondholders are viewed as having a risk-free bond and a short position in a put option on the firm's assets. If the value of assets is less than the face value of the debt, the put option will be exercised on the bondholders, resulting in their giving up the risk-free bond and receiving the firm's assets.

Bad leaver clause

LPs may include a bad-leaver clause, which is a for-cause removal of the GP that, if exercised (normally following a simple majority vote of the LPs), causes investments to be suspended until a new fund manager is elected or, in the extreme, the fund is liquidated.

Meta Risks

Meta risks, which are defined as "the qualitative risks beyond explicit measurable financial risks. They include human and organizational behavior, moral hazard, excessive reliance on and misuse of quantitative tools, complexity and lack of understanding of market interactions, and the very nature of capital markets in which extreme events happen with far greater regularity than standard models suggest. An example would be expenditures on elaborate office space, rather than hiring operational staff

Mitigating Estimation Error Risk in Mean-Variance Optimization

Mitigating Estimation Error Risk in Mean-Variance Optimization returns strives to reduce estimation error and typically is executed by: (1) repeated analysis of hypothetical returns simulated from the statistical parameters estimated from the original sample of returns; or (2) repeated analysis of new samples of returns generated from the original sample using draws with replacement

The three steps of unsmoothing a return series that contains a first-order autocorrelation

Step 1: Specify the form of the autocorrelation (in this case, first order) Step 2: Estimate the parameter(s) of the assumed autocorrelation process Step 3: Use the estimated autocorrelation coefficient to generate an unsmoothed return series

Intuition of the Black-Derman-Toy interest rate model

Observed spot rates drive rate levels while implied rate volatilities drive rate spreads Understanding the intuition of imposing these two conditions helps in understanding the essence of the BDT model. The spot rates in the currently observed term structure drive the overall levels of the rates that are projected throughout the binomial tree. The implied volatilities of options trading on short‐term rates (i.e., interest rate caplets) drives the spreads between the "up rates" and the "down rates" corresponding to the expiration dates of the caplets

What is the effect of rising interest rates on the market price of storable commodities?

Reducing the market price by decreasing the desire to carry inventories Commodities and interest rates: High real interest rates increase the opportunity costs of investors who hold commodities in storage, which leads to a temporary reduction in the potential demand for storable commodities. First, high interest rates reduce the potential demand for storable commodities (or increase the potential supply) through three channels: (1) by increasing the incentive for extraction today rather than tomorrow; (2) by decreasing firms' desire to carry inventories; and (3) by encouraging investors to shift out of commodity contracts into fixed-income instruments.

Why are hedonic price indices used in real estate?

To adjust for heterogeneity in property characteristics when using transactions to infer price changes

Describe the two issues related to the structure and use of ESG ratings.

One issue of importance in ESG ratings is whether the ratings are relative to a particular industry or not. For example, a particular oil and gas firm may be viewed as deserving of a negative ESG rating based on environmental concerns due to its line of business, but may be viewed as deserving a positive rating if it is a leader in ESG-related concerns within its industry. Another issue is criticism of the heterogeneity of ESG-related ratings for the same firms across ratings agencies. Barnett, CEO of a corporation with a vision of "a world in which all capital allocation is driven by environmental, social and financial returns" , asserts that "ESG ratings don't actually rate anything (if by which we mean assigning a comparable estimation on the likelihood of a future event)" and reports that "The big three credit rating agencies (Moody's, S&P, Fitch) have a [credit] ratings correlation of 0.9. Three of the largest ESG ratings organizations (MSCI, Sustainalytics, Reprisk) have an ESG ratings correlation of 0.32." In other words, while there is a high average correlation between credit ratings of the same firms across different rating agencies, there is a low correlation for ESG ratings between the same firms across different rating agencies.

Principal guaranteed commodity notes

Structured products that offer investors upside potential with downside protection Principal guaranteed commodity notes are structured products that offer investors the upside opportunity to profit if commodity prices rise, combined with a downside guarantee that some, potentially all (depending on the note's terms), of the principal amount will be returned at the maturity of the structure

Consider a family office evaluating which type of structure to use in order to gain exposure to real estate. What is an advantage for the family office of using a privately organized structure compared to a listed structure?

Tax benefits: For taxable investors, private structures may better flow through tax advantages such as depreciation and depletion. For the general partners, carried interest may be taxed at highly preferred long-term capital gains rates in some jurisdictions.

Describe the Global Reporting Initiative

The Global Reporting Initiative (GRI) is an independent not-for-profit organization that describes itself as helping "businesses and governments worldwide understand and communicate their impact on critical sustainability issues such as climate change, human rights, governance and social well-being."

PME method

The PME method is a cash-weighted metric (like IRR) that considers multiple negative and/or multiple positive cash flows. The intuition of the PME method is that it indicates the attractiveness of a private investment by comparing the cash-weighted returns of two identical cash flow streams: one invested in a specified private project and the other a hypothetical investment of the same cash flows into and out of a public equity market index

Describe the structure of the SASB Materiality Map.

The SASB Materiality Map analyzes ESG-related issues along two major dimensions: ESG category (e.g., environment) and industry (e.g., consumer goods). There are five ESG categories (Environment; Social Capital; Human Capital; Business Model and Innovation; and Leadership and Governance). These five ESG categories (such as environment), are further broken down into a total of 25+ sub-categories. For example, environment can be broken into air quality, energy management, and four other concerns. The other major dimension is industry. There are 10 industry categories (e.g., consumer goods, financials, and infrastructure) that are further broken down into subcategories. For example, the consumer goods industry is broken down into seven subcategories (e.g., E-Commerce and appliance manufacturing). Thus the map has had a dimension of roughly 25 ESG subcategories by 75 industry subcategories for a total of almost 2,000 locations on the map. Each location on the map (i.e., each possible combination of subcategories) is rated as falling into one of three categories: (1) likely to be material for more than 50% of the firms, (2) likely to be material for fewer than 50% of the firms, or (3) not likely at all. For example, within E-Commerce, energy management is indicated as being likely to be "material for more than 50% of industries in sector". However, the other environmental issues (e.g., GHG emissions and Air Quality) were rated as being unlikely to be material.

The bottom up approach

The approach places the most emphasis on the management of suitable investments The bottom-up approach is based on fund manager or security specific research, in which the emphasis is on screening all investment opportunities and picking the perceived best.

Sensitivities exhibited by Merton's structural model

The credit spread in Merton's structural model exhibits sensitivity to maturity. However, as the time to the debt's maturity is increased, the probabilities of default (and credit spreads) increase. Therefore, for firms with low leverage the term structure of credit spreads tends to be upward sloping

A hedge fund has a hardship exemption allowing employees to sell personal security holdings prior to the expiration of the fund's required holding period. What best describes the common basis for allowing such sales?

The employee wishes to cut his or her losses on a security with a declining price In certain cases, funds may employ a hardship exemption procedure, wherein an employee is allowed, with permission, to sell a security, especially at a loss, even if it is within the minimum holding period. A hardship exemption is commonly permitted to allow employees to limit personal losses.

The hedonic-pricing method (HPM)

The hedonic-pricing method (HPM) assumes that each of these attributes has its own market price. Examples of these attributes include the number of rooms, the size of the lot, the number of bathrooms, and so on. In other words, properties can be viewed as bundles of attributes and characteristics. We can observe the market price and the attributes or characteristics of the properties. It is thus required to unbundle and determine the implicit price or contribution of each of these attributes (i.e., the hedonic price) within the observed market price, including precise location, that renders them virtually unrepeatable and unique.

What is the key advantage of free ports for family office portfolio management?

The key advantage is that free ports charge no sales taxes. Taxes are charged by the country of destination when the art leaves the free port. Until then, while stored at the free port, the goods are considered "in transit" and typically not taxed. This makes free ports a convenient and often a permanent place of storage for art.

Leverage Aversion Theory

The leverage aversion theory argues that large classes of investors cannot lever up low-volatility portfolios to generate attractive returns and that, as a result, low-volatility stocks and portfolios are underpriced. Those investors who are not averse to leverage can exploit the potential underpricing of low-volatility portfolios and lever the attractive Sharpe ratios into attractive combinations of risk and return.

What best describes the borrowing base in asset-based lending

The maximum credit willing to be extended after considering the debt that would be senior to a loan The borrowing base is therefore the maximum potential quantity of credit the lender is willing to extend after reducing collateral values considering the level of outstanding debt that would be senior to the loan.

What is the "corpus" in the context of an endowment?

The nominal value of the endowment's initial gift An endowment fund may have specific restrictions on the capital, restricted gifts, that may require that the university maintain the corpus, the nominal value of the initial gift, while spending the income generated by the gift to benefit the stated purpose.

An options analyst describes an implied volatility structure as exhibiting a smirk. What is the distinguishing characteristic of this structure?

The options differ by strike price A volatility structure with a smile or a smirk is where out-of-the-money put options have higher levels of implied volatility than other options.

An infrastructure analyst is estimating a multiple regression model. Assuming that there is no multicollinearity, what is the effect of adding additional true factors?

The r-square value increases, indicating that more of the variation in the dependent variable has been explained A typical result of adding more true factors to a model is that the r-squared increases and the estimated intercept (ai) declines. The r-squared increases as the additional factors are explaining a greater portion of the variance in the dependent variable.

In the context of the Fama-French model, the conservative minus aggressive factor is designed to distinguish firms by which of the following aspects?

The rate of reported corporate asset investment The conservative minus aggressive factor is designed to distinguish firms by the rate of reported corporate asset investment (with conservative firms exhibiting a lower rate of investment in corporate assets).

Trade blotter

The running list of all trades desired and completed during each trading day is commonly referred to as a trade blotter.

Consider a portfolio allocation process in which the following two portfolio allocation strategies are being considered for use: 1. Minimum volatility portfolio weights 2. Risk parity portfolio weights In this particular portfolio allocation process, all the available investment opportunities have the same return volatilities but the return correlations between each pair of assets differ. Which of the following correctly identifies the strategies that will generate equal weightings, if any?

The weights of each asset will tend to be higher for low-volatility assets and higher for assets that have low correlations with the rest of the portfolio. Second, factor-based risk allocation requires asset owners to take extreme positions in some assets or asset classes.

Endowment intergenerational equity

There is a 50% probability that the endowment's inflation-adjusted value will be maintained in perpetuity Stated quantitatively, intergenerational equity may be expressed by a 50% probability of maintaining the real, or inflation-adjusted, value of the endowment in perpetuity.

Closed-end real estate mutual funds (CEMFs)

They are traded on stock exchanges and therefore offer liquidity *Watch out for "mutual" in the name* Closed-end real estate mutual funds (CEMFs) are exchange-traded mutual funds that have a fixed number of shares outstanding and that represent only a small portion of the listed real estate industry.

Ratios of the natural logarithms of substitutable commodities

To normalize ratios of contracts with different pricing specifications and contract sizes, one can study natural logs of the ratios of prices. The reason for this type of normalization is that price distributions can be approximated by a lognormal distribution, and therefore the distribution of the resulting ratio can be approximated by a normal distribution. This facilitates the testing of the difference to see if it is statistically significant. For example, one might look at the natural log of a series of ratios of heating oil to natural gas prices

Trade allocation

Trade allocation refers to the process by which trades are divided among the firm's various funds and/or accounts with best practice for a fund to maintain a predetermined trade allocation policy that does not favor one of the firm's funds or accounts at the expense of another.

Name the two primary European regulatory frameworks.

Undertakings for Collective Investments in Transferable Securities (UCITS), is the main European framework covering collective investment schemes. UCITS funds must be open-ended and liquid and typically invest in securities listed on public stock exchanges and regulated markets. The Alternative Investment Fund Managers Directive (AIFMD) regulates alternative investment managers - meaning any whose regular business is managing one or more alternative investment funds (AIFs). The AIFMD does not regulate AIFs directly. The AIFMD applies to non-UCITS investments such as private equity, venture capital, hedge funds, and real estate funds.

View commonality

View commonality refers to the fact that when the views of individual hedge fund managers (measured by their exposures) are aggregated in a hedge fund index, they tend to cluster into common themes that drive the overall performance of the index. For instance, if most equity long/short hedge fund managers have positive views on energy stocks, they may attempt to exploit this view by allocating assets to various companies that have exposure to the energy sector. In the index, these views are aggregated and are represented by increased exposure of the index to the energy sector, which could be captured by the replication product through increased allocations to an energy ETF.

Aggregation depends on correlation:

While aggregating returns is an additive process from the bottom up, calculating and aggregating risk measurements ultimately to the top level of a portfolio is not simply the sum of the constituent risk measures. Due to the impacts of correlations between positions, strategies, sectors, and other exposures, aggregating risk measures up to the portfolio level is a nonlinear and more complex exercise.

Altman's credit scoring model

Z < 1.81: Default group 1.81 < Z < 2.99: Gray zone Z > 2.99: Nondefault group

genetic algorithms

genetic algorithms seek to identify patterns in data using an approach modeled after the natural selection process found in biological evolution with various "genes" representing trading rules that survive within the model or perish based on the their estimated value in generating trading profits.

Name one of the other two funds (besides Amaranth) that collapsed due to market losses on listed securities and describe the fund's primary underlying position(s) that led to the collapse. Describe the key reason why the funds named collapsed.

i. CCC (MBSs) or LTCM (Treasuries) ii. The funds were applying high or excessive leverage

Ms. Lopez oversees another portfolio with a strategy involving distressed debt in the U.S. She wishes to implement that strategy within a fund that has a mandate of outperforming the S&P 500 index. She believes that the distressed debt portfolio will generate an alpha of 2% per year and plans to add S&P 500 exposure to the distressed debt fund by adding long positions in S&P 500 futures. i. What is the term that is used to describe the ability of a particular investment product or strategy "...to exploit alpha by investing in an alpha-producing strategy while simultaneously managing a target beta exposure"? (1 Point) ii. What other positions should be added to the portfolio of distressed debt (and S&P 500 futures) in order to increase the correlation of the strategy's returns with the returns of the S&P 500 index closer to 1? (1 point)

i. Portable alpha or porting alpha ii. Laying off credit and interest rate risk with interest rate and credit derivatives.

Fund of Fund biases

• Little or no hedge fund survivorship bias • No instant history bias • Less survivorship bias

An investor wishes to purchase a life insurance policy from a policyholder. What describes the bond-like nature of this life insurance settlement, from the perspective of the investor?

• Negative fixed coupons (the annual premiums) • An unknown duration (the policyholder's life expectancy) • A known principal (the face value of the policy)