Free CAIA Level I Practice Questions

D is correct. The law of one price states that two assets (or portfolios) that produce identical cash flows in every state of the world must have the same price. Any price discrepancy would create a riskless arbitrage opportunity.
Choice A is incorrect because assets within the same class can have different expected returns based on their individual risk characteristics.
Choice B is incorrect because while no-arbitrage pricing relates to fundamental value, the law of one price specifically addresses identical cash flow streams, not fundamental valuation broadly.
Choice C is incorrect because under no-arbitrage conditions, identical cash flow streams must trade at the same price regardless of transaction costs; the law of one price is a theoretical condition that assumes frictionless markets.

B is correct. Gamma measures the rate of change of delta with respect to the underlying price. Gamma is maximized for at-the-money options near expiration because small price movements cause the largest shifts in the probability of finishing in or out of the money, producing rapid changes in delta.
Choice A is incorrect because deep in-the-money options have delta close to 1 that changes very little with the underlying price, resulting in low gamma regardless of time to expiration.
Choice D is incorrect because deep out-of-the-money options have delta close to 0 that changes very little, also resulting in low gamma. These options are unlikely to move into the money before expiration.
Choice C is incorrect because while at-the-money options generally have higher gamma than in- or out-of-the-money options, longer time to expiration disperses gamma more evenly across strike prices, reducing the peak gamma compared to short-dated at-the-money options.

C is correct. The Gaussian copula model, which was the industry standard for pricing CDO tranches, assumes that the dependence structure between defaults follows a normal (Gaussian) distribution. This distribution has thin tails, meaning it assigns very low probability to scenarios where many assets default simultaneously. During the crisis, defaults clustered far beyond what the model predicted because real-world default dependence exhibits tail dependence (extreme co-movement during stress) that the Gaussian copula cannot capture. This caused catastrophic losses in tranches that had been rated investment grade.
Choice B is incorrect because the crisis-era problems were not caused by regulatory trading restrictions; CDO managers generally retained discretion to trade, but collateral values had deteriorated so severely that trading could not prevent losses.
Choice A is incorrect because while conflicts of interest existed in CDO structuring, the core model risk issue was the inadequacy of the mathematical framework for capturing correlated defaults, not deliberate mispricing.
Choice D is incorrect because while low interest rates affected excess spread over time, the acute crisis losses were driven by massive, correlated defaults that overwhelmed structural protections, not by the gradual erosion of excess spread from rate cuts.