® ® CAIA Level II Workbook September 2019 Chartered Alternative Investment Analyst Association® CAIA Level II Workbook, September 2019 Contents: Preface Section one: Review Questions & Answers Section Two: Glossary of Keywords 1 CAIA Level II Workbook, September 2019 Preface Congratulations on your successful completion of Level I and welcome to Level II of the Chartered Alternative Investment Analyst (CAIA) program. The CAIA program, organized by the CAIA Association and co-founded by the Alternative Investment Management Association (AIMA) and the Center for International Securities and Derivatives Markets (CISDM), is the only globally recognized professional designation in the area of alternative investments, the fastest growing segment of the investment industry. The following is a set of materials designed to help you prepare for the CAIA Level II exam. Workbook The exercises are provided to help candidates enhance their understanding of the reading materials. The questions that will appear on the actual Level II exam will not be of the same format as these exercises. In addition, the exercises presented here have various levels of difficulty, and, therefore, candidates should not use them to assess their level of preparedness for the actual examination. September 2019 Level II Study Guide It is critical that each candidate should carefully review the study guide. It contains information about topics to be studied as well as a list of equations that the candidate MAY see on the exam. The study guide can be found on the CAIA website, on the Curriculum page. Errata Sheet Correction notes appear in the study guide to address known errors existing in the assigned readings that are viewed as being substantive. Occasionally, additional errors in the readings and learning objectives are brought to our attention after publication. At those points, we will then post the errata directly to a separate errata sheet on the Curriculum and Study Materials section of the CAIA website. It is the responsibility of the candidate to review these errata prior to taking the examination. Please report suspected errata to [email protected]. The Level II Examination and Completion of the Program All CAIA candidates must pass the Level I examination before sitting for the Level II examination. Separate Study Guides are available for each level. As with the Level I examination, the CAIA Association administers the Level II examination twice annually. Upon successful completion of the Level II examination, and assuming that the candidate has met all the Association’s membership requirements, the CAIA Association will confer the CAIA Charter upon the candidate. Candidates should refer to the CAIA website, www.caia.org, for information about examination dates and membership requirements. 2 CAIA Level II Workbook, September 2019 Reading: Alternative Investments: CAIA Level II, 3rd edition, Wiley, 2016. Chapter 1: Asset Allocation Processes and the Mean-Variance Model Exercises 1. Mike Jennings is an assistant at XYZ, an investing consulting firm based in London. He is trying to measure the actual performance of a group of pension funds and the performance that would have been attained had the funds invested their capital in passively managed market indices, and according to the weights set forth in their investment policy statements. To this end, Mr. Jennings regressed the quarterly rates of return reported by a group of U.K. pension funds against passively managed benchmarks that were created using the weights proposed by the investment policy statements of the funds. The average r-squared of these regressions exceeded 85%, and this led Mr. Jennings to conclude that more than 85% of the average returns of these pension funds can be explained by the asset allocation decision described in their investment policy statements. Is the conclusion by Mike Jennings correct? 2. Suppose that an investor’s utility is the following function of wealth (W): ( ) = An investor currently has $150 and is considering √ whether to speculate on an investment with a 70% chance of earning 20%, and a 30% chance of losing 30%. Find the current and expected utility of the investor. Should the investor take the speculation rather than hold the cash? 3. Continuing with the previous exercise (#2), suppose instead that the investor’s utility is the following function of wealth (W): ( ) = W 0.005W 2 Should the investor take the speculation rather− than hold the cash? (Suppose once again that the investor currently has $150 and is considering whether to speculate on an investment with a 70% chance of earning 20%, and a 30% chance of losing 30%). 4. Suppose that an investor’s expected utility, E[U(W)], from an investment can be expressed as: 3 CAIA Level II Workbook, September 2019 [ ( )] = × 2 λ 2 − where W is wealth, μ is the expected rate of return on the investment, σ2 is the variance of the rate of return, and λ is a constant that represents the asset owner’s degree of risk aversion. Use the expected utility of an investor with λ = 0.7 to determine which of the following investments is more attractive: Investment X: μ = 0.05 and σ2 = 0.03 Investment Y: μ = 0.07 and σ2 = 0.10 5. In the previous exercise, suppose now that the investor is risk neutral. Would the answer change? 6. Briefly explain the major internal and external investment policy constraints. 7. An investor’s optimal portfolio has an expected return of 9%, which is 6% higher than the riskless rate. If the variance of the portfolio is 0.02, what is the investor’s degree of risk aversion, λ? 8. Suppose that an investor is using mean-variance optimization with one risky asset and a riskless asset. Suppose that the riskless rate is 2%, and that the expected rate of return on the risky asset is 7% per year. The standard deviation of the index is estimated to be 10% per year. What is the optimal investment in the risky asset for an investor with a risk aversion degree of 8? 9. Consider the case of mean-variance optimization and suppose that the expected annual rate of return of an optimal portfolio is 12%, and the riskless rate is 3% per year. What is the hurdle rate for a new asset that has a beta of 1.2 with respect to the optimal portfolio? What if the new asset has a beta of –0.5? 10. What are the three components of the expected return on all asset classes? Solutions 1. The conclusion by Mike Jennings is incorrect because the average r-squared of these regressions can be interpreted as implying that more than 85% of the return volatility (and not the average return, as Mr. Jennings claimed) of the portfolio through time can be explained by the asset allocation decision described in the investment policy. (Section 1.1) 4 CAIA Level II Workbook, September 2019 2. The current utility of holding the cash is 12.25, which can be found as (rounded): ( ) = 150 = 12.25 The expected utility of taking the speculation √ is found as (rounded): [ ( )] = (0.70 × 180 + 0.30 × 105) = 12.47 Where: 180 = 150 x 1.20; and 105 = √150 x 0.7. Because√ the investor has an expected utility of taking the speculation of 12.47, the investor would prefer to take the speculation as opposed to holding the cash, which has a utility of only 12.25. (Section 1.5.2) 3. With this utility function, the current utility of holding the cash is 37.50: ( ) = 0.005 = 150 0.005 × 150 = 37.50 2 2 In this case, the investor has − an expected utility of− taking the speculation of 27.56, found as (rounded): [ ( )] = 0.70 × (180 0.005 × 180 ) + 0.30 × (105 0.005 × 105 ) = 27.56 2 2 − − In this case, the investor would prefer to hold the cash. (Section 1.5.2) 4. The expected utility of the investments are found as: . Investment X: [ ( )] = 0.05 × 0.03 = 0.0395 0 7 − 2. Investment Y: [ ( )] = 0.07 × 0.10 = 0.0350 0 7 − 2 Investment X is more attractive because the investor’s expected utility of holding X is higher. (Section 1.5.4) 5. In the case of a risk neutral investor, λ=0. This means that: [ ( )] = . Therefore, Investment Y is more attractive than Investment X for a risk neutral investor, because: [ ( )] = 0.07 > [ ( )] = 0.05 (Section 1.5.4) 5 CAIA Level II Workbook, September 2019 6. Internal investment policy constraints are those that are imposed by the asset owner. The three main internal constraints are: a. Liquidity- the asset owner may have specific liquidity requirements that must be clearly acknowledged b. Time horizon- the investment horizon of the asset owner can affect its liquidity needs. Also, investors with a short time investment horizon should take less risk, as there is not enough time to recover from a potential large drawdown c. Sector and country limits- an asset owner may wish to impose constraints on allocations to specific countries or sectors. External investment policy constraints are driven by factors that are not directly under the control of the asset owner. The two main external constraints are: a. Tax status- most institutional investors are tax exempt, and for that reason allocations to tax-exempt investment vehicles are not as attractive to institutional investors as they are for taxable investors b. Regulations- some institutional investors are subject to rules and regulations regarding their investment strategies. (Section 1.6) 7. Using Equation 1.9, the degree of risk aversion (λ) can be obtained as follows: E R R = (1.9) p f � � − λ 2 σE R R 0.06 = = = 3 p f 0.02 � � − λ 2 (Section 1.5.8) σ 8.