Mock 1

Question 1

Altman Order

Answer 1

Z = [(1.2 × X1) + (1.4 × X2) + (3.3 × X3) + (0.6 × X4) + (1.0 × X5)]

X1 = working capital / total assets

X2 = retained earnings / total assets

X3 = earnings before interest and taxes / total assets

X4 = market value of equity / book value of total liabilities

X5 = sales / total assets

Question 2

Core-Satellite

Answer 2

A well-diversified core could allow for downside protection (risk aversion), while the less diversified satellite could allow for upside gains (risk seeking).

The core-satellite approach combines both passive investing (core) and active investing (satellite); it is not necessarily the case that the core dominates.

In some instances, the core-satellite approach allows greater focus on the satellite portfolio (e.g., more complex and intended to invest in higher risk and return assets) and less focus on the core portfolio (e.g., less complex and intended to invest in lower risk and return assets).

The core-satellite approach does not necessarily need to be more costly. For example, having a diversified core and less diversified satellite could achieve the dual benefit of adding value (e.g., diversification in the core) and lowering costs (e.g., higher returns in the satellite to offset costs).

Question 3

A risk analyst makes the following statements regarding tail risk in an endowment:

Statement 1: Tail risk is the risk of severe left-tail or right-tail events, which can cause significant portfolio volatility.
Statement 2: One common way of reducing an endowment’s tail risk is to reduce the allocation to risky alternative investments in favor of lower-risk investments.

Answer 3

Neither of the analyst’s statements is accurate. Tail risk is left-tail risk and reflects the risk of losses due to extreme events. Reducing the allocation to risky assets is less common because it would result in low returns, which is not consistent with an endowment’s mandate.

Question 4

Mortimer has $75 million in cash and cash-equivalent investments reserved for opportunistic investments, and $450 million in concentrated real estate investments. The most appropriate risk categorization, respectively, of the two investments is

Answer 4

Client risks can be categorized as aspirational (idiosyncratic) risk, market risk, and personal risk. Cash and cash equivalent investments address market risk, which is the risk of the investment’s price/value changes due to changes in financial markets. Real estate investments—especially concentrated positions—address aspirational risk, which is the risk unique to individual assets or small groups of assets. Also, note that cash can be categorized in the personal risk category if it is used for an emergency fund.

Question 5

A non-trend-following and discretionary commodity trading advisor (CTA) is attempting to find an appropriate benchmark. Which of the following items is the most appropriate benchmark for such a CTA?

Peer group, index etc

Answer 5

Peer Group

Question 6

An analyst is attempting to value a speculative real estate property that has high potential value-add. Which approach to determining the expected return of the property is likely to produce the most accurate result?

Answer 6

Using risk premiums is often useful for determining the current expected returns for core properties as well as for value-added and opportunistic properties.

The use of observed cap rates may be inaccurate due to problems with determining net operating income. The use of absolute hurdle rates may be inaccurate by not considering varying interest and inflation rates. The use of comparative returns is not one of the three key approaches

Question 7

An analyst has determined using the Black-Scholes option pricing model and other factors that N(d1) = 0.62. Using that information, the delta of a short straddle is closest to:

Answer 7

The delta of the call option is 0.62; the delta of the put option is N(d1) – 1 = –0.38.

The delta of the short straddle (short call and short put) is –0.62 – (–0.38) = –0.24.

Question 8

Which of the following statements regarding risk measurement and reporting for an investment portfolio is most accurate?

The more detailed the risk reporting, the better it is for management.

The more frequent the risk reporting, the better it is for management.

More frequent data collection usually results in more frequent valuations.

An exception report identifies risk breaches that should be remedied as soon as possible.

Answer 8

All else the same, when data is collected more frequently, the time between position valuations decreases—thereby increasing the number of valuations.

For both the level of detail and the frequency of reporting, it is a question of optimization. In some cases, the full details or daily reporting of certain metrics may be unnecessary for management. Instead, weekly reporting of certain account balances may be all that is needed, and it may be unnecessary and an inefficient use of time to provide management with daily reporting. Or, a summary line total rather than a detailed line-by-line level of account reporting may be optimal from a time and cost perspective.

An exception report identifies amounts that are out of typical range that initially only require additional investigation as opposed to remediation. It may well be that remediation is subsequently required, but that is a separate issue.

Question 9

SEC examinations of firm practices regarding cybersecurity have found which of the following areas most likely to require improved policies?

System maintenance.

Risk assessments of critical systems.

Penetration tests and vulnerability scans.

Maintenance of cybersecurity organizational charts.

Answer 9

Based on SEC examinations, many firms did not have adequate system maintenance, with examples such as using outdated operating systems not supported by security patches, or significant weaknesses noted from penetration tests or vulnerability scans that were not fully addressed in a reasonable amount of time.

Additionally, most firms performed regular risk assessments of critical systems. About half of all firms conducted penetration tests of firms, which was considered sufficient. Many firms maintained cybersecurity organizational charts or the equivalent.

Question 10

Which of the following statements least accurately describes a fallacy generated by averaging compounded rates of return?

Inverse ETFs suffer from wealth leakage.

Leveraged ETFs produce greater negative returns in an efficient market when volatility increases.

Rebalancing a portfolio’s assets creates wealth through better diversification.

Market inefficiencies and trading costs may cause an ETF to display a net present value other than zero.

Answer 10

It is true (and therefore not a fallacy) that market inefficiencies and trading costs can cause an ETF to display a net present value other than zero. In an efficient market, it is not theoretically possible to implement a strategy that will generate a nonzero NPV. The remaining statements are all fallacies that have been proven incorrect.

Question 11

Modeling derivatives using spreadsheets has an advantage over paper and pencil in all of the following ways except:

programming errors are easier to identify.

spreadsheets facilitate better predictions than using a standard calculator.

visualization allows for a better understanding of model inputs and outputs.

communication is made easier with managers who are not computer programming experts.

Answer 11

Spreadsheets and computer programs are often used to model derivatives because of the impracticality of using a calculator and pencil for large data sets. Spreadsheets provide the advantages of easier programming error identification, visualization to provide for better model understanding, and easier communications with individuals who are not computer programmers. However, spreadsheets do not provide “better” predictions than using a standard calculator—they are just a more efficient way to run the data.

Question 12

mechanics of the fundamental valuation process

Answer 12

While idea generation is one of the mechanics of the fundamental valuation process, superior returns are more likely to come from lesser-known sources as opposed to data that is fully vetted and broadly distributed. Determining the optimal trade, sizing the trade, and executing the trade are all mechanics of the process.

Question 13

Short-Sale Risk

Answer 13

Synchronization risk occurs when convergence in prices is slow to occur. Short-sale risk is the potential for loss due to a forced close to a short selling position. This risk comes from margin calls, a position crossing exit strategy parameters, and a short squeeze where technical factors can drive prices higher quickly.

Question 14

Which of the following components is least likely to cause a difference between the stated rate of income tax and the effective tax rate?

Deductions

Exemptions

Progressive Tax Rates

Gross Income

Answer 14

The stated rate of income tax is the percentage applied to reported income in a given period. The effective tax rate is the stated rate adjusted for deductions, exemptions, and progressive rate schedules. Gross revenues are the same no matter how you calculate the tax rate, so that will not cause the rates to differ. It is the adjustments after determining revenues that can lead to differences.

Question 15

An analyst plans to use the repeat-sales method to value real estate. The analyst is least likely to be concerned with:

A) backward adjustments to historical returns.

B) the risk of data scarcity due to infrequent sales.

C) the inevitable changes to a given property over time.

D) the focus on a single property as opposed to multiple properties.

Answer 15

One of the biggest advantages of the repeat-sales method is the focus on changes in a single property over time as opposed to multiple properties. The concerns would come from the disadvantages of the method, which include backward adjustments to historical returns, the risk of data scarcity, and the inevitable changes to a given property over time due to age, renovations, and so on.

Question 16

Based on studies of the data in the CISDM Fund of Funds Index, which of the following theories is least likely to explain the increase in beta and decrease in alpha?

A) As assets under management grow, it becomes harder to generate alpha.

B) An increase in the supply of hedge fund managers led to an increase in less qualified managers.

C) The capacity constraint hypothesis suggests that no fund manager can generate alpha consistently.

D) Increased allocations to hedge funds by investors with traditional portfolios led to increased correlations.

Answer 16

The increase in beta and decrease in alpha observed in the study could be explained by three theories:

Capacity constraint hypothesis, which suggests that the generation of alpha is a zero-sum game and only a few managers (not none) can generate alpha consistently—and as assets under management grow, it becomes harder to generate alpha.
Fund bubble hypothesis, which suggests there was an increase in the number of less qualified managers who were attracted to potentially higher incomes.
Increased allocations to active funds hypothesis, which led more investors with traditional portfolios to invest in hedge funds—and therefore, increasing correlations with more traditional assets.

Question 17

If a hedge fund manager is planning to allocate funds using the assets under management−weighted approach, he is likely to face all of the following challenges except:

A) declining alpha.

B) flawed classifications.

C) biased assets under management.

D) personal biases based on experience.

Answer 17

The personal allocation biases approach reflects allocations based on a fund manager or investor’s past experiences influencing future decisions. The assets under management−weighted approach may be a challenge to implement due to declining alpha, biased assets under management may be a challenge (because of self-reporting), and flawed classifications where strategies change and differing classification taxonomies can make it more difficult to categorize hedge funds.

Question 18

A U.S.-based private equity real estate fund manager projects that GDP in the United States will increase by 3% this year, inflation will increase by 2%, and default spreads will narrow by 50 basis points (0.5%). Based on her observations, the manager should expect that private equity real estate fund performance will be.. positively / negatively affected by….

Answer 18

Private equity real estate fund performance tends to be positively correlated with GDP growth and inflation (inflation increases the value of real assets like real estate). Fund performance is also positively related to default spread changes, since investors require a risk premium. Narrowing default spreads will therefore negatively impact fund performance.

Question 19

most favored nation clause in a side letter

Answer 19

o LP can be treated more favorably than the best negotiated rights for any other limited partner.

Question 20

In reviewing past performance data as a means of forecasting future performance, which of the following concerns is least accurately stated?

A) Appropriateness focuses on having the right manager in place for a specific fund and a specific investment strategy.

B) Gaming relates to fund investment activity that prioritizes improved performance over benefitting investors.

C) Accuracy relates to the correct reporting of data and whether there are biases that affect a fund’s performance.

D) Representativeness concerns may indicate that reported fund data does not provide a complete view of all fund data.

Answer 20

When relying on past data to forecast future returns, the five issues to consider are accuracy, representativeness, stationarity, gaming, and appropriateness. Each of the issues defined above are correctly stated except for appropriateness, which relates to performance measures that make sense and that are aligned with a fund’s investment strategy.

Question 21

Risk alert observations related to trends in due diligence for illiquid positions include all of the following except:

A) more detailed quantitative analysis and risk measurement.

B) greater use of quantitative analysis in investment decisions.

C) avoiding ambiguity in valuations, reporting, and measurement.

D) additional importance on using internal dealer quotes for valuations.

Answer 21

For illiquid positions that are not exchange-traded, to preserve independence and objectivity, valuations should be provided by external dealer quotes rather than from trading desks. More detailed (and greater use of) quantitative analysis and risk measurement, as well as avoiding ambiguity in valuations, reporting, and measurement, are all risk alert observations related to due diligence trends.

Question 22

As part of a due diligence effort regarding trade reconciliations, a two-way reconciliation will involve which set of parties?

Answer 22

In a two-way reconciliation, the fund’s data is matched to the prime broker’s data. A three-way reconciliation (triangular reconciliation) matches the fund’s data against the counterparties and the third-party administrator.

Question 23

The factors that impact the interest rates for an auto loan-backed security (ALBS) include all of the following except the borrower’s:

credit score

previous rates

employment

gross income

Answer 23

A borrower’s credit score, employment history, and gross income levels (and history) are all relevant factors that impact interest rates on auto loan−backed securities. Previous interest rates on borrowings will not impact the current rates for these securities.

Question 24

The two primary risks for cross-border real estate investors who receive cash flows in the domestic currency include the specific volatilities associated with:

Answer 24

The volatility of cash flows and of exchange rates are the two risks that cross-border real estate investors must consider when cash flows are measured in the domestic currency.

Question 25

Age -> Discount Rate -> Liability

Answer 25

In the study, a four-to-five-year increase in the longevity of plan members meant a 15%−20% increase in the liability value

Question 26

Briefly describe two reasons why a firm would adopt the Asset Manager Code.

Answer 26

The purpose of the Asset Manager Code is to foster a culture of ethical and professional behavior throughout the firm that protects the interests of investors, protects and enhances the reputation of the firm, and provides a useful framework for asset management firms to provide services in a fair and professional manner with full disclosure. Gaining the confidence of clients is a purpose of the AMC and would be part of earning higher profits and higher return.

Question 27

Logsdon indicates that she would be happy to defer taxes to a later date. Explain how Logsdon can use the investment in the apartment building to defer taxes.

Answer 27

Yes, the tax shield is likely to be less than the present value of the tax shield just calculated because properties often maintain or increase in value, and depreciation lowers the book value of the property, thus increasing the gain on which the investor pays taxes. Logsdon expects the property to maintain or increase in value, so she will have a larger gain—and larger tax bill upon selling the asset—than if she had not depreciated the property. The net gain from the depreciation tax shield will likely be lower than $1,743,783.