CAIA CAIA Risk Management 1 — Questions and Answers
Question 1: Value at Risk (VaR) at the 95% confidence level over a 1-day horizon means:
- The portfolio will lose exactly this amount on 95% of trading days
- Losses will not exceed this amount on 95% of trading days, or equivalently will exceed it on 5% of days (Correct answer)
- The maximum possible loss over any 1-day period
- The expected loss given that a loss event occurs
Correct answer: Losses will not exceed this amount on 95% of trading days, or equivalently will exceed it on 5% of days
95% 1-day VaR states that losses will exceed the VaR threshold only 5% of trading days (1 in 20 days).
Question 2: Which risk measure addresses the main limitation of VaR by estimating the expected loss in the tail beyond the VaR threshold?
- Beta
- Expected Shortfall (CVaR) (Correct answer)
- Sharpe Ratio
- Tracking Error
Correct answer: Expected Shortfall (CVaR)
Expected Shortfall (also called Conditional VaR or CVaR) measures the average loss in scenarios that exceed the VaR, capturing tail risk that VaR ignores.
Question 3: Liquidity risk in alternative investments is best described as:
- The risk that a fund manager will underperform the benchmark
- The risk of being unable to sell or exit a position without significant price impact or within a required timeframe (Correct answer)
- The risk of rising interest rates reducing bond prices
- The risk of currency fluctuations in international portfolios
Correct answer: The risk of being unable to sell or exit a position without significant price impact or within a required timeframe
Liquidity risk is the inability to transact at a fair price quickly, which is especially acute in illiquid alternatives like private equity and real estate.
Question 4: Counterparty risk in the context of OTC derivatives refers to:
- The risk that market prices move against the position
- The risk that the other party to a contract defaults before settlement (Correct answer)
- The risk of operational errors in trade execution
- The risk of regulatory changes invalidating contracts
Correct answer: The risk that the other party to a contract defaults before settlement
Counterparty risk arises when one party to an OTC contract may fail to fulfill its obligations, exposing the surviving party to replacement cost risk.
Question 5: Stress testing in risk management is designed primarily to:
- Provide a single point estimate of daily losses under normal market conditions
- Assess portfolio behavior under extreme but plausible adverse scenarios beyond normal VaR (Correct answer)
- Replace historical simulation as the primary VaR methodology
- Evaluate manager alpha generation during bull markets
Correct answer: Assess portfolio behavior under extreme but plausible adverse scenarios beyond normal VaR
Stress tests apply hypothetical or historical extreme scenarios (e.g., 2008 crisis, COVID crash) to evaluate portfolio vulnerability beyond statistical VaR.
Question 6: Which of the following best describes 'fat tails' (leptokurtosis) in the return distribution of hedge funds?
- Returns are normally distributed with low volatility
- Extreme returns (both gains and losses) occur more frequently than predicted by a normal distribution (Correct answer)
- The return distribution is skewed positively
- Mean returns are higher than median returns
Correct answer: Extreme returns (both gains and losses) occur more frequently than predicted by a normal distribution
Leptokurtic distributions have excess kurtosis, meaning extreme outcomes occur more often than a normal distribution predicts, making standard deviation an underestimate of true risk.
CAIA CAIA Risk Management 1
Value at Risk (VaR) at the 95% confidence level over a 1-day horizon means: