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CAIA LEVEL II SAMPLE EXAM
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CAIA LEVEL II SAMPLE EXAM
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CAIA LEVEL II SAMPLE EXAMIntuition of the Black-Derman-Toy interest rate model - Answers-Observed spot rates
drive rate levels while implied rate volatilities drive rate spreads
Understanding the intuition of imposing these two conditions helps in understanding the
essence of the BDT model. The spot rates in the currently observed term structure drive
the overall levels of the rates that are projected throughout the binomial tree. The
implied volatilities of options trading on short‐term rates (i.e., interest rate caplets) drives
the spreads between the "up rates" and the "down rates" corresponding to the
expiration dates of the caplets
Mitigating Estimation Error Risk in Mean-Variance Optimization - Answers-Mitigating
Estimation Error Risk in Mean-Variance Optimization returns strives to reduce
estimation error and typically is executed by:
(1) repeated analysis of hypothetical returns simulated from the statistical parameters
estimated from the original sample of returns; or
(2) repeated analysis of new samples of returns generated from the original sample
using draws with replacement
Which of the following correctly identifies the strategies that will generate equal
weightings, if any? - Answers-The weights of each asset will tend to be higher for low-
volatility assets and higher for assets that have low correlations with the rest of the
portfolio.
Second, factor-based risk allocation requires asset owners to take extreme positions in
some assets or asset classes.
In the context of the Fama-French model, the conservative minus aggressive factor is
designed to distinguish firms by which of the following aspects? - Answers-The rate of
reported corporate asset investment
The conservative minus aggressive factor is designed to distinguish firms by the rate of
reported corporate asset investment (with conservative firms exhibiting a lower rate of
investment in corporate assets).
Sensitivities exhibited by Merton's structural model - Answers-The credit spread in
Merton's structural model exhibits sensitivity to maturity.
However, as the time to the debt's maturity is increased, the probabilities of default (and
credit spreads) increase. Therefore, for firms with low leverage the term structure of
credit spreads tends to be upward sloping
Altman's credit scoring model - Answers-Z < 1.81: Default group
1.81 < Z < 2.99: Gray zone
, Z > 2.99: Nondefault group
Three challenges of empirical multifactor models - Answers-I. False identification of
factors
II. Potential sufficiency of the CAPM
III. Factor return correlation v. causation
• p263: First, widespread searches for statistically significant factors run the risk of false
identification of useful factors
• p264: A second potential difficulty is in differentiating between factors that are
correlated with returns and those that cause returns
• P264-265: A key challenge in using an empirical multi-factor model lies in justifying
why it should perform better than the CAPM in describing the tradeoff between risk and
return
The bottom up approach - Answers-The approach places the most emphasis on the
management of suitable investments
The bottom-up approach is based on fund manager or security specific research, in
which the emphasis is on screening all investment opportunities and picking the
perceived best.
The top-down approach - Answers-A top-down approach analyzes the macroeconomic
environment and then determines the weights and the combination of industry sectors,
countries, and so on that best meet the program objectives under the likely scenarios.
Leverage Aversion Theory - Answers-The leverage aversion theory argues that large
classes of investors cannot lever up low-volatility portfolios to generate attractive returns
and that, as a result, low-volatility stocks and portfolios are underpriced. Those
investors who are not averse to leverage can exploit the potential underpricing of low-
volatility portfolios and lever the attractive Sharpe ratios into attractive combinations of
risk and return.
Ho and Lee model - Answers-An arbitrage-free model that is calibrated to the observed
term structure of interest rates
Ho and Lee (1986) proposed the first arbitrage‐free model of interest rates. The Ho and
Lee model is a single‐factor model that assumes that the short‐term interest rate follows
a normally distributed process, with a drift parameter that is chosen so that the modeled
term structure of interest rates fits the observed term structure of interest rates.
In the context of investment policy statements, which of the following best describes
well-written asset allocation guidelines?
A. Discussing broad asset categories using allocation targets and ranges
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