CAIA Level 2 Quiz 114

This question tests the understanding of how commodity futures are used to hedge against price fluctuations in a producer’s input costs. An airline’s primary fuel cost is jet fuel. Therefore, to hedge against the negative impact of rising jet fuel prices on its profit margins, an airline would benefit from purchasing call options on jet fuel. Call options provide the right, but not the obligation, to buy the underlying asset (jet fuel) at a specified price (the strike price). If jet fuel prices rise significantly above the strike price, the airline can exercise its option to buy jet fuel at the lower strike price, thereby mitigating the increased cost. Conversely, buying put options on jet fuel would be beneficial if the airline were a seller of jet fuel and wanted to protect against falling prices. Hedging with wheat futures would be irrelevant to an airline’s fuel costs, and selling call options would expose the airline to unlimited losses if jet fuel prices surged.

The question tests the understanding of the regulatory framework for managed futures in the United States. The Commodity Futures Trading Commission (CFTC) was established in 1974 to oversee futures and derivatives trading. The National Futures Association (NFA), created in 1982, acts as a self-regulatory organization in partnership with the CFTC, primarily responsible for auditing member firms, including CTAs and CPOs. While the CFTC has broad oversight, the NFA plays a crucial role in the day-to-day auditing and oversight of industry participants. Therefore, the NFA is the primary overseer of FCMs, IBs, CPOs, and CTAs, working in conjunction with the CFTC.

The core of effective monitoring in private equity, as highlighted in the provided text, lies in the Limited Partner’s (LP) ability to gather and interpret information. While direct interaction with fund managers for qualitative insights and standardized data from back offices are crucial components, the text emphasizes that the private equity sector’s ‘private’ nature inherently limits transparency. Therefore, LPs must actively seek to fill information gaps. Networking with other LPs is presented as a key informal method for gaining market intelligence, understanding other funds’ performance, and potentially accessing deals or secondary opportunities that might otherwise be unavailable. This collaborative intelligence gathering directly supports informed decision-making and can lead to a competitive advantage by providing proprietary information that complements the standard reporting.

The question tests the understanding of how government subsidies can impact farmland values. The provided text indicates that government payments are often capitalized into land values, potentially creating a price floor. However, it also presents a counterargument from studies suggesting that land prices are not sensitive to these payments due to the flexibility of land use over the long term. The most prudent approach for an investor, as suggested by best practice, is to analyze cash flows under both scenarios: one assuming continued subsidies and another assuming their discontinuation. This allows for a more robust assessment of the investment’s resilience to policy changes. Therefore, the most accurate statement is that the investor should prepare projections for both the presence and absence of government support.

The question tests the understanding of how a General Partner’s (GP) personal capital contribution, often referred to as ‘hurt money,’ aligns their interests with Limited Partners (LPs) and mitigates excessive risk-taking. A significant personal investment by the GP means they directly share in any losses, making them more cautious and less likely to pursue high-risk strategies solely for the potential of carried interest. This direct financial exposure incentivizes prudent decision-making and a focus on long-term value creation, aligning the GP’s objectives with the LPs’ desire for capital preservation and growth. Options B, C, and D describe other aspects of fund structure or incentives but do not directly address the primary mechanism by which a GP’s personal capital contribution curbs excessive risk.

The provided exhibit demonstrates that while short-term correlations between commodity returns and inflation can be volatile and weak, longer-term averages reveal a more consistent positive relationship, particularly for energy and industrial metals with U.S. inflation. The text explicitly states that over longer periods (three and five years), correlations become stronger and more stable, suggesting that commodities, especially energy, can serve as a more reliable inflation hedge when viewed through a longer investment horizon. The question tests the understanding of how investment horizon impacts the observed relationship between commodity returns and inflation, as depicted in the exhibit.

The question tests the understanding of how different private equity fund types exhibit varying levels of systematic risk, as indicated by their betas. Venture capital (VC) funds, by their nature, invest in early-stage, high-growth potential companies, which are inherently more volatile and sensitive to market downturns. This increased sensitivity translates to higher betas. The provided text explicitly states that VC betas were in the range of 1.40 to 2.42, with a mean of 1.94, indicating a significantly higher systematic risk compared to other private equity subclasses like buyouts or balanced funds. Therefore, a VC fund would command a higher risk premium to compensate investors for this elevated risk.

The passage highlights that top-tier private equity teams often raise funds through word-of-mouth referrals and direct outreach, rather than relying on a broad solicitation of investment proposals. This proactive approach involves identifying and engaging with promising teams even before they begin their fundraising cycles, necessitating a forward-looking calendar of their expected market entry. Reactive sourcing, which involves sifting through numerous proposals, is deemed inefficient for selecting high-quality managers. Therefore, building and leveraging a robust network of industry contacts is paramount for identifying and securing access to these sought-after managers.

Operational due diligence is crucial for institutional investors in hedge funds because it aims to identify and document potential operational risks. The International Association of Financial Engineers (IAFE) defines operational risk as losses stemming from issues related to people, processes, technology, or external events. Understanding these risks is as vital as assessing investment risk. While larger hedge funds typically have more resources for robust operations and risk management, smaller funds may have limitations. Therefore, a key aspect of operational due diligence is to gauge the hedge fund manager’s commitment to building and maintaining strong operational infrastructure and practices, regardless of the fund’s size.

Managed accounts offer investors direct control over their assets and the ability to liquidate positions at any time, thereby avoiding the typical lock-up periods associated with pooled investment vehicles like hedge funds. This enhanced liquidity and direct oversight are key advantages. While transparency is a benefit, it’s a consequence of direct control rather than the primary structural advantage. The reduced pool of managers and administrative responsibilities are drawbacks, not primary benefits. The ability to choose leverage parameters is a feature enabled by direct control, but the core benefit is the control itself and the resulting liquidity.