Mar 2012 Level i Study Guide 20110930

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March 2012CAIA Level I Study Guide

Chartered Alternative InvestmenAnalyst Association


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Contents

Introduction to the Level I Program.................................................................................... 1Foundations of the CAIA Curriculum ................................................................................ 1 Preparing for the Level I Examination................................................................................ 2Level I Examination Topic Weights ................................................................................... 3Errata Sheet ......................................................................................................................... 3 Calculator Policy ................................................................................................................. 3 Level I Sample Questions ................................................................................................... 4The Level II Examination and Completion of the Program ............................................... 4CAIA Level I Outline ......................................................................................................... 5

Topic 1: Professional Standards and Ethics .................................................................... 8 Topic 2: Alpha Drivers and Beta Drivers ..................................................................... 12 Topic 3: Real Estate ...................................................................................................... 17Topic 4: Hedge Funds ................................................................................................... 21Topic 5: Commodities and Managed Futures ............................................................... 34 Topic 6: Private Equity ................................................................................................. 40Topic 7: Credit Derivatives ........................................................................................... 46

Sample Questions Answer Key ........................................................................................ 52 Action Words .................................................................................................................... 53


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March 2012 Level I Study Guide 1

Introduction to the Level I Program

Congratulations on becoming a Chartered Alternative Investment AnalystSM candidate,and welcome to the Level I examination program. The CAIA program, organized bythe CAIA Association

and co-founded by the Alternative Investment Management

Association (AIMA) and the Center for International Securities and Derivatives Markets(CISDM), is designed to be the only globally recognized professional designation in thearea of alternative investments, the fastest growing segment of the investment industry.

The CAIA curriculum provides breadth and depth by first placing emphasis onunderstanding alternative asset classes and then by building applications in managerselection, risk management, and asset allocation. The CAIA program asks candidates towork through the curriculum to identify and describe various asset classes, risk-returncharacteristics of each asset class, the role of each class in a diversified portfolio, the roleof active management in investment processes, the manager selection method, and riskmanagement.

The business school faculty and industry practitioners who have helped create ourprogram bring years of experience in the financial services industry. Consequently, ourcurriculum is consistent with recent advances in the financial industry and reflectsfindings of applied academic research in the area of investment management.

Passing the Level I examination is an important accomplishment and will require asignificant amount of preparation. All candidates will need to study and become familiarwith the CAIA Level I curriculum material in order to build confidence and be successfulon examination day.

Our study guides are organized to facilitate quick learning and easy retention. Each topicis structured around keywords and learning objectives with action words that helpcandidates concentrate on what is most important for the examination. For these reasons,we believe that the CAIA Association has built a rigorous program with high standardswhile also maintaining an awareness of the value of candidates time.

Foundations of the CAIA Curriculum

Candidates for the CAIA exam are assumed to have an understanding of the centralconcepts of quantitative analysis and finance. This includes awareness of the instrumentsthat trade in traditional markets, models used to value these instruments, and the tools and

methods used to analyze data. These concepts are typically covered in dedicatedundergraduate courses or MBA level investment and business statistic courses.

At the beginning of each topic, specific references to relevant Foundations of the CAIACurriculum materials are listed.


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2 Copyright (C) 2011, Chartered Alternative Investment Analyst Association, Inc. All Rights Reserved.

While most college investment and business statistic textbooks could serve as resourcesfor learning the content included in the Foundations of the CAIA Curriculum, the CAIAAssociation recommends the following two books:

Investments. Bodie, Z., A. Kane, and A. Marcus. McGraw Hill Publishers, 9th

Edition. 2010. ISBN-13: 978-0073530703.

Quantitative Investment Analysis. DeFusco, R., D. McLeavey, J. Pinto, and D.Runkle. Wiley Publishers. 2nd Edition. 2007. ISBN: 978-0470052204.

CAIA candidates can expect to see knowledge, skills, and concepts included in theFoundations of the CAIA Curriculum incorporated into Level I examination questions.For example, a candidate may be asked to evaluate the output of a regression analysis orcalculate the value of a bond (both are concepts included in Foundations of the CAIACurriculum) as part of a response to a broader examination question.

For further information about Foundations of the CAIA Curriculum, please visitwww.caia.org/caia-program/curriculum/foundations.

Preparing for the Level I Examination

Candidates should obtain all the reading materials and follow the outline provided in thisstudy guide. The reading materials for the Level I curriculum are:

Standards of Practice Handbook. 10th edition. Charlottesville, Virginia: CFAInstitute, 2010. ISBN: 978-0938367222.

CAIA Level I: An Introduction to Core Topics in Alternative Investments. Wiley.2009. ISBN: 978-0-470-44702-4.

The learning objectives in this study guide are an important way for candidates toorganize their study, as they form the basis for the examination questions. Learningobjectives provide guidance on the concepts and keywords that are most important tounderstanding the CAIA curriculum. A candidate who is able to meet all learningobjectives in this study guide should be well-prepared for the examination. Keywordscan help candidates focus their progress towards fulfilling the learning objectives.Candidates should be able to define all keywords provided, whether or not they are statedexplicitly in a learning objective.

The action words used within the learning objectives help candidates determine what theyneed to learn from the relevant passages and what type of questions they may expect tosee on the examination. Note that actual examination questions are not limited in scopeto the exact action word used within the learning objectives. For example, the actionword "understand" could result in an examination question that asks candidates to define,explain, calculate and so forth. A complete list of the action words used within learningobjectives is provided in the back of this study guide in the Action Words Table.


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Candidates should be aware that an equation sheet will not be provided on theexamination. All equations in the readings are important to understand. Some equationsmay be provided as part of an examination question.

Preparation Time

Regarding the amount of time necessary to devote to the program, we understand that allcandidates are different. Therefore, it is nearly impossible to provide guidelines thatwould be appropriate for everyone. Nevertheless, based on candidate feedback, weestimate that Level I requires 150 - 200 hours of study.

Examination Format

The Level I examination, administered twice annually, is a five-hour computer-administered examination that is offered at test centers throughout the world. The Level I

examination is composed of 200 multiple-choice questions. For more information visitthe CAIA website at www.caia.org.

Level I Examination Topic Weights

Topic Approximate Exam WeightProfessional Standards and Ethics 15% - 20%

Introduction to Alpha Drivers and Beta Drivers 10% - 15%

Real Estate 10% - 15%

Hedge Funds 20% - 25%

Commodities and Managed Futures 10% - 15%

Private Equity 10% - 15%

Credit Derivatives 10% - 15%

Errata Sheet

Correction notes appear in this study guide to address known errors existing in theassigned readings. Occasionally, additional errors in the readings and learning objectivesare brought to our attention and we will then post the errata on the Curriculum page ofthe CAIA website: www.caia.org. It is the responsibility of the candidate to review theseerrata prior to taking the examination. Please report suspected errata to

[email protected].

Calculator Policy

You will need a calculator for the Level I examination. The calculations that candidatesare asked to perform range from simple mathematical operations to more complexmethods of valuation. The CAIA Association allows candidates to bring into the


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examination the TI BA II Plus (including the Professional model) or the HP 12C(including the Platinum edition). No other calculators or electronic devices will beallowed in the testing center. The examination proctor will require that all calculatormemory be cleared prior to the start of the examination.

Level I Sample QuestionsThe sample questions included in this study guide are designed to be representative of theformat and nature of actual CAIA Level I examination questions in March 2012. Thesample questions are not a facsimile of the actual questions. The sample questions do notcover all of the study materials that comprise the CAIA Level I curriculum, nor have theybeen verified to be equally difficult as the actual questions. Accordingly, these samplequestions should not be used to assess a candidates level of preparedness for theexamination.

Candidates should be aware that multiple-choice examination questions ask for the best

answer. In some cases this means that it is possible that a choice is technically accuratebut is not the correct answer because it is superseded by another choice.

The Level II Examination and Completion of the Program

All CAIA candidates must pass the Level I examination before sitting for the Level IIexamination. A separate study guide is available for the Level II curriculum. As with theLevel I examination, the CAIA Association administers the Level II examination twiceannually. Upon successful completion of the Level II examination, and assuming that thecandidate has met all the Associations membership requirements, the CAIA Association

will confer the CAIA designation upon the candidate. Candidates should refer to theCAIA website, www.caia.org, for information about examination dates and membershiprequirements.


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CAIA Level I Outline

Topic 1: Professional Standards and Ethics

Reading:

Standards of Practice Handbook. 10th Edition, CFA Institute, 2010

Standard I: Professionalism

Standard II: Integrity of Capital Markets

Standard III: Duties to Clients

Standard IV: Duties to Employers

Standard V: Investment Analysis, Recommendations, and Actions

Standard VI: Conflicts of Interest

Introduces the practices and standards for dealing with ethical considerationsexperienced in the investment profession on a daily basis; the Handbook addresses the

professional intersection where theory meets practice and where the concept of ethical

behavior crosses from the abstract to the concrete.

Topic 2: Alpha Drivers and Beta Drivers

Reading:

CAIA Level I: An Introduction to Core Topics in Alternative Investments. Wiley.2009.Part I Introduction to Alpha Drivers and Beta Drivers, Chapters 1 5.

What is an Alternative Asset Class?

Why Alternative Assets are Important

The Beta Continuum

Alpha versus Beta

The Calculus of Active Management

Explains the importance of alternative assets and discusses the sources of return to this

asset class in terms of beta and alpha drivers. Approaches to active asset management

and the concept of the continuum of beta offered by managers are described. Details of

alpha-beta separation and the calculus of active management are explained in terms of

the information ratio, the information coefficient, and the breadth.

Topic 3: Real Estate

Reading:

CAIA Level I: An Introduction to Core Topics in Alternative Investments. Wiley.2009.Part II Real Estate, Chapter 6 9.


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Real Estate Investment Trusts

Introduction to NCREIF and the NCREIF Indexes

Real Estate as an Investment

Core, Value-Added, and Opportunistic Real Estate

Discusses real estate investment trusts and direct real estate investments and their role ininvestment portfolios. Introduces candidates to various real estate indices and describes

approaches such as core, value added, and opportunistic to real estate investment.

Topic 4: Hedge Funds

Reading:

CAIA Level I: An Introduction to Core Topics in Alternative Investments. Wiley.2009.Part III Hedge Funds, Chapter 10 17.

Introduction to Hedge Funds Establishing a Hedge Fund Investment Program

Due Diligence for Hedge Fund Managers

Risk Management Part I: Hedge Fund Return Distributions

Risk Management Part II: More Hedge Fund Risks

Hedge Fund Benchmarks and Asset Allocation

Hedge Fund Incentive Fees and the Free Option

Hedge Fund Collapses

Describes various hedge fund strategies, explains their sources of risk and return and

provides historical data showing their distributional characteristics. Discusses how asset

allocation is applied to hedge funds and explains the role of hedge funds in diversified portfolios. The process of establishing a hedge fund program and conducting due

diligence is presented. Describes risk management tools and processes that are employed

by investors. Discusses the role of incentive fees in the performance of hedge funds and

analyzes several cases involving hedge fund liquidations.

Topic 5: Commodities and Managed Futures

Reading:

CAIA Level I: An Introduction to Core Topics in Alternative Investments. Wiley.2009.

Part IV Commodities and Managed Futures, Chapters 19 22.

Introduction to Commodities

Investing in Commodity Futures

Commodity Futures in a Portfolio Context Managed Futures


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Commodity markets are introduced and various methods of investing in commodities are

described. Futures markets and theories explaining the relationship between spot and

futures prices are discussed. The role of commodities and managed futures in a

diversified portfolio is analyzed. Trend following and discretionary trading strategies

are defined and compared.

Topic 6: Private Equity

Reading:

CAIA Level I: An Introduction to Core Topics in Alternative Investments. Wiley.2009.Part V Private Equity, Chapter 23 - 26.

Introduction to Venture Capital Introduction to Leveraged Buyouts

Debt as Private Equity Part I: Mezzanine Debt

Debt as Private Equity Part II: Distressed Debt Trends in Private Equity

The Economics of Private Equity

Various investment products covered under the generic name of private equity are

described: venture capital, leveraged buyouts, and mezzanine debt. The role of private

equity in asset allocation process is discussed. Economic foundations of private equity

and various performance measures are presented. An analysis of industry trends in

private equity markets is provided.

Topic 7: Credit Derivatives

Reading:

CAIA Level I: An Introduction to Core Topics in Alternative Investments. Wiley.2009.Part VI Credit Derivatives, Chapters 29 31.

Introduction to Credit Derivatives

Collateralized Debt Obligations Risks and New Developments in CDOs

Describes various features of credit derivatives and explains risks and payoffs of these

instruments. Structured products, collateralized debt obligations, and other instrumentsare analyzed.


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Topic 1: Professional Standards and Ethics

Readings

Standards of Practice Handbook. 10th

edition. Charlottesville, Virginia: CFA Institute,2010. ISBN: 978-0938367222.Standard I: ProfessionalismStandard II: Integrity of Capital Markets

Keywords

Buy-sideDue diligenceFirewallsFraud

Insider tradingMarket manipulationMaterial nonpublic informationMosaic theoryPlagiarism

Pump and dumpRestricted listSell-sideSoft commissions

Soft dollarsThinly traded securityWatch listWhistle-blowing

Learning Objectives

1. State and interpret Standard I with respect to:a. knowledge of the law.b. independence and objectivity.

c. misrepresentation.d. misconduct.

2. Understand procedures for compliance with Standard I with respect to:a. knowledge of the law.b. independence and objectivity.c. misrepresentation.d. misconduct.

3. State and interpret Standard II with respect to:a. material nonpublic information.b. market manipulation.

4. Understand procedures for compliance with Standard II with respect to material

nonpublic information.


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Standard III: Duties to ClientsStandard IV: Duties to Employers

Keywords

Best executionBlock allocationBlock tradesBrokerageCommissionsCompositesCustodyDirected brokerageDisclosureExecution of ordersFair dealing

"Flash" report

Global Investment PerformanceStandards (GIPS)

"Hot issue" securitiesIndependent contractorsMaterial changesMisappropriationOversubscribed issueRound-lotSecondary offeringsSelf-dealingWhisper number

Learning Objectives

1. State and interpret Standard III with respect to:a. loyalty, prudence, and care.b. fair dealing.c. suitability.d. performance presentation.e. preservation of confidentiality.

2. Understand procedures for compliance with Standard III with respect to:

a. loyalty, prudence and care.b. fair dealing.c. suitability.d. performance presentation.e. preservation of confidentiality.

3. State and interpret Standard IV with respect to:a. loyalty.b. additional compensation arrangements.c. responsibilities of supervisors.

4. Understand procedures for compliance with Standard IV with respect to:a. additional compensation arrangements.

b. responsibilities of supervisors.

Standard V: Investment Analysis, Recommendations, and ActionsStandard VI: Conflicts of Interest

Keywords

Additional compensation Blackout/restricted periods


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Front-runningIncentive feesPerformance fees

Referral feesSecondary research

Learning Objectives

1. State and interpret Standard V with respect to:a. diligence and reasonable basis.b. communication with clients and prospective clients.c. record retention.

2. Understand procedures for compliance with Standard V with respect to:a. diligence and reasonable basis.b. communication with clients and prospective clients.c. record retention.

3. State and interpret Standard VI with respect to:a. disclosure of conflicts.

b. priority of transactions.c. referral fees.4. Understand procedures of compliance with Standard VI with respect to:

a. disclosure of conflicts.b. priority of transactions.

Professional Standards and Ethics Sample Questions

1. According to the Code and Standards, what is the first step that a member shouldtake if he or she has grounds to believe that imminent or ongoing employeractivities are illegal or unethical?

a. Maintain a file with proper documentation of the activity or activities.b. Bring the activity to the attention of his or her employer through his or hersupervisor.

c. Move to establish a formal written policy identifying types of violations andtheir penalties within the firm.

d. Maintain confidentiality in order to preserve the integrity of the firm.

2. According to the Code and Standards, which of the following BEST describesappropriate conduct related to the acceptance of gifts from clients?

a. Members may accept gifts from clients if they are disclosed and if the

employer finds that the gifts will not affect independence and objectivity.b. Members may accept gifts so long as their market value is less than US $100.c. Members cannot accept gifts under any circumstances because research has

shown that any gift, large or small, impairs ethical judgment.

3. Marco Cancellara, CAIA, is a security analyst who places trades through anumber of brokerage firms. The president of one particular brokerage firm is


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appreciative of Mr. Cancellaras business and offers Mr. Cancellara the use of hisvacation home for a week. Mr. Cancellara accepts this offer.

Which of the following statements regarding Mr. Cancellaras actions isconsistent with the Code and Standards?

a. There is no violation because the Code and Standards do not precludecustomary entertainment.b. Mr. Cancellara violated the Code and Standards by entering into a soft-dollar

arrangement.c. Mr. Cancellara violated the Code and Standards by accepting a gift that could

compromise his independence and objectivity.

4. Joanna Wasic, CAIA, is a research analyst for a fund of hedge funds. She learnsthat a portion of the firms research, prepared by another department, is affectedby survivorship bias such that some of the firms performance is exaggerated.Ms. Wasic presents the report to prospective clients in order to solicit new

business, but steers clear of any reference to the exaggerated performance.

Which of the following describes Ms. Wasics behavior with respect to the Codeand Standards?

a. Ms. Wasic violated the Code and Standards because the report misrepresentsperformance.

b. Ms. Wasic violated the Code and Standards because the report was preparedby multiple sources and she failed to explicitly acknowledge those sources.

c. Ms. Wasic did not violate the Code and Standards because the biased datacame from another department.

5. Nadia Petrav, CAIA, is an investment advisor for a multinational investmentcompany located in the United States. Ms. Petrav, however, is registered in, doesbusiness in, and lives in an emerging country with laws and regulationsconsidered less strict than the Code and Standards. Her home country does notallow advisors to hold short positions for their clients or in their personalaccounts. Which of the following BEST describes the requirements on Ms.Petrav, according to the Code and Standards?

a. Ms. Petrav is required to apply the Code and Standards in all aspects of herbusiness and is not allowed to hold short positions in her clients accounts, butcan hold short positions in her personal account as long as they are disclosed.

b. Ms. Petrav is required to apply the Code and Standards in all aspects of herbusiness, and is allowed to hold short positions in both her clients accountsand in her personal account.

c. Ms. Petrav is required to apply the Code and Standards in all aspects of herbusiness, and is not allowed to hold short positions in either her clientsaccounts or in her personal account.


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Topic 2: Alpha Drivers and Beta Drivers

Foundations*

Investments. Bodie, Z., A. Kane, and A. Marcus. McGraw Hill Publishers. 9th Edition.2010. Chapters 1, 2, 5, 6, 8, 9 and 24.

Quantitative Investment Analysis. DeFusco, R., D. McLeavey, J. Pinto, and D. Runkle.Wiley Publishers. 2nd Edition. 2007. Chapters 3, 8, 9 and11.

Readings

CAIA Level I: An Introduction to Core Topics in Alternative Investments. Wiley.2009.ISBN: 978-0-470-44702-4. Part I Introduction to Alpha Drivers and Beta Drivers,Chapters 1 5.

Chapter 1

What is an Alternative Asset Class?

Keywords

Super asset classes

Learning Objectives

1. Describe super asset classes.

2. Describe the asset allocation process and compare strategic and tactical assetallocation.

3. Compare efficient versus inefficient asset classes and explain their relationshipswith traditional and alternative asset classes.

4. Compare constrained versus unconstrained investing.5. Compare asset location and trading strategy.6. Compare asset class risk premiums versus trading strategy risk premiums.

* To understand the CAIA Curriculum and to pass the CAIA Level I exam successfully, candidates must befamiliar with the concepts that are covered in Foundations. For further information seewww.caia.org/caia-program/curriculum/foundations


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Chapter 2

Why Alternative Asset Classes are Important

Keywords

Absolute return strategiesAlpha driversAlternative/cheap betaBeta driversConcentrated portfoliosEquity risk premium (ERP)

Long/short investingMarket segmentationNonlinear return processesStrategic asset allocation (SAA)Tactical asset allocation (TAA)

Learning Objectives

1. Describe the asset allocation process and compare strategic and tactical assetallocation.

2. Explain and identify beta drivers and alpha drivers as investment products.3. Explain the application of beta and alpha drivers in constructing investment

portfolios.

Chapter 3

The Beta Continuum

Keywords

Active betaAlphaAlternative betaBespoke betaBulk betaCheap beta

Classic betaEndogenous alphaExchange-traded funds (ETFs)Exogenous alphaFundamental beta

Learning Objectives

1. Compare various types of beta investment products or trading strategies (classical,bespoke, alternative, fundamental, cheap, active, and bulk), and explain how eachtype is typically constructed.

2. Describe the proper way to estimate the alpha of an investment product.3. Given available information on factor returns and factor exposures, calculate

alpha of investment products.


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Chapter 4

Alpha versus Beta

Keywords

Process drivers Product innovators

Learning Objectives

1. Describe product innovators, process drivers and balanced mandate assetmanagers in asset management industry.

2. Explain why multi-factor alpha determination models may fail to provide accurateestimates of alpha, describe its implications for asset managers, and explain howthe alpha estimation process may be improved.

3. Argue why alpha may or may not be a zero-sum game.4. Describe the risks associated with information asymmetry in the asset

management industry and explain how governance models can address theserisks.

5. Describe the four business models that are likely to be available to asset managersin the future.

Chapter 5

The Calculus of Active Management

Keywords

130/30 products

BreadthFundamental Law of Active

Management

Information coefficient(IC)

Information ratio (IR)Transfer coefficient

Learning Objectives

1. Describe and calculate an ex-post information ratio.2. Explain why the Sharpe ratio is not an appropriate performance measure for

individual managers and calculate whether a new manager should be added to aportfolio.

3. Describe and apply the relationship between the t-statistic and the information

ratio.4. Understand and identify the components of the information ratio on an ex-post

and ex-ante basis.5. Calculate an ex-ante information ratio.6. Explain and calculate the weights of active positions in optimal portfolios.7. Describe the process for the construction of benchmarks for alternative assets and

identify the variables that affect the ex-post information ratio in this approach.


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8. Discuss the role of the transfer coefficient in measuring the ex-ante informationratio and explain the impact of the transfer coefficient on the information ratio oftraditional and active management products.

9. Describe 130/30 portfolios and explain how they are constructed and why theyhave attracted attention.

Correction to reading:Page 49, Equation (5.10). Instead of the standard deviation of the residual risk, thevariance of the residual risk should appear in the denominator.

Alpha Drivers and Beta Drivers Sample Questions

1. Which of the following sets of investment categories or products is MOSTaccurately described as being driven by beta rather than alpha?

a. Enhanced index and 130/30 fundsb. Enhanced index and long/short investingc. Passive index and nonlinear returnsd. Passive index and absolute returns

2. Which of the following types of beta is most associated with active returns ratherthan with systematic risk premiums?

a. Classic betab. Bespoke betac. Alternative betad. Bulk beta

3. How are beta driven products generally described?

a. As requiring substantial information to implement.b. As difficult to create without relatively high costs.c. As having returns uncorrelated with the overall market.d. As attempting to capture systematic risk premiums.

4. What is considered to be the most important task in distinguishing alpha frombeta in the performance of an investment manager?

a. Identifying true systematic risk exposures.b. Observing alpha and properly deducing beta.c. Measuring the returns of relevant factors.

5. Which of the following statements is accurate with regard to the informationcoefficient (IC) in the Fundamental Law of Active Management (FLoAM)?


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a. The IC is the correlation between portfolio returns and market returns acrossactive bets.

b. The IC is the correlation between portfolio returns and market returns throughtime.

c. The IC is the correlation between forecasted returns and actual returns across

active bets.d. The IC is the correlation between forecasted returns and actual returns throughtime.


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Topic 3: Real Estate

Foundations*

Investments. Bodie, Z., A. Kane, and A. Marcus. McGraw Hill Publishers, 9th Edition.2010. Chapter 4 and the chapters cited in Topic 2.

Quantitative Investment Analysis. DeFusco, R., D. McLeavey, J. Pinto, and D. Runkle.Wiley Publishers. 2nd Edition. 2007. Chapters 1 and 2.

Readings

CAIA Level I: An Introduction to Core Topics in Alternative Investments. Wiley.2009.ISBN:978-0-470-44702-4. Part II Real Estate, Chapter 6 9.Chapter 6

Real Estate Investment Trusts

Keywords

Dedicated REIT Hybrid REITsDown-REIT Mortgage REITs Single-property REITEquity REITs Umbrella Partnership REIT (an UPREIT)Finite life REIT

Learning Objectives

1. Explain the advantages and disadvantages of real estate investment trusts(REITs).

2. Differentiate the types of REITs as they pertain to investment philosophy,structure, and the markets in which they invest.

3. Discuss the rules that REITs must obey to obtain tax-advantage status.4. Discuss the economic benefits of REITs compared to other assets.

Chapter 7

Introduction to NCREIF and the NCREIF Indexes

Keywords

Appraised values Hedonic price indexComparable sales method NCREIF Property Index (NPI)

* To understand the CAIA Curriculum and to pass the CAIA Level I exam successfully, candidates must befamiliar with the concepts that are covered in Foundations. For further information seewww.caia.org/caia-program/curriculum/foundations.


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Learning Objectives

1. Classify and describe the types of properties underlying the NPI.2. Describe the two methods used to appraise properties and critique appraisal-based

indices.

3. Explain the three practical effects arising from the smoothing process, includingthe effects of adding leverage to the NPI, and the methods used to unsmooth theNPI.

Correction to reading:

Page 89, Exhibit 7.7, and 93, Exhibit 8.1, the Sharpe ratio for the unsmoothed NCREIFindex should be 0.43.

Chapter 8

Real Estate as an Investment

Keywords

Smoothed indices Unsmoothed indices

Learning Objectives

1. Explain the five goals for adding real estate to an investment portfolio.2. Compare historical risk, return, and risk-adjusted real estate returns to other asset

classes and draw relevant conclusions.

3. Describe the diversification benefits of real estate in terms of its correlationcoefficients with other asset classes, as a hedge against inflation, and its capacityto expand the efficient frontier when combined to a portfolio of stocks and bonds.

Chapter 9

Core, Value-Added, and Opportunistic Real Estate

Keywords

Private equity real estate (PERE) Style boxes

Learning Objectives

1. Compare and contrast the three National Council of Real Estate InvestmentFiduciaries (NCREIF) real estate styles and discuss the eight attributes that help todistinguish the type of property.

2. Assess the returns and risks associated with real estate style boxes from anabsolute and a relative return investor perspective.

3. Describe the cross-section distribution of NPI component property returns.


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4. Discuss the characteristics of private equity real estate.

Real Estate Sample Questions

1. Which of the following scenarios MOST accurately describes the typical US

income tax implications of real estate investment trust (REIT) dividends forpension funds?

a. REITs would pay taxes on their income and pension funds would pay taxes onthe dividends received from REITs.

b. REITs would not pay taxes on their income but pension funds would paytaxes on the dividends received from REITs.

c. REITs would pay taxes on their income but pension funds would not paytaxes on the dividends received from REITs.

d. REITs would not pay taxes on their income and pension funds would not paytaxes on the dividends received from REITs.

2. According to the Level I source material, how do real estate investment trusts(REITs) perform as diversifiers for balanced portfolios of bonds and stocks?

a. REITs tend to diversify bond portfolios very well and diversify large stockportfolios better than small stock portfolios.

b. REITs tend to diversify bond portfolios very poorly and diversify large stockportfolios better than small stock portfolios.

c. REITs tend to diversify bond portfolios very well and diversify small stockportfolios better than large stock portfolios.

d. REITs tend to diversify bond portfolios very poorly and diversify small stock

portfolios better than large stock portfolios.

3. How is the National Council of Real Estate Investment Fiduciaries (NCREIF)Property Index (NPI) calculated?

a. Monthly based on monthly appraisalsb. Monthly with varied appraisal intervalsc. Quarterly based on quarterly appraisalsd. Quarterly with varied appraisal intervals

4. What style of real estate investing is characterized by being the most liquid, themost developed, the least leveraged, and the most recognizable?

a. Coreb. Satellitec. Value-addedd. Opportunistic


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5. Which of the following is a characteristic of private equity real estate (PERE)investments?

a. Low to moderate leverageb. Low risk real estate holdings

c. Easy valuation using transactions datad. Frequent origination in Europe


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Topic 4: Hedge Funds

Foundations*

Investments. Bodie, Z., A. Kane, and A. Marcus. McGraw Hill Publishers. 9th Edition.2010. Chapters 3, 7, 11, 14-16, 18, 20-21 and the chapters cited in Topics 2 and 3.

Quantitative Investment Analysis. DeFusco, R., D. McLeavey, J. Pinto, and D. Runkle.Wiley Publishers. 2nd Edition. 2007. Chapters 4, 5 and 10.

Readings

CAIA Level I: An Introduction to Core Topics in Alternative Investments. Wiley.2009.ISBN:978-0-470-44702-4. Part III Hedge Funds, Chapter 10 17.Chapter 10

Introduction to Hedge Funds

Keywords

144A securities Factor models

Accredited investor Fixed income arbitrage

Activist hedge funds Fixed income yield alternatives

Alpha engines Fund of funds (FoFs)

Arbitrage Fundamental equity long/shortBottom-up analysis

Convergence trading

Generalized Autoregressive

Heteroskedasticity (GARCH)

Conversion ratio Global macro

Convertible arbitrage Hedge fund

Convertible bond arbitrage Hedge fund of funds (FoFs)

Corporate governance Long Term Capital Management

Corporate restructuring Market directional

Delta Market neutral

Delta hedge Statistical arbitrage

Distressed debt hedge funds Stub-trading

Dollar neutral Top-down analysis

Equity long/short Volatility arbitrage

Event-driven Yield curve arbitrage



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Learning Objectives

1. Describe the major characteristics of hedge funds and contrast them with mutualfunds.

2. Determine whether a particular hedge fund strategy is best categorized as a

market directional, corporate restructuring, convergence trading, or opportunistichedge fund.3. For equity long/short strategies:

a. define the strategy.b. identify the portfolio risk and return effects from the ability to go both long

and short.c. define fundamental equity long/short strategies.d. define quantitative equity long/short strategies.

4. For short selling strategies:a. define the strategy.b. compare the exposures of short selling with traditional long-only managers.

c. compare the styles of short selling with equity long/short managers.5. For activist investing:a. define the strategy.b. define the source of return.c. describe the available evidence regarding its performance.

6. For distressed securities strategies:a. define the strategy.b. define capital structure arbitrage.c. describe a particular distressed securities strategy that is most likely to overlap

with private equity firms activities.7. For merger arbitrage strategies:

a. define the strategy.b. identify the main sources of return.8. For event-driven strategies:

a. define the strategy.b. identify the main sources of return.c. contrast with merger arbitrage and distressed securities strategies.

9. For regulation D hedge fundsa. define the strategy.b. identify the source of return.

10.For fixed income arbitrage strategies:a. define the strategy.b. describe the investment universe.c. identify the main sources of return.d. define mortgage-backed security arbitrage strategies.e. identify the main risk exposures of mortgage-backed security arbitrage

strategies.11.For convertible bond arbitrage strategies:

a. define the strategy.b. identify the sources of return.


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c. identify the role of the delta/hedge ratio.d. identify the components of total return to the strategy.e. identify the main risk exposure.f. calculate the number of shares required in a hedge.

12.For market neutral strategies:

a. define the strategy.b. define the rule of one alpha.c. define the term dollar neutral.d. define the role of factor models.

13.For relative value arbitrage strategies:a. define the strategy.b. identify the market neutral nature of the strategy.c. define stub trading strategies.d. define volatility arbitrage strategies.

14.For global macro strategies:a. define the strategy.

b. describe the investment universe.c. explain why global macro funds have fallen out of favor.15.For funds of funds:

a. define the role of funds of funds managers.b. identify the main advantages and disadvantages associated with funds of funds

as compared to direct investment in hedge funds.16.For multi-strategy hedge funds:

a. describe the advantages and disadvantages of multi-strategy hedge funds.b. compare multi-strategy hedge funds to funds of hedge funds.


Page 139, 6th

paragraph under the heading Convertible bond arbitrage; 4th

sentence:

The conversion ratio is based on the current price of the underlying stock, $45, and thecurrent price of the convertible bond (i.e. $900/$45).

Should be:

The conversion ratio denotes the number of shares obtained if the holder of the bondelects to convert it into equity.

Chapter 11Establishing a Hedge Fund Investment Program

Keywords

Absolute returnBenchmark

Cash substituteCatastrophe bias


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CorrelationEquitizationHedge fund of fundsHurdle rateIdiosyncratic risk

Investment opportunity setPerformance persistencePortable alphaRisk budgeting

Learning Objectives

1. Explain why hedge funds should be part of a diversified portfolio.2. For historical performance of hedge funds:

a. contrast the historical absolute performance of hedge funds with theperformance of the S&P 500.

b. contrast the historical volatility of hedge fund returns with the historicalvolatility of the S&P 500 returns.

c. discuss the academic evidence on the contribution of hedge fund allocations tothe performance of a broad stock market based portfolio.

d. discuss the academic evidence on the diversification benefits of hedge fundallocations.e. identify the main drawbacks of the academic evidence on hedge fund

performance.3. Discuss the academic evidence on hedge fund return persistence.4. Discuss the academic evidence regarding the impact of hedge funds on the

financial markets.5. Identify potential goals of a hedge fund investment program.6. Identify the opportunistic investment potential of hedge funds.7. Identify the goals of an opportunistic hedge fund investment program.8. Identify the purpose of a hedge fund of funds program.

9. Discuss the academic evidence on hedge fund of funds programs.10.Define risk budgeting.11.Identify the risk budgeting potential of hedge fund investments.12.Calculate hedge fund allocations based on risk budgeting constraints.13.Calculate the hurdle rate for a hedge fund of funds investment as an addition to a

diversified portfolio.14.Understand the portable alpha strategy.15.Calculate alpha of a hedge fund and explain how it can be ported to another

investment product.16.Discuss the academic evidence regarding hedge fund investments as substitutes

for investment grade bonds.17.Identify the absolute return nature of hedge fund products.

Corrections to reading:

The reference to Figure 11.4 (and its discussion) on pages 154, 162 and 164 (bothoccasions) should refer to the following matrix rather than the Figure 11.4 on page 160:

Continued on next page:


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Correlation Matrix

S&P50 0

10YR

UST

NASDAQ EAFEHFRI

COMP.HFRIFO F

S&P 500 1.00 -0.01 0.82 0.69 0.73 0.51

10-year UST -0.01 1.00 -0.08 -0.03 -0.08 -0.06

NA SDAQ 0.82 -0.08 1.00 0.55 0.72 0.49

EAFE 0.69 -0.03 0.55 1.00 0.64 0.50

HFRI C omposite 0.73 -0.08 0.72 0.64 1.00 0.86

HFRI F OF 0.51 -0.06 0.49 0.50 0.86 1.00

Figure 11.4 that appears on page 160 is correct in regards to the discussion on page 160.

Page 165, middle of page:

$405,000,000 ($250 1,300) = 1,246 S&P500 futures contracts

Should be:

$405,000,000 ($250 1,300) = 1,246 S&P500 futures contracts.

Chapter 12

Due Diligence for Hedge Fund Managers

Keywords

Account representativeActive risk

Administrative reviewAssets under managementBenchmarkCapacityClawbackCounterparty riskDisaster planningDrawdownDue diligenceFeesHigh watermark

Incentive feeInvestment marketsInvestment securitiesInvestment style

Legal reviewLimited partnership

Lockup periodMargin callMaster trustNotice periodOutside service providersPassive securities benchmarkPrime brokerRedemptionsReference checksRegulatory registrationsRisk management

Separate accountsShort volatility riskShorting volatilitySubscription amount

Learning Objectives

1. Describe the phases of due diligence.


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2. Identify three fundamental questions for understanding the nature of a hedge fundmanagers investment program.

3. Identify three essential questions for understanding a hedge fund managersinvestment objective.

4. Discuss the black box investment process.

5. Define process risk.6. Identify two distinct information processing skills.7. Understand the structural review phase of due diligence.8. Define master trust.9. Identify tax consequences of a master trust structure to investors.10.Identify relevant questions about the hedge fund managers organization.11.Identify the role of the CFO of a hedge fund in the relationship between a hedge

fund manager and an investor.12.Identify the role of hedge fund ownership in due diligence analysis.13.Identify the various regulatory registrations required of a hedge fund manager

(U.S.).

14.Identify relevant outside service providers to hedge fund managers.15.Identify the role of prime brokers in the hedge fund business.16.Discuss documentation of hedge fund investment styles, hedge fund investment

markets, and hedge fund investment securities.17.Define the short volatility strategy.18.Identify the role of passive benchmarks in evaluating hedge fund manager

performance.19.Identify the role of hurdle rates in evaluating hedge fund manager performance.20.Identify the role of current portfolio position snapshots in the due diligence

process.21.Discuss the hedge fund investment idea generation process.22.Discuss capacity in hedge fund investments.23.Identify three relevant performance review questions.24.Define drawdown.25.Contrast drawdown in long-only investments with drawdown in hedge fund

investments.26.Identify the role of withdrawals in due diligence analysis.27.Identify three relevant questions for the risk review phase of due diligence

analysis.28.Define active risk, short volatility risk, and counterparty risk.29.Identify the role of leverage limits in hedge fund risk management.30.Discuss the review of civil, criminal and regulatory actions in due diligence

analysis.31.Identify potential effects of high employee turnover on hedge fund performance.32.Define the role of an account representative.33.Identify the role of disaster planning in the hedge fund business.34.Identify the main implications of the limited partnership structure of a hedge fund

investment.35.Contrast separate accounts with limited partnerships.36.For hedge fund fees, define:


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a. the 2 and 20 fee structure.b. high watermarks.c. incentive fees.d. clawback.

37.Define the lock-up period.

38.Identify the benefits of a lock-up period to an investor.39.Define the notice period.40.Identify the role of high subscription amounts in hedge fund investments.41.Identify the role of maximum subscription amounts in hedge fund investments.42.Identify potential sources for due diligence reference checks.43.Identify relevant due diligence questions to be asked to existing hedge fund

clients.

Chapter 13

Risk Management Part I: Hedge Fund Return Distributions

Keywords

Asset-based analysisDouble alpha strategyKurtosisLeptokurtosisLong bias

Market riskMomentsPlatykurtosisSkewnessShort volatility exposure

Learning Objectives

1. Describe the style analysis and asset-based approach to modeling hedge fund

returns.2. Describe the academic evidence on the suitability and limitations of the use of

market factors.3. Describe the major risks affecting:

a. market directional funds.b. corporate restructuring funds.c. convergence trading funds.d. opportunistic funds.

4. Compare and contrast the skewness and kurtosis of return distributions forconvergence trading and corporate restructuring funds with:a. hedge funds having more market exposure.

b. hedge funds that minimize credit risk and market risk.5. Explain the similarities and differences among the return distributions of equity

long/short funds, short selling funds, emerging markets funds, and activist funds.6. Explain the similarities and differences among the return distributions for

distressed securities funds, merger arbitrage funds, event driven funds, andRegulation D funds.


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7. Explain the similarities and differences among the return distributions of fixedincome arbitrage funds, convertible bond arbitrage funds, equity market neutralfunds, fixed income yield alternative funds, and relative value arbitrage funds.

8. Explain the similarities and differences among the return distributions of globalmacro funds and funds of funds.

9. Identify three strategies that have positively skewed returns.10.Describe the distribution of returns for three strategies that exhibit the mostmarket risk.

11.Identify the similarities between selling insurance, convergence trading, andcorporate restructuring funds.

12.Explain the risk management implications of the similarities between sellinginsurance and convergence trading, and corporate restructuring funds.

13.Identify two strategies that have both low market risk and low insurance risk.14.Define short volatility risk.15.Explain the purpose of multi-moment optimization.


Page 215: 2nd

paragraph under the headingActivist hedge funds, 3rd

sentence:

that the kurtosis associated with the return pattern is almost the same as that of thegeneral stock market: 8.29.

Should read:

that the kurtosis associated with the return pattern is almost the same as that of the SBHigh Yield Index of 7.65.

Chapter 14

Risk Management Part II: More Hedge Fund Risks

Keywords

BackfillingBeta expansion riskCatastrophe biasCredit risk

Data riskEvent riskLiquidation biasLiquidity riskMapping riskMultimoment optimizationPerformance measurement risk

Process riskRisk bucketsSelection biasShort volatility risk

Short volatility biasStyle analysisShort volatility strategySurvivorship biasTransparency riskValue at Risk (VaR)Volatility event


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Learning Objectives

1. Define process risk.2. Identify ways of managing process risk.3. Define mapping risk.

4. Identify ways of managing mapping risk.5. Define transparency risk.6. Explain the effect of lack of transparency on portfolio-level risk aggregation.7. Define and calculate Value at Risk (VaR).8. Define risk management risk.9. Identify the drawbacks of applying the VaR methodology to hedge fund

investments.10.Define data risk.11.Define survivorship bias.12.Define selection bias.13.Define backfilling.

14.Explain differences in the academic evidence of hedge fund returns.15.Define catastrophe/liquidation bias.16.Define performance measurement risk.17.Identify the difficulties of using a Sharpe ratio analysis to compare hedge fund

returns.18.Define short volatility bias.19.Define volatility event.20.Define event risk.21.Identify the liquidity risk exposure of arbitrage strategies.22.Define beta expansion risk.

Correction to Reading: Level I: An Introduction to Core Topics in Alternative

Investments

Part III Hedge Funds, Chapter 14, Page 247

The 3rd, 4th and 5th paragraphs of this page discuss the performance of various hedge fundstrategies during the recent financial crisis. As the text states, the first signs of the crisisappeared in July and August of 2007. Almost one year later in September and October2008 we saw the culmination of the crisis when Lehman Brothers filed for bankruptcyand AIG had to be rescued through U.S. government intervention. The discussion refersto figures appearing in Exhibit 14.7. However, the data presented in this exhibit is

incomplete and in some cases incorrect. The following Exhibit presents the complete setof performance figures for both the 2007 and 2008 event periods and the followingparagraphs present the correct discussion of those figures.

Continued on next page:


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Chapter 15

Hedge Fund Benchmarks and Asset Allocation

Keywords

Backfill biasCrowded shortsHazard rate

Instant historyLiquidation biasSurvivorship bias

Learning Objectives

1. Describe the problem with estimating the size of the hedge fund universe.2. Describe survivorship bias and the way it may affect databases and hedge fund

indices.3. Describe instant history bias and the way it may affect databases and hedge fund

indices.

4. Explain the problem associated with strategy definition and its impact on hedgefund databases.

5. Explain the major trade-off that must be taken into account in constructinginvestable hedge fund indices.

6. Describe the typical fee structure of hedge funds that report to databases and itsimpact on the reported monthly returns.

7. Identify the factors that affect performance of various hedge fund indices andexplain why performance of these indices may differ substantially from eachother.

8. Explain the problems with using the mean-variance expected utility approach toasset allocation with hedge funds.

Chapter 16

Hedge Fund Incentive Fees and the Free Option

Keywords

Incentive fee option

Learning Objectives

1. Understand typical hedge fund fee structures.

2. Understand the option-like nature of hedge fund fees.3. Discuss the empirical evidence on the hedge fund incentive fee option value.4. Understand how the option-like nature of hedge fund fees can affect manager

behavior.


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Page 276, Exhibit 16.1, the 5th, 6th, 8th and 9th Sharpe ratios should be 2.29, 2.27, 1.74 and1.78, respectively.

Chapter 17

Hedge Fund Collapses

Learning Objectives

1. Explain Amaranths main trading strategy and the major factors behind itscollapse.

2. Explain Pelotons main trading strategy and the major factors behind its collapse.3. Explain Carlyles main trading strategy and the major factors behind its collapse.

4. Explain Bayous main trading strategy and the major factors behind its collapse.5. Explain Marin Capitals main trading strategy and the major factors behind itscollapse.

6. Explain Bernie Madoffs scheme.7. Understand the conclusions that can be drawn from these cases.

Hedge Funds Sample Questions

1. Which of the following terms is defined as a decline in the net asset value of ahedge fund during a specific period of time?

a. Capacityb. Leveragec. Drawdownd. Lock-up

2. An equity long/short hedge fund has the following portfolio composition:

Long positions 150% of the portfolio valueShort positions 50% of the portfolio value

The long exposure comprises a single asset with a beta of 1.25 whereas the short

exposure comprises an exchange trade fund that passively replicates the overallstock market. What is the beta of this equity long/short fund?

a. 1.125b. 1.250c. 1.375d. 1.875


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3. In which types of securities do Regulation D hedge funds typically invest?

a. Private securities of companies in financial distress or in bankruptcyb. Public securities of companies in financial distress or in bankruptcyc. Private securities that are newly issued by public companies

d. Public securities that are newly issued by companies going public

4. For what primary reason would an investor examine the serial correlation ofhedge fund returns?

a. To investigate whether performance persistence exists.b. To measure the extent to which hedge funds are diversifiers.c. To provide an improved risk measure of idiosyncratic risk.d. To estimate the sign and magnitude of the funds alpha.

5. Derek Fund combines a well-hedged position in competitively-priced assets with

very large, simultaneous short positions in out-of-the-money calls and puts. Adue diligence analysis focused on a time period exhibiting relative marketcalmness would be expected to show the fund exhibiting which of the followingreturn characteristics?

a. High alpha and platykurtosisb. High alpha and leptokurtosisc. Negative alpha and platykurtosisd. Negative alpha and leptokurtosis


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Topic 5: Commodities and Managed Futures

Foundations*

Investments. Bodie, Z., A. Kane, and A. Marcus. McGraw Hill Publishers. 9th Edition.2010. Chapters 12, 22 and 23 and the chapters cited in Topics 2 - 4.

Quantitative Investment Analysis. DeFusco, R., D. McLeavey, J. Pinto, and D. Runkle.Wiley Publishers. 2nd Edition. 2007. Chapters cited in Topics 2 - 4.

Readings

CAIA Level I: An Introduction to Core Topics in Alternative Investments. Wiley.2009.ISBN:978-0-470-44702-4. Part IV Commodities and Managed Futures, Chapters 19 22.

Chapter 19

Introduction to Commodities

Keywords

Capital assets Interest rate parity theoremCommodity futures contracts Maintenance marginCommodity-linked notes Margin callContango Normal backwardationConvenience yield Storage costs

Financial futures Variation marginInitial margin

Learning Objectives

1. Compare commodities to capital assets.2. For exposure to commodities, describe:

a. the purchasing of the underlying commodity.b. a pure play investment.c. commodity futures contracts and margin requirements.d. commodity swaps, forward contracts, commodity-linked notes, and

commodity exchange-traded funds.3. For the relationship between futures prices and spot prices:a. calculate the futures price for an asset that pays no income.b. calculate the futures price for an asset with a known dividend yield.

*To understand the CAIA Curriculum and to pass the CAIA Level I exam successfully, candidates must befamiliar with the concepts that are covered in Foundations. For further information seewww.caia.org/caia-program/curriculum/foundations.


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c. identify arbitrage opportunities for situations where futures prices are higherthan fair value.

d. identify arbitrage opportunities for situations where futures prices are lowerthan fair value.

e. calculate the futures price for a currency contract.

f. formulate the interest rate parity relationship.g. define storage cost.h. calculate the futures price for a commodity futures contract.i. define convenience yield.j. identify mispricing arbitrage opportunities in the commodity markets.

4. For economics of the commodity markets:a. define normal backwardation.b. define a contango market.c. identify the role of futures in hedging producers risk.d. identify the role played by speculators in the commodity market.e. compare backwardated commodity markets to contango markets.

f. identify the determinants of speculator profits in the commodity markets.g. compare pricing of commodities to pricing of financial assets.


Page 319, Exhibit 19.6,

In the "Cash Inflow" column, the 2nd line reads: "F (receive principal and interest)." Itshould read: "Ser(T-t) (receive principal and interest)."

In the "Cash Outflow" column, the 1st line reads: "S (to purchase the asset)." It should

read "S (to borrow the asset).

Chapter 20

Investing in Commodity Futures

Keywords

Collateral yieldCommodity futures indicesCommodity Research Bureau (CRB)

IndexDow Jones-AIG Commodity Index(DJ-AIGCI)

Managed futures accounts

Mount Lucas Management Index(MLMI)

Real assets

Roll yieldStandard & Poors Goldman SachsCommodity Index

Note: The Dow-Jones-AIG Commodity Index is now the Dow Jones-UBS CommodityIndex. However, we will continue to refer to the index as it was named prior to thechange in 2009.


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Learning Objectives

1. Define real assets.2. Compare and contrast commodity and capital asset price movements with respect

to the business cycle and event risk.

3. Discuss the empirical evidence for the diversification potential of commodityfutures added to portfolios of financial assets.4. For commodity indices:

a. identify desirable characteristics.b. define an unleveraged index.c. discuss the economic exposure.d. contrast the returns with those earned by managed futures accounts.e. identify sources of return.f. define collateral yield.g. calculate roll yield.h. distinguish between circumstances resulting in positive roll yield and those

resulting in negative roll yield.5. For the Goldman Sachs Commodity Index (GSCI):a. identify the main characteristics.b. describe the weighting methodology.c. identify the five groups of real assets represented.d. identify the main characteristics of the historical return distribution.

6. For the Dow Jones-AIG Commodity Index (DJ-AIGCI):a. identify the main characteristics.b. identify the components.c. describe the weighting methodology.d. identify the main characteristics of the historical return distribution.

7. Describe the Reuters/Jefferies Commodity Research Bureau (CRB) Index.8. For the Mount Lucas Management Index (MLMI):a. identify the main characteristics.b. identify the components.c. describe the weighting methodology.d. identify the main characteristics of the historical return distribution.

Chapter 21

Commodity Futures in a Portfolio Context

Keywords

Downside risk protectionEfficient frontier

Treasury inflation-protected securities(TIPS)

Learning Objectives

1. Explain how real assets such as commodity futures can hedge against the declineof stocks and bonds prices in an inflationary environment.


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2. Explain why commodities are perceived to be a better inflationary hedging toolthan Treasury inflation protected securities (TIPS).

3. Identify why international stocks generally do not offer inflationary protection fora U.S. portfolio of stocks and bonds.

4. Compare the risk and return characteristics of commodity indices to traditional

broad market indices.5. Define the efficient frontier.6. Identify how adding a passive commodity index to a portfolio of stocks and bonds

changes the efficient frontier.7. Compare the effects of adding the Goldman Sachs Commodity Index (GSCI), the

Dow Jones-AIG Commodity Index (DJ-AIGCI), and the Mount LucasManagement Index (MLMI) to a portfolio of stocks and bonds.

8. Identify how extreme market events can affect the return correlation of equityinstruments.

9. Identify the potential of downside risk protection offered by commodities whenadded to portfolios of stocks and bonds.


Page 354, Exhibit 21.1 reference, 2nd to last paragraph, last sentence (referring to Exhibit21.2) reads: The two lowest-yielding classes over this time period are the DJ-AIGCI andthe MSCI EAFE This should read: The two lowest-yielding classes over this timeperiod are the CRB and the EAFE

Chapter 22

Managed Futures

Keywords

Chicago Board of Trade (CBOT)Chicago Mercantile Exchange (CME)Commodity Exchange ActCommodity Futures Trading

Commission (CFTC)Commodity pool operator (CPO)Commodity poolsCommodity trading advisor (CTA)

Individually managed accountManaged futuresNational Futures Association (NFA)New York Mercantile Exchange

(NYMEX)Private commodity poolsPublic commodity pools

Learning Objectives

1. Define:a. commodity pool.b. public commodity pool.c. private commodity pool.


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2. Define the relationship between commodity pool operators (CPOs) andcommodity trading advisors (CTAs).

3. Describe the history of organized futures trading in the U.S.4. Identify standard fees charged by CTAs and CPOs.5. For the Commodity Exchange Act, identify the:

a. standards established by the Act.b. registration requirements established by the Act.c. role of the National Futures Association (NFA) as established by the Act.

6. Discuss the empirical evidence on the portfolio performance benefits ofinvestment in CTAs, private and public commodity pools.

7. Describe how one can detect the level of skill of a CTA by using a navebenchmark.

8. Describe conclusions that can be made by analyzing historic return distributionsfor different managed futures indices.

9. Compare the effects of adding managed futures versus adding passivecommodities to a portfolio of stocks and bonds.

10.Identify the potential downside risk protection offered by managed futures forportfolios of stocks and bonds.

Commodities and Managed Futures Sample Questions

1. Which of the following comes closest to the fair price on a 6-month futurescontract on the Standard & Poors (S&P) 500 index given the followinginformation: an index at 1500, the risk-free rate at 5%, and the dividend yield at1%?

a. $1,530

b. $1,545c. $1,560d. $1,590

2. Consider the case of a non-dividend-paying financial asset where F > Ser(T-t).How, in this case, can the hedge fund manager earn a profit?

a. By buying the underlying asset and selling the futures contract.b. By buying the underlying asset and buying the futures contract.c. By selling short the underlying asset and buying the futures contract.d. By selling short the underlying asset and selling the futures contract.

3. Contango futures markets have an upward sloping forward curve. Which of thefollowing BEST explains the shape of the forward curve?

a. The additional risk accepted by hedgers over short periodsb. The additional risk accepted by hedgers over long periodsc. The additional risk accepted by speculators over short periodsd. The additional risk accepted by speculators over long periods


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4. According to the Level I readings, what is the effect of adding managed futures toa diversified portfolio of stocks and bonds?

a. Increased downside risk and a worsened risk-return tradeoff

b. Increased downside risk and an improved risk-return tradeoffc. Decreased downside risk and a worsened risk-return tradeoffd. Decreased downside risk and an improved risk-return tradeoff

5. Consider a situation in which the domestic one-year risk-free interest rate is 10%,the current spot exchange rate with a particular foreign currency is 1.00, and aone-year futures contract on the foreign currency has a price of 1.05 domesticunits per unit of foreign currency. Assuming continuous compounding, which ofthe following rates is closest to the one-year risk-free interest rate in the foreigncurrency?

a. 5.12%b. 10.24%c. 15.36%d. 20.48%


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Topic 6: Private Equity

Foundations*

Investments. Bodie, Z., A. Kane, and A. Marcus. McGraw Hill Publishers. 9th Edition.2010. Chapter 18 and the chapters cited in Topics 2 5.

Quantitative Investment Analysis. DeFusco, R., D. McLeavey, J. Pinto, and D. Runkle.Wiley Publishers. 2nd Edition. 2007. Chapters cited in Topics 2 5.

Readings

CAIA Level I: An Introduction to Core Topics in Alternative Investments. Wiley.2009.ISBN:978-0-470-44702-4. Part V Private Equity, Chapter 23 - 28.

Chapter 23Introduction to Venture Capital

Keywords

Alpha testing Investment advisorsBalanced VC funds J-curve effectBeta testing Late stageBurn rate Mezzanine financingClawback Private equityDistressed debt Prudent person

Expansion Venture capitalGatekeeper

Learning Objectives

1. List four distinct strategies encompassed by the term private equity.2. Define venture capital.3. Identify important developments in the history of venture capital.4. Describe expected returns in the venture capital market relative to those in the

public stock market.5. Identify the venture capitalists relationship with investors including the role of

protective covenants and venture capital fees.6. List and describe the aspects of the entrepreneurs business opportunity upon

which venture capitalists focus.7. List sources of venture capital and describe how the structure of the venture

capital marketplace has changed over previous years.



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8. List and describe various venture capital investment vehicles.9. List specializations within the venture capital industry.10.Explain the life cycle of a venture capital fund and describe each of the stages of

financing.


Pages 413-414. Note: The discussions involving beta testing and alpha testing are notentirely correct. First, typically, the alpha testing refers to the first test of newlydeveloped products (e.g., hardware or software) in a laboratory setting. When the firstround of bugs has been fixed, the product goes into beta test with actual users. Betatesting, therefore, refers to a test of new or revised product that is performed by users attheir facilities under normal operating conditions. This beta testing follows alpha testing.For example, vendors of packaged software often offer their customers the opportunity ofbeta testing of new releases.

Page 413, under heading Early stage venture capital

1st

paragraph, replace the 1st, 2

ndand 3

rdsentences with: The start-up company should

now have a viable product that has been alpha-tested in the laboratory and has been beta-tested with potential users. The next step is to test the second-generation prototype withpotential end users.

4th paragraph, replace 2nd sentence with: Some of this will have been accomplished withthe alpha and beta testing of the product.

Page 414, under heading The J Curve For a Start-Up Company

4th

paragraph, 5th

sentence revised as: It is not until the product is tested using thesecond-generation prototype with potential end users that revenues may be generated andthe start-up becomes a viable concern.

Chapter 24

Introduction to Leveraged Buyouts

Keywords

Agency costsBuy and buildCorporate governanceEarnings before interest, taxes,

depreciation, and amortization(EBITDA)

Economic value-added (EVA)Equity kicker

Exit strategyJunk bondsLeveraged build-upLeveraged buyout (LBO)Management buyout (MBO)Material adverse change clauseMerchant bankingVintage year


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Learning Objectives

1. Define leveraged buyouts (LBOs).2. Identify important developments in the history of LBOs and describe the recent

historical performance of LBOs.

3. Define earnings before interest, taxes, depreciation, and amortization(EBITDA).4. Compute the annual compounded return for a theoretical LBO investment.5. Describe the layers of LBO financing.6. Compare the five general categories of value creation methods through LBOs.7. Describe the role of the material adverse change clause in LBO failures.8. Compare the structure of LBO funds to that of hedge funds and venture capital

funds.9. Describe fee structures for LBO firms.10.Explain the concept of a vintage year as it relates to the J-curve effect.11.Compare LBOs to venture capital deals.12.Outline risks associated with LBOs.

13.Define corporate governance and list three types of agency costs associated withLBOs.14.Describe three important benefits for the public market that result from principles

of corporate governance applied by LBO firms.15.Describe the practice of merchant banking.


Page 436, last paragraph, 3rd

sentence should read present value stream ofmanagement fees worth $1.006 billion.

Chapter 25

Debt as Private Equity Part I: Mezzanine Debt

Keywords

Blanket subordinationInter-creditor agreementMezzanine debtMezzanine financing

Payment-in-kindSpringing subordinationStory creditsTakeout provisions

Learning Objectives

1. Describe the general purpose of mezzanine financing and the rationale for itsreturn expectations.

2. Compare mezzanine funds to other forms of financing.3. Recognize the type of transactions that use mezzanine financing.4. Identify advantages of mezzanine debt to the investor and to the issuer.


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5. Describe restrictions on the senior creditor and the mezzanine investor that maybe included in the inter-creditor agreement.

Chapter 26

Debt as Private Equity Part II: Distressed Debt

Keywords

Chapter 7 bankruptcyChapter 11 bankruptcyCovenant-light loansCramdown

Debtor-in-possession (DIP) financingDistressed debt investingVulture investors or Vultures

Learning Objectives

1. Identify factors that have influenced growth in the distressed debt market since the

1990s.2. Describe the nature of distressed debt investors.3. Understand the basics of the Chapter 11 bankruptcy process.4. Illustrate how an investor can gain control of a company through Chapter 11

bankruptcy proceedings.5. Recognize the types of active and passive distressed debt strategies.6. Describe an arbitrage strategy in the distressed debt market.7. Identify two of the main risks of distressed debt investing.

Chapter 27

Trends in Private Equity

Keywords

Auction marketClub dealDeath spiralDirect secondariesLeveraged loans

Structured PIPEs or StructuredPrivate Investment in Public Entities

(PIPEs)Toxic PIPEs

Learning Objectives

1. Describe the efficiency and development of an auction market environment forprivate equity.

2. Describe the advantages and disadvantages of the club deal in the LBO market.3. Describe the advantages and disadvantages of the development of a secondary

market for private equity.4. Contrast deal terms for hedge funds with deal terms for private equity firms.5. Define leveraged loans.


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6. Describe the interest of the various parties in the leveraged loan market includingequity firms and collateralized loan obligation funds.

7. For private investments in public entities (PIPEs):a. describe how a traditional PIPE transaction works.b. explain how toxic PIPEs work.

c. describe a safeguard that can help prevent toxic PIPEs and death spirals.

Chapter 28

The Economics of Private Equity

Keywords

Distressed debtDiversificationLeveraged buyout (LBO)

Mezzanine debtVenture capital

Learning Objectives

1. Compare the investment results of investing in the four private equity categories tothat of investing in the S&P 500.

2. Compare the return distributions of the four private equity categories, given by theaverage, standard deviation, skewness, and kurtosis.

3. Rank the risk-adjusted average returns (Sharpe ratio) for the four private equitycategories and understand reasons for the differences in performance.

4. Discuss the diversification benefits of including private equity in a portfolio oftraditional investments.


Page 518, Exhibit 28.7, note below Exhibit states a Kurtosis value of 2.81. This shouldbe 32.81.

Private Equity Sample Questions

1. In general, the return patterns for leveraged buyouts (LBOs) are shown to exhibitwhich of the following characteristics?

a. Significant negative skewnessb. Significant positive skewnessc. A near symmetrical distributiond. Significant negative kurtosis

2. Which of the following is TRUE of mezzanine financing?

a. It is senior to debt represented by bank loans.


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b. Mezzanine financing typically has an equity kicker.c. Return expectations for mezzanine funds is at about the same level as

leveraged buyout (LBO) funds.d. Mezzanine financing tends to attract the most capital in a robust economy.

3. Which of the following describes the J-curve effect in the typical life cycle of aventure capital firm?

a. Profits in the early years followed by losses in the later years.b. Flat revenues in the early years followed by profits in the later years.c. Losses in the early years followed by profits in the later years.d. Moderate profits in the early years followed large profits in the later years.

4. What characteristic of mezzanine investing allows an investor to purchase thesenior debt once it has been repaid to a certain level?

a. Priority of paymentb. The takeout provisionc. Accelerationd. Subordination

5. Which of the following statements BEST describes the risk spectrum of privateequity strategies?

a. Leveraged buyouts are most risky and distressed debt is least risky.b. Venture capital is most risky and mezzanine debt is least risky.c. Leveraged buyouts are most risky and mezzanine debt is least risky.d. Venture capital is most risky and distressed debt is least risky.


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Topic 7: Credit Derivatives

Foundations*

Investments. Bodie, Z., A. Kane, and A. Marcus. McGraw Hill Publishers. 9th Edition.2010. Chapters 22, 23 and the chapters cited in Topics 1 - 6.

Quantitative Investment Analysis. DeFusco, R., D. McLeavey, J. Pinto, and D. Runkle.Wiley Publishers. 2nd Edition. 2007. Chapters cited in Topics 1 - 6.

Readings

CAIA Level I: An Introduction to Core Topics in Alternative Investments. Wiley.2009.ISBN:978-0-470-44702-4. Part VI Credit Derivatives, Chapters 29 31.Chapter 29

Introduction to Credit Derivatives

Keywords

Credit call optionCredit default swap (CDS)

Nationally Recognized Statistical RatingOrganizations (NRSROs)

Credit linked note (CLN)Credit put option

Qualifying affiliate guaranteesQualifying guarantees

Credit spread risk Rating migrationDefault risk Revolvers

Downgrade risk Spread productInternational Swaps and DerivativesAssociation (ISDA)

Learning Objectives

1. Compare and contrast the three types of credit risk.2. Describe two methods of measuring credit risk.3. Describe three traditional methods of managing credit risk.4. Understand the diversification potential of credit risky investments.5. Describe the high yield debt market.

6. Describe the leveraged bank loan market.7. Compare and contrast revolvers with term loans.8. Describe the emerging markets debt market.9. Describe the distressed debt market.10.List four advantages that credit derivatives provide.



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11.Understand credit put options and credit call options.12.Explain why an investor would purchase a credit linked note (CLN).13.Compare and contrast the cash flows of a total return credit swap for the swap

buyer with those for the swap seller.14.Compare and contrast a total return credit swap with a credit default swap (CDS).

15.List five types of terms negotiated by parties to a CDS.16.List six kinds of trigger events provided by the International Swaps andDerivatives Association (ISDA).

17.List four types of risks associated with credit derivatives.


Page 535 Next to the last paragraph, the average monthly return on leveraged loans should read+0.05% rather than -0.05%.

Page 543, 1st

paragraph, 5th

sentence:

The credit protection buyer takes on all of the economic risk.

Should read:

The credit protection seller takes on all of the economic risk .

Page 548, the 3rd

line should read In general, the credit protection buyer can deliver thefollowing:

Chapter 30

Collateralized Debt Obligations

Keywords

Arbitrage CDOsBalance sheet CDOsBankruptcy remoteCash flow CDOCash-funded CDOsCollateralized bond obligation (CBO)Collateralized debt obligation (CDO)Collateralized loan obligation (CLO)Correlation productsCredit enhancementCredit tranching

External credit enhancementFirst-loss trancheOvercollateralizationReserve accountSpecial purpose vehicle (SPV)Spread enhancementSubordinationSynthetic arbitrage CDOsSynthetic CDOsUnfunded CDOWaterfall


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Learning Objectives

1. Explain factors impacting the growth (or contraction) in the collateralized debtobligation (CDO) market.

2. Compare and contrast the structure of:

a. balance sheet CDOs with arbitrage CDOs.b. cash funded CDO with synthetic CDOs.c. cash flow CDO with market value CDOs.d. funded with unfunded CDOs.

3. Explain how special purpose vehicles work in the CDO market.4. Describe the structure of a cash funded balance sheet CDO.5. Calculate the net gain (or loss) of a synthetic balance sheet CDO using a total

return swap to the bank sponsoring a credit loan obligation (CLO) trust.6. Explain why synthetic CDOs using credit default swaps (CDSs) are often called

correlation products.7. Identify key benefits to banks from CLOs.

8. Compare and contrast cash flow arbitrage CDOs to market value arbitrage CDOs.9. Describe synthetic arbitrage CDOs.10.Calculate the profits from an arbitrage CDO trust.11.Describe three phases of most arbitrage CDOs.


Page 568, Exhibit 30.10, the X-axis label Default Rate should be Decline in PortfolioValue.

Chapter 31

Risks and New Developments in CDOs

Keywords

CDO squaredCollateralized commodity obligation

(CCO)Distressed debt CDOHedge fund CDOsMarket Value CDOs

Private equity CDOsSingle-tranche CDOWeighted average rating factor

(WARF)Weighte

Mar 2012 Level i Study Guide 20110930

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