CAIA Level II Sample Exam 2024 Questions & Answers (Scored A+)
Intuition of the Black-Derman-Toy interest rate model - ANSWER-Observed spot rates drive rate levels while implied rate volatilities drive rate spreads
Understanding the intuition of imposing these two conditions helps in unders...
consider a portfolio allocation process in which t
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CAIA Level II Sample Exam 2024 Questions & Answers (Scored A+)
Intuition of the Black-Derman-Toy interest rate model - ANSWER-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 - ANSWER-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
The three major types of credit risk modeling approaches - ANSWER-I. The structural approach
II. The reduced-form approach
III. The empirical approach
The structural approach - ANSWER-In the structural approach, the framework is set around an explicit relationship between capital structure and default. The value of a firm's assets is set equal to the value of its equity plus the value of its debt. Equity of the
firm is viewed as a call option on the firm's assets, with the strike price being the face value of the debt due at the time of exercise. In contrast, bondholders are viewed as having a risk-free bond and a short position in a put option on the firm's assets. If the value of assets is less than the face value of the debt, the put option will be exercised on the bondholders, resulting in their giving up the risk-free bond and receiving the firm's assets.
Consider a portfolio allocation process in which the following two portfolio allocation strategies are being considered for use:
1. Minimum volatility portfolio weights
2. Risk parity portfolio weights In this particular portfolio allocation process, all the available investment opportunities have the same return volatilities but the return correlations between each pair of assets differ.
Which of the following correctly identifies the strategies that will generate equal weightings, if any? - ANSWER-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? - ANSWER-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 - ANSWER-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 - ANSWER-Z < 1.81: Default group
1.81 < Z < 2.99: Gray zone Z > 2.99: Nondefault group
Three challenges of empirical multifactor models - ANSWER-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
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