CAIA Level 2 Quiz 37

This question tests the understanding of how quantitative equity market neutral strategies leverage statistical relationships between securities. Co-integration identifies pairs of assets whose price movements are statistically linked over time, despite potentially diverging in the short term. A strategy based on co-integration would involve taking a long position in the underperforming asset and a short position in the outperforming asset within a co-integrated pair, expecting their price relationship to revert to its historical norm. This is a core concept in pairs trading, a common quantitative equity market neutral strategy.

The question tests the understanding of how investors gain exposure to commodity markets. While direct physical ownership is an option, it’s often impractical due to storage costs and perishability for many commodities. Equity ownership in commodity-producing firms offers indirect exposure but mixes equity risk with commodity risk. Commodity index swaps, on the other hand, are a preferred institutional method for gaining exposure to commodity indices by exchanging cash flows based on an index against an interest rate. This method allows for efficient capture of commodity price movements without the logistical challenges of physical ownership or the commingled risks of equity investments. Therefore, commodity index swaps are highlighted as a primary vehicle for institutional investors seeking commodity index exposure.

This question assesses the understanding of risk management principles in global macro trading, specifically the rationale behind setting stop-loss levels. Bruce Kovner’s philosophy, as cited, emphasizes that a stop-loss should be triggered by a change in the market’s assessment of the trade’s viability, rather than a predetermined maximum acceptable loss. This implies that the stop-loss level should be tied to the underlying logic and expected price action of the trade itself. Option A correctly captures this by linking the stop-loss to the point where the trade’s premise is invalidated. Option B is incorrect because while managing maximum dollar loss is a component of overall risk management, it’s not the primary determinant of a stop-loss level according to the cited principle. Option C is incorrect as it focuses on the psychological comfort of the trader, which is contrary to the disciplined, objective approach advocated. Option D is incorrect because while market volatility can affect execution, the initial placement of the stop-loss should be based on the trade’s fundamental validity, not solely on anticipating execution slippage.

The question probes the understanding of how real options, specifically the option to shut down production, influence commodity futures curves. When commodity prices fall below the marginal cost of production, producers may choose to halt operations rather than sell at a loss. This decision-making process, driven by the embedded option to cease extraction, limits the downside volatility of future prices. Consequently, this real option tends to flatten the forward curve, as the potential for extremely low future prices is curtailed by the producer’s ability to withhold supply. The other options describe different market phenomena or incorrect impacts of real options. An upward-sloping curve (contango) indicates higher future prices, which isn’t directly caused by the option to shut down. A humped curve is a specific shape that may result from various factors, but the option to shut down primarily flattens the curve. The impact on volatility is a consequence, but the direct effect on the curve’s shape is flattening.

The question probes the understanding of how investor participation, particularly from financial entities like hedge funds and swap dealers, can influence the structure of commodity futures markets. The provided text highlights that increased presence of these participants can lead to greater price efficiency and tighter co-integration between near-term and longer-maturity futures contracts. This is because these sophisticated investors often engage in strategies that exploit term structure relationships, thereby reducing arbitrage opportunities and making the market more reflective of underlying supply and demand dynamics across different delivery periods. Option B is incorrect because while increased investor participation can lead to more efficient markets, it doesn’t inherently guarantee a shift towards backwardation; the term structure is influenced by many factors. Option C is incorrect as the text suggests increased efficiency and co-integration, not necessarily a reduction in volatility, which can be influenced by broader market conditions. Option D is incorrect because while investor activity can impact price discovery, the primary effect discussed in relation to their presence is on the term structure and market efficiency, not a direct suppression of all price discovery mechanisms.

The Limited Partnership Agreement (LPA) is the foundational document governing a private equity fund. It meticulously outlines the rights, responsibilities, and economic arrangements between the General Partner (GP) and the Limited Partners (LPs). While the LPA addresses various aspects of the fund’s operation, including investment strategy, key-person provisions, and termination clauses, its primary function is to establish the legal and financial framework. The Private Placement Memorandum (PPM) serves as a marketing and disclosure document, detailing the investment proposal, but it is the LPA that legally binds the parties and defines the operational and economic terms. The Subscription Agreement formalizes the LP’s commitment of capital and specifies securities law exemptions, but it is subordinate to the overarching LPA. Therefore, the LPA is the most comprehensive document defining the fund’s structure and terms.

The MF Global bankruptcy highlighted a critical difference in investor protection between futures markets and traditional securities markets. In the futures industry, customer funds are required to be segregated, meaning they should be held separately from the FCM’s own assets. However, unlike investors in securities markets who are protected by SIPC insurance, futures investors lack a similar government-backed insurance mechanism. This means that in the event of an FCM’s insolvency, customer losses are not covered by an external insurance fund, and they may have to absorb losses directly or rely on the recovery of assets from the bankrupt estate, which can be a lengthy and uncertain process. The question tests the understanding of the regulatory framework and investor protections specific to the managed futures industry compared to other financial markets.

The question tests the understanding of how combining factors with low correlations can improve a portfolio’s risk-adjusted return. The Fama-French three-factor model (Mkt-RF, SMB, HML) is introduced, and the concept of an equally weighted (EW) portfolio combining these factors is presented. Exhibit 37.3 shows that the EW portfolio has a higher annualized return divided by annualized standard deviation (Ann.Ret/Ann.Std) of 0.61 compared to Mkt-RF (0.28), SMB (0.26), and HML (0.48). This improvement is attributed to the low correlations between the factors, which allow for diversification benefits. Therefore, a quantitative equity strategy that combines factors with low inter-correlations is expected to enhance the portfolio’s Sharpe ratio (or a similar risk-adjusted return metric).

The core issue with appraisal-based real estate indices, such as the NCREIF NPI, is the inherent ‘smoothing’ effect. This smoothing arises from several factors: infrequent formal appraisals (often annual or biennial), the cost of appraisals leading to valuations based on older data, and delays in appraisers adopting new valuation standards or reflecting immediate market shifts. Consequently, these indices do not accurately reflect rapid changes in property values. In contrast, market indices derived from REIT prices are continuously updated and thus provide a more real-time reflection of market sentiment and value changes. Therefore, a significant decline in asset prices occurring mid-quarter would not be immediately captured by an appraisal-based index due to these valuation lags.

This question tests the understanding of how currency momentum strategies are implemented and the underlying logic. A momentum strategy involves taking long positions in currencies that have recently appreciated and short positions in currencies that have recently depreciated. The profit calculation for a long position in a currency (FCU) that has appreciated is based on the expectation that this appreciation will continue. Therefore, if the spot rate at time t+1 (St+1) is greater than the spot rate at time t (St), the strategy profits. Conversely, if the trend reverses and St+1 is less than St, the strategy incurs a loss. The formula provided in the study material directly reflects this: Profit/Loss = St+1 – St if St / St-1 > 1 (indicating appreciation). Option B incorrectly suggests a profit if the spot rate decreases, which is contrary to a momentum strategy. Option C describes a carry trade logic based on interest rate differentials, not momentum. Option D incorrectly links profit to the ratio of spot rates rather than the absolute change or comparison to the previous period’s trend.

The question probes the understanding of the primary purpose of an offering memorandum within the context of hedge fund investments. While it serves as a marketing tool and provides a broad overview of the fund’s structure, investment objectives, management, fees, and subscription/redemption terms, it is explicitly stated that it is not the legally binding document. The legally operative document is typically the subscription agreement or the fund’s governing documents, which are executed by the investor. Therefore, relying solely on the offering memorandum for definitive legal commitments or precise operational details without cross-referencing the operative agreements would be a misinterpretation of its role.

Convertible arbitrage strategies aim to profit from mispricings in convertible bonds. A common approach involves shorting the underlying stock and buying the convertible bond. This strategy is sensitive to changes in interest rates, which affect the bond’s value. Rho, in the context of the Black-Scholes model for options, measures the sensitivity of an option’s price to a change in the risk-free interest rate. For a convertible bond, the embedded call option component will generally have a positive rho, meaning its value increases with interest rates. However, the bond component’s value decreases with rising interest rates. The net effect on the convertible bond’s price, and thus the arbitrage strategy’s profitability, depends on the interplay of these two components and the specific terms of the convertible. Therefore, understanding rho is crucial for managing the interest rate risk of such a strategy.

The question tests the understanding of how to benchmark private equity fund performance against public market equivalents. The Public Market Equivalent (PME) is a method used to compare the performance of a private equity investment to a hypothetical investment in a public market index. It accounts for the timing and size of cash flows. The calculation involves discounting all cash flows (contributions and distributions) to a common point in time using the public index’s performance. The Net Present Value (NPV) of these discounted cash flows, when divided by the public index’s performance at the time of the last cash flow, provides the PME. A PME greater than 1 indicates that the private equity fund outperformed the public market equivalent, while a PME less than 1 indicates underperformance. The scenario provides cash flows for PE Fund 1 and the CAC 40 index performance. To calculate the PME, one would discount all contributions and distributions of PE Fund 1 using the CAC 40’s annual growth rate and then compare the present value of distributions to the present value of contributions. The provided solution indicates that PE Fund 1’s IIRR is 16.53% and the CAC 40 index performance over the period suggests a lower average return. Therefore, a PME calculation would likely show that PE Fund 1 outperformed the public market equivalent, meaning the PME would be greater than 1. The explanation that the PME is calculated by comparing the present value of distributions to the present value of contributions, both discounted at the public market’s rate of return, is the core concept being tested. The other options describe different performance metrics or misinterpretations of the PME concept.

The question tests the understanding of liquidity risk management for endowments, specifically concerning the timing and impact of capital calls and distributions from illiquid alternative investments. The provided text highlights that during a crisis, distributions slow down while capital calls continue, creating a liquidity crunch. A key strategy to mitigate this is to align the timing of new commitments with expected distributions from existing, maturing investments. This ‘laddering’ approach, as described by Siegel (2008), aims to ensure that cash flows from exited investments can cover ongoing capital calls, thereby reducing the need to sell assets at distressed prices or borrow heavily. Option A correctly identifies this proactive matching of cash inflows and outflows as the most effective strategy. Option B is incorrect because while overcommitment can be a strategy, it doesn’t directly address the timing mismatch of calls and distributions. Option C is incorrect as focusing solely on the speed of drawdown for new commitments doesn’t account for the crucial element of incoming distributions. Option D is incorrect because while reducing illiquid assets helps, it’s a reactive measure rather than a proactive management of the cash flow cycle.

The provided exhibit indicates that commodity futures exhibit positive returns during the early phase of a recession, while stocks and bonds tend to have negative returns during this period. This contrasting performance suggests that commodities can act as a hedge against the downturn experienced by traditional assets in the initial stages of an economic contraction. The question tests the understanding of how commodities’ performance relative to stocks and bonds varies across different economic cycles, specifically focusing on their hedging properties during recessions.

The question tests the understanding of how commodity-based equities provide exposure to commodities and the limitations thereof. While owning equity in commodity-producing firms offers a way to gain commodity exposure, the correlation with the underlying commodity price can be diluted by several factors. These include the firm’s hedging activities, which can alter their exposure based on price expectations, and the inherent business risks of the company itself, which are separate from commodity price movements. The Gorton and Rouwenhorst study highlighted that commodity company stocks behave more like equities than commodity futures, exhibiting higher correlation with the S&P 500, making them less ideal for diversification purposes compared to futures. Therefore, the most significant drawback is the potential for diluted and less predictable commodity exposure due to these corporate-level factors.

Operational due diligence for hedge funds involves a thorough assessment of the fund’s infrastructure, processes, and controls to ensure they are robust and capable of supporting the investment strategy while mitigating operational risks. The Asset Managers’ Committee (AMC) report highlights five key areas: Disclosure, Valuation, Risk Management, Trading and Business Operations, and Compliance, Conflicts, and Business Practices. While all these areas are crucial, the question asks about the most fundamental aspect of ensuring the fund can operate effectively and manage its day-to-day activities. Sound and controlled trading and business operations, supported by adequate resources and checks and balances, form the bedrock of a hedge fund’s ability to execute its strategy, manage risk, and comply with regulations. Without this foundational operational capability, even strong disclosure, valuation, risk management, or compliance frameworks would be undermined. Therefore, assessing the robustness of trading and business operations is paramount in operational due diligence.

Managed futures strategies, particularly trend-following, are often characterized by their reliance on technical analysis of past price and volume data to identify and capitalize on market trends. Unlike market timing strategies, which may incorporate fundamental analysis to anticipate market shifts, trend followers aim to confirm the existence and strength of a trend before committing capital. This systematic approach, driven by quantitative models, leads to a more reactive rather than proactive stance on market movements. The core principle is to follow established price directions, whether upward or downward, rather than attempting to predict turning points.

The provided exhibit shows that during a strong expansionary phase of the business cycle, characterized by increasing industrial production, the energy index exhibits the highest average return (37.37%). This is because heightened economic activity directly correlates with increased demand for energy commodities, leading to price appreciation. While other indices also show positive returns, energy commodities are most sensitive to this demand surge. The question tests the understanding of how different commodity sectors react to specific phases of the economic cycle, as depicted in the exhibit.

The core purpose of monitoring in private equity is to act as a control mechanism within the broader investment process. It’s not merely about information gathering or ensuring compliance with the limited partnership agreement (LPA), but about actively observing, verifying, and influencing the portfolio’s performance towards desired outcomes. While identifying problems is a key step, the ultimate goal is to implement corrective actions. The text emphasizes that monitoring is part of a larger control system aimed at making the portfolio perform as intended, which directly aligns with the concept of controlling the investment’s trajectory.

The core issue with appraisal-based real estate indices like the NCREIF NPI, as described in the text, is that appraisals tend to lag behind actual market price movements. This smoothing effect reduces the observed volatility and introduces autocorrelation into the return series. When a market experiences a sharp downturn, such as in late 2008 and early 2009, appraised values do not immediately reflect the full extent of the decline. Instead, they adjust gradually over subsequent periods. This gradual adjustment means that the reported returns for the smoothed series will be less extreme than the true market returns, and the negative returns will be spread out over time, leading to a lower observed standard deviation and a positive autocorrelation. The REIT index, based on market prices, is presented as a proxy for true returns and exhibits higher volatility and less autocorrelation, as expected in an efficient market.

The question probes the strategic implications of a pension plan sponsor’s decision to freeze a Defined Benefit (DB) plan. Freezing a plan means that participants no longer accrue additional benefits based on future service. However, their accrued benefits up to the freeze date remain protected. Option A correctly identifies that the plan sponsor’s obligation to pay the accrued benefits continues, necessitating ongoing management of plan assets to meet these future liabilities. Option B is incorrect because while the plan is frozen, it is not necessarily terminated; termination involves a complete cessation of the plan and distribution of assets. Option C is incorrect as the employer’s liability for benefits accrued up to the freeze date persists, even if new accruals cease. Option D is incorrect because the primary goal of managing a frozen DB plan is to ensure sufficient assets to cover the existing liabilities, not to reduce the employer’s contribution to zero, as the accrued benefits still need to be funded.

The question probes the fundamental role of Funds of Hedge Funds (FoFs) in the hedge fund ecosystem, specifically their impact on the observed universe of hedge funds. The provided text highlights that FoFs act as a screening mechanism. By conducting due diligence and selecting skilled managers, FoFs effectively channel capital towards better-performing funds. This process discourages the formation or continuation of underperforming (or ‘bad’) hedge funds, as they are less likely to receive funding either directly from skilled investors or indirectly through FoFs. Consequently, the hedge funds that are visible in databases are likely to be a select group, biased towards those with superior performance or operational capabilities, compared to the theoretical universe of all hedge funds that might exist without the presence of FoFs. This is distinct from reporting biases, which relate to whether funded funds choose to report their data to databases.

The question probes the regulatory framework for managed futures in the U.S. The Commodity Futures Trading Commission (CFTC) was established by Congress in 1974 to oversee futures and derivatives trading. The National Futures Association (NFA), an industry-supported self-regulatory organization, was created in 1982 and partners with the CFTC in auditing member firms, including CTAs and CPOs. While the CFTC has broad oversight, the NFA plays a crucial role in direct auditing and dispute resolution through arbitration. Foreign exchange futures, however, are noted as an area with less regulation, despite currency futures falling under CFTC purview since 1972. Therefore, the NFA’s role as a primary overseer and auditor, in conjunction with the CFTC, is the most accurate description of the regulatory structure.

The core purpose of monitoring in private equity is to act as a control mechanism within the broader investment process. It’s not merely about information gathering or ensuring compliance, but about actively observing, verifying, and influencing the portfolio’s performance towards desired outcomes. This involves identifying potential issues and formulating strategies to address them, recognizing that the illiquidity of PE funds limits the investor’s ability to react quickly. Therefore, monitoring is intrinsically linked to the control system designed to manage the investment’s trajectory.

Operational due diligence for hedge funds involves a thorough examination of the fund’s internal processes and controls to ensure operational efficiency, risk management, and compliance. When assessing a long/short equity manager’s short selling practices, a key area of focus is the management of borrowed shares. Understanding whether the manager utilizes a single prime broker or multiple sources for borrowing, and their capability to source difficult-to-borrow securities, is crucial. This directly impacts the manager’s ability to execute their strategy effectively and manage settlement risk. Naked short selling, where borrowing arrangements are not in place before selling, is a significantly riskier practice and often subject to regulatory restrictions, making its assessment vital. The question probes the understanding of these operational aspects related to short selling, which are fundamental to assessing the operational robustness of a hedge fund strategy.

The core concept here is the distinction between anticipated and unanticipated inflation and their impact on asset returns. In an informationally efficient market, anticipated inflation is already priced into assets, meaning nominal returns adjust to reflect expected price level changes. Therefore, anticipated inflation itself does not drive returns. However, unanticipated inflation, which is the difference between realized and expected inflation, can significantly impact returns. This is because unexpected changes in inflation alter future inflation expectations, which in turn affect asset prices. Real estate, particularly properties with leases tied to inflation or financed with fixed-rate debt, can benefit from unanticipated inflation. Conversely, properties with long-term fixed-rate leases or adjustable-rate mortgages may be negatively impacted. The question tests the understanding that only the unexpected component of inflation is a true return driver due to its effect on future expectations.

The provided text emphasizes that due diligence in private equity fund selection is primarily an information-gathering and evaluation process, not a decision-making tool itself. While it helps to filter out inferior funds, the final investment decision should incorporate the due diligence findings alongside the overall portfolio composition and strategic fit. Therefore, a fund manager’s decision to commit capital should not solely rely on the due diligence outcome but rather on how that outcome informs a broader investment strategy.

The question tests the understanding of liquidity risk management for endowments, specifically concerning the timing and impact of capital calls and distributions from illiquid alternative investments. The provided text highlights that during a crisis, distributions from private equity and real estate funds slow down significantly, while capital calls continue. This mismatch can create a liquidity crunch, forcing endowments to sell assets at unfavorable prices or borrow. The concept of ‘liquidity betas’ exceeding 1.0 for alternative investments, as mentioned in the text, directly relates to their heightened sensitivity to market liquidity. Therefore, an endowment with a substantial allocation to private equity and real estate, coupled with a high spending rate and significant leverage, would face the most acute liquidity risk when distributions lag behind capital calls.

Capital at Risk (CaR) in managed futures represents the maximum potential loss if all positions in a portfolio simultaneously hit their predetermined stop-loss levels within a single trading period. The provided exhibit calculates CaR by taking a percentage (1%) of the notional value of each individual futures contract. Summing these individual potential losses gives the total CaR. In the exhibit, the S&P 500 E-mini futures contract has a notional value of $207,250. A 1% adverse price movement would result in a loss of $2,073 (0.01 * $207,250). This calculation is repeated for each contract, and the sum of these individual losses constitutes the total CaR for the portfolio. Therefore, the $2,073 figure for the S&P 500 contract accurately reflects the potential loss at its 1% stop-loss level.