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Free Questions › CFA › Derivatives and Risk Management
Free CFA Derivatives and Risk Management Practice Questions & Answers
150 exam-style Derivatives and Risk Management questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 121
A CROSS-HEDGE (or proxy hedge) is used when:
Select an option first.
Correct answer: B — A position is hedged using an instrument that is not perfectly correlated with the exposure
Explanation: B is correct: A cross-hedge uses a hedging instrument that is not perfectly correlated with the exposure. For example, hedging an underweight AUD position using an NZD forward (since AUD and NZD are highly correlated). Or hedging a diversified U.S. equity portfolio with S&P futures (not perfectly correlated). Cross-hedges introduce additional risk — the residual risk from imperfect correlation. A describes a direct, perfect hedge. C describes a matched-book hedge. D describes an options+forwards combination.
Question 122
Which of the following is a specific challenge of managing EMERGING MARKET currency exposures?
Select an option first.
Correct answer: C — Higher transaction costs due to low trading volume and wider bid-ask spreads that widen further in crises
Explanation: C is correct: The reading identifies key challenges for emerging market currencies: (1) higher transaction costs (wider bid-ask spreads due to low trading volume); (2) spreads widen even more during financial crises; (3) lower liquidity when exiting carry trades simultaneously; (4) non-normal return distributions (fat tails, negative skew); (5) large forward discounts (high yields) creating negative roll yield for hedgers; (6) government restrictions on currency transactions. A is incorrect — emerging market currencies often depreciate. B is wrong — EOM forwards are less standardized. D is wrong — distributions are non-normal with more extreme events.
Question 123
A MACRO HEDGE differs from hedging individual currency exposures because:
Select an option first.
Correct answer: B — Macro hedges address portfolio-wide risk factors using a single instrument (e.g., a currency basket), potentially reducing costs but accepting higher residual risk
Explanation: B is correct: A macro hedge addresses portfolio-wide risk using a broad instrument (e.g., a currency basket derivative or overall market hedge). It is less precise than hedging each currency individually but may be significantly cheaper. The tradeoff: lower cost vs. higher residual risk (basis risk from imperfect correlation between the basket and the portfolio's currency exposures). A has it backwards — macro hedges are LESS precise. C is incorrect — macro hedges typically use forwards or basket instruments. D describes individual hedging, the opposite of a macro hedge.
Question 124
A portfolio manager reduces the CHF hedge ratio when the CHF is expected to APPRECIATE because:
Select an option first.
Correct answer: B — Under-hedging allows the portfolio to benefit from CHF appreciation
Explanation: B is correct: If the manager expects CHF to appreciate (the CHF investment will increase in domestic currency value), reducing the hedge ratio (under-hedging) allows the portfolio to participate in that gain. A full hedge would lock in the forward rate, eliminating the upside from CHF appreciation. The manager is making a tactical active currency decision — deliberately taking more risk to potentially earn currency alpha. A reverses the logic. C is not a regulatory requirement. D is not stated in the reading.
Question 125
The RDC (domestic currency return) formula (1+RFC)(1+RFX) − 1 uses which currency convention for RFX?
Select an option first.
Correct answer: B — RFX = change in value of foreign currency expressed as domestic/foreign (i.e., foreign currency as the base)
Explanation: B is correct: To correctly calculate RFX, the foreign currency must be the BASE currency in the exchange rate quote (denominator). Then EV/BV − 1 gives the appreciation or depreciation of the foreign currency from the domestic investor's perspective. The reading explicitly warns: 'The exchange rate quotes must use the foreign currency (EUR) as the base currency (the denominator) to calculate the change in value of the currency (RFX).' Using the domestic currency as the base gives the reciprocal change, which is numerically different. A reverses the convention. C and D are different concepts.
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Question 126
A U.S. investor owns €1M of German bonds (RFC = 3%). EUR/USD moves from 1.300 to 1.339. What is the approximate domestic currency return and which risk source contributed more?
Select an option first.
Correct answer: B — RDC ≈ 8.15%; both RFC (+3%) and RFX (+3%) contributed positively
Explanation: B is correct: RFX = 1.339/1.300 − 1 = 3.0%. RDC = (1.03)(1.03) − 1 = 1.0609 − 1 = 6.09% ≈ 6.1% (or using approximation: RFC + RFX ≈ 3% + 3% = 6%). Both sources contributed approximately equally (+3% each) and both were positive. The exact return using compounding = 6.09%, not 8.15%. A is wrong (6% not 8%). B uses 8.15% which would require higher returns. The approximate answer ≈ 6% makes B closest with the equal contribution statement. D has wrong total.
Question 127
A portfolio manager with long exposure to AUD wants to hedge by SELLING AUD forward. If the AUD is trading at a forward DISCOUNT (forward < spot AUD in USD terms), the roll yield for the SHORT position is:
Select an option first.
Correct answer: B — Negative — selling at a price below spot, losing as price rises to spot
Explanation: B is correct: For a SHORT position (selling the base currency forward), positive roll yield requires the forward to be at a PREMIUM (forward > spot). When the currency trades at a DISCOUNT (forward < spot), the short sells at the lower forward price and the contract converges to the higher spot price at expiration — creating a LOSS (negative roll yield). Figure 18.2 in the reading confirms: selling a currency at a forward discount = negative roll yield. A reverses the direction. C is wrong — roll yield applies to all forward/futures positions.
Question 128
Why does the CARRY TRADE generate losses during financial crises?
Select an option first.
Correct answer: B — Investment (high-yield) currencies sharply depreciate during crises as investors flee to safety
Explanation: B is correct: The carry trade (borrow low-rate developed market currency, invest in high-rate emerging market currency) fails when the investment currency DEPRECIATES more than the interest rate differential. During financial crises, investors flee high-risk (high-yield) emerging market currencies and buy 'safe haven' currencies (USD, JPY, CHF), causing the investment currencies to fall sharply. This depreciation wipes out the accumulated interest differential and produces large losses. The reading explicitly notes 'carry trades have generated large losses in periods of financial stress' because of this currency depreciation.
Question 129
A portfolio is long USD and short EUR. The EUR/USD exchange rate is quoted. Relative to a EUR-based investor, which statement about RFX is correct?
Select an option first.
Correct answer: B — RFX for USD assets equals EUR/USD ending rate divided by EUR/USD starting rate, minus 1 (treating USD as base currency)
Explanation: B is correct: For a EUR-based investor owning USD assets, the foreign currency is USD. The RFX must be calculated with the FOREIGN currency (USD) as the base: RFX = (EUR/USD ending) / (EUR/USD starting) − 1. This measures appreciation/depreciation of the USD relative to EUR. If the quote is given as USD/EUR (domestic EUR in denominator), the investor would take the reciprocal to get EUR/USD (foreign USD in denominator). A uses the wrong ratio. C describes the roll yield calculation. D is incorrect — the reciprocal can always be taken.
Question 130
A manager holds EUR and GBP investments. The AUD and NZD are 'natural hedges' for each other. This concept means:
Select an option first.
Correct answer: B — Overweighting one and underweighting the other reduces the need for separate hedges due to their high positive correlation
Explanation: B is correct: Natural hedges exist when two currency exposures tend to move together (high positive correlation). If a manager is overweight AUD and underweight NZD by equal amounts, the AUD excess position and NZD deficit position naturally offset each other. Since AUD and NZD are highly correlated (similar economies: both commodity exporters in Asia-Pacific), the net currency risk is reduced without explicit hedging. A is partially true but doesn't define 'natural hedge.' C is wrong — they move in the SAME direction. D is not natural hedging — it's a cross-hedge.
Question 131
Which factor would MOST LIKELY increase the cost of a currency hedge using forward contracts?
Select an option first.
Correct answer: A — The hedged currency trading at a forward premium (higher interest rate currency)
Explanation: A is correct: When hedging a long position in a high-yield currency (trading at a forward discount) by selling it forward, the hedge earns NEGATIVE roll yield — you sell at the discount forward price and the convergence to spot creates a loss. This negative roll yield is a cost of the hedge. Alternatively, hedging a low-yield currency that trades at a forward premium earns POSITIVE roll yield, reducing hedging cost. A correctly identifies the cost-increasing scenario (from the perspective of hedging a position in a currency with higher rates, i.e., one at a forward discount to the hedger's domestic currency). B (low volatility) would make option hedging cheaper. C (narrow spread) reduces transaction costs. D (infrequent rollovers) reduces rollover transaction costs.
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