Practice questions · Finance & Accounting
CAIA (CAIA Association): Practice Questions
Original concept-check questions for the CAIA, spanning both levels: ethics, the quantitative foundations, the alternative asset classes (hedge funds, private equity, private credit, real assets, structured products), risk and due diligence. Each answer is explained, including why the others are wrong. Filter by domain or difficulty. These are concept checks - not real exam questions.
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Under the CAIA professional standards, when a conflict of interest arises a member should:
Correct answer: C. When a conflict arises, a member must disclose it and place clients' interests first. 'Hide it from clients' withholds material information, 'trade ahead of clients' is front-running that exploits the conflict, and 'ignore it if small' fails the duty to disclose regardless of size. -
The main purpose of the CAIA professional standards is to:
Correct answer: C. The standards uphold ethics and investor protection. They do not guarantee returns or set fees. -
Acting with integrity under the standards means a member should:
Correct answer: B. Integrity means being honest and avoiding misrepresentation in dealings with clients. 'Promise specific returns' misleads about uncertain outcomes, 'favour the most profitable client' breaches fair dealing, and 'withhold bad news' is a form of misrepresentation by omission. -
The Sharpe ratio measures:
Correct answer: C. The Sharpe ratio measures excess return (return above the risk-free rate) per unit of total risk, measured by standard deviation. 'Total return' ignores risk, 'the risk-free rate' is just one input, and 'assets under management' is a size measure, not a risk-adjusted return. -
The illiquidity premium is the extra return investors expect for:
Correct answer: C. The illiquidity premium compensates investors for holding assets that are hard to sell quickly. 'Taking more leverage' is a financing risk, 'paying higher fees' is a cost not a premium, and 'using derivatives' is unrelated to compensation for limited exit ability. -
A limitation of using standard deviation alone for hedge-fund returns is that those returns:
Correct answer: D. Hedge-fund returns are frequently skewed and fat-tailed, so standard deviation understates tail risk. -
Which is a real asset?
Correct answer: B. Infrastructure is a real (tangible) asset. Bonds, fund shares and options are financial instruments. -
Real assets are often used as an inflation hedge because:
Correct answer: C. Real assets such as property and commodities are inflation hedges because their values and cash flows tend to rise with inflation. 'They never lose value' and 'they are risk-free' overstate their safety, and 'they pay fixed coupons' describes bonds, whose fixed payments actually lose real value in inflation. -
Infrastructure investments are typically characterised by:
Correct answer: C. Infrastructure assets are long-lived with relatively stable, often regulated cash flows (toll roads, utilities). 'No regulation' is wrong since many are heavily regulated, 'short lives and volatile cash flows' is the opposite of their profile, and 'daily liquidity' is false because they are illiquid, long-term holdings. -
A hedge-fund 'lock-up' period is:
Correct answer: A. A lock-up is a period during which investors cannot redeem their capital, giving the manager stable funding. 'A fee holiday' waives fees, 'a trading halt' suspends market trading, and 'a margin call' demands more collateral - none restricts investor redemptions. -
The classic '2 and 20' hedge-fund fee structure means:
Correct answer: B. It denotes a management fee (~2%) plus an incentive fee (~20% of gains). -
A 'high-water mark' ensures a hedge-fund manager earns performance fees only on:
Correct answer: B. The high-water mark prevents charging performance fees on gains that merely recover prior losses. -
A long/short equity hedge fund:
Correct answer: A. A long/short equity fund holds both long positions (stocks it expects to rise) and short positions (stocks it expects to fall). 'Only uses cash' and 'only buys bonds' exclude equities entirely, and 'avoids equities' contradicts the strategy's name. -
In a private-equity fund, the General Partner (GP) is:
Correct answer: A. The GP manages the fund; Limited Partners are the investors. -
'Carried interest' is:
Correct answer: C. Carried interest is the general partner's share of fund profits, earned once returns clear a hurdle rate. An audit fee pays for an audit, a loan is borrowed capital, and a management fee is the flat annual charge on committed capital - none is the GP's profit share. -
The 'J-curve' in private equity describes:
Correct answer: B. Fees and early write-downs depress early returns, which then rise as investments mature. -
A leveraged buyout (LBO) acquires a company using:
Correct answer: C. An LBO acquires a company using a significant amount of debt alongside equity, so borrowed funds amplify returns. 'Government grants' are not the financing source, 'no capital' is impossible, and 'only equity' contradicts the defining use of leverage. -
A private fund's 'vintage year' is:
Correct answer: B. Vintage year is when the fund starts deploying capital, used to compare funds. -
Private credit (direct lending) involves:
Correct answer: A. Private credit is non-public lending, often direct to mid-market firms. -
Compared with public bonds, private credit typically offers:
Correct answer: D. Private credit pays more to compensate for illiquidity and complexity, with credit risk. -
Securitisation is the process of:
Correct answer: D. Securitisation packages cash-flow-producing assets into tradable securities. -
A 'tranche' in a structured product is:
Correct answer: A. A tranche is a slice of a structured product with a defined risk/return profile and a set payment priority (seniority). 'A management fee' is a cost, 'a type of hedge fund' is a different vehicle, and 'a regulator' is a supervisory body - none describes a payment-priority slice. -
Value at Risk (VaR) estimates:
Correct answer: B. VaR is a threshold loss at a confidence level, not the maximum possible loss. -
Using leverage in an alternative fund:
Correct answer: B. Leverage amplifies both gains and losses, increasing the fund's risk as well as its potential return. 'Only increases gains' ignores the downside, 'has no effect' is false, and 'removes risk' is the opposite of what borrowing does. -
Adding low-correlation alternatives to a portfolio primarily:
Correct answer: C. Low-correlation assets diversify, lowering portfolio volatility. They do not guarantee returns or remove all risk. -
A key reason hedge-fund returns can look smoother than reality is:
Correct answer: C. Illiquid positions are priced infrequently, smoothing reported returns and understating risk. -
Operational due diligence on a hedge fund focuses on:
Correct answer: D. Operational due diligence assesses the firm's processes and controls, not just performance. -
A 'fund of funds':
Correct answer: D. A fund of funds invests in multiple underlying funds to spread risk across managers and strategies. 'Is a regulator' and 'is a type of bond' misidentify the vehicle, and 'invests in a single stock' is the opposite of its diversified, multi-fund structure. -
The main purpose of manager due diligence is to:
Correct answer: B. Due diligence evaluates capability and soundness before committing capital. -
Survivorship bias in a hedge-fund index:
Correct answer: D. Dropping failed funds leaves only survivors, inflating the index's apparent average return. -
Under the CAIA Member Agreement, members and candidates must comply with applicable laws and regulations. If a local law is less strict than the CAIA standards, a member should follow:
Correct answer: C. When a law and a professional standard differ, the member follows the stricter requirement, so conduct meets the highest applicable bar. Following the less strict local law would breach the higher standard, choosing whichever is cheaper ignores the duty entirely, and 'neither' abandons both obligations. -
A CAIA member is asked to value an illiquid private holding for a client report. Acting professionally, the member should:
Correct answer: A. Professional conduct requires a fair, reasonable, well-documented valuation so the client gets an honest figure. Always choosing the highest or lowest value introduces deliberate bias, and skipping valuation leaves the client with no usable information about a real asset. -
Fair dealing under professional standards means an investment professional must:
Correct answer: B. Fair dealing requires treating all clients fairly when acting and recommending, not favouring some over others. Giving the largest client every advantage and allocating the best trades to the firm both breach fairness, and disclosing nothing about allocations hides how clients are treated. -
When presenting past performance of an alternative fund to prospective investors, a member should:
Correct answer: A. Performance must be presented fairly, without misrepresentation or any implication that past results guarantee the future. Showing only the best year cherry-picks, implying assured returns misleads about uncertainty, and omitting fees overstates the net result investors would actually receive. -
Maintaining client confidentiality means a member should keep client information private unless:
Correct answer: D. Confidential client information may be disclosed only when the law requires it or the client authorises it. Sharing it to satisfy curiosity, to win business, or to tell a conference story all breach the duty of confidentiality. -
The internal rate of return (IRR) is often preferred over a simple time-weighted return for a private-equity fund because the IRR:
Correct answer: D. Because the GP controls when capital is called and returned, a money-weighted measure like IRR captures that timing and size, which is why it is used for private funds. It does not ignore timing (that is its strength), it is not always higher, and it does not remove risk. -
A multiple on invested capital (MOIC) of 2.0x on a private investment means the investor:
Correct answer: A. MOIC is total value divided by capital invested, so 2.0x means the investor received twice what was put in. It is not a loss, not a 2% return (MOIC is a multiple, not a percentage), and not break-even (which would be 1.0x). -
Two assets with a correlation of -1 will, when combined, allow a portfolio's risk to be:
Correct answer: C. Perfectly negative correlation lets the assets' moves offset, so with the right weights portfolio risk can in principle be driven to zero. Correlation of -1 minimises rather than increases risk, does not leave it unchanged, and does not double it. -
The Sortino ratio differs from the Sharpe ratio because it measures excess return relative to:
Correct answer: B. The Sortino ratio divides excess return by downside deviation, penalising only harmful volatility, whereas the Sharpe ratio uses total standard deviation. Beta measures market sensitivity and assets under management is a size figure, neither of which the Sortino ratio uses. -
'Beta' of an alternative strategy to a stock index measures the strategy's:
Correct answer: D. Beta measures how much the strategy's return moves with the index, capturing its market sensitivity. Total return is the raw gain, fee level is a cost, and liquidity is how easily positions can be sold, none of which beta describes. -
'Alpha' in performance evaluation refers to return that is:
Correct answer: B. Alpha is the return earned beyond what the strategy's beta exposures would predict, often attributed to skill. Return explained entirely by market exposure is beta, the risk-free rate is a baseline, and leverage scales existing exposure rather than creating alpha. -
Compared with listed REITs, direct (private) real estate typically has:
Correct answer: D. Direct real estate is valued infrequently (often by appraisal) and is hard to sell quickly, so it is less liquid than listed REITs. It does not offer higher daily liquidity or continuous pricing, and it does produce income such as rent. -
A 'core' real estate strategy, versus 'opportunistic', is generally characterised by:
Correct answer: B. Core real estate holds stable, well-leased, income-producing properties with relatively low risk and leverage. Heavy development risk, maximum leverage with distressed assets, and 'no real property' describe opportunistic or non-real-estate profiles, not core. -
Investing in commodities through futures, an investor earns or loses 'roll yield' when:
Correct answer: B. Roll yield arises from replacing expiring futures with later-dated ones along the curve: backwardation tends to add and contango to subtract. A static spot price would not drive it, commodities pay no dividends, and roll yield is precisely about rolling rather than taking delivery. -
A commodity futures market in 'contango' has:
Correct answer: A. Contango means longer-dated futures trade above the spot price, which tends to create negative roll yield for long positions. Futures below spot is backwardation, 'no futures' contradicts the term, and a fixed price is not how futures curves behave. -
Timberland and farmland are attractive to some allocators mainly because they offer:
Correct answer: A. These natural-resource assets earn from biological growth and crop or timber prices and tend to have low correlation with equities. They do not guarantee returns, are illiquid rather than daily-traded, and are clearly exposed to weather and commodity cycles. -
A global macro hedge fund primarily seeks returns from:
Correct answer: B. Global macro takes directional positions across currencies, interest rates, commodities and equity indices based on top-down economic views. Small-cap stock picking is a narrow equity approach, holding only cash earns no macro return, and auditing funds is not an investment strategy. -
A merger-arbitrage (event-driven) strategy typically profits from:
Correct answer: C. Merger arbitrage buys the target below the deal price and captures the spread as the merger completes, bearing the risk it breaks. Government-bond interest is unrelated, buying every IPO is a different strategy, and the approach seeks corporate events rather than avoiding them. -
A 'market-neutral' equity strategy aims to:
Correct answer: A. Market-neutral funds size longs and shorts so net market (beta) exposure is near zero, isolating stock-selection skill. A large net long keeps market exposure, holding one stock is undiversified and directional, and tracking an index is passive market exposure, the opposite of neutral. -
A managed futures (CTA) strategy most commonly uses:
Correct answer: D. Managed futures (commodity trading advisors) typically follow trends across many futures markets, taking long or short positions as signals dictate. Buy-and-hold equities, private real estate and bank deposits are not the systematic, long-or-short futures approach that defines CTAs. -
A hedge-fund 'side pocket' is used to:
Correct answer: A. A side pocket separates illiquid or hard-to-value positions so redeeming investors are not unfairly advantaged or disadvantaged. It is not a fee mechanism, it cannot guarantee returns, and its legitimate purpose is fair treatment, not hiding losses from regulators. -
A 'gate' provision in a hedge fund allows the manager to:
Correct answer: A. A gate caps the proportion of fund assets that can be redeemed in a period, protecting remaining investors during heavy redemptions. It is not a leverage trigger, a fee mechanism, or a licence to change strategy daily. -
A fund's 'redemption notice period' is the time an investor must:
Correct answer: B. The notice period is the advance warning an investor must give before redeeming, letting the manager raise cash in an orderly way. It is not about investing after closure, a fee holiday, or waiting for an audit. -
In a private-equity fund, 'committed capital' is:
Correct answer: B. Committed capital is the total amount limited partners have pledged, drawn down over time as the GP calls it. It is not the same as already-invested cash (that is called or deployed capital), not the annual fee, and not the GP's personal wealth. -
A 'capital call' (drawdown) in a private fund is when the GP:
Correct answer: D. A capital call draws down part of investors' committed capital when the GP needs cash to invest or pay expenses. Returning money is a distribution, and paying staff or filing taxes are operational tasks, not the act of calling committed capital. -
Venture capital differs from a typical leveraged buyout because venture capital usually:
Correct answer: B. Venture capital takes minority equity stakes in early-stage, high-growth firms and rarely uses leverage. Heavy debt on mature companies describes buyouts, buying public bonds is debt investing, and 'avoids equity entirely' contradicts venture's equity focus. -
A 'hurdle rate' (preferred return) in a private fund is the return that:
Correct answer: D. The hurdle is the minimum return LPs must receive before the GP shares in profits via carried interest. It does not cap investor gains, is not guaranteed GP income, and is separate from the management fee. -
A 'clawback' provision in a private-equity fund protects investors by:
Correct answer: A. A clawback forces the GP to repay carried interest it collected early if final performance does not justify it, ensuring LPs get their agreed split. It is the opposite of letting the GP keep early profits, and it does not change the fee or remove the hurdle. -
A secondary-market transaction in private equity involves:
Correct answer: D. A PE secondary is the sale of an existing limited-partner interest from one investor to another, giving liquidity in an otherwise locked-up asset. It is not a public share issue, a bank loan, or a carried-interest payment. -
'Dry powder' in private equity refers to:
Correct answer: D. Dry powder is committed capital the GP has not yet deployed and can still invest. Distributed profits are the opposite of undeployed capital, the management fee is a cost, and buyout debt is borrowed financing rather than uncalled equity. -
A 'unitranche' loan in private credit combines:
Correct answer: A. A unitranche blends senior and subordinated debt into one facility at a single blended interest rate, simplifying the borrower's capital structure. It is not a combination of two funds, of equity and a hedge, or of a bond and a stock. -
Most direct-lending loans are floating rate, which means that when benchmark rates rise, the lender's interest income generally:
Correct answer: C. Floating-rate loans reset with a benchmark, so rising rates increase the lender's interest income. It does not fall or stay fixed (that is fixed-rate behaviour), and it certainly does not go to zero. -
A loan covenant in private credit is best described as:
Correct answer: D. Covenants are conditions (such as leverage limits) the borrower must satisfy, giving lenders protection and early warning of trouble. They do not guarantee repayment, are not the interest rate, and are not an equity stake. -
Mezzanine debt sits in the capital structure:
Correct answer: C. Mezzanine ranks below senior debt but above equity, so it carries more risk and a higher expected return than senior debt. It is not the most senior claim, not external to the company, and far riskier than government bonds. -
'Distressed debt' investing involves buying the debt of companies that are:
Correct answer: A. Distressed investors buy the debt of troubled firms at a discount, seeking gains from a turnaround or restructuring. Healthy companies, government ownership, and record dividends all describe the opposite of distressed situations. -
In a securitisation, the 'equity' (first-loss) tranche:
Correct answer: C. The equity tranche is last in the payment waterfall and absorbs the first losses, so it offers the highest potential return to compensate. It is not paid first or risk-free, not government-guaranteed, and carries the lowest, not highest, credit rating. -
A collateralised loan obligation (CLO) is a structured product backed primarily by:
Correct answer: A. A CLO pools leveraged corporate loans and issues tranches against them. Residential mortgages back RMBS, government treasuries are not the collateral, and single company shares are equity, not a loan pool. -
'Credit enhancement' in a structured product is designed to:
Correct answer: C. Credit enhancement (such as overcollateralisation or subordination) raises the credit quality and protection of senior tranches. It reduces rather than increases default risk, does not remove collateral, and is not limited to raising the equity-tranche coupon. -
The 'waterfall' in a structured product describes:
Correct answer: C. The waterfall sets the order in which cash flows pay each tranche, senior first and equity last. It is not a marketing plan, a salary schedule, or an audit timetable. -
A key weakness of Value at Risk (VaR) is that it:
Correct answer: D. VaR gives a threshold loss at a confidence level but is silent about how large losses can be once that threshold is breached. It does not always overstate risk, it can be calculated, and it does not eliminate tail risk, which is exactly the part it ignores. -
Conditional VaR (expected shortfall) improves on VaR by measuring:
Correct answer: C. Conditional VaR estimates the average loss in the tail beyond the VaR cut-off, capturing the severity VaR ignores. It is not the average return, the fee, or the risk-free rate. -
Stress testing a portfolio involves:
Correct answer: B. Stress testing estimates how a portfolio would behave in severe but plausible adverse scenarios, complementing statistical measures. It does not assume static markets, is not about removing hedges, and goes beyond average performance to examine extremes. -
Counterparty risk in a derivatives or financing transaction is the risk that:
Correct answer: D. Counterparty risk is the chance the other party defaults on its obligations, such as failing to pay or deliver. Changing interest rates is market risk, rising inflation is inflation risk, and an early market close is an operational matter, not counterparty default. -
Liquidity risk for an alternative fund is the danger that:
Correct answer: C. Liquidity risk is the risk that holdings cannot be sold quickly without accepting a worse price, which is acute in illiquid alternatives. It is not about returns always being negative, low fees, or an auditor resigning. -
'Tail risk' refers to the risk of:
Correct answer: A. Tail risk is the danger of rare, extreme losses in the distribution's tails, which standard deviation can understate. Small frequent gains, average outcomes, and management fees are unrelated to extreme tail events. -
A risk that diversification across many hedge-fund managers does NOT remove is:
Correct answer: B. Spreading across managers reduces idiosyncratic problems like one fund's fraud, operational failure or style drift, but a broad systematic shock can hit many strategies simultaneously and is not diversified away. The other three are exactly the manager-specific risks diversification helps with. -
Investment due diligence (as opposed to operational due diligence) focuses mainly on:
Correct answer: A. Investment due diligence examines the strategy, competitive edge, process and the drivers of return and risk. Back-office controls, the custodian and the administrator's systems are the province of operational due diligence, not investment due diligence. -
A 'red flag' in operational due diligence would be:
Correct answer: C. A manager that both administers and values its own illiquid positions with no independent oversight is a classic red flag. Independent administration, a reputable auditor, segregated assets and clean audited statements are reassuring signs, not warnings. -
Backfill bias in a hedge-fund database arises when:
Correct answer: D. Backfill bias occurs because a fund's favourable prior track record is filled in when it starts reporting, inflating the database's history. Daily reporting, auditing and fee disclosure do not create this selection effect. -
Checking a manager's references and background as part of due diligence primarily helps assess:
Correct answer: C. References and background checks help judge the manager's integrity, real track record and reliability of key people. They cannot reveal exact future returns or the next market move, and they are not about the tax code. -
Style drift, discovered during ongoing monitoring, means a manager has:
Correct answer: A. Style drift is when a manager strays from the agreed strategy, changing the risk investors expected. Keeping to the mandate is the opposite, and lower fees or better liquidity are unrelated to drifting from the stated style. -
Compared with a single hedge fund, a fund of funds adds an extra layer of:
Correct answer: B. A fund of funds charges its own fee on top of the underlying funds' fees, the price of diversification and manager selection. It does not guarantee returns, its liquidity benefit is not free, and it does not replace regulation. -
An institution that wants alternatives exposure but more control and lower fees than a fund of funds might instead use:
Correct answer: A. Investing directly in funds and taking co-investments alongside GPs gives more control and typically lower fees than a fund-of-funds wrapper. A savings account, listed equities only, or a single government bond do not provide alternatives exposure in that way. -
A common reason large investors add alternatives to a traditional stock-and-bond portfolio is to:
Correct answer: A. Alternatives are added chiefly to diversify and tap return sources with low correlation to public markets. They do not guarantee outperformance, they usually raise fees, and they require more, not less, due diligence. -
Incorporating ESG factors into alternative-investment analysis means the investor:
Correct answer: B. ESG integration weighs environmental, social and governance risks and opportunities alongside traditional financial analysis. It does not ignore returns, cannot guarantee a social outcome, and is not limited to government bonds. -
Compared with the CFA Program, the CAIA program is best described as:
Correct answer: D. The CAIA specialises in alternative investments, while the CFA is broader across general investment analysis. It is not an auditing or tax-preparation credential. -
A '13-week cash flow' or similar liquidity-planning tool matters in alternatives because many holdings:
Correct answer: D. Because alternatives are often illiquid and involve capital calls, investors plan liquidity carefully to meet commitments and redemptions. The holdings cannot generally be sold instantly at no cost, do not pay daily dividends, and do have cash flows over time.
Practice questions FAQ
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