CAIA CAIA Risk Management 2 — Questions and Answers
Question 1: Model risk in alternative investments refers to:
- The risk that a portfolio manager follows trends rather than models
- The risk that a quantitative model is incorrectly specified, estimated, or applied (Correct answer)
- The risk of losing money when volatility increases
- The risk of regulatory model approval being denied
Correct answer: The risk that a quantitative model is incorrectly specified, estimated, or applied
Model risk arises from reliance on flawed mathematical models for pricing, risk measurement, or trading, which can lead to systematic mispricing or loss.
Question 2: The maximum drawdown metric measures:
- The average daily loss over a 12-month period
- The peak-to-trough decline in portfolio value over a specified period (Correct answer)
- The annualized standard deviation of returns
- The percentage of months with negative returns
Correct answer: The peak-to-trough decline in portfolio value over a specified period
Maximum drawdown captures the largest cumulative loss from a peak to a subsequent trough, indicating the worst historical experience for an investor.
Question 3: In the context of hedge funds, 'redemption gates' are used to:
- Prevent new investors from entering the fund during volatile markets
- Limit the percentage of fund assets that can be redeemed in any given period to protect remaining investors (Correct answer)
- Lock in profits at a predetermined price level
- Restrict trading activity during market closures
Correct answer: Limit the percentage of fund assets that can be redeemed in any given period to protect remaining investors
Redemption gates cap redemptions (e.g., 25% of NAV per quarter) to prevent fire sales of illiquid assets that would harm investors who remain in the fund.
Question 4: Operational risk in alternative investment funds most commonly arises from:
- Macro-economic policy changes by the Federal Reserve
- Failures in internal processes, people, systems, or external events such as fraud or cyber attacks (Correct answer)
- Rising correlation between asset classes during market stress
- Poor benchmark selection by the investment committee
Correct answer: Failures in internal processes, people, systems, or external events such as fraud or cyber attacks
Operational risk encompasses non-market risks including trade settlement errors, valuation manipulation, cybersecurity breaches, and key-person dependency.
Question 5: Correlation risk in a multi-strategy portfolio refers to:
- The risk that individual strategy correlations to the market exceed the Sharpe ratio
- The risk that asset correlations increase during market stress, reducing diversification benefits precisely when they are most needed (Correct answer)
- The risk that a manager calculates correlation incorrectly
- The risk that a benchmark correlation is misspecified
Correct answer: The risk that asset correlations increase during market stress, reducing diversification benefits precisely when they are most needed
During crises, correlations between previously uncorrelated strategies tend to spike toward 1.0, eliminating diversification benefits at the worst possible time.
Question 6: Which risk management approach combines scenario analysis with sensitivity testing to assess portfolio vulnerability to specific factor changes?
- Monte Carlo simulation
- Factor stress testing (Correct answer)
- Bootstrap historical simulation
- Kelly criterion optimization
Correct answer: Factor stress testing
Factor stress testing evaluates how a portfolio responds to targeted changes in specific risk factors (e.g., credit spreads widening 200bps, equity markets falling 30%).
CAIA CAIA Risk Management 2
Model risk in alternative investments refers to: