Caia®
2009
march
Level 1
CAIA®
Book 2
Schweser Study Notes for the CAIA® Exam
FouNdAtIoNS oF ALtErNAtIvE
INvEStmENtS
Part 5, topic 26
Cross-Reference to CAIA Association Assigned Reading – Anson, Chapter 14
LO 26.5: Define the efficient frontier.
the efficient frontier is a graph in risk/return space of the most efficient combinations of
risky assets. each point on the efficient frontier represents the combination of risky assets
that prod uces the highest level of return for a given level of risk or the lowest amount of risk
for a give n return.
LO 26.6: Identify how adding a passive commodity index to a portfolio of stocks
and bonds changes the efficient frontier.
adding a commodity futures index to a portfolio will produce a more efficient
portfolio. that is, for each level of risk, the portfolio’s returns are higher, and for each level
of return, the portfolio’s risk is lower.
figure 2 shows a representative efficient frontier generated by investing in the s&P 500 and
u.s. treasury bonds, as well as a possible efficient frontier when commodity futures are
added (in blue).
Figur
A
e 2: dding Commodity Futures to the Efficient Frontier
LO 26.7: Compare the effects of adding the Goldman Sachs Commodity Index
(GSCI), the Dow Jones-AIG Commodity Index (DJ-AIGCI), and the Mount Lucas
Investment Management Index (MLMI) to a portfolio of stocks and bonds.
adding each of the commodity indices (GsCi, dJ-aiGCi, and mLmi) to a portfolio
of stocks and bonds produces a more efficient set of portfolios. risk-averse investors will
benefit most from the inclusion of commodity futures in their portfolios.
LO 26.8: Identify how extreme market events can affect return correlation of
equity instruments.
empirical studies have reported an increased correlation among equity markets from
different countries during periods of economic downturns. for example, the impact of an oil
©2008 kaplan schweser
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Part 5, topic 26
Cross-Reference to CAIA Association Assigned Reading – Anson, Chapter 14
price shock will affect all economies and the equity values in those economies. these higher
correlations reduce the diversification benefits of adding international equities to a portfolio.
the development of linkages between countries has increased the correlations among
international equity markets. all of the following have been cited as possible reasons for a
more integrated (and more correlated) global equity market:
1. international efforts (e.g., treaties) between countries to coordinate their fiscal and
monetary policies.
2. an increase in multinational companies with operations in numerous countries.
3. increases in capital flows between countries.
4. Greater individual investor access to foreign investments.
LO 26.9: Identify the potential of downside risk protection offered by commodities
when added to portfolios of stocks and bonds.
an analysis of historical returns indicates that including any of the four commodity futures
indices in a portfolio of u.s. stocks and bonds will improve the downside risk protection
over just holding stocks and bonds. including international stocks in the portfolio provides
less downside protection than adding any of the commodity indices. figure 3 summarizes the
historical results when commodity indices are included in portfolios.
if the downside risk is defined as the average of the negative returns to a portfolio, the
downside protection is defined as the downside return of the portfolio with a commodity
index as part of the portfolio of stocks and bonds less the downside return of the portfolio
with only stocks and bonds.
the portfolio with the dJ-aiGCi has the highest sharpe ratio and provides the most
downside protection. all four commodity futures indices provide downside protection
of 8.53% to 25.98% per year.
Figur
S
e 3: ummary of Portfolio Return Performance and Downside Risk Protection
Measures—Monthly Returns, 1990–2005
Portfolio Performance measures
Portfolio Composition
expected
standard
sharpe
average
downside
return
deviation
ratio
downside
Protection
Stocks Bond Other
Other
%
Rank
%
Rank Ratio Rank
%
Rank
%
Rank
%
%
%
Index
60
40
—
—
0.81
2
2.64
2
0.16
3
–2.03
5
—
55
35
10
GsCi
0.81
2
2.44
3
0.17
2
–1.88
2
13.66
3
dJ-
55
35
10
0.84
1
2.37
6
0.19
1
–1.80
1
25.98
1
aiGCi
55
35
10
CrB
0.75
4
2.44
3
0.14
5
–1.93
4
8.53
4
55
35
10
mLmi 0.79
6
2.38
5
0.16
3
–1.89
3
16.80
2
55
35
10
eafe
0.77
5
2.72
1
0.14
5
–2.23
6
–6.51
5
*
table is adapted from exhibit 14.16 of anson, mark J.P., 2006, Handbook of Alternative Assets,
2nd edition, frank J. fabozzi, ed., new York: John Wiley & sons, 350.
Page 258
©2008 kaplan schweser
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Part 5, topic 26
Cross-Reference to CAIA Association Assigned Reading – Anson, Chapter 14
Ke
y Concepts
1.
t
he positive correlation between commodity futures indices and inflation provides a
hedge against the declining values of stocks and bonds that occur during periods of
high inflation. (Lo 26.1)
2.
Commodities are a better inflationary hedge than tiPs because commodities increase
in value during periods of inflation, while tiPs only preserve the purchasing power
of the bond. therefore, during periods of high inflation, increases in the value of
commodities can offset the decline in the value of stocks and bonds. (Lo 26.2)
3.
Because of their negative correlation with inflation, international stocks do not provide
inflation protection for u.s. stocks or u.s. bonds. (Lo 26.3)
4.
although commodity futures indices are volatile, each of the four commodity indices
has low or negative correlation with the s&P 500, u.s. treasury bonds, and foreign
stocks. therefore, commodity futures should be considered in the construction of a
diversified portfolio. (Lo 26.4)
5.
the efficient frontier is a graph of the most efficient combinations of risky assets
in terms of risk and return. each point on the efficient frontier represents the
combination of assets that produces the highest level of return for a given level of risk
or the lowest amount of risk for a given return. (Lo 26.5)
6.
adding a commodity futures index to a portfolio will produce a more efficient
portfolio. that is, for each level of risk, the portfolio’s returns are higher, and for each
level of return, the portfolio’s risk is lower. (Lo 26.6)
7.
adding commodity indices to a portfolio of stocks and bonds produces a more
efficient set of portfolios. risk-averse investors will benefit most from the inclusion of
commodity futures in their portfolios. (Lo 26.7)
8.
empirical studies have reported an increased correlation among equity markets from
different countries during periods of economic downturns. Higher levels of correlation
reduce the diversification benefits of a portfolio that includes equities from many
different countries. (Lo 26.8)
9.
an analysis of historical returns indicates that including any of the four commodity
futures indices as a portion of a portfolio of u.s. stocks and u.s. bonds will improve
the downside risk protection of the portfolio. (Lo 26.9)
©2008 kaplan schweser
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Part 5, topic 26
Cross-Reference to CAIA Association Assigned Reading – Anson, Chapter 14
Concept Checkers
1.
Which of the following indicates that commodity futures can be an effective
inflationary hedge for a portfolio of stocks and bonds?
a. Higher volatility for commodity futures.
B. Lower sharpe ratio for commodity futures.
C. Higher returns for commodity futures.
d. Positive correlation between commodity futures and inflation.
2.
Which of the following indicates that international stocks do NOT provide
inflationary protection for a portfolio of u.s. stocks? the eafe index:
a. is more volatile than u.s. stocks.
B. is negatively correlated with inflation.
C. has a smaller average downside return measure than u.s. stocks.
d. has a higher sharpe ratio than u.s. stocks.
3.
Which of the following statements about the inflationary hedging tools is most
correct?
a. the negative correlation between commodity futures and inflation indicates that
commodity futures are a good inflationary hedging tool.
B. although tiPs maintain the value of the bond during periods of high inflation,
they do not provide adequate inflation protection for a portfolio of financial
assets.
C. the negative correlation between international stocks and inflation indicates
that they are a good inflationary hedging tool.
d. tiPs adjust the principal amount of the bond based on expected inflation rates
derived from the u.s. treasury yield curve.
4.
Which of the following is NOT a reason for the apparent increase in the correlation
between the returns of foreign stock markets and u.s. stock markets?
a. Positive correlation between inflation and foreign equity returns.
B. treaties that require that countries coordinate monetary policy.
C. the relaxing of capital flow restrictions.
d. increased number of companies with operations in numerous countries.
5.
according to anson, which of the following portfolios will most likely provide the
best performance as measured by the sharpe ratio?
a. 60% u.s. stocks and 40% u.s. bonds.
B. 55% u.s. stocks, 35% u.s. bonds, and 10% eafe.
C. 55% u.s. stocks, 35% u.s. bonds, and 10% dJ-aiGCi.
d. 55% u.s. stocks, 35% u.s. bonds, and 10% GsCi.
Page 260
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Part 5, topic 26
Cross-Reference to CAIA Association Assigned Reading – Anson, Chapter 14
Concept Checker Answers
1. D
the correlation between commodity futures indices and inflation is positive, whereas
the correlation between inflation and stocks and bonds is negative. therefore, the
declining stocks and bonds prices due to high inflation can be offset by the rising prices of
commodities that occur during times of high inflation.
2. B Like u.s. stocks and bonds, the eafe index is also negatively correlated with inflation.
therefore, international stocks do not provide any more inflation protection than u.s. stocks
and bonds.
3. B although the use of tiPs protects the value of the bond from declining in inflationary
environments, tiPs only preserve the purchasing power of the bond. the use of commodity
futures in a portfolio, however, provides a better hedge against inflation because their values
will increase in times of high inflation when stocks and bond values are falling. inflation
adjustments for tiPs are based on movements in the CPi, not the treasury yield curve.
4. A the development of linkages between countries has increased the correlations among
international equity markets. for example, the impact of international treaties that require
countries to coordinate their fiscal and monetary policies, the increase in multinational
companies with operations in numerous countries, increases in capital flows, and the
reduction in the restriction on capital flows that provide individuals greater access to foreign
investments have produced a more integrated global equity market.
5. C Because of the low correlation between commodity futures indices and financial assets, the
addition of commodity futures will increase the risk-return efficiency of the portfolio. the
results reported in the reading indicate that the portfolio with the dJ-aiGCi had the highest
sharpe ratio (0.19) during the 1990–2005 period.
©2008 kaplan schweser
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2009
march
Level 1
CAIA®
Book 3
Schweser Study Notes for the CAIA® Exam
PrACtICE ExAmS
Exam 1 Part 1
Q
uantitative Methods
1.
When compared to mutual funds, hedge funds have:
a. more disclosure requirements and more strategies available to them.
B. more disclosure requirements and fewer strategies available to them.
c. fewer disclosure requirements and more strategies available to them.
D. fewer disclosure requirements and fewer strategies available to them.
2.
Which of the following is NOT a main sub-category of the long/short hedge fund
style?
a. the dedicated short selling style.
B. the emerging markets style.
c. the alpha style.
D. the market timer style.
3.
For a relative value arbitrage style, the main source of return and the main risk
exposures from the convertible arbitrage style are from the potential:
a. decline in a stock’s price to a specified strike level and the further decline beyond
that strike level, respectively.
B. increase in a stock’s price and the potential decline in a stock’s price, respectively.
c. decline in a stock’s price and the potential increase in a stock’s price, respectively.
D. increase in a stock’s price to a specified strike level and the further increase
beyond that strike level, respectively.
4.
the growth of the hedge fund industry has led to self-institutionalization. a major
reason behind the movement toward self-institutionalization is:
a. fear in the hedge fund industry of regulatory controls.
B. the need for better performance.
c. the client’s high tolerance for risk.
D. the greater volatility of markets.
5.
the approach that uses a consistent Nav across the entire fund and requires that an
adjustment be made to the price that each individual investor uses to buy into the
fund is known as the:
a. multiple share approach.
B. equalization factor approach.
c. equalization shares approach.
D. equalization adjustment approach.
©2008 Kaplan Schweser
Page 7
Level 1 Book 3.indb 7
10/24/2008 12:40:15 PM
exam 1
Part 1
6.
the potential for inequity between a new investor and an existing investor of a
hedge fund is greatest for:
a. onshore funds.
B. offshore funds.
c. fund of funds.
D. long/short funds.
7.
Which of following statements concerning beta is CORRECT?
a. Beta measures only unsystematic risk.
B. Beta measures both systematic and unsystematic risk.
c. Beta measures neither systematic nor unsystematic risk.
D. Beta measures only systematic risk.
8.
Which of the following statements is TRUE concerning the use of (t – 1) in the
denominator of the sample variance equation? By using (t – 1) in the denominator
of the sample variance equation:
a. the sample mean becomes an unbiased estimator of the population mean.
B. the sample variance becomes an unbiased estimator of the population variance.
c. the sample variance becomes a biased estimator of the population variance.
D. the sample mean becomes a biased estimator of the population mean.
Use the following information for Questions 9 and 10.
Hedge Fund
Months of Returns
Skewness
Kurtosis
allison
60
–0.3
1.1
Fries
60
0
1.8
Kelly
120
–0.5
0.8
torrey
120
0.4
–1.0
9.
the Bera-Jarque statistic for the allison Hedge Fund is closest to:
a. 4.
B. 3.
c. 5.
D. 6.
10.
Using a 5% level of significance (critical value = 5.99), which fund’s hypothesis that
returns follow a normal distribution cannot be rejected?
a. Fries.
B. Kelly.
c. torrey.
D. allison.
Page 8
©2008 Kaplan Schweser
Level 1 Book 3.indb 8
10/24/2008 12:40:16 PM
exam 1
Part 1
11.
Based on information in the table below and a risk-free rate of 3%, which of the
following is closest to the m2 measure for the Benson Fund?
Benson Fund
S&P 500 Index
average return
23.2%
13.8%
Standard
18%
23%
deviation
Beta
0.9
1.0
a. 12%.
B. 29%.
c. 25%.
D. 15%.
12.
Which of the following statements regarding the rovar measure is FALSE?
a. the rovar measure will provide the same ranking for a group of funds
regardless of the confidence level used to calculate var.
B. the rovar and the Sharpe ratio are related, but may provide different rankings
for a group of funds.
c. rovar can be customized for different holding periods.
D. the denominator for rovar is positive, even though percentage var measures
are usually negative.
13.
Which of the following is NOT a benefit of a relative peer group benchmark?
a. the peer group benchmarks do not contain any of the biases (e.g., survivorship
and self-selection) that are embedded in broader indices.
B. Peer group benchmarks allow us to compare the manager’s performance against
a group of peers following a similar style.
c. the peer group benchmark accounts for transactions costs and fees charged by
hedge fund managers.
D. the peer group benchmark reveals similarities between managers’ strategies.
14.
Jeremy Shastri, an up and coming fund manager with Global Platinum Funds,
would like to begin reporting his great success to several hedge fund databases.
Shastri expects the database to include performance data for the last two years and
then to report current performance. one database manager said that it would not
be possible to include the historical performance numbers in the database because it
would lead to:
a. backfill bias.
B. self-selection bias.
c. self-reporting bias.
D. database bias.
15.
Bridget Packard needs to estimate a 95% confidence interval for a correlation
coefficient. the sample size is 150 and the correlation coefficient is 0.60. the
confidence interval is closest to:
a. 0.5315 to 0.8548.
B. 0.6000 to 0.6000.
c. 0.4865 to 0.6936.
D. 0.6000 to 0.8548.
©2008 Kaplan Schweser
Page 9
Level 1 Book 3.indb 9
10/24/2008 12:40:16 PM
Exam 1 Part 1 Answers
Q
uantitative Methods
1. C
the lack of disclosure requirements and ability to pursue a greater number of strategies are
the result of the private nature of hedge funds. (topic 1, Lo 2)
2. C For the equity long/short style, the main sub-categories are the dedicated short selling style,
the emerging markets style, and the market timer style. (topic 1, Lo 7.b)
3. C the main source of return is from the decline in the price of the short stock position. the
short position exposes the fund to the risk of losses from an increase in the price of the stock.
(topic 1, Lo 9.d)
4. A the main reasons behind self-institutionalization are the fear of regulatory controls and the
demands made by institutions, which represent a large potential source of new investments.
(topic 2, Lo 2)
5. B the equalization factor approach uses a consistent Nav across the entire fund and requires
that an adjustment be made to the price that each individual investor uses to buy into the
fund. (topic 2, Lo 10.a)
6. B Unlike onshore funds, offshore funds are often open-ended. the open-ended structure is
likely to create the potential for inequity between current and new investors. the close-ended
structure does not create these potential inequities. (topic 2, Lo 8)
7. D Beta measures only systematic risk. a beta greater than one indicates the fund has a higher
than average sensitivity to the benchmark, while a beta lower than one indicates the fund has
a lower than average sensitivity to the benchmark. (topic 3, Lo 32)
8. B By using (t – 1) in the denominator of the sample variance equation, the sample variance
becomes an unbiased estimator of the population variance. (topic 3, Lo 13)
t
2
2
kurtosis
9. A Bera-Jarque statistic =
skewness +
6
4
60
2
2
1
( .1)
Beraa-Jarque =
(−0.3) +
= 3.925 ≈ 4
6
4
(topic 3, Lo 20)
©2008 Kaplan Schweser
Page 89
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10/24/2008 12:40:21 PM
exam 1
Part 1 Answers
60
2
2
1
( .1)
10. D Bera-Jarque statistic
=
−
+
=
allison
( 0.3)
3.9
6
4
2
60
2
1
( .8)
Bera-Jarque statistic
=
(0) +
=
Fries
8 1
.
6
4
2
120 − 2 (0 8.)
Bera-Jarque statistic
=
( 0 5
. ) +
=
Kelly
8 2
.
6
4
2
120
2
−
( 1.0)
Bera-Jarque statistic
=
(0 4
. ) +
=
torrey
8 2
.
6
4
the Bera-Jarque statistic evaluates whether data is normally distributed. the critical value
for a level of significance of 5% is 5.99. For a level of significance of 1%, the critical value
is 9.21. allison’s Bera-Jarque statistic of 3.925 is less 5.99. Because allison’s statistic does
not lie in the rejection area to the right of 5.99, the hypothesis that returns follow a normal
distribution is not rejected. the remaining Funds’ Bera-Jarque statistic are higher than 5.99.
therefore, the hypothesis that these Fund’s returns follow a normal distribution must be
rejected. (topic 3, Lo 20)
11. B r = σ (r −r )/ σ +r
p*
m
p
f
p
f
r
.
=
p
0 23 (0.232 0.0 )
* =
×
−
3 /0.
18 + 0.003
0 288
.
m2 = 0.288 = 28.8% ≈ 29% (topic 4, Lo 6)
12. A rovar is calculated as the return of the portfolio divided the absolute value at risk. Like
var, rovar can be customized for different holding periods and risk periods. rovar may
give different rankings for a group of funds if the confidence level used to calculate var is
different. in other words, rovar may give one ranking for a group of funds where risk is
calculated at the 99% confidence level, but a completely different ranking if risk is calculated
at the 95% confidence level due to the different risk definitions. (topic 4, Lo 11.b)
13. A the relative peer group benchmark approach has three primary benefits:
• allows for comparisons of the manager’s performance with a group of peers following a
similar style.
• accounts for transactions costs and fees charged by hedge fund managers.
• reveals similarities between manager’s strategies. (topic 5, Lo 8.c)
14. A Backfill (or instant history) bias results when a database includes historical returns from a
manager. the manager will probably not report until he or she has achieved a track record
of positive results, putting upward pressure on the historical performance reported in the
database. (topic 5, Lo 4)
Page 90
©2008 Kaplan Schweser
Level 1 Book 3.indb 90
10/24/2008 12:40:22 PM
