CAIA Level 1

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What is the term for a private management advisory firm that serves a group of related and ultra-high net worth investors?

Family office

What is the primary cause of the shape of teh J-curve of interim private equity fund returns?

It is caused by a combination of early expense recognition, early loss recognition, and deferred gain recognition.

What are the three costs of carry that determine the price of a forward contract on a physical asset?

Storage costs, convenience yield (when viewed as a negative cost), and interest (financing) charges.

What is the primary reason that causes a commodity futures market to be in contango or backwardation?

(1) Backwardation, contango, and, in fact, the entire slope and shape of the term structure are determined by differences in cost of carry, and (2) in an efficient market, all forward contracts offer equal risk-adjusted expected returns, regardless of the slope and shape of the term structure of forward prices.

What is the value of the beta of the following three investments: a fund that tracks the overall market index, a riskless asset, and a bet at a casino table?

+1, 0, 0 (assuming the casino bet is a traditional bet not based on market outcomes)

Describe the evolution of the buyout market.

1) 1970s - KKR was founded with $3m of its own funds to ivnest 2) 1980s - the rise of a key element of the growth in buyouts: financing the buyouts using bonds with low credit ratings (i.e. junk bonds). Buyouts reached a peak in 1989, when KKR bought the giant food conglomerate RJR Nabisco for $31bn 3) 1990s - Buyout activity declined for two reasons: 1) the recession of 1990-91 pushed credit spreads to high levels which lowered the attractiveness of junk bond financing for buyouts, and 2) in 1998, the Russian government defaulted on its sovereign bonds, which also sent credit spreads upward. 4) 2000s - started quietly for the buyout market before availability of credit created a boom from 2003 to 2007 before falling off after the liquidity bubble burst in late 2007 5) 2010s - buyout activity resumed growth, but have yet to reach pre-crisis levels of 2006 to 2007

Name two prominent time periods when structure mortgage products are believed to have increased systematic risk and led to a financial crisis? What is the major difference between the underlying economic events that led to the losses in these two crises?

1) 1994 and 2007 2) In 1994, the combination of extended maturities and higher interests caused market values of many CMO tranches to collapse based more on interest rate risk than default risk. In 2007, the creditworthiness of the CMOs caused the market values of many tranches to fall substantially. In both situations, the dramatic fall in market values caused investors and institutions to liquidate their positions which exacerbated the crisis by lowering CMO valuations even further.

Name the two primary approaches for estimating the volatility used in computing value at risk.

1) A common approach is to estimate the standard deviation as being equal to the asset's historical standard deviation of returns. 2) Another method of forecasting volatility is based on market prices of options. Estimates of volatility are based on the implied volatilities from option prices.

Provide two major sources of distressed debt

1) A company with a deteriorated financial condition 2) Debt issued by a private equity firms or leveraged buyout firm

List several advantages of separately managed accounts (SMAs) relative to funds.

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, whereas an SMA may have objectives tailored to suit the specific needs of its only investor, such as tax efficiency. 3) A fund is often opaque to its investors to promote confidentiality; an SMA offers transparency to its investor. 4) Fund investors may suffer adverse consequences from other investors' redemptions (withdrawals) and subscriptions (deposits), but an SMA provides protection from these liquidity issues for its only investor.

List several advantages of Separately Managed Accounts relative to funds.

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.

List several advantages of Separately Managed Accounts (SMAs) relative to funds.

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.

List the there primary elements that differentiate a hedge fund from other investment pools.

1) A hedge fund is privately organized in most jurisdictions 2) A hedge fund usually offers performance-based fees to its managers 3) A hedge fund usually can apply leverage, use derivatives or utilize other investment flexibility

What are the two methods of detecting outliers in a statistical analysis?

1) Detection through visual inspection of plots 2) Ordered listings of the variables and regression residuals

What is the difference between a spin-off and a split-off?

1) A spin-off occurs when a publicly traded firm splits into two publicly traded firms, with shareholders in the original firm automatically becoming shareholders in the new firm. 2) A split-off occurs when Company A splits off (divests) Company B and the investors in Company A have the choice to retain their ownership in Company A or exchange their shares in A for shares in the newly created firm (Company B)

List the three primary categories of single-strategy event-driven hedge funds.

1) Activist Hedge Funds 2) Merger Arbitrage Funds 3) Distressed Securities Funds

Provide two common interpretations of the investment term alpha.

1) Alpha refers to an excess or deficient investment return after the return has been adjusted for the time value of money (the risk-free rate) and for the effects of baring systematic risk (beta). 2) Alpha can also refer to the extent to which the skill, information, and knowledge of an investment manager generates superior risk-adjusted returns (or inferior risk-adjusted return in the case of negative alpha). 3) Note that the first interpretation can include high returns from luck.

What are the two steps to an analysis of ex ante alpha using historical data?

1) An asset pricing model or benchmark must be used to divide the historical returns ino the portions attributable to systematic risks (and the risk-free rate) and those attributable to idiosyncratic effects. 2) The remaining returns, meaning the idiosyncratic returns (i.e., ex post alpha), should be statistically analyzed to estimate the extent, if any, to which the superior returns may be attributable to skill rather than luck.

What differentiates the angel investing stage of VC from the seed stage of venture capital financing?

1) Angel investing is the earliest stage of venture capital. Angel investors are often friends and family, and they fund an entrepreneur's ideas. At this stage, the angel investor is funding an idea. There is no formal business plan, no management team, no product, no market analysis, just an idea. This phase usually raises $50,000 to $500,000. 2) The seed stage is the first stage where institutional investors commit their capital into a venture and is typically prior to having established the viability of the product. At this stage, the business plan is completed, some members of management have been assembled, and the entrepreneur and management team have performed market analysis and addressed parts of the business plan. This phases usually raises $1m to $5m.

List two major factors that drive informational market efficiency through facilitating better investment analysis.

1) Assets will also tend to trade at prices closer to their informationally efficient values when there is easier access to better information. 2) Assets will also tend to trade at prices closer to their informationally efficient values when there is less uncertainty about their valuation. In other words, when there are better valuation methods.

Describe Bad-leaver and good-leaver clauses in PE partnerships.

1) Bad-leaver clause: a for-cause removal of the GP that, if exercised, causes investments to be suspended until a new fund manager is elected or, in the extreme, the fund is liquidated. 2) Good-leaver clause: enables investors to cease additional funding of the partnership with a vote requiring a qualified majority. This "without-cause" clause provides a clear framework for shutting down a partnership that is not working, or when confidence is lost.

List the seven kinds of potential trigger events in the standard ISDA agreement?

1) Bankruptcy 2) Failure to pay 3) Restructuring 4) Obligation acceleration 5) Obligation default 6) Repudiation/moratorium 7) Government intervention

Provide two common interpretations of the investment term beta.

1) Beta is the proportion by which an asset's excess return moves in response to the market portfolio's excess return (the return of the asset minus teh return of the riskless asset). 2) Beta refers to any of a number of measures of risk or the bearing of risk, wherein the underlying risk is systematic (shared by at least some other investments and usually unable to be diversified or fully hedged without cost) and is potentially rewarded with expected return without necessarily specifying that the systematic risk is the risk of the market portfolio.

What are the steps invovled in directly estimate VaR from historical data rather than through a parametric technique?

1) Collect the perecentage price changes 2) Rank the gains/losses from the highest to the lowest 3) Select the outcome (loss) reflecting the quantile specified by the VaR (e.g., for a VaR based on 95% confidence pick the observation with a loss larger than 95% of the other outcomes).

List four reasons why commodities should help diversify a portfolio of traditional assets.

1) Commodities have prices that are not directly determined by the discounted value of future cash flows. 2) Nominal commodity prices should be positively correlated with inflation largely because commodity prices form part of the definition and computation of inflation. 3) They may react very differently at different parts of the business cycle. The value of stocks and bonds is derived from expectations regarding long-term earnings or coupon payments. Commodities are often priced more on the state of current economic conditions and factors regarding short-term supply and demand. 4) Commodities are a major cost of some corporate producers. In the short run, a major increase in commodity prices (e.g., oil) may cause a substantial decline in corporate profits, and a decline in commodity prices may result in an increase in profits.

Identify three major methods of executing an exit from VC.

1) Conducting an initial public offering of the company's securities 2) Sale to acquiring firms 3) Leveraged recapitalization (where the proceeds from the debt are paid to the venture capitalist)

List the components of the returns of a traditional convertible arbitrage straegy.

1) Convertible Bond Arbitrage Income: -(Bond Interest - Stock Dividends + Short Stock Rebate - Financing Expenses) 2) Convertible Bond and Stock Net Capital Gains and Losses: -(Capital Gains on Stock and Bond - Capital Losses on Stock and Bond)

Name the three styles of real estate investing.

1) Core 2) Value Added 3) Opportunistic

Provide an example of a common real estate investment for each of the three styles of real estate investing.

1) Core: Office, retail, industrial, multifamily, and hotels 2) Value Add: hotels, resorts, assisted-care living facilities, low-income housing, outlet malls, hospitals, and the like 3) Opportunistic: Development of raw property, redevelopment of property that is in disrepair, or acquisition of property that experiences substantial improvement in prospects through major changes, such as urban renewal.

Distinguish discretionary fund trading from systematic fund trading

1) Discretionary fund trading is where the decisions of the investment process are made directly by the judgement of human traders. 2) Systematic fund trading, often referred to as black-box model trading because the details are hidden in complex software, is where ongoing trading decisions of the investment process are automatically generated by computer programs.

Name the four return characteristics that differentiate traditional and alternative investments.

1) Diversification 2) Illiquidity 3) Inefficiency 4) Non-normality

Name five benefits to investing in funds of funds that may lead to lower investment risk to limited partners without sacrificing expected return.

1) Diversification 2) Liquidity 3) Regulation 4) Currentcy Hedging 5) Educational Role

What are the differences between duration, modified duration and effective duration?

1) Duration is a measure of the sensitivity of a fixed income security to a change in the general level of interest rates. Traditional duration may also be viewed as a weighted average of the longevity of the cash flows of a fixed-income security. 2) Modified duration is equal to traditional duration divided by the quantity [1 + y/m], where y is the stated annual yield, m is the number of compounding periods per year, and y/m is the periodic yield. With continuous compounding periods per year, and y/m is the periodic yield. With continuous compounding, m is infinity, and traditional duration equals modified duration. Modified duration scales traditional duration to adjust for the compounding assumption used in the interest rate computations. 3) Effective duration is a measure of the interest rate sensitivity of a position that includes the effects of embedded option characteristics. As such it is not generally equal to the weighted average longevity of the cash flows.

What is the difference between economic and social infrastructure? Provide an example of each.

1) Economic infrastructure assets are assets with economic value that is driven by the revenue they generate, typically with end users paying for the services provided by these assets. Examples include toll roads and bridges, railways, airports, and maritime terminals. 2) Social infrastructure assets that have end users who are unable to pay for the services or that are used in such a way that it is difficult to determine how many services were used by each person. Examples include schools, public roads, prisons, administrative offices, and other government buildings.

Name four benefits to investing in funds of funds that may lead to higher net returns to limited partners without causing higher risk.

1) Economies of Scale 2) Informational Advantage 4) Access to Certain Managers 5) Negotiated Fees

List the five general categories of LBOs designed to create value.

1) Efficiency buyouts 2) Entrepreneurship stimulators 3) The overstuffed corporation 4) Buy-and build strategies T 5) Turnaround Strategies

What are the three phases in the relationship between LPs and GPs of PE funds?

1) Entry and establish 2) Build and harvest 3) Decline, exit, or transition to new managers

Name the two primary approaches for estimating the voaltility used in computing value-at-risk.

1) Estimate the standard deviation (volatility) as being equal to the asset's historical standard deviation of returns. 2) Estimate volatility based on the implied volatilities from option prices.

List the five dimensions of shareholder activists

1) Financial versus social activists 2) Activists versus pacifists 3) Imitators versus followers 4) Friendly versus hostile activists 5) Active activists versus passive activists

List the five dimensions of shareholder activists.

1) Financial versus social activists 2) Activists versus pacifists 3) Initiators versus followers 4) Friendly versus hostile activists 5) Active activists versus passive activists

Describe the double layer of fees in fund of funds

1) FoF managers effectively pass on to their investors all fees charged by the underlying hedge funds in their portfolios, while also charging an extra set of fees for their own work as well as for an additional layer of service providers. 2) Many Fofs charge a 1% management fee and a 10% performance fee on top of the average underlying hedge fund management fee of 2% and incentive fee of 20% for the hedge funds.

What are the five stages of the lifecylce of a VC fund?

1) Fundraising 2) Sourcing Investments 3) Investing 4) Operations and Management 4) Windup and Liquidation

What two roles do PE firms play in a partnership and how do carried interest and management fees line up with those two roles?

1) General partner (GP) to Partnership 2) Investment Advisor

Describe six differences between typical PE and hedge fund fees.

1) Hedge fund incentive fees are front loaded. PE fund fees tend to be collected at the termination of deals. 2) Hedge fund incentive fees are based on changes in net asset value whether the gains are realized or unrealized. PE fund fees are based on realized values of exited positions. 3) Hedge fund incentive fees are collected on a regular basis, either quarterly or semiannually. PE fund incentive fees tend to be collected at the time of an event, such as exit. 4) Investor capital does not need to be returned first to collect incentive fees in a hedge fund. PE funds typically do not distribute incentive fees until the original investor capital has been repaid. 5) Hedge funds often have no provisions for the clawback of management or incentive fees. PE funds typically have clawback provisions requiring the return of fees on prior profits when subsequent losses are experienced. 6) Hedge funds rarely have a preferred rate (hurdle rate) of return (e.g. 6%) that must be exceeded before the hedge fund manager can collect an incentive fee. Most PE funds have a hurdle rate.

List three potential disadvantages of real estate as an investment.

1) Heterogeneity 2) Lumpiness 3) Illiquidity

List three potential disadvantages of real estate as an investment?

1) Heterogeneity 2) Lumpiness 3) Illiquidity

Other than moneyness of the best available use, what are three factors regarding the uses that would cause a multiple-use option to have a low value?

1) High similarity among the profitability of each alternative 2) Low volatility of the profitability of each alternative 3) High correlation between the profitability of each alternative.

What are the two primary conflicts of interest that emanate from the potentially lucrative compensation schemes offered to existing management teams in a management buy-in?

1) Incumbent management has a strong incentive to resist any buyout attempt that displaces them as managers if the buyout does not provide them with generous compensation even if the buyout benefits shareholders. 2) Incumbent management has a strong incentive to encourage buyouts that offer them generous compensation even if the buyout benefits shareholders.

What are the three constraints against achieving alternative investment benefits through liquid products?

1) Leverage constraints 2) Concentration constraints 3) Constraints on illiquid assets

What are the three constraints against achieving alternative investment benefits through liquid products?

1) Leverage: there is a 300% asset coverage rule that requires a mutual fund to have assets totaling at least three times the total borrowings of the fund, thus limiting borrowing to 33% of assets. UCITS restrictions are even tighter. 2) Regulatory constraints on concentration 3) Illiquidity constraints

List the four major categories of funds of funds.

1) Market-Defensive Fund of Funds 2) Conservative Fund of Funds 3) Strategic Fund of Funds 4) Diversified Fund of Funds

What are the three major forms of private debt introduced in the chapter?

1) Mezzanine debt 2) Distressed debt 3) Leveraged loans

Are investors in commercial mortgages typically more or less concerned than investors in residential mortgages about: (a) rental income, (b) default risk, and (c) prepayment risk?

1) More concerned (residences are owner-occupied) 2) More concerned (residential mortgages are usually insured) 3) Less concerned (commercial loans are less subject to prepayment without penalty.

List the three major types of model misspecification in the context of estimating systematic risk.

1) Omitted (or misidentified) systematic return factors 2) Misestimated betas 3) Nonlinear risk-return relationships

List the six primary types of structure product wrappers.

1) Over-the-counter contracts (OTC) 2) Medium term notes/certificates/warrants 3) Funds 4) Life insurance policies 5) Structured deposits 6) Islamic wrappers

List the three major approaches to estimating the value of a highly complex structure product

1) Partial differential equation approach (PDE approach) 2) Simulation, such as Monte Carlo simulation 3) The building blocks approach (i.e., portfolio approach)

What are the three factors that determined the expected credit loss of a credit exposure?

1) Probability of default (PD), which specifies the probability that the counterparty may fail to meet its obligations 2) Exposure at default (EAD), which specifies the nominal value of the position that is exposed to default at the time of default 3) Loss given default (LGD), which specifies the economic loss in case of default

What are the four inputs to the simplified model of intellectual property values?

1) Probability of generating large positive cash flows 2) First Cash Flow 3) Required rate of return 4) The rate at which expected cash flows diminish each year after their initial potential

List three important propositions regarding the accrual of roll return through holding futures contracts through time.

1) Proposition 1: Roll return is not generated at the time that one position is closed and a new position is opened. 2) Proposition 2: Realized roll return is not necessarily positive when markets are backwardated. 3) Proposition 3: A position that generated a positive roll return does not indicate that the position's total returns were superior (i.e., that there was alpha).

Describe the three major advantages of REIT ownership relative to direct real estate ownership.

1) REITs provide management services in the selection and operation of properties. 2) REITs provide liquid access to an illiquid asset class. Investors can add to or trim their exposure to real estate quickly and easily through purchase and sale of shares in REITs. 3) REITs avoid taxation of income at the corporate level. This would be an advantage to an investor otherwise holding the real estate in a taxable corporation.

Name four major methods of analysis that distinguish alternative investments from traditional investments.

1) Return Computation Methods 2) Statistical Methods 3) Valuation Methods 4) Portfolio Management Methods

What are the two major types of investor motivations to investing in a tranche of a CMO rather than investing directly in mortgages similar to the mortages of the CMO's collateral pool?

1) Risk management: Investors may be better able to manage risk through structure products (e.g. by selecting tranches with specific longevities) 2) Return enhancement: Investors may be better able to establish positions that will enhance returns if the investor's market view is superior.

List two major economic motivations to the CDO structuring of non-investment grade debt.

1) Risk management: Investors may be better able to manage risk through structure products by selecting tranches that match their preferences 2) Return enhancement: Investors may be better able to establish positions that will enhance returns if the investor's market view is superior.

What are the main differences between the formula for semistandard deviation, semivolatility, and the target semistandard deviation?

1) Semistandard deviation, sometimes called semideviation, is the square root of semivariance. 2) Semivolatility is similar to semistandard deviation except that it is unambiguously based on only the number of observations below the mean or threshold (T*) and it subtracts 0.5, rather than 1.0, from that number. 3) Target semistandard deviation (TSSD) is simply the square root of the target semivariance.

How does mezzanine debt tend to differ from high-yield bonds and leveraged loans in seniority, term, and liquidity?

1) Seniority: Mezzanine debt is usually lower in seniority than high-yield bonds and, especially, leveraged loans 2) Term: Mezzanine debt is usually 4-6 years, similar to leveraged loans but shorter than high-yield bonds 3) Liquidity: Mezzanine debt has minimal liquidity, especially compared the relatively high liquidity of leveraged loans.

List the four functions of fund of funds management.

1) Strategic and Manager Selection 2) Portfolio Construction 3) Risk Management and Monitoring 4) Due Diligence

What are the characteristics that distinguish syndications from other real estate investment vehicles?

1) Syndications are formed by a group of investors 2) Syndications are usually formed to undertake a particular real estate project.

Contrast the NAREIT and NCREIF real estate indices as measures of private commercial real estate performance.

1) The NAREIT US Real Estate Index Series is a family of REIT-based performance that covers different sectors of the U.S. commercial real estate space. The returns of the NAREIT indices are based on equity REIT transaction data. 2) The NCREIF Property Index (NPI) is a large popular, value-weighted index published quarterly and is based on unleveraged commercial-property appraisals.

How does the annuity view of hedge fund fees differ from the option view of hedge fund fees?

1) The annuity view of hedge fund fees represents the prospective stream of cash flows from fees available to a hedge fund manager through the long term. 2) The option view of incentive fees uses option theory to demonstrate the ability of managers to increase the present value of their fees by increasing the volatility of the fund's assets.

List the two major approaches to valuing private commercial real estate equity.

1) The comparable sale prices approach values real estate based on transaction values of similar real estate, with adjustments made for differences in characteristics by a valuation professional such as an appraiser. 2) The income approach values real estate by projecting expected income or cash flows, discounting for time and risk, and summing them to form the property's total value and is similar to the discounted cash flow method (DCF method) used for valuing stocks and bonds.

What is the market portfolio and what is a market-weight?

1) The market portfolio is a hypothetical portfolio containing all tradable assets in the world. 2) The market weight of an asset is the proportion of the total value of that asset to the total value of all asset in the market portfolio.

Name three factors that theory suggests should drive the extent to which natural resource price changes drive the performance of firms that process those natural resources.

1) The price elasticity of the demand for the good 2) The price elasticity of the supply for the good 3) The extent to which an operating firm is exposed to or has hedged its expenses and revenues (i.e. its profits).

What are the five variables that determine the price of an option on a non-dividend stock according to the Black-Scholes option pricing model?

1) The price of the underlying asset 2) The strike price 3) the return volatility of the underlying asset 4) The time to the option's expiration 5) The riskless rate

List the two key characteristics that can make risk-neutral modeling a powerful tool for pricing financial derivatives.

1) The risk-neutral modeling approach provides highly simplified and easily tractable modeling, and 2) Often derivative prices generated by risk-neutral modeling must be the same as the prices in an economy where investors are risk-averse.

In Merton's structural model, how is debt with default risk viewed as having exposure to a put option?

1) The risky debt of a levered firm can be viewed as being equivalent to owning a riskless bond and writing a put option that allows the stockholders to put the assets of the firm to the debt holders without further liability (i.e. in exchange for the debt). 2) Debt of Levered Firm = + Riskless Bond - Put Option on Firm's Assets

In Merton's structural model, what is the conflict of interest between stockholders and debt holders with regard to asset risk and how does this conflict relate to structure products?

1) There is an inherent conflict between the stockholders and the bondholders with regard to the optimal level of risk for the firm's assets. The equity holders, with their long position in a call option prefer higher levels of risk, especially when the value of the firm's assets is near or below the face value of the debt. Conversely, bond holders prefer safer projects and reduced asset volatility as seen through their short position in a put option. The conflict of interest may be viewed as a zero sum game in which managers can transfer wealth from bondholders to stockholders by increasing the risk of the firm's assets (or vice versa) 2) The conflict of interest between stockholders and bondholders in the capital structure of a firm is analogous to the case of structured products with multiples tranches. The manager of the collateral pool can cause wealth transfers between tranches by altering the risk of the assets. In most structures, high levels of asset risk benefit junior tranche holders at the expense of senior tranche holders.

Summarize two major unresolved risk-related issues of equity REIT returns.

1) There is no consensus on whether the high correlation of REIT returns with equity markets return is unique to public REITs or simply masked in private REIT and appraisal-based returns. 2) Another unresolved issue is whether owners of a publicly traded REIT receive an expected return that includes a risk premium for illiquidity.

Define tracking error and average tracking error?

1) Tracking error indicates the dispersion of the returns of an investment relative to a benchmark return, where a benchmark return is the contemporaneous realized return on an index or peer group of comparable risk. 2) Average tracking errors imply refers to the average difference between an investment's return relative to its benchmark. In other words, it is the numerator of the information ratio.

List the six major potential risks of managed futures funds.

1) Transparency Risk 2) Model Risk 3) Capacity Risk 4) Liquidity Risk 5) Regulatory Risk 6) Lack of Trends Risk

List the six major potential risk of managed futures funds.

1) Transparency risk 2) Capacity risk 3) Liquidity risk 4) Model risk 5) Regulatory risk 6) Lack of trends risk

List four explanations that commodities should help diversify a portfolio of traditional assets.

1) Unlike financial securities, commodities have prices that are not directly determined by the discounted value of future cash flows 2) More so than traditional asset prices, nominal commodity prices should be positively correlated with inflation largely because commodity prices form part of the definition and computation of inflation 3) Commodity price changes may be negatively correlated with the returns to stocks and bonds is that they may react very differently at different parts of the business cycle. 4) Low or negative correlation between commodity prices and financial assets is based on commodities being a major cost of corporate production and thus consistent with lowered corporate profits.

What is the difference bewteen value at risk and conditional value-at-risk?

1) Value at risk (VaR or VAR) is the loss figure associated with a particular percentile of a cumulative loss funtion. In other words, VaR is the maximum loss over a specified time period within a specified probability. 2) Conditiona value-at-risk (CVaR), also known as expected tail loss, is the expected loss of the investor given that the VaR has been equaled or exceeded. CVaR will exceed VaR (if the overall maximum potential loss exceeds VaR).

List three questions in evaluating a systematic trading system.

1) What is the trading system, and how was it developed? 2) Why and when does the trading system work, and why and when might it not work? 3) How is the trading system implemented?

List three questions to ask when evaluating a systematic trading system.

1) What is the trading system, and how was it developed? 2) Why and when does the trading system work, and why and when might it not work? 3) How is the trading system implemented?

List major contrasts between venture capital and buyouts.

1) Whereas VC funds target nascent, start-up companies, buyouts target more established and mature companies. 2) VC is necessary to get a prototype product or service out the door. In a buyout, the capital is necessary not for product development but to take the company private so that it can concentrate on maximizing operating efficiencies. Venture capital relies on new technology or innovation; buyouts look to see where they can add operating efficiencies or expand product distribution. 3) A VC firm typically acquires a substantial but minority position in the company. Control is not absolute. Conversely, in a buyout, all of the equity is typically acquired, and control is absolute. 4) Venture capital and buyout firms target different internal rates of return. While both are quite high, not surprisingly, VC targets are higher. The reason is simple: There is more risk funding a nascent company with brand-new technology than an established company with regular and predictable cash flows.

Approximately when did average-quality corporate bonds and international equities become commonly viewed as institutional-quality investments in the United States?

1950-1980

What makes a binomial tree a recombining tree?

A binomial tree with an upward movement followed by a downward movement that recombines with a pathway with a downward movement and an upward movement. A recombining binomial tree has n+l possible final outcomes for an n period tree, rather than 2^n outcomes.

In which scenario will a clawback clause lead to payments?

A clawback clause, clawback provision or clawback option is designed to return incentive fees to LPs when early profits are followed by subsequent losses.

In which scenario will a clawback lead to payments?

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 a club deal?

A club deal is when two or more LBO firms work together to share costs, present a business pan and contribute capital to the deal.

What are the three major option strategies that resemble the ownership of a mezzanine tranche?

A collar position, a bull call spread and a bull put spread.

What is a compound option and how do compound options relate to VC?

A compound option is an option on an option. It allows its owner the right but not the obligation to pay additional money at some point in the future to obtain and option. As it relates to VC financing, the owners of this option is able to delay further capital until new information has arrived or the entrepreneur has reached a new milestone.

The covariance between the returns of two financial assets is equal to the product of the standard deviations of the returns of the two assets. What is the primary statistical terminology for this relationship?

A correlation coefficient of +1 indicates that the two assets move in the exact same direction and in the same proportion, a result known as perfect linear positive correlation.

For what type of interest rate shift is duration-neutral position best protected?

A duration-neutral position is protected from value changes due to shifts in the yield curve that are small (infinitesimal), immediate (instantaneous), and parallel (additive).

Summarize two major unresolved issues risk-related issues of equity REIT returns.

A fascinating and unresolved issue is whether owners of publicly traded REITs receive an expected return that includes a risk premium for illiquidity. On the one hand, the underlying properties are illiquid and it is possible that they are acquired at prices that are discounted for their illiquidity given that the real estate trades in a market dominated by private investors. On the other hand, competition by investors to receive a positive illiquidity premium while holding a liquid REIT would appear to drive property values up to the point that they no longer offer a risk premium for illiquidity. Dividend yields on private REIT structures tend to be moderately higher than those on public REITs, suggesting that public REITs offer little or no risk premium for holding illiquid real estate.

What is the economic term for a person or entity who allows others to pay initial costs and then benefits from those expenditures?

A free rider

What is the economic term for a person or an entity that allows others to pay initial costs and then benefits from those expenditures?

A free rider is a person or entity that allows others to pay initial costs and then benefits from those expenditures.

What is a fulcrum security and how might it facilitate a private equity strategey?

A fulcrum security is the senior-most debt security that is most likely to be repaid with equity in the reorganized firm.

Consider a position in a single forward contract. What distinguishes a fully collateralized position in this forward contract from a partially collateralized position?

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.

Which is more likely to be more liquid, a forward contract or a futures contract?

A futures contract is more likely to be more liquid.

What is the primary defining difference between greenfield projects and brownfield projects?

A greenfield project is new, whereas a brownfield project is existing.

What is the difference between a hard hurdle rate and a soft hurdle rate?

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.

What is the difference between a hard hurdle rate and a soft hurdle rate?

List the three primary elements that differentiate a hedge fund from other investment pools.

A hedge fund is an investment pool or investment vehicle that (1) is privately organized in most jurisdictions; (2) usually offers performance-based fees to its managers; and (3) can usually apply leverage, invest in private securities, invest in real assets, actively trade derivative instruments, establish short positions, invest in structured products, and generally hold relatively concentrated positions.

What two asset form a long straddle?

A long call and a long put with the same strike price.

What two assets form a long straddle?

A long call and long put form a long straddle

What simple option portfolio mimics the payout to an absolute returns structured product?

A long position in an at-the-money straddle, which generate profits via large movements in either direction (of the price of the underlier)

What is maintenance margin?

A maintenance margin is collateral put up by the investor on an ongoing basis until the position is closed out.

What s the primary difference between a management buy-in LBO and a management buyout LBO?

A management buyout is led by the target firm's current management, whereas a management buy-in is led by an outside management team. Thus the buy-out retains all or most top management while the buy-in replaced all or most top management.

Describe the role of a market maker in the context of taking and/or providing liquidity in a market with anxious traders.

A market maker is a market participant that offers liquidity, typically both on the buy side and placing bid orders and on the sell side by placing offer orders. A market maker meets imbalances in supply and demand for shares caused by idiosyncratic trade orders from anxious traders. Typically, the market maker's purpose for providing liquidity is to earn the spread between the bid and the offer prices by buying at the bid price and selling at the offer price.

What is moral hazard?

A moral hazard refers to the actions one party may take to the detriment of the other.

Define mortgage

A mortgage loan is a loan secured by property

What is the name of an option that offers a payout in a currency based no the numerical value of an underlying asset with a price that is expressed in another currency?

A quanto option is an option with a payoff based on one currency using the numerical value of the underlying asset express in a different currency.

What is the primary difference between a fund of funds and a multistrategy fund?

A multistrategy fund deploys its underlying investments with a variety of strategies and sub-managers, much as a corporation would use its divisions. In a multistrategy fund, there is a single layer of fees, and the sub-managers are part of the same organization. The underlying components of a fund of funds are themselves hedge funds, with independently organized managers and a second layer of hedge fund fees to compensate the manager for activities relating to portfolio construction, monitoring, and oversight.

What is the name of an option with no expiration date? Would that option typically be a European option or an American option?

A perpetual option is an American option with no expiration date.

What is the name of an option with no expiration date? Would that option typically be a European option or an American option.

A perpetual option. A perpetual option is an American option because if it were European it would never be able to be exercised and would be worthless.

What is a qualified majority?

A qualified majority is generally more than 75% of LPs in contrast to the over 50% required for a simple majority.

What is the complementary option type to financial options?

A real option is an option on a real asset rather than a financial security. The real option may be a call option to purchase a real asset, a put option to sell a real asset, or an exchange option involving exchange of nonfinancial assets.

What is the complementary option type to financial options?

A real option. A real option is an option on a real asset rather than a financial security. The real option may be a call option to purchase a real asset, a put option to sell a real asset, or an exchange option involving exchange of nonfinancial assets.

What is an ex post excess return?

A realized return (an observed historical return) expressed as an excess return by subtracting the riskless return from the asset's total return.

What differentiates a relative pricing model from an absolute pricing model?

A relative pricing model prescribes the relationship between two prices. An absolute pricing model attempts to describe a value, or a price level, based on its underlying economic factors.

When and why are risk-neutral probabilities used?

A risk-neutral probability is a probability that values assets correctly if, everything else being equal, all market participants were risk neutral. A risk-neutral probability may be viewed as being equal to a statistical probability that has been adjusted for risk so that it can be used to price risky assets in a risk-neutral framework.

What is a springing board remedy?

A springing board remedy occurs when the investor designates a majority of the defaulting issuer's board of directors.

How does the interest rate risk of a variable-rate mortgage compare to that of a fixed-rate mortgage from the perspective of the lender?

A variable-rate type of mortgage to a lender protects the lender from the valuation fluctuations due to interest rate changes experienced with fixed-rate mortgages. To the extent that rates adjust quickly and completely, the variable-rate loan tends towards having little or no interest rate risk.

An investor observes a one-year bond with a yield of 1.95% and a two-year bond with a yield of 2.15%, both expressed on a continuously compounded basis. Other than time until maturity, all other bond characteristics are the same and both bonds are assumed to be default-free. What is the implied one-year forward rate? A) 2.35%. B) 2.41%. C) 2.47%. D) 2.52%

A) 2.35% = (2.35 * 2) - (1.95 *1) / (2 - 1)

Which phrase best completes Standard III(E): Preservation of Confidentiality? "Members and candidates must keep information about current, former, and prospective clients confidential, unless: A) disclosure is required by law." B) the member or candidate thinks the information might be illegal." C) the client or prospective client cannot be located and the information is material." D) doing so would violate Standard IV(A): Loyalty to the Client."

A) All information about current and former clients and prospects must be kept confidential unless it pertains to illegal activities, disclosure is required by law, or the client or prospect gives permission for the information to be disclosed.

Gail Stefano, CAIA, an analyst for a U.S. brokerage firm that serves U.S. investors, researches public utilities in South American emerging markets. Stefano makes the following statement in recent report: "Based on the fact that the South American utilities sector has seen rapid growth in new service orders, we expect that most companies in the sector will be able to convert the revenue increases into significant profits. We also believe the trend will continue for the next three to five years." The report goes on to describe the major risks of investing in this market, in particular the political and exchange rate instability associated with South American countries. Stefano's report: A) has not violated the Standards B) violated the Standards by failing to properly distinguish factual information from opinions. C) violated the Standards by recommending an investment that would not be suitable for all of its clients. D) violated the Standards by failing to properly identify details related to the operations of South American utilities.

A) Historical growth can be cited as a fact because it actually happened. Stefano states that her firm expects further growth and profitability, which is an opinion. She does not claim that these are facts. In addition, Stefano identifies relevant factors and highlights in particular the most significant risks of investing in South American utilities. She has fully complied with Standard V(B): Communication With Clients and Prospective Clients. Under the Standard, it is not necessary to include every detail about a potential investment in a report. Members and candidates are expected to use their judgement and identify the most important factors to include.

Claire Marlin manages an investment fund specializing in foreign currency trading. Marlin writes a report to investors describing the basic characteristics of her strategy. The strategy is based on an expected appreciation of the euro relative to other major currencies. The report is available to all existing and potential investors via the firm's website. In the report, Marlin shows the projected returns from the strategy if the euro appreciates less than 5%, between 5% and 10%, or more than 10%, while clearly stating that these forecasts are her opinion. Has marling violated the Standard related to communication with clients? A) Yes. B) No, because she disclosed the basic characteristics of the investment. C) No, because she distinguished fact from opinion and discussed how the strategy may perform under a range of scenarios. D) No, because all existing and potential clients have access to the report.

A) Standard V(B): Communication with Clients and Prospective Clients requires that members and candidates communicate the risk associated with the investment strategy used and how the strategy is expected to perform in a range of scenarios. These scenarios should include those different from the current trend. Marlin should have discussed how her strategy would perform if the euro depreciates instead of appreciating as she expects.

Which of the following is NOT a component of the cost of carry for a commodity? A) Collateral yield. B) Financing cost. C) Spoilage cost. D) Storage cost

A) The cost of carry is a measure of the storage costs of a commodity. The cost of carry is calculated as follows: financing costs + storage costs + spoilage costs. Collateral yield is not a component of the cost of carry.

Ed Ingus, equity analyst, visits the headquarters and main plant of Bullitt Company and observes that inventories of unsold goods appear unusually large. From the CFO, he learns that a recent increase in returned items may result in earnings for the current quarter that are below analysts' estimates. Based on his visit, Ingus changes his recommendation on Bullitt to "sell". Has Ingus violated the Standard concerning material nonpublic information? A) Yes. B) No, because the information he used is not material C) No, because his actions are consistent with the mosaic theory. D. No, because Bullitt executives willingly disclosed the information.

A) The statement from the CFO about the current quarter's earnings is material nonpublic information. Ingus violated Standard II(A): Material Nonpublic Information by acting or causing others to act on it.

Which of the following factors is least likely to drive the correlations between firm returns and the price changes for the associated commodities of those firms? A) The operating firm's use of leverage. B) Price elasticity of the good's supply. C) Price elasticity of the good's demand. D) Operating firm's hedging of revenues and expenses

A) There are three primary factors that drive the correlations between price changes for the associated commodities of firms and the returns of these same firms: • The price elasticity of the good's demand • The price elasticity of the good's supply • The extent that an operating firm has exposure to the commodity (i.e., does the firm hedge its exposure and how reliant is the firm's operations on the good)

Define active management.

Active management refers to efforts of buying and selling securities in pursuit of superior combinations of risk and return.

How do agency risks and political risks relate to institutional ownership of farmland?

Agency risk is the economic dispersion resulting from the consequences of having another party (the agent) making decisions contrary to the preferences of the owner (the principal) In the case of farmland, the agency risk is the possibility, and perhaps the likelihood, that a farmer will fail to maximize the net economic benefits to the owner. Political risk is economic uncertainty caused by changes in government policy that may affect returns, perhaps dramatically. Political risk can arise both from government's failure to take beneficial actions and its initiation of harmful actions. For example, political risk of farmland ownership includes the risk that the government will terminate support payments, such as corn ethanol subsidies, and the risk that the government will abrogate ownership rights or expropriate land, as reportedly occurred in recent years in Venezuela.

What is the primary challenge that causes difficulty in calculating the return performance of a forward contract or another position that requires no net investment? How is that challenge addressed?

Alternative investing often includes assets for which there is no clear starting value other than perhaps zero. Examples can include derivative contracts, such as forward contracts and swaps. The return on notional principal divides economic gain or loss by the notional principal of the contract. Notional principal or notional value of a contract is the value of the asset underlying, or used as a reference to, the contract or derivative position.

Describe an incomplete market.

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.

Explain how and why an increase in the portion of loans that are covenant-lite will affect default rates and the magnitude of losses given default.

An increase in covenant-lite loans will likely lead to higher default rates and lower recovery rates. Covenants protect the creditor's interests by requiring the borrower to comply with certain requirements, such as maintaining a debt service coverage ratio, or prohibit them from certain actions, such as increasing their debt load or issuing higher seniority debt. Not having these covenants could cause the company to over-lever and, in the event of a default, could increase the risk to the creditor in the bankruptcy process.

What is the name of the point in a decision tree at which new information arrives?

An information node denotes a point in a decision tree at which new information arrives.

How do agency risks and political risks relate to institutional ownership of farmland?

An investor in farmland does not necessarily actively manage the crops. As such, the investor relies on payment from the lessee (the agent) that operates the property. That risk that the lessor (the principal or investor) does not get paid by the agent is agency risk. Political risk is the economic uncertainty due to changes in government policy that may affect returns. The investor in farmland can be hurt by such political issues such as decreases in support payments or changes in land ownership rights.

What is the "option" in an option adjustable-rate mortgage loan?

An option adjustable-rate mortgage loan (option ARM) is an adjustable-rate mortgage that provides borrowers with the flexibility to make one of several possible payments on their mortgage every month. The payment alternatives from which borrowers may select each month typically include an interest-only payment, one or more payments based on given amortization periods, or a prespecified minimum payment amount.

Describe the difference between an analytical solution and a solution estimated with numerical methods.

Analytical solutions such as the Black-Scholes model are exact, because the model can be solved using a finite set of common mathematical operations. A solution estimated with numerical methods is not exact. It utilizes a potentially complex set of procedures to form an estimate.

Which of the following participants is LEAST LIKELY to be classified as an outside service provider to a fund: Arbitrageurs, accountants, auditors, or attorneys?

Arbitrageurs

Which of the following participants is LEAST Likely to be classified as an outside service provider to a fund: Arbitrageurs, accountants, auditors, or attorneys?

Arbitrageurs

What is the term used to describe a framework for specifying the return or price of an asset, based on its risk as well as future cash flows and payoffs?

Asset Pricing Model

What is the term used to describe a framework for specifying the return or price of an asset based on its risk, as well as future cash flows and payoffs?

Asset pricing model.

Autoregressive

Autoregressive refers to when subsequent values to a variable are explained by past values of the same variable.

Why would an analyst want to use a relative pricing model? A) They want to include consensus views on unemployment in their pricing methodology. B) They want to ignore probability in their model. C) They believe in their ability to reliably make forecasts and estimates. D) They are valuing the price of an individual stock.

B) A relative pricing model does not use probabilities is considering outcomes. It focuses on price relationships relative to another asset. Absolute pricing models consider estimates, fundamental factors, and probabilities.

Which of the following statements about the Standard of misconduct is most accurate? A) Misconduct applies only to a member or candidate's professional activities. B) Neglecting to perform due diligence when required is an example of misconduct. C) A member or a candidate commits misconduct by engaging in any illegal activity. D) When possible, a member or a candidate must attempt to invest in socially responsible companies.

B) Failing to act when required by one's professional obligations, such as neglecting to perform due diligence related to an investment recommendation, violates Standard I(D): Misconduct. Acts as member commits outside his professional capacity are misconduct if they reflect poorly on the member's or candidates honesty, integrity or competence (e.g. theft or fraud). Violations of the law that do not reflect on the member's or candidates honesty, integrity, or competence (e.g., an act related to civil disobedience) are not necessarily regarded as misconduct. There is no requirement for members or candidates to invest in socially responsible companies.

A test that always correctly identifies a false null hypothesis most likely has: A) zero Type I error. B) zero Type II error. C) 100% Type I error. D) 100% Type II error.

B) If the test always identifies an untrue null hypothesis, then it never fails to reject an untrue hypothesis. A Type II error equals the probability of failing to reject an untrue null hypothesis. Therefore, if the test always correctly identifies a false null hypothesis, then there is no Type II error.

Consider a fund with a 2.5% ex ante alpha. Last year, the fund outperformed the market by 3% and outperformed funds with similar risk by 4%. What portion of the ex post alpha was generated purely by luck? A) 0.5%. B) 1.5%. C) 2.5%. D) 3.0%

B) Luck is the difference between ex post alpha and ex ante alpha (i.e., skill). We are given an ex ante alpha of 2.5% and can infer that the ex post alpha is 4.0%. Therefore, the portion attributable to luck is calculated as 0.04 - 0.025 = 0.015, or 1.5%.

Which of the following actions is a required, rather than recommended, action under the Standard regarding diligence and a reasonable basis for a firm's research recommendations? A) Compensate analysts based on a measure of the quality of their research. B) Review the assumptions used and evaluate the objectivity of third-party research reports. C). Have a policy requiring that research reports and recommendations have a basis that can be substantiated as reasonable and adequate. D) Have written procedures that provide a minimum acceptable level of scenario testing for computer-based models.

B) Standard V(A): Diligence and Reasonable Basis requires analysts who use third-party research to review its assumptions and evaluate the independence and objectivity of the research. The other choices are recommended procedures for compliance with the Standard.

What advantage does target semistandard deviation present relative to semistandard deviation? A) Target semistandard deviation directly measures the dollar loss below the mean result, which is a role that semistandard deviation does not conduct B) Target semistandard deviation enables a risk manager to measure expected deviation from a targeted return, which is central to the goals of many alternative asset managers. C) Target semistandard deviation measures peer group relative deviation while semistandard deviation measures benchmark relative deviation. D) Target semistandard deviation directly measures the dollar loss below a target value, which is a role that semistandard deviation does not conduct

B) Target semistandard deviation measures expected deviation relative to a goal (target). This enables risk managers to better understand potential volatility in percentage terms. Often, alternative asset managers need to measure results relative to a targeted return.

Which of the following is a characteristic of the Standard & Poor's Goldman Sachs Commodity Index (S&P GSCI)? A) The index follows only one commodity sector: energy. B) The index is a production-weighted index. C) Index weights are determined by trading data using five-year averages. D) Tier and component weights used to construct the index are subjective but intended to reflect their global economic importance

B) The Standard & Poor's Goldman Sachs Commodity Index (S&P GSCI) is a long-only, tradable index of 24 nearby physical commodity futures. It is a production-value weighted index, using five-year averages data to reflect the economic importance of each component. It includes precious metals, industrial metals, livestock, agriculture, and energy.

Why is the market for fixed income securities other than riskless bonds often termed the spread product market?

Because other U.S. dollar-denominated fixed income products, such as bank loans, high-yield bonds, investment grade corporate bonds, or emerging markets debt, trade at yields containing a credit spread relative to U.S. Treasury securities.

Which of the following statements about lognormal distribution is most accurate? The lognormal distribution: A) is symmetrical B) is skewed to the right C) includes both positive and negative values D) is useful for leveraged investments due to its range from negative infinity to positive infinity

B) The lognormal distribution is skewed to the right (and therefore not symmetrical). It contains only positive investment values (i.e. simple returns of -100% are largest possible loss)

Assume the risk-free rate equals 4% and the return on the derivative instrument equals 2%. Assuming continuous compounding, the partially collateralized return for a position with 20% collateral is closest to A) 6% B) 14% C) 34% D) 44%

B) The partially collateralized return is as follows: Rpcoll = [(1 / 0.2) × ln(1.02)] + 0.04 = 0.139 = 13.9%.

The value at risk (VaR) for a portfolio is the sum of the individual asset VaRs if the returns for the individual assets A) are perfectly negatively correlated. B) are perfectly positively correlated. C) are not correlated. D) follow an ARCH process.

B) The portfolio VaR equals the sum of the individual asset VaRs only if the returns for the individual assets are perfectly positively correlated.

Which of the following is NOT a way in which commercial mortgages differ from residential mortgages? A) Commercial mortgages are typically partially amortized, while residential mortgages are typically fully amortized. B) Commercial mortgages typically contain fewer covenants due to the greater sophistication of the borrowers. C) Commercial properties are more likely to generate cash flows. D) Commercial borrowers tend to be companies, while residential borrowers tend to be individuals

B) While covenants exist for residential mortgages, covenants for commercial mortgages are more detailed and abundant. The other answer choices are correct.

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?

Back office operations

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?

Back office operations

What is the primary difference between the motivations of creating a balance sheet CDO and creating an arbitrage CDO?

Balance sheet CDOs are created to assist a financial institution in divesting assets from its balance sheet. Arbitrage CDOs are created to attempt to exploit perceived opportunities to earn superior profits through money management.

Briefly summarize the evidence on whether the offering prices of structured products are over-priced or underpriced relative to the values of similar exposures composed of market-traded products.

Based on evidence, the offering prices of some structured products are over-priced to the values of similar exposures composed of market-traded products. 1) Deng and others (2011) find that the fair price of ARBNs "is approximately 4.5% below the actual issue price on average" 2) McCann and Luo estimate that "between 15% and 20% of the premium paid by investors is a transfer of wealth from unsophisticated investors to insurance companies and their sales forces"

What is the name of the following quantity: the spot price of a commodity minus a forward price on the commodity?

Basis

What is the term for investment products trying to deliver systematic risk exposure with an emphasis on doing so in a highly cost-effective manner?

Beta drivers (or passive indexers)

Approximately when did average-quality corporate bonds and international equities become commonly viewed as institutional-quality investments in the United States?

Between 1950 to 1980

What is the similarity between a structure product and the capital structure of an operating firm?

Both are used to structure risk (and longevity). The capital structure of an operating firm is used to structure risk in the business enterprise, whereas the structure product is used to structure risk of a financial portfolio.

How does a long position in an up-and-in call differ from a short position in a down-and-out put?

Both option positions are bullish, but the up-and-in call has a payoff that is positively correlated with the underlying asset only in the region above the strike price and barrier, while bullish payoff region of the short put position is below its strike price. The up-and-in call has unlimited profit potential while the profit potential of the short position in the down-and-out put is limited to the premium received.

What is a breakout strategy?

Breakout strategies focus on identifying the changes from a sideways market to the commencement of a new trend by observing the range of recent market prices (e.g. looking back at the range of prices over a specific time period).

How can one party to a CDS terminate credit exposure (other than counterparty risk) to a CDS without the consent of the counterparty to the CDS?

By entering an offsetting position, by assigning the contract to a dealer or other approved counterparty (with permission of the original counterparty), or by reaching an agreement with the original counterparty to mutually terminate the contract

How could a financial market become less complete?

By having a reduction in the number of unique investment opportunities or an increase in the number of uncertainties facing investors.

The correlation between successive ex post alphas for a hedge fund equals zero. Which of the following statements most accurately describes the performance of the hedge fund? A) The fund's investment results are attributed solely to managerial skill. B) The fund is a good diversifier. C) The fund's investment results are attributed solely to luck. D) The fund's investment results are attributed neither to skill nor to luck.

C) Abnormal return persistence refers to the tendency of idiosyncratic performance in one period to be correlated with the idiosyncratic performance in the subsequent period. A zero correlation suggests that performance is random from one period to the next, which is indicative of luck.

Which of the following is least likely to be a problem related to the return characteristics of alternative investments? A) Illiquidity. B) Inefficiency. C) Absolute returns. D) Non-normal returns.

C) Alternative investments exhibit different risk and return characteristics than traditional investments in therms of diversification, illiquidty, inefficiency, and return non-normality. Illiquidity creates uncertainty in the relationship between recent and expected prices for an asset. Inefficient markets may suffer from fewer participants, lower competition, higher transaction costs, and an inability to establish long or short positions. Non-normal return distributions create problems when utilizing traditional mean-variance portfolio optimization techniques. Absolute return products often provide uncorrelated returns and serve as diversifiers. This reduces risk without significantly modifying portfolio return expectations, which is a benefit of (not a problem with) alternative investment returns.

Which of the following statements best reflects an example of moral hazard that a partners wishes to reduce through a limited partnership agreement? A) Cooperation challenges between the general and limited partner. B) A limited partner who does not wish to be involved in the partnership's daily operations. C) A general partner whose compensation structure is based almost entirely on incentive fees. D) A general partner seeking investments that have negative correlations to traditional equity.

C) An example of a moral hazard is when the general partner has a significant portion of their compensation tied to performance and incentives, such that they may be inclined to take on a lot of risk to potentially earn higher returns. A limited partner should not be involved in the day-to-day operations of the partnership. It is appropriate for a general partner to look for investments with negative correlations to traditional equity.

An option strategy that combines a long put option with a higher strike price and short put option with a lower strike price is: A) a bull spread. B) a straddle. C) a bear spread. D) a covered call

C) An option strategy that combines a long put option with a higher strike price and a short put option with a lower strike price is a bear spread. The investor can benefit from the price decline of the underlying security starting at the higher strike price put, but bound by the lower strike price put. A bull spread is a long position in a lower strike price option and a short position in a higher strike price option. A straddle is a long (or short) position in both a call and a put on the same underlying security, with the same expiration date and same strike prices. A covered call combines a long position in the underlying security with a short call option on the same security (typically at a strike price above the market price).

A distribution of returns that has a greater percentage of small deviations from the mean and a greater percentage of extremely large deviations from the mean compared to a normal distribution: A) is positively skewed B) is negatively skewed C) has positive excess kurtosis D) has negative excess kurtosis

C) If the sample skewness exceeds zero, the distribution is positively skewed. In positively skewed distributions, the mean exceeds the median.

Sarah Johnson, a portfolio manager, is offered a bonus directly by a client if Johnson meets certain performance goals. To comply with the Standard that governs additional compensation arrangements, Johnson should: A) disclose this arrangement in writing to both her employer and her clients. B) decline to accept a bonus outside of her compensation from her employer. C) disclose this arrangement to her employer in writing and obtain her employer's permission. D) disclose this arrangement to her employer only if she actually meets the performance goals and receives the bonus.

C) Johnson should disclose her additional compensation arrangement in writing to her employer and obtain her employer's written consent before accepting this offer, in accordance with Standard IV(B): Additional Compensation Arrangements.

Which of the following statements regarding the tax characteristics of MLPs is most accurate? A) A disadvantage of MLPs is double taxation. B) An advantage of MLPs is the simplicity of filing the K-1 form. C) An advantage of MLPs is that profits are taxed but actual distributions are not. D) A disadvantage of MLPs is that the return of capital distributions is taxed initially and they lower the basis.

C) Profits flow down to MLP investors and they are taxed, regardless of whether any distributions have occurred. Distributions are not taxed. Double taxation is a significant disadvantage for C corporations rather than MLPs. The K-1 form is very complicated and often causes delays in the filing of investor tax returns. Return of capital distributions do lower tax basis for investors, but they are not taxed initially.

Which of the following least likely describes the trend in institutional investing over the last century? A) Government debt was popular prior to 1920. B) Agricultural debt was a common investment in the first half of the 20th century. C) Real estate did not become a key part of institutional investor portfolios until the 1980s. D) Modern portfolio theory heavily impacted investment decisions beginning in the 1950s.

C) Real estate was a popular investment for institutional portfolios prior to 1920. Even though alternative investments as an asset class gained in popularity in the 1980s, real estate on its own was popular well before the latter half of the century. Government and agricultural debt was popular during the first half of the 20th century, and modern portfolio theory and the concept of diversification began to take hold in the 1950s.

Assuming an annual interest rate of 5%, the Hotelling theory predicts that the price of: A) a $100 bushel of grain will be $105 in one year. B) a $100 bushel of grain will be greater than $105 in one year. C) a $45 barrel of oil will be $47.25 in one year. D) a $45 barrel of oil will be greater than $47.25 in one year.

C) The Hotelling theory predicts that the price of an exhaustible commodity such as oil will increase at the rate of interest. As a result, the price of oil should increase by 5% in one year, from $45 to $47.25. Grain is a nonexhaustible commodity.

The Sortino ratio is best defined as a portfolio's excess return per unit of: A) total risk. B) systematic risk. C) downside risk. D) tracking error

C) The Sortino ratio scales a portfolio's excess returns to target semistandard deviation (TSSD), which is also known as downside risk.

The TVPI for the Archid Private Equity Fund is 13.90%. Cumulative contributions to the plan are $4.3 million, and cumulative distributions total $206,400. Which of the following statements is most accurate A) The RVPI is equal to 4.80%. B) The DPI is equal to 9.10%. C) The total value of unrealized investments is $391,300. D) The total realized return is $597,700

C) The TVPI of 13.90% will consist of the DPI and the RVPI. The DPI is equal to 4.80%, which is the cumulative distributions of $206,400 divided by the cumulative contributions of $4,300,000. The remaining portion of the 13.90% TVPI is the RVPI, which must be 9.10%. A 9.10% RVPI on a base of $4,300,000 in contributions implies an unrealized investment value of $391,300.

An investor holds a nine-month t-bill with a market price of $981.50. If the one-year t-bill has a market price of $976.25, the forward price of a three-month t-bill to be delivered in nine months is closest A) $978.88 B) $986.75 C) $994.65 D) $1,005.38

C) The forward price of a three-month T-bill to be delivered in one year is going to be the amount that will make the following equation work: [(($981.50)(F)) / 1,000] = $976.25. Using algebra, then ($976.25 / $981.50) × 1,000 = $994.65. In theory, the combination of a nine-month T-bill at $981.50 and the forward price of $994.65 for a three-month T-bill to be delivered in one year is valued the same as a one-year T-bill at $976.25.

An investor takes a short position of five shares of XYZ stock at $50 per share. The terms from the lender include collateral of 102% and a rebate of 1.2%. XYZ pays a dividend of $2 per year. After one year, the price goes up to $55 and the transaction is closed. If the fees are $0.10 per share per trade, what is the total loss on the position for the investor?

C) The total loss calculation consists of four components. The stock price increasing from $50 to $55, for five shares, equals a $25 capital loss. The dividend of $2 per share on five shares results in a $10 loss. The rebate of 1.2% of $250 ($50 x five shares) is $3, which is an offset to the loss. And finally, fees of $0.10 per share on five shares equals $0.50. So, the total loss is calculated as: $25 + $10 - $3 + $0.50 = $32.50

Observation of fixed-income markets suggests that mispricings sometimes exist. These arbitrage opportunities are linked with which theory? A) Unbiased expectations theory. B) Liquidity preference theory. C) Market segmentation theory. D) Arbitrage pricing theor

C) Unbiased expectations theory suggests no arbitrage opportunities should exist because all bonds of different maturities offer the same return over a given investment horizon. Liquidity preference theory suggests that longer-term bonds should have higher risk premiums than shorter-term bonds. Market segmentation theory points to localized mispricings due to differing investor preferences.

A trader has a long position with an initial margin requirement of $22,000 and maintenance margin requirement of $17,500. A decline in the value of the underlying asset results in a loss of $10,000. The amount of margin that the trader must deposit is closest to: A) $4,500 B) $7,500 C) $10,000 D) $12,000

C) When a loss in a trading position causes the margin balance to fall below the maintenance margin level, the margin call will require the trader to deposit enough to get the balance back to the initial margin level. Here, the loss of $10,000 will cause the margin balance to decline from $22,000 to $12,000 (below the required level of $17,500). The trader will be required to deposit $10,000 to bring the balance back up to the initial margin requirement of $22,000.

What CDS product should an investor consider when attempting to hedge the credit risk of a very large portfolio of credit risks rather than the hedge a few issues?

CDS index products.

What is the equation for put-call parity?

Call + bond - Put = Underlying Asset

What is the primary distinction between Chapter 7 bankruptcy and Chapter 11 bankruptcy in the US?

Chapter 7 bankruptcy is where the company is no longer viewed as a viable business and the assets of the firm are liquidated. Chapter 11 bankruptcy attempts to maintain operations of a distressed corporation that may be viable as a going concern.

What is a commodity trading adviser (CTA)?

Commodity trading advisers (CTAs) are professional money managers who specialize in the futures markets.

What is a commodity trading advisor (CTA)?

Commodity trading advisers (CTAs) are professional money managers who specialize in the futures markets.

What are the steps involved in directly estimating VaR from historical data rather than through a parametric technique?

Consider a data set with a long-term history of deviations of an ETF's return from its mean return. We wish to estimate a five-day 99% VaR. We might collect the daily percentage price changes of the ETF for the past 5,000 days and use them to form 1,000 periods of five days each. We then rank the five-day deviations from the highest to the lowest. Suppose we find that exactly 10 of these 1,000 periods had price drops of more than 6.8%, and all the rest of the periods (99%) had better performance. The 99% five-day VaR for our ETF position could then be estimated at 6.8% of the portfolio's current value, under the assumption that past price changes are representative of future price changes.

Describe consolidation in the hedge fund industry in recent years.

Consolidation in the hedge fund industry has been manifested in much higher percentages of assets being invested with the biggest funds. Institutional investors are showing a clear preference for the largest funds.

What is contagion in financial market?

Contagion is the general term used in finance to indicate any tendency of major market movements, especially declines, to be transmitted from one financial market to other financial markets.

What is contagion in a financial market?

Contagion is the general term used in finance to indicate any tendency of major market movements—especially declines in prices or increases in volatility—to be transmitted from one financial market or sector to other financial markets or sectors.

When do convergent strategies generate profit?

Convergent strategies profit when relative value spreads move tighter, meaning that two securities move toward relative values that are perceived to be more appropriate. This tends to be associate with calm markets rather than turbulent markets.

Why would activist hedge fund managers need to understand corporage governance?

Corporate governance is central to the activist hedge fund's investment strategy as it is the means to assert change or threat of change into the management of the target corporation.

The process of comparing a portfolio's return to multiple factors is known as: A) benchmarking, in general. B) peer group analysis C) index benchmarking D) portfolio attribution

D) Benchmarking is the overall process of comparing a portfolio's return to a reference point. It could be either peer group relative or index relative. These are both single-variable options. However, portfolio attribution considers multiple factors and their granular impact on portfolio returns. This is the highest level of detail available.

What is the term that describes additional equity being issued at below-market values, causing the per-share value of the holdings of existing shareholders to be diminished?

Dilution

An analyst using a currency option pricing model derived from the Black-Scholes model will incorporate into the model: A) one currency and one risk-free interest rate. B) one currency and two risk-free interest rates. C) two currencies and one risk-free interest rate. D) two currencies and two risk-free interest rates.

D) A currency option pricing model is used to value the option price for exchanging one currency at one risk-free interest rate for another currency at a different risk-free interest rate. Therefore, the model will incorporate two currencies and two risk-free rates.

A liquid alternative fund that focuses on passive positive returns that have a low correlation to U.S. equities and has limited leverage levels is most likely to be classified as: A) A replication fund. B) A constrained clone. C) An unconstrained clone D) A diversified/absolute return fund

D) A liquid alternative investment fund that focuses on earning positive returns regardless of the investment environment and focuses on ensuring low correlation with traditional investments should be categorized as a diversified/absolute return product.

Bill Cooper finds a table of historical bond yields on the website of the U.S. Treasury that supports the work he has done in his analysis and includes the table as part of his report without citing the source. Has Cooper violated the Code and Standards? A) Yes, because he did not cite the source of the table. B) Yes, because he did not verify the accuracy of the information. C) Yes, because he failed to request and receive permission to reproduce the data. D) No, because the table is from a recognized source of financial or statistical data.

D) According to Standard I(C): Misrepresentation, members and candidates must cite the sources of information they use in their analysis, unless the information is factual data (as opposed to analysis or opinion) from a recognized financial or statistical reporting service. The U.S. Treasury is one example of a recognized source of factual data.

The process of comparing a portfolio's return to multiple factors is known as: A) benchmarking, in general. B) peer group analysis. C) index benchmarking. D) portfolio attribution.

What is the term that describes when additional equity is issued at below market values causing the per share value of the holdings of existing shareholders to be diminished?

Dilution

Which of the following best describes commodity exposure to event risk? A) Commodity prices tend to increase as a result of exposure to economic events that increase supply. B) Commodity prices tend to decrease initially after an economic event but then increase over the long term. C) Commodity prices are generally unaffected by event risk, allowing them to serve as defensive investments. D) Commodity prices tend to benefit from events that hurt stock and bond prices.

D) Events that benefit commodities tend to hurt stocks and bonds through reductions in raw materials. As a result, commodity returns tend to be uncorrelated or negatively correlated with financial assets.

If an options trader is most concerned about the sensitivity of an option's delta to the change in the underlying asset price, she will focus on: A) rho. B) vega. C) delta. D) gamma

D) Gamma is the second derivative of the option price sensitivity to changes in the underlying asset price, and it represents the rate of change of the option delta relative to the underlying asset price. Rho measures option sensitivity to interest rate changes, vega measures option sensitivity to underlying asset volatility, and delta is the change in the option price relative to the change in the underlying

A successful venture capital project is preparing for its IPO. Which of the following statements regarding this process is most accurate? A) Existing owners of the venture capital project will be forced to liquidate their entire investment before the IPO. B) Regulations prohibit retail banks, but not dealer banks, from serving as underwriters for new securities. C) If the firm would like to be listed on non-U.S. exchanges, an American depository receipt (ADR) would need to be created for the firm's securities. D) While the issuing firm receives the proceeds of the securities sale, the underwriter is responsible for origination, risk bearing, and distribution of the securities.

D) If a venture capital project goes public, owners will sell part or all of their ownership in the venture. For IPOs, an underwriter is responsible for origination (design, planning, and registration of the issue), risk bearing (underwriter insures or guarantees the prices by purchasing the securities), and distribution (sale of the issue), while the issuing firm receives the proceeds of the sale. In primary markets, dealer banks and retail brokers play a crucial role in that they both may serve as underwriters, intermediaries, and liquidity providers. Global depository receipts (not ADRs) would be used if the firm chose to list its securities on a non-U.S. exchange.

A stock pays a continuously compounded dividend of 2.75%. The riskless rate for a forward contract on the stock is 25 basis points lower than the dividend rate. The forward curve applicable to this situation will be: A) flat. B) vertical C) upward sloping D) downward sloping

D) If the riskless rate is below the dividend yield (which is the case here), r < q, and the forward price will be less than the spot price. As a result, the forward curve will be downward sloping.

An analyst conducts a test of the null hypothesis that a fund's monthly average alpha equals zero. The analyst runs the test over a large sample of months and finds that the test statistic is less than its critical value. Which of the following summarizes the conclusion that the analyst should reach? A) Accept the null hypothesis. B) Reject the null hypothesis. C) Fail to reject the alternative hypothesis. D) Fail to reject the null hypothesis

D) If the test statistic is less than the critical value, then the test statistic is not large enough to reject the null hypothesis. Therefore, the analyst should fail to reject the null hypothesis.

The combined costs of producing a film are often called: A) the negative costs because the signs of all prebox office cash flows are negative. B) the slate costs because it is the slate of expenses that is required to get the film ready for distribution. C) the preproduction costs because the largest part of the costs occurs before initial print of the film. D) the negative costs because they were all the costs required to produce the film negative before the digital era of filmmaking

D) Negative costs are the combined costs to create a film. The word "negative" does not refer to the signs of the cash flows but to the fact that these were the costs to create the film negative in the predigital era.

Analyst Edwin Douglas studies a group of funds attempting to identify funds that perform well. The funds examined by Douglas have identical systematic risks. Douglas finds that 20 managers out of 100 produced significantly better-than-average performances. From his results, Douglas concludes that some of the superior performance is attributable to skill. Analyst Sharon Smith examines a group of funds with dissimilar systematic risks and estimates ex post alphas using a multifactor asset pricing model. Smith concludes that a statistically positive alpha indicates that the fund earned an above-average risk-adjusted return. Which of the analysts have drawn a correct conclusion? A) The conclusions of both Douglas and Smith are correct. B) The conclusion of Douglas is incorrect, while the conclusion of Smith is correct. C) The conclusion of Douglas is correct, while the conclusion of Smith is incorrect. D) The conclusions of both Douglas and Smith are incorrect

D) Neither conclusion is correct. Douglas should have examined returns using a risk-adjusted benchmark, rather than comparing funds to each other. It is possible that none of the sampled fund managers possess skill. Smith's conclusion also is incorrect. The test conducted by Smith is a test of the joint hypothesis that her multifactor model is properly specified and the alpha is zero. A rejection of the null hypothesis could merely indicate that her model has been rejected.

What are the names of the first and second derivatives of an option price with respect to the price of the option's underlying asset?

Delta and gamma

What is the difference between delta and theta in measuring the price sensitivity of an option?

Delta is the change in the value of the option with respect to a change in the value of the underlying asset, whereas theta is the change in the value of the option with respect to the time to expiration of the option (i.e., passage of time).

What is the general term denoting compound interest when the interest is not continuously compounded?

Discrete compounding

What is the general term denoting compound interest when the interest is not continuously compounding?

Discrete compounding

Distinguish discretionary fund trading from systematic fund trading.

Discretionary fund trading occurs when the decisions of the investment process are made according to the judgment of human traders. Systematic fund trading, often referred to as black-box model trading because the details are hidden in complex software, occurs when the ongoing trading decisions of the investment process are automatically generated by computer programs.

By what standards or measures is distressed debt usually distinguished from non-distressed debt?

Distressed debt is often defined as debt that has deteriorated in quality since issued and that: has a market price less than half its principal value, yields 1,000 or more basis points over the riskless rate, or has a credit rating of CCC (Caa) or lower.

Name the four return characteristics that differentiate traditional and alternative investments.

Diversification, Illiquidity, Inefficiency, and Nonnormality.

Is an IRR a dollar-weighted return or a time-weighted return? Why?

Dollar-weighted returns are averaged returns that are adjusted for and therefore reflect when cash has been contributed or withdrawn during the averaging period. The IRR is the primary method of computing a dollar-weighted return.

What are the differences between duration, modified duration, and effective duration?

Duration is a measure of the sensitivity of a fixed-income security to a change in the general level of interest rates. Modified duration is equal to traditional duration divided by the quantity [1 + (y/m)], where y is the stated annual yield, m is the number of compounding periods per year, and y/m is the periodic yield. Effective duration is a measure of the interest rate sensitivity of a position that includes the effects of embedded option characteristics.

What are the three terms used to describe convertible bonds differentiated by whether their implicit option is in-the-money, at-the-money, or out-of-the-money?

Equity like convertibles, hybrid convertibles, and busted convertibles

Name the three major types of equity hedge funds, and describe their typical systematic risk exposures.

Equity long/short funds tend to have net positive systematic risk exposure from taking a net long position, with the long positions being larger than the short positions. Equity market-neutral funds attempt to balance short and long positions, ideally matching the beta exposure of the long and short positions and leaving the fund relatively insensitive to changes in the underlying stock market index. Finally, short-bias funds have larger short positions than long positions, leaving a persistent net short position relative to the market index that allows these funds to profit during times of declining equity prices.

What are the three terms used to describe convertible bonds differentiated by whether the implicit option in the bond is in-the-money, at-the-money, or out-of-the-money?

Equity-like convertible, hybrid convertibles, busted convertibles, respectively.

Why are event-driven hedge funds often characterized as selling insurance?

Event-driven hedge funds are often characterized as selling insurance because they purchase shares during the period near an event (such as a proposed merger announcement) and the eventual resolution of uncertainty regarding the event. This act may be viewed as providing event risk insurance to the equity market.

Describe the difference between an ex ante return and an ex post return in the case of a financial asset.

Ex ante returns are the future possible (anticipated) returns. Ex post returns are the realized returns.

Describe the difference between an ex ante return and an ex post return in the case of a financial asset.

Ex post returns are realized outcomes rather tan anticipated outcomes. Future possible returns and their probabilities are referred to as expectational or ex ante returns.

Which of the following is least likely associated with beta nonstationarity? A) Beta expansion B) Beta creep C) Market timing D) Beta driver

Examples of beta nonstationarity include beta creep, beta expansion, and market timing. Beta drivers refer to a process of delivering beta cheaply and efficiently.

In a market trending upward, explain how the value of a simple moving average compares to the value of an exponential moving average.

Exponential moving averages (EMAs) are weighted toward the most recent prices, but the rate of decrease between one price and its preceding price is not consistent. The difference in the decrease is exponential.

In a market trending upward, explain how the value of a simple moving average compares to the value of an exponential moving average?

Exponential moving averages place higher weights on more recent observations for typical values of the exponential weighting parameter. If prices are trending upward the exponential moving average will tend to recognize an upward trend more quickly and more profoundly due to the higher weight on the more recent (and higher) prices.

What is fee bias?

Fee bias is when index returns overstate what a new investor can obtain in the hedge fund marketplace because the fees used to estimate index returns are lower than the typical fees that a new investor would pay.

In terms of financial regulation, what is the FCA?

Financial Conduct Authority - the primary regulator of financial services in the UK.

What is the financing risk in the context of an event-driven investment strategy?

Financing risk is the economic dispersion caused by failure or potential failure of an entity, such as an acquiring firm, to secure the funding necessary to consummate a plan such as an acquisition.

What is the effects of smoothed or stale asset values on the estimates of long-term average returns?

For large samples there would typically be only a small difference between mean based on stale returns and the mean based on true returns, so the use of stale valuation tends to have little effect on the estimations of long-run returns.

What is the effect of smoothed or stale asset values on the estimation of long-term average returns?

For large samples there would typically be only a small difference between the mean based on stale returns and the mean based on true returns, so the use of stale valuation tends to have little effect on estimations of long-run returns. This is important information to understand when stale (or smoothed) return series are used.

Which is likely to be more liquid, a forward contract or a futures contract?

Futures Contracts

What is the general statistical issue addressed when the GARCH method is used in a time-series analysis of returns?

GARCH (generalized autoregressive conditional heteroskedasticity) is an example of a time-series method that adjusts for varying volatility.

Describe the strategy of a global macro fund.

Global macro funds have the broadest investment universe: They are not limited by market segment, industry sector, geographic region, financial market, or currency and therefore tend to offer high diversification. They search diverse markets for perceived opportunities to achieve attractive returns.

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.

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.

Name assets that are often characterized as traditional by some and as alternatives by others for each of the following categories: hedge funds, private equity, and real assets.

Hedge Funds = Liquid Alternative Mutual Funds Private Equity = Closed End Funds with illiquid holdings Real Assets = Public real estate and public equities of corporations with performance dominated by stable positions in real assets

List the three major types of alternative investments other than real assets in the CAIA curriculum.

Hedge Funds, Private Equity/Private Credit, Structured Products (including credit derivatives)

List the three major types of alternative investments other than real assets in the CAIA curriculum.

Hedge funds, Private Equity, and Structured Products

Heteroskedasticity

Heteroskedasticity is when the variance of a variable changes with respect to a variable, such as itself or time.

Homoskedasticity

Homoskedasticity is when the variance of a variable is constant.

Explain the implications of Hotelling's Theory of long-term commodity prices.

Hotelling's theory states that prices of exhaustible commodities, such as various forms of energy and metals, should increase by the prevailing nominal interest rate - perhaps with a risk premium. Therefore, ignoring storage costs, expected spot prices of a commodity should be equal to the future value of the current spot price compounded at the nominal riskless rate plus a risk premium.

Explain the implications of Hotelling's Theory on long-term commodity prices.

Hotelling's theory states that prices of exhaustible commodities, such as various forms of energy and metals, should increase by the prevailing nominal interest rate—perhaps with a risk premium.

What is an example of a perverse incentive caused by incentive fees?

If a fund experiences negative returns within a reporting period, the fund's managers may view the fund as likely to close, in which case the managers may have a strong incentive to take excessive risks in an attempt to recoup losses and stay in business. Even if the managers do not fear that the fund will close, the fund's NAV falls substantially below its HWM, the managers may foresee no realistic chance of earning incentive fees in the near term unless the fund's risk is increased. Thus, an incentive fee structure may encourage enormous and inappropriate risk taking by the managers.

How would a large increase in the kurtosis of a return distribution affect its shape?

If a return distribution has positive excess kurtosis, meaning it has more kurtosis than the normal distribution, it is said to be leptokurtic, leptokurtotic, or fat tailed, and to exhibit leptokurtosis.

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?

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.

What is the primary difference between a fund of funds and a multi-strategy fund?

In a multistrategy fund, there is a single layer of fees, and the submanagers are part of the same organization. The underlying components of a fund of funds are themselves hedge funds with independently organized managers and with a second layer of hedge fund fees to compensate the manager for activities relating to portfolio construction, monitoring, and oversight.

In normal distributions, the standard deviation is approximately equal to: A) the mean absolute deviation B) 1.25 multiplied by the mean absolute deviation C) 1.65 multiplied by the mean absolute deviation D) 2 multiplied by the mean absolute deviation

In a normal distribution, the standard deviation is approximately equal to 1.25 multiplied by the mean absolute deviation.

From an investor's viewpoint, what is the difference between owning a tranche in a sequential-pay CMO and a tranche in a targeted amortization class CMO in a rising interest rate environment?

In a sequential-pay CMO the order or prepayment does not change: the senior most tranche is paid first, the next senior tranche second, and so on. In the targeted amortization class CMO the tranches receive payments in accordance with a more complex priority that changes with major changes in prepayment speeds such that various tranches may experience substantial increases or decreases in seniority in receiving cash distributions.

How many tranches can be in a single-tranche CDO?

In a single-tranche CDO, the CDO may have multiple tranches but the sponsor issues (sells) only one tranche from the capital structure to an outside investor.

Using statistical terminology, what does the volatility of a return mean?

In investment terminology, volatility is a popular term that is used synonymously with the standard deviation of returns.

How would the exposure to credit risk of the most senior and most junior tranches of a CDO tend to compare to the average credit risk of the collateral pool?

In one sense the tranches should have credit risks that are dispersed above and below the credit risk of the underlying assets. The amount of credit risk in the senior tranches would be lower than in the collateral pool. The credit risk of the most junior tranche would be higher than the credit risk of the collateral pool. Diversification and credit enhancements make the relationship complex.

What is the primary difference between a total return swap on an asset with credit risk and a credit default swap on that same asset?

In the case of a credit default swap, the credit protection buyer makes fixed payments, known as the swap premium, to the credit protection seller. In the case of a total return swap, the credit protection buyer makes payments to the credit protection seller based on the total market return of the underlying asset. The total market return is comprised of any coupon payments and any change in the underlying bond's market price.

Contrast the kurtosis and the excess kurtosis of the normal distribution.

In the case of a normally distributed variable, the estimated kurtosis has a value that approaches 3.0 (as the sample size is increased). The second adjustment that analysts often perform to create a more intuitive measure of kurtosis is to subtract 3.0 from the result to derive a measure, known as excess kurtosis. Excess kurtosis provides a more intuitive measure of kurtosis relative to the normal distribution because it has a value of zero in the case of the normal distribution. Since 3.0 is the kurtosis of a normally distributed variable, after subtracting 3.0 from the kurtosis, a positive excess kurtosis signals a level of kurtosis that is higher than observed in a normally distributed variable, an excess kurtosis of 0.0 indicates a level of kurtosis similar to that of a normally distributed variable, and a negative excess kurtosis signals a level of kurtosis that is lower than that observed in a normally distributed variable.

In the case of a financial asset with returns that have autocorrelation approaching +1, what is the relationship between the standard deviation of the asset's monthly returns and the standard deviation of the asset's annual return?

In the perfectly correlated case the standard deviation of a multiperiod return is proportional to T. In the case the annual vol is 12 times the monthly vol.

How does the numerator of a pretax discounting approach differ from the numerator of an after-tax discounting approach?

In the pretax discounting approach, pre-tax cash flows are used in the numerator. In the after-tax discounting approach the estimated after-tax cash flows are used in the numerator.

To what extent have gold prices driven the equity values of gold mining firms based on data from the during the financial crisis in late 2008?

In the short run, it appeared that the operationally-intensive firms related to gold production were driven more by the volatility of the equity markets than by the volatility of the gold prices.

Describe an incomplete market.

Incomplete markets refer to markets with insufficient distinct investment opportunities.

List four major types of real assets other than land and other types of real estate.

Infrastructure, Intellectual Property, Commodities, Natural Resources

Define investment

Investment is deferred consumption

What does the modified Fisher equation express regarding minimal interest rate determinants?

It expresses the nominal interest rate as the combination of the after-tax real interest rate, r, and the anticipated rate of inflation, with an adjustment for income tax.

Is subordination an internal or external credit enhancement?

It is an internal credit enhancement involving the structure of the product.

When is Monte Carlo analysis most appropriate as an estimation technique?

It is best used in difficult problems where it is not practical to find expected values and standard deviations using mathematical solutions.

What does it mean to bootstrap a yield curve?

It is the process of recursively estimating spot rates using one or more zero-coupon bonds on the short end and coupon bonds on the medium- and long-term regions of the term structure.

Describe the intuition of Jensen's alpha.

Jensen's alpha is a direct measure of the absolute amount by which an asset is estimated to outperform, if positive, the return on efficiently priced assets of equal systematic risk in a single- factor market model.

How would a large increase in the kurtosis of a return distribution affect its shape?

Kurtosis is typically viewed as capturing the fatness of the tails of a distribution, with high values of kurtosis, or positive values of excess kurtosis, indicating fatter tails (i.e. higher probabilities of extreme outcomes) than is found in the case of a normally distributed variable. Kurtosis can also be viewed as indicating the peakedness of a distribution, with a sharp narrow peak in teh center being associated with high values of kurtosis, or positive values of excess kurtosis.

Contrast the kurtosis and the excess kurtosis of the normal distribution.

Kurtosis serves as an indicator of the peaks and tails of a distribution. In the case of a normally-distributed variable the kurtosis is 3. Excess kurtosis is equal to kurtosis minus 3. Thus a normally distributed variable has an excess kurtosis of 0. Excess kurtosis provides a more intuitive measure of kurtosis relative to the normal distribution since it varies around zero to indicate kurtosis that is larger (positive) or smaller (negative) than the case of the normal distribution.

What is the relationship between the recovery rate and the loss given default?

Loss given default (LGD) = (1-RR), where RR = the recovery rate

Why are most listed MLPs in the U.S. involved in producing, processing and distributing energy products?

MLPs receive tax treatment predicated on adhering to regulations, including that at least 90% of the entities' revenues come from specified businesses, such as energy (in the U.S.)

Describe the strategy of a managed futures.

Managed futures refers to active trading of futures and forward contracts on physical commodities, financial assets, and exchange rates. The purpose of the managed futures industry is to enable investors to receive the risk and return of active management with the futures market, while enhancing returns and diversification.

How can managerial coinvesting contribute to optimal contracting?

Managerial coinvesting is an agreement between fund managers and fund investors that the managers will invest their own money in the fund. The idea is that by having their own money in the fund, managers will work hard to generate high returns and control risk, thus aligning interests (optimal contracting).

What does market risk mean in the context of macro investing?

Market risk refers to exposure to directional moves in general market price levels. Macro funds typically do not focus on equity markets, as equities can be highly influenced by microeconomic factors, such as company-specific events. However, macro funds can take substantial and concentrated risks in currency, commodity, and sovereign debt markets, especially when it is believed that changes in governmental policies will lead to large moves in the underlying markets.

What does market risk mean in context of macro investing?

Market risk refers to exposure to directional moves in general market price levels. The definition is this context is not restricted to equity market risk.

What distinguishes mean neutrality from variance neutrality in equity market-neutral strategies?

Mean neutrality is when a portfolio is shown to have zero bet exposure or correlation to the underlying market index. In other words, when the market experiences a move in one direction, mean-neutral portfolios are no more likely to move in the same direction as in the opposite direction. Variance neutrality is when portfolio returns are uncorrelated to changes in market risk.

Briefly describe mezzanine financing.

Mezzanine debt derives its name from its position in the capital structure of a firm: between the ceiling of senior secured debt and the floor of equity. Mezzanine finance defines generalization. Mezzanine financing is highly customized, often focused on equity appreciation while still maintaining the characteristics of (usually, high yield) debt, i.e. principal and interest payments.

What is a qualified majority?

More than 75% of LPs voting to make a decision (e.g., the decision to extend the investment period or the fund's distribution.

Conditionally Heteroskedastic

Most financial market prices are conditionally heteroskedastic, meaning that they have different levels of return variation even when specified conditions are similar (e.g., when they are viewed at similar price levels).

What is the name of the modeling approach that combines the factor scores of a number of independent anomaly signals into a single trading signal?

Multiple-factor scoring models.

Why might the incentive fees of a multistrategy fund differ substantially from the incentive fees of an otherwise similar fund of funds even if the stated fees are equal?

Multistrategy funds net the profits and losses of all underlying investment to determine any profit on which an incentive fee is paid. Funds of funds structures pay out incentive fees to each underlying manager separately, meaning that the profitable fund managers receive full incentive fees but there is no offset to aggregate incentive fees due to underlying managers with losses.

List the four major types of real assets other than land and other types of real estate.

Natural resources, commodities, infrastructure, and intellectual property.

Define net operating income

Net operating income (NOI) is a measure of periodic earnings that is calculated as the property's rental income minus all expenses associated with maintaining and operating the property.

Define net operating income.

Net operating income (NOI) is a measure of periodic earnings that is calculated as the property's rental income minus all expenses associated with maintaining and operating the property.

Is Form 13F a U.S.-required form that is targeted towards activist hedge funds?

No, Form 13F is a required quarterly filing of all long positions by all U.S. asset managers who over $100m in assets under management, including hedge funds and mutual funds, among other investors.

An analyst computes the IRR of one 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%?

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.

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%?

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.

In an informationally efficient market, can a structured product be engineered to offer both any payoff diagram shape and any payoff diagram level?

No. The level drives whether the opportunity has a positive, negative or zero net present value.

Do infrastructure assets need to have all seven of the elements that identify investable infrastructure? Why or why not?

No. There are no clear, hard lines separating infrastructure from other assets. Gray areas exist. Most infrastructure assets lack one or more of the seven elements, but they must contain many or most.

What is the name of the condition in which the expected spot price of a commodity in one year exceeds the one-year forward price of the commodity?

Normal backwardation

Does ex ante alpha lead to ex post alpha?

Not necessarily. While ex ante alpha may be viewed as expected idiosyncratic return, ex post alpha is realized idiosyncratic return. Simply put, ex post alpha is the extent to which an asset outperformed or underperformed its benchmark in a specified time period. Ex post alpha can be the result of luck and/or skill. To the extent that an investor suffers bad luck, ex ante will not guarantee ex post alpha.

What are the four inputs to the smiplified model of intellectual property values?

P = the probability of generating large positive cash flows CFI = Denote the first-year cash flows of the project g = perpetual growth r = discount rate

Fill in the blanks of the following sentence using the terms PE fund, PE firm, and underlying business enterprises: A______ serves as the general partner to a _______ that invests its money in _______.

PE firm, PE fund, Underlying business enterprises

What is the name of a lot of land that is vacant and approved for development but for which infrastructure construction has not commenced?

Paper Lot

What is the name of a lot of land that is vacant, approved for development but for which infrastructure construction has not commenced?

Paper lots

What is the primary term for financial arrangements that protect an investor's portfolio from tail risk?

Portfolio insurance

Is investable intellectual property a public good or a private good?

Private good because the cash generated can be privately received and owned.

List four major legal documents necessary for establishing and managing a hedge fund.

Private-placement memoranda, partnership agreement, subscription agreement, management company operating agreement.

List four major legal documents necessary for establishing and managing a hedge fund?

Private-placement memorandum, partnership agreement, subscription agreement, management company operating agreement

What is the term used to describe when a government entity sells a public asset to a private operator?

Privatization

What is the term used to describe when a governmental entity sells a public asset to a private operator?

Privatization

What is progressive taxation of income?

Progressive taxation places higher percentage taxation on individuals and corporations with higher incomes.

What distinguishes use of the term pure arbitrage from the more general usage of the term arbitrage?

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 distinguishes use of the term pure arbitrage from the more general use of the term arbitrage

Pure arbitrage is the attempt to earn risk-free profits through the simultaneous purchase and sale of identical positions trading at different prices in different markets. Modern finance often derives pricing relationships based on the idea that the actions of arbitrageurs will force the prices of identical assets toward being equal, such that pure arbitrage opportunities do not exist or at least do not persist. The term arbitrage is often used to represent efforts to earn superior returns even when risk is not eliminated because the long and short positions are not in identical assets or are not held over the same time intervals. To the extent that investment professionals use the term arbitrage more loosely, these investment programs can be said to contain active risk and to generate relative returns.

Which of the five structures that differentiate traditional and alternative investments relates to the taxation of an instrument?

Regulatory Structures

Name the five structures that differentiate traditional and alternative investments

Regulatory Structures, Securities Structures, Trading Structures, Compensation Structures, and Institutional Structures.

Name four major methods of analysis that distinguish the analysis of alternative investments from the analysis of traditional investments.

Return Computation Methods, Statistical Methods, Valuation Methods, Portfolio Management Methods.

Name the four major methods of analysis that distinguish the analysis of alternative investments from the analysis of traditional investments.

Return Computation Methods, Statistical Methods, Valuation Methods, Portfolio Management Methods.

Define return on VaR

Return on VaR (RoVaR) is simply the expected or average return of an asset divided by a specified VaR (expressing VaR as a positive number)

Define return on VaR.

Return on VaR (RoVaR) is simply the expected or average return of an asset divided by a specified VaR (expressing VaR as a positive number):

the return on a fully collateralized position, Rfcoll, can be expressed as

Rfcoll = ln(1+R)+ Rf

When and why are risk-neutral probabilities used?

Risk-neutral probabilities are often used in derivative pricing models. A risk-neutral probability may be useful to price derivatives even when investors are risk neutral because the derivative pricing model is being calculated relative to the price of the underlying asset and because the price of the underlying asset can often be viewed as already reflecting risk aversion.

What is the definition of roll return that is earned through holding futures contracts?

Roll return or roll yield from holding futures contracts is defined as the portion of the return of a futures position attributable only from the change in the contract's basis through time.

What is the difference between row cropland and permanent copland?

Row cropland is annual cropland that produces row crops, such as corn, cotton, carrots, or potatoes from annual seeds. Permanent cropland refers to land with long-term vines or trees that produce crops, such as grapes, cocoa, nuts, or fruit.

Is the New York Stock Exchange a secondary or third market?

Secondary market

What is a seeding fund?

Seeding funds, or seeders, are funds of funds that invest in newly created individual hedge funds, often taking an equity stake in the management of companies of the newly-minted hedge funds.

What is the relationship between selection bias and self-selection bias in hedge fund datasets?

Selection bias is a distortion in relevant sample characteristics from the characteristics of the population, caused by the sampling method of selection or inclusion used by the data manager. If the selection bias originates from the decision of fund managers to report or not to report their returns, then the bias is referred to as a self-selection bias.

Are dealer banks described as buy-side or sell-side market participants?

Sell side

Are dealer banks described as buy-side or sell-side market participants?

Sell-side market participants

Who is the initial investor in debtor-in-possession financing?

Senior and subordinated creditors

How is short selling of equity in a distressed firm similar to an option position?

Shares in highly leveraged firms resemble call options, therefore short-selling distressed equities is analogous to writing naked call options on the firm's assets and generates a negatively skewed return distribution. An investor has a naked option position when the investor is short an option position for which the investor does not also have a hedged position.

Define short volatility exposure

Short volatility exposure is any risk exposure that causes losses when underlying asset return volatilities increase.

Does whipsawing tend to occur in a trending market or a sideways market?

Sideways market

Does whipsawing tend to occuer in a trending market or a sideways market?

Sideways markets where upward and downward movements tend to alternate.

An IRR is estimated for a fund based on an initial investment when the fund was created, several annual distributions and an estimate of the fund's value prior to its termination. What type of IRR is this?

Since Inception IRR

An IRR is estimated for a fund based on an initial investment when the fund was created, several annual distributions, and an estimate of the fund's value prior to its termination. What type of IRR is this?

Since Inception IRR

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?

Since Inception IRR

Discuss the following statement: empirical evidence indicates that investors in listed BDCs are subject to greater return volatility and enjoy less diversification benefits than investors in private equity that is not publicly traded.

Since private equity lacks liquid market price data, such empirical evidence is likely formed by comparing liquid market prices with illiquid pricing data. Analysis of prices for private equity based on illiquid trading data or professional judgement can be argued to understate risk. Returns based on illiquid trading data or professional judgement are likely smoothed and therefore analysis based on those data should be expected to underestimate true return volatilities and correlations.

What is the effect of smoothed or stale asset values on the estimation of historic return volatility?

Smoothed asset values understate risk, therefore historical return volatility will be lower than unsmoothed risk.

Specifically, if autocorrelation is positive (i.e., returns are trending), then the standard deviation of returns over T periods will be larger than the single-period standard deviation multiplied by the square root of T.

If a speculator believes that the financial condition of XYZ Corporation will substantially deteriorate relative to expectations reflected in market prices, should the speculator purchase a credit call option on a spread or a price?

Spread. Deterioration in credit increases credit spreads and lowers risk bond price.

Define standardized unexpected earnings, and describe how the measure is used.

Standardized unexpected earnings (SUE) is a measure of earnings surprise, with some measure of unexpected earnings in the numerator and some measure of earnings volatility in the denominator.

What is systemic risk?

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 are the main differences between the formula for semistandard deviation and target semistandard deviation?

Target semivariance is similar to semivariance except that target semivariance substitutes the investors' target rate of return in place of the asset's mean return.

Is an IRR a dollar-weighted return or a time-weighted return? Why?

The IRR is the primary method of computing a dollar weighted return.

Is an IRR a dollar-weighted return or a time-weighted return? Why?

The IRR is the primary way of computing a dollar-weighted return.

What is the primary cause of the shape of the J-curve of interim private equity fund returns?

The J-curve is caused by a combination of early expense recognition, early loss recognition, and deferred gain recognition.

What is the difference between the formulas for the Sharpe and Treynor ratios?

The Treynor ratio differs from the Sharpe ratio by the use of systematic risk rather than total risk in the denominator.

Why would activist hedge fund managers need to understand corporate governance?

The activist investment strategy involves efforts by shareholders to use their rights, such as voting power or the threat of such power, to influence corporate governance to their financial benefit as shareholders.

What is the name of the following quantitiy: the spot price of a commodity minus a forward price of the commodity?

The basis of the commodity contract

What is the formula for the beta of an asset using common statistical measures?

The beta of an asset is defined as the covariance between the asset's returns and a return such as the market index, divided by the variance of the index's return, or, equivalently, as the correlation coefficient multiplied by the ratio of the asset volatility to market volatility.

What are the carrying costs (and benefits) of physical inventory such as a commodity?

The carrying costs of physical inventory include interest (r) and storage (c), the benefit of physical inventory is the convenient yield.

Describe the positions used in a classic convertible bond arbitrage trade.

The classic convertible bond arbitrage trade is to purchase a convertible bond that is believed to be undervalued and to hedge its risk using a short position in the underlying equity.

Describe the positions utilized in a classic convertible bond arbitrage trade.

The classic convertible bond arbitrage trade is to purchase a convertible bond that is believed to be undervalued and to hedge its risk using a short position in the underlying equity.

Suppose that the total value of the collateral pool of a CDO remains constant but the riskiness of the pool increases. If the value of the senior-most tranches decreases, what should happen to the combined value of the other tranches?

The combined value of the other tranches will increase.

List the components of the returns of a traditional convertible arbitrage strategy.

The components of convertible arbitrage returns include interest, dividends, rebates, and capital gains and losses.

What is the primary reason that the forward price of an asset could be substantially smaller than the price generated by the cost-of-carry model?

The cost of carry model indicates a maximum forward price. When arbitrageurs cannot borrow a commodity without incurring expenses (other than the time value of money), it is possible that forward prices will be less than those implied by the cost of carry model.

The covariance will equal the product of the standard deviations when correlation coefficient is equal to one.

What two spot interest rates imply the value of a six-month forward contract from a six-month Treasury bill?

The current six-month and 12-month spot rates are needed to find the six-month forward contract for a six-month Treasury bill.

What is the primary difference between a cash-funded CDO and a synthetic CDO?

The distinction focuses on whether the SPV obtains the risk of the portfolio using actual (cash) holdings of assets or through derivative positions. A cash-funded CDO holds the portfolio of risk securities as collateral for the trust, whereas the synthetic CDO obtains the risk exposure through the use of a credit derivative.

How does the equity residual approach to real estate valuation differ from a discounted cash flow approach applied to the assets of a real estate project?

The equity residual approach focuses on the perspective of the equity investor by subtracting the interest expense and other financing outflows due to mortgage holders (in the numerators) and by discounting the remaining cash flows using an interest rate reflective of the required rate of return on the equity of a leveraged real estate investment (in the denominator). The discounted cash flow approach discounts all cash flows from assets using a rate commensurate with the risk of the assets, not the equity.

In the context of analyzing the returns of futures contracts, what is excess return?

The excess return of a futures contract is the return generated exclusively from changes in futures prices. The term "excess return" is used elsewhere in investment with a different meaning: the total return minus the riskless rate.

List the four stages in the evolution of credit derivative activity.

The first, or defensive, stage, which started in the late 1980s was characterized by ad hoc attempts by banks to lay off some of their credit exposures. The scond stage, which began about 1991 was the emergence of an intermediated market in which dealers applied derivatives technology to transfer of credit risk and investors entered the market to seek exposure to credit risk. The third stage was maturing into resembling other forms of derivatives with major regulatory guidance. Dealers began warehousing risks and running hedged and diversified portfolios of credit derivatives. The fourth stage centered on the development of a liquid market.

Central Limit Theorem

The formal statistical explanation for the idea that a variable will tend toward a normal distribution as the number of independent influences becomes larger.

Define high-water-mark in the context of hedge fund fee computation.

The high-water mark (HWM) is the highest NAV of the fund on which an incentive fee has been paid.

Define the high-water mark in the context of hedge fund fee computation.

The high-water mark (HWM) is the highest NAV of the fund on which an incentive fee has been paid. Thus, the HWM is the highest NAV recorded on incentive fee computation dates but not necessarily the highest overall NAV.

How can managerial co-investing contribute to optimal contracting?

The idea is taht by having their own money in the fund, through co-investing, managers will work hard to generate high returns and control risk, i.e. helping to align the interests of the hedge fund managers with that of the investors. Specifically, managerial co-investing may mitigate "gaming" emanating from large incentive fees.

In which scenario will a clawback clause lead to payments?

The idea of typical clawback provisions is that incentive fees distributed to managers are returned when a firm experiences losses after profits so that the total incentive fees paid, ignoring the time value of money, are equal to the incentive fees that would be due if all profits and losses had occurred simultaneously.

List the tow major approaches to valuing private commercial real estate equity.

The income approach and valuations based on comparable sale prices

How does the equity residual approach to real estate valuation differ from a DCF approach applied to the assets of a real estate project?

The income or DCF approach involves projecting all cash flows, including a terminal value (net sale proceeds), and discounting the cash flows using a rate commensurate with the investment's longevity and risk. An alternative approach, often termed the equity residual approach, focuses on the perspective of the equity investor by subtracting the interest expense and other cash outflows due to mortgage holders (in the numerator) and by discounting the remaining cash flows using an interest rate reflective of the required rate of return on the equity of a leveraged real estate investment (in the denominator).

What is the name of the measure that describes managerial skill as the correlation between managerial return predictions and realized return?

The information coefficient, which measures managerial skill as the correlation between managerial return predictions and realized returns

An investment has two solutions for its IRR. What can be said about the investment and the usefulness of the two solutions?

The investment is a multiple sign change IRR. The two solutions cannot be used.

What is the explanation, based on option theory, as to why the junior-most tranche of a CDO would fall in value when the collateral pool of assets becomes more diversified?

The junior-most tranche of a CDO is similar to a long call position on the collateralized asset. As the collateral pool of assets becomes more diversified, thus less risky, the value of the long call position declines due to its negative vega.

What would be the primary justification for believing that the use of mezzanine financing can lower a firm's weighted average cost of capital?

The justifications for advantages of mezzanine debt are based on inefficiencies and imperfections in the capital markets for the size companies that tend to utilize mezzanine financing.

Consider a skilled manager implementing a pairs trading strategy. What is the concern that tends to limit the size of the positions that the manager might take in attempting to increase alpha?

The limits to arbitrage, which refers to the potential inability or unwillingness of speculators, such as pairs traders, to hold their positions without time constraints or to increase their positions without size constraints. Very large positions with high degrees of leverage increase the probability of financial ruin and the inability to survive short-term displacements.

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?

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.

Two investments are being compared to ascertain which 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 investments provide an unreliable indication of which would add more value?

The major challenge with comparing IRRs across investments occurs when investments have scale differences. Scale differences are when investments have unequal sizes and/or timing of their cash flows. When comparing investments with different scales, an investment with a higher IRR may be inferior to an investment with a lower IRR.

What is the empirical evidence on the very long-term annual financial returns of works of art?

The median real return to holding art over extended periods of time is 2.2%

How does increased interest rate volatility affect the borrower of a fixed-rate mortgage in which the borrower can make unscheduled principal payments?

The option to prepay is a call option in which the mortgage borrower, much like a corporation with a callable bond, can repurchase its debt at a fixed strike price. Mortgage borrowers, like all call option holders on fixed income securities, benefit from increased interest rate volatility.

List two major factors that drive informational market efficiency through facilitating better investment analysis.

The overall driver of informational market efficiency is greater competition among informed buyers and sellers. Thus, markets tend to attain higher degrees of informational market efficiency when there are more traders using all available information, and when those traders can transact with low costs.

What does a participation rate indicate in a structure product?

The participation rate indicates the ratio of the product's payoff to the value of the underlying reference, asset or index.

How does the numerator of a pre-tax discounting approach differ from the numerator of an after-tax discounting approach?

The pre-tax discounting approach is commonly used in finance, where pre-tax cash flows are used in the numerator of the present value analysis (as the cash flows to be received), and the pre-tax discount rate is used in the denominator. An alternative is to use an after-tax approach. In an after-tax discounting approach, the estimated after-tax cash flows (e.g., after-tax bond payments) are discounted using a rate that has been reduced to reflect the net rate received by an investor with a specified marginal tax rate.

What is the primary role of structuring in an economy?

The primary economic role of structure products is usually market completion - making available a broader spectrum of investment opportunities.

What are the two main differences between the formula for variance and the formula for semivariance?

The semivariance uses a formula otherwise identical to the variance formula except that it only includes the negative deviations in the numerator and a smaller number of observations in the denominator.

Does an analyst select a p-value or a significance level in preparation for a test?

The significance level. The p-value is the output of the statistical computations.

What is the general statistical issue addressed when the GARCH method is used in a time series analysis of returns?

The tendency of an asset's variance to change through time.

Describe the strategy of a managed futures fund.

The term managed futures refers to the active trading of futures and forward contracts on physical commodities, financial assets, and exchange rates.

Why is an empirical test of informational market efficient a test of joint hypotheses?

The test is a joint hypothesis of the appropriateness of the particular model of returns (in determining what constitutes an abnormal return) and a test of whether a particular investment has generated statistically significant abnormal returns.

In which theory of the term structure of interest rates do all bonds have the same expected return?

The unbiased expectations theory hypothesizes that all fixed-income securities offer the same expected return over the same time interval (i.e., there are no risk premiums), therefore serving as a useful tool in risk-neutral modeling in which all interest rates are formed purely on interest rate expectations.

Jane studies past prices and volume of trading in major public equities and establishes equity market neutral positions based on her forecasts of prices. Jane consistently outperforms market indices of comparable risk. Does the performance indicate that the equity market is informationally inefficient at the semistrong level?

The underlyin equity market is informationally inefficient at both the weak level and the semi-strong level since an inefficiency at a "lower" level indicates inefficiency at a "higher" level because the underlying information sets are cumulative moving from weak to strong.

In the case of a financial asset with returns that have zero autocorrelation, what is the relationship between the variance of the assets daily returns and the variance of the asset's monthly returns?

The variance of the monthly returns are T times the variance of the daily returns where T is the number of trading days in the month.

In theory, how would the volatility of an eqully-weighted portfolio of 16 uncorrelated, zero-beta and equally-risky funds compare to the volatility of a single such fund?

The volatility of an equally-weighted portfolio of sixteen uncorrelated, zero-beta and equally-risky funds would be reduced through division by the square root of the number of funds.

What is the WARF of a portfolio?

The weighted average rating factor (WARF) as described by Moody's is a numerical scale from 1 (for AAA-rated credit risks) to 10,000 (the worst credit risks) that reflects the estimated probability of default.

What is the difference between a yield curve and a term structure of interest rates?

The yield curve plots yields to maturity of coupon bonds, while the term structure of interest rates generally is used to denote actual or hypothetical yields of zero-coupon bonds.

Over a period from January 2000 through December 2018, commodities returns exhibited which of the following attributes? A) The Sharpe ratio was positive and slightly exceeded the global equities Sharpe ratio. B) The mean commodities return was higher than the mean global equities return. C) The commodities standard deviation of returns was higher than the global equities standard deviation of returns. D) Commodity returns were positively skewed

There are several observations regarding historical commodity returns between January 2000 and December 2018, including a negative Sharpe ratio (-0.05); an average return of 1.4%, which falls well behind the 4.5% global equities return; a 22.4% standard deviation of returns (greater than the global equities 15.0% standard deviation of returns); and negatively skewed (skewness = -0.4) returns.

An investment has two solutions for its IRR. What can be said about the investment and the usefulness of the two solutions?

There are two sign changes in the cash flow stream. None of the IRRs should be used.

Explain how limits to arbitrage prevent markets from being prefectly efficient.

There is a limit to the risk that an arbitrager can tolerate and/or is allowed to take, which provides a limit on the level of arbitrage activity by a single manager. 1) Managers who want to be successful in the long run must limit the risk of their fund, especially in periods where their strategy might be out of favor (e.g., value managers in the late 1990s/early 2000). This might prevent them from taking aggressive bets. 2) Market structures may prevent successful arbitrage in some cases. For example, institutional investors may be too large to participate in micro-cap stocks. 3) Limits on short selling could be a limit on arbitrage. Some countries do not allow short selling altogether, recent IPOs or spin-offs may not have shares available to be shortened, or some shares may be temporarily unavailable for borrowing when the demand to sell the shares short exceeds the supply of borrowable shares.

What have empirical studies generally concluded bout the relationship between the net stock issuance of a firm and the subsequent returns of the firm's shareholders?

There is evidence that positive or negative net stock issuance is one of the most profitable anomalies. Companies that issue large amounts of new shares, such as more than 20% of the shares currently outstanding, frequently see their stock price substantially underperform the market.

Why are most listed MLPs in the United States involved in producing, processing, and distributing energy products?

There is limited commodity price risk.

Why might a PE fund of funds be especially appropriate for an investor new to PE?

They can provide the necessary resources and addresses the information gap for inexperienced PE investors through the expertise in due diligence, monitoring, and restructuring.

What is the role of a Timberland investment management organization (TIMO)?

Timberland investment management organizations provide management services to timberland owned by institutional investors such as pension plans, endowments, foundations, and insurance companies.

What is the primary purpose of using a copula approach to analyze a CDO?

To ascertain the risks of tranches due to potential default risk in the CDO portfolio.

What is the goal of an empirical investigation of abnormal return persistence?

To identify ex ante alpha.

Define tracking error and average tracking error.

Tracking error indicates the dispersion of the returns of an investment relative to a benchmark return, where a benchmark return is the contemporaneous realized return on an index or peer group of comparable risk. Although tracking error is sometimes used loosely simply to refer to the deviations between an asset's return and the benchmark return, the term tracking error is usually defined as the standard deviation of those deviations. The term average tracking error simply refers to the excess of an investment's return relative to its benchmark.

What is the primary difference between a traditional PIPE and a toxic PIPE?

Traditional PIPEs allow investors to buy common stock at a fixed price. A toxic PIPE is a PIPE with adjustable conversion terms that can generate high levels of shareholder dilution in the event of deteriorating prices in the firm's common stock.

What are the positions utilized in a traditional merger arbitrage strategy?

Traditional merger arbitrage generally uses leverage to buy the stock of the firm that is to be acquired and sell short the stock of the firm that is to be the acquirer in a stock-for-stock merger.

What are the positions used in a traditional merger arbitrage strategy?

Traditional merger arbitrage generally uses leverage to buy the stock of the firm that is to be acquired and to sell short the stock of the firm that is the acquirer.

What is the extension risk and contraction risk of the PO tranche to a CMO?

Typically, principal-only tranches are positively exposed to extension risk in that their values decline when their payments extend in longevity (i.e., prepayment slow) since PO holders receive no coupons. Conversely, principal-only tranches are negatively exposed to contract risk; typically, as interest rates decline, the speed of prepayments accelerates and the values of PO's rise.

To what extent have gold prices driven the short-term equity values of gold mining firms based on data from the United States during the financial crisis in late 2008?

U.S. gold mining firms did not fare so well over the same period. The average price of these firms was quite volatile and generally moved downward.

What is the acronym for fund vehicles that are regulated and allow retail access of hedge-fund-like investment pools in the European Union?

UCITS

What investment pools in the United States and Europe provide liquid access of investors to alternative investment strategies?

UCITS in the EU and some '40 Act funds in the US

In which theory of the term structure of interest rates do all bonds have the same expected return?

Unbiased expectations theory.

What is the relationship between a forward interest rate and its expected value at settlement under the unbiased expectations hypothesis and the liquidity premium hypothesis?

Under the unbiased expectations hypothesis, forward bond prices (whether implied by spot rates or observed in the forward price of forward contracts) are unbiased predictors of subsequent spot or cash market prices.

How do unscheduled principal payments affect the lender of a fixed-rate mortgage at different levels of market interest rates?

Unscheduled principal payments cause a wealth transfer between the borrower and the lender, depending on the relationship between the mortgage's interest rate and current market interest rates. When market rates are lower than the mortgage rate, unscheduled principal payments generally benefit the borrower and harm the lender. The lender receives additional cash flows that if reinvested at prevailing interest rates will earn less return than the mortgage offers. Borrowers can make unscheduled prepayments to reduce the total interest costs of their mortgage by an amount greater than the amount that they could earn from interest income in the market. Thus, borrowers have an incentive to make prepayments on mortgages when interest rates decline below the mortgage's rate.

What is the difference between value at risk and conditional value at risk?

VaR is the maximum loss over a specified time period within a specified probability. Conditional value-at-risk (CVaR), also known as expected tail loss, is the expected loss of the investor given that the VaR has been equaled or exceeded. Thus, if the VaR is $1 million, then the CVaR would be the expected value of all losses equal to or greater than $1 million. The CVaR provides the investor with information about the potential magnitude of losses beyond the VaR.

In the case of a financial asset with returns that have zero autocorrelation, what is the relationship between the variance of the asset's daily returns and the variance of the asset's monthly return?

Variance of the monthly return is equal to the sum of the month's daily return variances.

What is the key difference between a volatility swap and a variance swap?

Variance swaps are forward contracts wherein one party agrees to make a cash payment to the other party linearly based on the realized variance of a price or rate in exchange for receiving a predetermined cash flow. A volatility swap mirrors a variance swap except that the payoff of the contract is linearly based on the standard deviation of a return series rather than the variance.

Using statistical termniology, what does the volatility of a return mean?

Volatility is often used synonymously with standard deviation in investments.

What does it mean when a future is marked-to-market?

When a future is marked-to-market, it means that the side of a futures contract that benefits from a price change receives cash from the other side of the contract (and vice versa) throughout the contract's life.

A real estate project is estimated to offer a 10% after-tax rate of return when the depreciation allowed for tax purposes is equal to the true economic depreciation. In what direction would the expected rate of return change if the depreciation allowed for tax purposes were accelerated relative to the true economic depreciation, and why?

When depreciation for tax accounting purposes is accelerated in time relative to true economic depreciation, the after-tax return generally increases and exceeds the pretax return reduced by the stated income tax rate.

What can cause the after-tax rate of return of a product with tax deferral and tax deduction to be higher than the after-tax return of an otherwise identical product with tax deferral only?

When the income tax rate at withdrawal (e.g., retirement) is lower than the income tax rate of the investor when the contribution was made.

Why might the operational risks of a multistrategy fund differ substantially from the operational risks of a fund of funds?

While funds of funds diversify operational risk across 10 to 20 independent management organizations, a multistrategy fund has a single operational infrastructure. Market risk my also be a concern, as a catastrophic loss in even on of the multi-strategy fund's underlying strategies may sink the entire fund. Conversely, the failure of one of a fund of funds' 20 managers may subject investors to only a 5% loss and not affect the fund's other investments.

Does mezzanine debt with an equity kicker exhibit the J-curve return patter of private equity? Why or why not?

With a mezzanine fund, the J-curve effect is not a factor. One of the distinct advantages of mezzanine financing is its immediate cash-on-cash return. Mezzanine debt bears a coupon that requires twice-yearly interest payments to investors. As a result, mezzanine financing funds can avoid the early negative accounting returns associated with venture capital or leveraged buyout funds.

Jane studies past prices and the volume of trading in major public equities and establishes equity market-neutral positions based on her forecasts of prices. Jane consistently outperforms market indices of comparable risk. Does the performance indicate that the equity market is informationally inefficient at the semistrong level?

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