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CAIA Level II Test Bank | Actual Questions and Answers 100% Verified by Expert | Latest Updated 2024 What advantage do multi-factor models have over single-factor models, such as the Capital Asset Pricing Model? Multi-factor models tend to explain systematic returns much better than do single-fact...

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CAIA Level II Test Bank | Actual Questi ons and Answers 100% Verified by Expert | Latest Updated 202 4 What advantage do multi -factor models have over single -factor models, such as the Capital Asset Pricing Model? - ANSWER Multi -factor models tend to explain systematic returns much better than do single -factor models. By doing so, multi -
factor models are generally believed to produce better estimates of idiosyncratic returns. List the three major categories of factors that drive asset returns. - ANSWER Macroeconomic factors, fundamental/style/investment/dynamic factors, and statistical factors. What are the three steps of an empirical factor model? - ANSWER First, the risk-free rate is subtracted from the returns of each security to form an excess return, which is used as the dependent variable; Second, the researcher selects a set of potential factors that serve as independent variables; Third, statistical analysis is used to identify those factors that are significantly correlated with returns. What factor is contained in the Fama -French -Carhart model that is not contained in the Fama -French model? - ANSWER Momentum What are the three challenges associated with empirical multi -factor models? - ANSWER False identification of factors, factor return correlation vs. causation, and justifying why the CAPM may not be sufficient. Regarding factor investing, list the three important observations as described by Ang (2014). - ANSWER Ang (2014) observes that: factors matter, not assets; assets are bundles of factors; and different investors should focus on different factors. What are two examples of bond factors? Describe both. - ANSWER The credit risk premium and the term premium. The credit risk strategy takes long positions in bonds with low credit quality and short positions in bonds with high credit quality. The term strategy takes long positions in long -term bonds and short positions in short -term bonds. In theory, an investor could passively allocate to several factors that could produce attractive results, but how might they implement a more sophisticated approach to multi -factor investing? - ANSWER Not all factor premiums are the same, so a sophisticated strategy would take advantage of these differences by allocating higher weights to factors that are believed to be offering more attractive risk premiums. Compare a factor with an arbitrage opportunity. - ANSWER A source of return that is a legitimate factor should perform poorly during "bad" times and "good" during normal times. If a source of return performs well in both "bad" and "good" times, it's an arbitrage opportunity. Describe the four practical implications of an adaptive view on markets. - ANSWER 1)tradeoff between risk and return is not stable over time and risk premiums can be predicted based on technical and fundamental variables 2)Market efficiency is a relative concept instead of an absolute one; market displays varying degrees of efficiency depending on the point in time and the participant. 3)It is necessary to use adaptable investment approaches to handle changes in the market environment. 4)With time, alpha becomes beta due to innovation and competition. Why are stochastic discount factors important for a portfolio that includes alternative investments? - ANSWER In a multi -factor portfolio that includes alternative investments, different pieces of the portfolio will require different types of multi -factor methods, such as recognizing that cash flows must be valued differently depending on good vs. bad times and differently based on time horizons, different liabilities, and illiquidity profiles. Describe a theoretical, normative, time -series model of equity returns that might be used by a hedge fund to guide a high frequency trading strategy. - ANSWER Theoretical models tend to explain behavior accurately in more simplified situations where the relationships among variables can be somewhat clearly understood through logic. Normative economic models tend to be most useful in helping explain underlying forces that might drive rational financial decisions under idealized circumstances and, to a lesser extent, under more realistic conditions. Time -series models analyze behavior of a single subject or a set of subjects through time. For example, a model that hypothesized the impact of large orders in an equity market with risk -averse traders of limited capital in a world of informational asymmetries in which the large orders were driven by exogenous shocks to the institutions placing the orders would qualify. Theoretical models - ANSWER Theoretical models tend to explain behavior accurately in more simplified situations where the relationships among variables can be somewhat clearly understood through logic Normative economic models - ANSWER Normative economic models tend to be most useful in helping explain underlying forces that might drive rational financial decisions under idealized circumstances and, to a lesser extent, under more realistic conditions. Time -series models - ANSWER Time -series models analyze behavior of a single subject or a set of subjects through time. What are the two main disadvantages of the Ho and Lee model? - ANSWER The main disadvantages of the Ho and Lee model are that interest rates can be negative and that it assumes a very simple binomial process for bond prices. Between a P -Measure and a Q -measure, which is typically based on an assumption of risk neutrality? - ANSWER A Q-Measure in finance is typically based on an assumption of risk neutrality Describe the relationship between the probability of default and the credit spread with respect to the following four important properties of the Merton model: 1. Sensitivity to maturity, 2. Sensitivity to asset volatility, 3. Sensitivity to leverage, and 4. Sensitivity to the riskless rate. - ANSWER Sensitivity to maturity: The probability of default increases, at a decreasing rate, as the time to maturity increases. The credit spread increases with maturity initially but then begins to decline slightly as maturity increases. Sensitivity to asset volatility: The probability of default increases, at a decreasing rate, as the volatility of the asset increases. The credit spread will also increase as the volatility of the asset increases. Sensitivity to leverage: As leverage increases, both the probability of default and the credit spread increase.

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