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CHAPTER 3

MACHINE LEARNING

1. (B) unsupervised learning.

Explanation
Dimension reduction and clustering are examples of unsupervised learning
algorithms.
(Module 3.3, LOS 3.d)
Related Material
SchweserNotes - Book 1

2. (C) Dimension reduction.

Explanation
Big Data refers to very large data sets which may include both structured
(e.g. spreadsheet) data and unstructured (e.g. emails, text, or pictures) data and
includes a large number of features as well as number of observations. Dimension
reduction seeks to remove the noise (i.e., those attributes that do not contain
much information) when the number of features in a data set
(its dimension) is excessive.
(Module 3.3, LOS 3.d)
Related Material
SchweserNotes - Book 1

3. (A) least absolute shrinkage and selection operator (LASSO).

Explanation
LASSO (least absolute shrinkage and selection operator) is a popular type of
penalized regression in which the penalty term comprises summing the absolute
values of the regression coefficients. The more included features, the larger the
penalty will be. The result is that a feature needs to make a sufficient contribution
to model fit to offset the penalty from including it.
(Module 3.2, LOS 3.c)
Related Material
SchweserNotes - Book 1

Hanna Kowalski is a senior fixed-income portfolio analyst at Czarnaskala BP.

Kowalski supervises Lena Nowak, who is a junior analyst.

Quantitative Methods 1 Machine Learning

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Over the past several years, Kowalski has become aware that investment firms are
increasingly to improve their investment decision making. Kowalski has become
particularly interested in machine learning techniques and how they might be
applied to investment management applications.
Kowalski has read a number of articles about machine learning in various journals
for financial analysts. However, she has only a minimal knowledge of how she
might source appropriate model inputs, interpret model outputs, and translate
those outputs into investment actions.
Kowalski and Nowak meet to discuss plans for incorporating machine learning into
their investment model. Kowalski asks Nowak to research machine learning and
report back on the types of investment problems that machine learning can
address, how the algorithms work, and what the various terminology means.
After spending a few hours researching the topic, Nowak makes a number of
statements to Kowalski on the topics of:
• Classification and regression trees (CART)
• Hierarchical clustering
• Neural networks
• Reinforcement learning (RL) algorithms.
Kowalski is left to work out which of Nowak's statements are fully accurate and
which are not.

4. (A) discrete target variable, producing a cardinal tree.

Explanation
Classification and regression trees (CART) are generally applied to predict either a
continuous target variable, producing a regression tree, or a categorical target
variable, producing a classification tree.
(Module 3.2, LOS 3.c)
Related Material
SchweserNotes - Book 1

5. (B) Bottom-up hierarchical clustering begins with each observation being its own
cluster.
Explanation
Agglomerative (bottom-up) hierarchical clustering begins with each observation
being its own cluster. Then, the algorithm finds the two closest clusters, and
combines them into a new, larger cluster. Hierarchical clustering is an
unsupervised iterative algorithm. Divisive (top-down) hierarchical clustering
progressively partitions clusters into smaller clusters until each cluster contains
only one observation.
(Module 3.3, LOS 3.d)
Related Material
SchweserNotes - Book 1

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6. (A) are effective in tasks with non-linearities and complex interactions among
variables.
Explanation
Neural networks have been successfully applied to solve a variety of problems
characterized by non-linearities and complex interactions among variables. Neural
networks have three types of layers: an input layer, hidden layers, and an output
layer. The hidden layer nodes (not the input layer nodes) each consist of a
summation operator and an activation function; these nodes are where learning
takes place.
(Module 3.3, LOS 3.e)
Related Material
SchweserNotes - Book 1

7. (C) take into consideration the constraints of its environment.

Explanation
The reinforcement learning (RL) algorithm involves an agent that will perform
actions that will maximize its rewards over time, taking into consideration the
constraints of the environment. Unlike supervised learning, reinforcement learning
has neither instantaneous feedback nor direct labeled data for each observation.
(Module 3.3, LOS 3.e)
Related Material
SchweserNotes - Book 1

8. (A) Regression Classification

Explanation
When the Y-variable is continuous, the appropriate approach is that of regression
(used in a broad, ML context). When the Y-variable is categorical (i.e., belonging to a
category or classification) or ordinal (i.e., ordered or ranked), a classification model
is used.
(Module 3.1, LOS 3.a)
Related Material
SchweserNotes - Book 1

9. (C) supervised learning.

Explanation
Supervised learning is a machine learning technique in which a machine is given
labelled input and output data and models the output data based on the input data.
In unsupervised learning, a machine is given input data in which to identify patterns
and relationships, but no output data to model. Deep learning is a technique to
identify patterns of increasing complexity and may use supervised or unsupervised
learning.
(Module 3.1, LOS 3.a)
Related Material
SchweserNotes - Book 1

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10. (B) principal components analysis.
Explanation
Principal components analysis (PCA) is an unsupervised machine learning algorithm
that reduces highly correlated features into fewer uncorrelated composite variables
by transforming the feature covariance matrix. K-means partitions observations into
a fixed number (k) of non-overlapping clusters. Hierarchical clustering is an
unsupervised iterative algorithm used to build a hierarchy of clusters.
(Module 3.3, LOS 3.d)
Related Material
SchweserNotes - Book 1

11. (C) There is no labeled data.

Explanation
In unsupervised learning, the ML program is not given labeled training data. Instead,
inputs are provided without any conclusions about those inputs. In the absence of
any tagged data, the program seeks out structure or inter-relationships in the data.
Clustering is one example of the output of unsupervised ML program while
classification is suited for supervised learning.
(Module 3.1, LOS 3.a)
Related Material
SchweserNotes - Book 1

12. (B) reduce signal-to-noise ratio.

Explanation
Random forest is a collection of randomly generated classification trees from the
same data set. A randomly selected subset of features is used in creating each tree
and hence each tree is slightly different from the others. Since each tree only uses a
subset of features, random forests can mitigate the problem of over fitting. Because
errors across different trees tend to cancel each other out, using random forests can
increase the signal-to-noise ratio.
(Module 3.2, LOS 3.c)
Related Material
SchweserNotes - Book 1

13. (C) bias error plus variance error plus base error.
Explanation
Out-of-sample error equals bias error plus variance error plus base error. Bias error
is the extent to which a model fits the training data. Variance error describes the
degree to which a model's results change in response to new data from validation
and test samples. Base error comes from randomness in the data.
(Module 3.1, LOS 3.b)
Related Material
SchweserNotes - Book 1

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Joyce Tan manages a medium-sized investment fund at Marina Bay Advisors that
specializes in international large cap equities. Over the four years that she has
been portfolio manager, Tan has been invested in approximately 40 stocks at
time.
Tan has used a number of methodologies to select investment opportunities from
the universe of investable stocks. In some cases, Tan uses quantitative measures
such as accounting ratios to find the most promising investment candidates. In
other cases, her team of analysts suggest investments based on qualitative factors
and various investment hypotheses.
Tan begins to wonder if her team could leverage financial technology to make
better decisions. Specifically, she has read about various machine learning
techniques to extract useful information from large financial datasets, in order to
uncover new sources of alpha.

14. (A) continuous.

Explanation
Supervised learning can be divided into two categories: regression and
classification. If the target variable is categorical or ordinal (e.g., determining a firm's
rating), then it is a classification problem. If the target variable to be predicted is
continuous, then the task is one of regression.
(Module 3.1, LOS 3.a)
Related Material
SchweserNotes - Book 1

15. (C) k – 1 samples will be used as training samples.

Explanation
In the K-fold cross-validation technique, the data is shuffled randomly and then
divided into k equal sub-samples. One sample is saved to be used as a validation
sample, and the other k — 1 samples are used as training samples.
(Module 3.1, LOS 3.b)
Related Material
SchweserNotes - Book 1

16. (B) more accurate and more stable.

Explanation
Ensemble learning, which is a technique of combining the predictions from a
number of models, generally results in more accurate and more stable predictions
than a single model.
(Module 3.2, LOS 3.c)
Related Material
SchweserNotes - Book 1

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17. (C) Neural networks work well in the presence of non-linearities and complex
interactions among variables.
Explanation
Neural networks have been successfully applied to a variety of investment tasks
characterized by non-linearities and complex interactions among variables.
Neural networks with at least three hidden layers are known as deep learning nets
(DLNs). Reinforcement learning algorithms use an agent that will maximize its
rewards over time, within the constraints of its environment.
(Module 3.3, LOS 3.e)
Related Material
SchweserNotes - Book 1

18. (A) "find the pattern, apply the pattern."

Explanation
One elementary way to think of ML algorithms is to "find the pattern, apply the
pattern." Machine learning attempts to extract knowledge from large amounts of
data by learning from known examples in order to determine an underlying
structure in the data. The focus is on generating structure or predictions without
human intervention.
(Module 3.1, LOS 3.a)
Related Material
SchweserNotes - Book 1

19. (B) higher forecasting accuracy in out-of-sample data.

Explanation
Over fitting results when a large number of features (i.e., independent variables) are
included in the data sample. The resulting model can use the "noise" in the
dependent variables to improve the model fit. Overfitting the model in this way will
actually decrease the accuracy of model forecasts on other (out-of-sample) data.
(Module 3.1, LOS 3.b)
Related Material
SchweserNotes - Book 1

20. (B) Typical data analytics tasks for supervised learning include classification and
prediction.
Explanation
Supervised learning utilizes labeled training data to guide the ML program but does
not need “human intervention.” Typical data analytics tasks for supervised learning
include classification and prediction.
(Module 3.1, LOS 3.a)
Related Material
SchweserNotes - Book 1

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21. (B) support vector machine (SVM).
Explanation
Support vector machine (SVM) is a linear classifier that aims to seek the optimal
hyperplane, i.e. the one that separates the two sets of data points by the maximum
margin. SVM is typically used for classification.
(Module 3.2, LOS 3.c)
Related Material
SchweserNotes - Book 1

22. (A) generalization.

Explanation
Generalization describes the degree to which, when predicting out-of-sample, a
machine learning model retains its explanatory power.
(Module 3.1, LOS 3.b)
Related Material
SchweserNotes - Book 1

23. (C) reinforcement learning.

Explanation
Reinforcement learning algorithms involve an agent that will perform actions that
will maximize its rewards over time, taking into consideration the constraints of its
environment. Neural networks consist of nodes connected by links; learning takes
place in the hidden layer nodes, each of which consists of a summation operator
and an activation function. Neural networks with many hidden layers (often more
than 20) are known as deep learning nets (DLNs) and used in artificial intelligence.
(Module 3.3, LOS 3.e)
Related Material
SchweserNotes - Book 1

Quantitative Methods 7 Machine Learning