Free CAIA Level I Hedge Funds Practice Questions

B is correct. The variance risk premium is the well-documented tendency for implied volatility (the market's expectation of future volatility, as priced in options) to exceed the actual realized volatility on average. This premium compensates sellers of volatility for bearing the risk of large adverse moves.
Choice A is incorrect because it states the opposite relationship. Realized volatility is on average lower than implied volatility, which is what creates a positive variance risk premium for volatility sellers.
Choice D is incorrect because the relationship between equity volatility and interest rates is a macroeconomic correlation, not a description of the variance risk premium.
Choice C is incorrect because the relationship between long-dated and short-dated implied volatility describes the term structure of volatility, not the variance risk premium.

C is correct. Dispersion trading exploits the tendency for implied correlation among index constituents to be overpriced. The strategy involves buying options (volatility) on individual stocks and selling options (volatility) on the index. If the implied correlation embedded in index option prices exceeds the actual realized correlation among individual stocks, the portfolio of single-stock options outperforms the index option, generating a profit.
Choice B is incorrect because buying long-dated and selling short-dated options on the same underlying describes a calendar spread, which trades the term structure of volatility on a single asset, not the correlation across multiple assets.
Choice A is incorrect because selling deep out-of-the-money index puts is a directional short volatility strategy (collecting tail risk premium), not a dispersion trade that exploits the correlation between individual stocks and the index.
Choice D is incorrect because trading the spread between two equity indices is a relative value index trade, not dispersion trading. Dispersion specifically involves individual stock options versus the index those stocks comprise.

C is correct. When the stock price is near the conversion price, the embedded equity option is approximately at-the-money and gamma is at its highest. High gamma means the delta changes rapidly with small stock price movements, requiring more frequent rebalancing of the equity short position to maintain delta neutrality.
Choice A is incorrect because when the stock is far above the conversion price, the convertible's delta approaches 1.0 and gamma is low. Delta is relatively stable, requiring infrequent rebalancing.
Choice B is incorrect because when the stock is far below the conversion price, the convertible's delta approaches 0 and gamma is also low. The bond behaves like a fixed-income instrument with little equity sensitivity, requiring minimal delta hedge adjustments.
Choice D is incorrect because rebalancing frequency is directly related to gamma, which varies significantly with the stock price's proximity to the conversion price. Rebalancing is not uniform across all price levels.