Chartered Alternative Investment Analyst Association (CAIA) Practice Exam

The payout profiles of most private equity investments are most similar to which option type?

1. At-the-money put option.

2. Out-of-the-money call option.

3. At-the-money call option.

4. In-the-money call option.

The correct answer is: Out-of-the-money call option.

The payout profiles of most private equity investments are most similar to an out-of-the-money call option because, in both cases, there is a potential for significant upside while the initial investment remains at risk. Private equity investments typically involve acquiring stakes in companies that can appreciate significantly over time, much like how an out-of-the-money call option has the potential to generate large returns if the stock price rises above the strike price. However, until that appreciation occurs, the investment may not yield returns, and if it fails to achieve sufficient growth or liquidity events, the investor could lose their capital. In contrast, the other options represent different risk-reward dynamics. An at-the-money put option would provide a different payoff structure that is not characteristic of private equity since it functions as a hedge against price declines. An at-the-money call option would require the underlying asset to be currently valued at the strike price to begin yielding profits, while an in-the-money call option would already be profitable, which is not reflective of the risk profile in private equity where the investment may still be at a loss until a successful exit occurs.