Chartered Financial Analyst · Level I
CFA L1 Alternative Investments: practice questions with answers
6 free exam-style questions on Alternative Investments for CFA L1 Level I. Try each one, then open the answer to read the explanation. Fincora has 52 original questions on this syllabus area.
Question 1
Compared with traditional investments in publicly traded stocks and bonds, alternative investments are least likely to be characterised by:
- A higher fees
- B high liquidity and frequent, transparent pricing
- C limited and potentially biased historical return data
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Answer: B. Common features of alternative investments include illiquidity, specialised manager expertise, low correlation with traditional assets, less regulation and transparency, limited and potentially biased performance data, high fees and use of leverage. High liquidity and transparent, frequent pricing describe traditional public market investments.
Question 2
Compared with a greenfield infrastructure investment, a brownfield infrastructure investment is most likely to have:
- A higher construction risk
- B higher expected returns with greater uncertainty
- C an operating history and more predictable cash flows
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Answer: C. Greenfield investments are in infrastructure assets to be built, so they carry construction and demand risk and offer higher potential returns. Brownfield investments are in existing assets with an operating history, often with established revenues, so cash flows are more stable and risk and expected return are lower.
Question 3
The Wrexford University Endowment is a limited partner in several buyout funds. It is considering adding co-investments alongside those funds' general partners instead of committing more capital to the funds themselves. A disadvantage of co-investing compared with fund investing is most likely that:
- A the endowment may face adverse selection, because general partners may be less likely to offer their most attractive deals for co-investment.
- B the endowment will usually pay higher management and incentive fees on co-investments than on its fund commitments.
- C the endowment must source, structure and manage each portfolio company itself, without any involvement from a general partner.
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Answer: A. There are three main ways to invest in private alternatives. Fund investing: the investor commits capital to a fund and pays management and incentive fees; it has the least control and the least need for in-house expertise. Co-investing: the investor invests in a deal directly, alongside a fund, usually with reduced or no fees, and gains experience and some say over its capital. Its disadvantages include less control than direct investing and adverse selection: the general partner chooses which deals to offer and may keep the best ones for its fund. Direct investing: the investor buys stakes in companies or assets itself, with the most control and lowest fees but the highest need for expertise and the least diversification.
Question 4
Lyndhurst Plaza, a fully let shopping center, produced net operating income (NOI) of USD 1.80 million in the year just ended. NOI is expected to grow at 2.0% a year indefinitely, and investors require a return of 8.0% on similar properties. Using a discounted cash flow approach with constant growth, based on next year's expected NOI, the value of Lyndhurst Plaza today is closest to:
- A USD 23.0 million
- B USD 30.0 million
- C USD 30.6 million
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Answer: C. When NOI grows at a constant rate, the DCF value of a property is V0 = NOI1 / (r - g), which is the direct capitalization formula with a cap rate equal to r - g. NOI1 = 1.80 x 1.02 = USD 1.836 million. Cap rate = 8.0% - 2.0% = 6.0%. V0 = 1.836 / 0.06 = USD 30.6 million. The cap rate is lower than the required return because investors also expect income growth.
Question 5
A consortium of custodian banks builds a distributed ledger on which only vetted member institutions can view records and validate transactions. Compared with a permissionless blockchain such as Bitcoin, this network is most likely to:
- A be more decentralized and resistant to censorship, because it relies on anonymous miners.
- B allow any user in the world to join and validate transactions, as long as they hold the network's token.
- C offer greater privacy and faster, cheaper validation, at the cost of being more centralized.
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Answer: C. Distributed ledger technology (DLT) networks can be permissionless (open: anyone can join, view the ledger and validate transactions, as with Bitcoin) or permissioned (participation and validation are limited to approved members, sometimes with restricted viewing rights). Permissionless networks are highly decentralized and resistant to censorship but can be slow and energy-intensive. Permissioned networks give users more privacy and control and can process transactions faster and more cheaply, which suits uses such as interbank settlement, but they are more centralized and rely on trust in the members who validate transactions.
Question 6
A hedge fund buys convertible bonds issued by a company and short sells the same company's ordinary shares, aiming to profit from mispricing between the bond's embedded option and the shares. This strategy is best classified as:
- A event driven.
- B macro.
- C relative value.
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Answer: C. Hedge fund strategies are commonly grouped as equity-related (long/short, market neutral, short bias), event driven (merger arbitrage, distressed securities, activist), relative value (fixed income arbitrage, convertible bond arbitrage) and opportunistic (global macro, managed futures). Convertible arbitrage buys convertibles that appear cheap and hedges the equity exposure by shorting the shares, earning returns from the bond's income and from mispriced volatility.
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