Chartered Alternative Investment Analyst (CAIA) Hedge Funds and Managed Futures Syllabus

Define event-driven hedge fund strategies in general.

Strategies that seek to profit from price movements caused by specific corporate events such as mergers, acquisitions, bankruptcies, restructurings, spin-offs, or recapitalizations, where the outcome depends largely on event resolution rather than market direction.

Describe merger (risk) arbitrage and the classic trade in a cash deal vs. a stock deal.

Merger arbitrage profits from the spread between a target's market price and the deal price. In a cash deal, the arbitrageur buys the target's shares. In a stock-for-stock deal, the arbitrageur buys the target and shorts the acquirer in the deal's exchange ratio to capture the spread while hedging acquirer price moves.

What is the main risk in merger arbitrage, and what return profile does it resemble?

The main risk is deal break (the merger failing), which causes the target price to collapse. The payoff resembles writing a put option / selling insurance: small steady gains most of the time, with occasional large losses, producing negatively skewed returns.

What is distressed securities investing?

Investing in the debt or equity of companies that are in or near bankruptcy or financial distress, often at deep discounts, to profit from a successful restructuring, reorganization, or liquidation. Returns hinge on legal/restructuring outcomes and recovery values.

In distressed investing, what does the 'fulcrum security' refer to?

The fulcrum security is the most senior class of debt that is not fully repaid in a reorganization and is therefore most likely to be converted into the new equity of the restructured company. Owning it gives the investor control of the post-restructuring entity.

What does 'special situations' investing encompass?

An opportunistic event-driven category targeting corporate events outside mergers and pure distress—such as spin-offs, share buybacks, recapitalizations, restructurings, index additions/deletions, and management changes—where the catalyst is expected to unlock value.

What is activist investing as a special-situations strategy?

An activist takes a significant equity stake in a company and uses that position to pressure management or the board (via board seats, proxy fights, public campaigns) to change strategy, capital allocation, or governance in order to unlock shareholder value.

Define relative value arbitrage.

Strategies that exploit pricing discrepancies between related securities by going long the relatively cheap security and short the relatively expensive one, profiting when their prices converge while hedging out broad market direction.

Describe convertible bond arbitrage and its typical position.

Buying a convertible bond (which embeds a call option on the stock) and short-selling the underlying equity to hedge equity exposure (delta hedge). The arbitrageur seeks to profit from cheap embedded optionality/volatility, the bond's coupon, and the short rebate while remaining roughly delta-neutral.

What is fixed-income arbitrage?

A relative-value strategy exploiting mispricings between related fixed-income instruments (e.g., on-the-run vs. off-the-run Treasuries, swap spreads, yield-curve trades, basis trades). Spreads are small, so it relies on high leverage to generate meaningful returns.

What is volatility arbitrage?

A relative-value strategy that trades the difference between an option's implied volatility and the expected/realized volatility of the underlying (or between volatilities of related options), typically via delta-hedged option positions to isolate the volatility view.

What is the LTCM example a classic warning about for relative value arbitrage?

It illustrates that convergence trades with small spreads require heavy leverage, and during liquidity crises spreads can widen rather than converge (divergence risk), triggering margin calls and forced liquidation—relative value carries severe tail/liquidity risk despite low day-to-day volatility.

Define global macro hedge fund strategies.

Strategies that take directional positions across global markets—equities, bonds, currencies, commodities—based on top-down macroeconomic views (interest rates, growth, inflation, geopolitics), often using leverage and derivatives, with broad mandate flexibility.

What distinguishes discretionary global macro from systematic global macro?

Discretionary macro relies on a manager's judgment to form and size macroeconomic trades; systematic macro uses quantitative models and rules to generate positions algorithmically, removing emotion and enforcing discipline.

Why do arbitrage strategy returns typically exhibit negative skewness and excess kurtosis (fat tails)?

Arbitrage trades earn small, frequent gains from spread convergence but suffer occasional large losses when spreads diverge or liquidity dries up (option-selling-like payoff). This produces a left-skewed, fat-tailed return distribution that understates risk if judged only by volatility.

What are the main return drivers and risks of arbitrage strategies?

Return drivers: convergence of mispriced spreads, carry/coupon income, liquidity provision, and volatility/optionality. Risks: model risk, leverage, liquidity risk, divergence risk, counterparty risk, and tail risk that standard deviation fails to capture.

What is a managed futures strategy and who typically runs it?

A strategy that takes long and short positions in exchange-traded futures and forward contracts across asset classes (commodities, currencies, rates, equity indices). It is typically run by Commodity Trading Advisors (CTAs) registered with the CFTC/NFA.

What is the most common managed futures / CTA approach, and what is its core principle?

Trend-following (momentum): systematically going long markets that are rising and short markets that are falling, based on the premise that price trends persist. It is direction-agnostic and trades many markets to diversify.

Why are managed futures said to provide 'crisis alpha' or 'long volatility' characteristics?

Trend-following CTAs tend to perform well during sustained market crises because they can go short falling markets and capture prolonged trends; their returns are often positively skewed and uncorrelated/negatively correlated with equities during drawdowns.

In a managed futures account, why does most of the cash earn interest rather than being 'invested'?

Futures require only a small margin deposit, so the bulk of the capital is held in cash/T-bills earning interest. CTA total return therefore combines the trading P&L (excess return) plus the collateral/interest return on the cash.

Distinguish a trend-following CTA from a counter-trend (mean-reversion) CTA.

A trend-follower buys strength and sells weakness expecting trends to continue, profiting in persistent directional markets. A counter-trend trader fades extremes expecting reversion to a mean, profiting in choppy, range-bound markets and often losing during strong trends.

What are the typical components of a systematic trading system?

Data inputs (prices, fundamentals), signal-generation rules (entry/exit), position-sizing/risk-management rules (volatility targeting, stop-losses), portfolio construction (market selection, diversification), and execution algorithms—all applied mechanically without discretion.

What is the danger of overfitting (data mining) when building a systematic trading system?

Optimizing a model to fit historical data too closely captures noise rather than a real signal, producing excellent backtests but poor live performance. Mitigants include out-of-sample/walk-forward testing, parsimony, and economic rationale for signals.

What does volatility targeting accomplish in a systematic CTA's position sizing?

It scales position sizes inversely to each market's recent volatility so each position contributes a similar risk amount and the portfolio maintains a roughly constant target volatility, increasing exposure when volatility is low and cutting it when volatility rises.

What is a fund of hedge funds (FoHF) and its primary value proposition?

A fund that invests in a diversified portfolio of underlying hedge funds. It offers diversification across managers/strategies, professional manager selection, due diligence, and access to closed or high-minimum funds for smaller investors.

What is the main drawback of a fund of hedge funds regarding fees?

Double layer of fees: investors pay the FoHF's own management and incentive fees on top of the underlying funds' fees (e.g., adding ~1 and 10 to each fund's 2 and 20), which significantly erodes net returns.

How can netting risk hurt a fund of hedge funds investor?

Incentive fees are paid to each winning underlying manager individually, but losses at other managers cannot offset those fees at the FoHF level. So the investor can owe performance fees on winners even when the overall FoHF return is flat or negative.

Define hedge fund replication and its two broad approaches.

Replication aims to reproduce hedge fund returns with cheaper, more liquid, transparent instruments. Approaches: (1) factor-based (rules/regression on liquid risk factors to mimic exposures) and (2) payoff-distribution/mechanical (rule-based trading to copy the return distribution or known strategy mechanics).

What are the main advantages and limitations of hedge fund replication products?

Advantages: lower fees, daily liquidity, transparency, and no manager-specific (idiosyncratic) risk. Limitations: they capture systematic/beta-like return drivers but generally fail to reproduce true manager alpha, and factor models rely on lagged, smoothed reported returns.

Distinguish investment due diligence from operational due diligence (ODD) for hedge funds.

Investment due diligence evaluates the strategy, edge, portfolio, performance, and risk management (can the manager generate returns?). Operational due diligence evaluates the business infrastructure—valuation, custody, administration, controls, compliance, counterparties, and personnel integrity (can the firm be trusted to operate safely?).

In operational due diligence, why is independent (third-party) administration and valuation a key item, and what classic fraud does it guard against?

Independent administrators and pricing sources prevent the manager from self-reporting inflated or fabricated NAVs. Lack of independent verification was central to the Madoff fraud; ODD red flags include self-administration, an unknown/affiliated auditor, and self-custody of assets.