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Free Questions › CFA › Derivatives
Free CFA Derivatives Practice Questions & Answers
500 exam-style Derivatives questions. Pick your answer, hit Check answer, and see the worked solution — free to start, no signup.
100% free · No login to startQuestion 331
Dynamic hedging using options or delta-hedged positions requires:
Select an option first.
Correct answer: B — Continuous or frequent rebalancing as the underlying price and delta change
Explanation: ✔ Why correct: Delta changes as the underlying moves (gamma effect). To maintain a delta-neutral hedge, the position must be rebalanced frequently — more so when gamma is high. ✘ Why others are wrong: A is a static hedge. C is not required. D is not standard practice.
Question 332
A synthetic long stock position can be created by:
Select an option first.
Correct answer: B — Buying a call and selling a put at the same strike and expiration
Explanation: ✔ Why correct: Long call + short put at the same strike and expiry creates the same payoff profile as owning the stock — this follows directly from put-call parity. ✘ Why others are wrong: A is a synthetic short stock. C and D are spread strategies.
Question 333
The primary purpose of using equity swaps in a cross-border investment is:
Select an option first.
Correct answer: A — To avoid withholding taxes on foreign dividends in some structures
Explanation: ✔ Why correct: Equity swaps can provide economic exposure to foreign equities without direct ownership, sometimes resulting in more favorable withholding tax treatment depending on the jurisdiction. ✘ Why others are wrong: B increases risk undesirably. C is physical ownership, not swaps. D confuses asset classes.
Question 334
Variance swaps differ from volatility swaps in that variance swaps:
Select an option first.
Correct answer: B — Pay based on the square of realized volatility (variance), not volatility itself
Explanation: ✔ Why correct: A variance swap pays (realized variance − strike variance) × notional. Since variance = σ², it weights large moves more than small ones compared to a volatility swap. ✘ Why others are wrong: A is wrong; both are OTC. C is not applicable. D is debatable but not the defining difference.
Question 335
A basis swap is most useful when:
Select an option first.
Correct answer: B — A borrower has debt tied to one floating benchmark and an asset tied to a different floating benchmark
Explanation: ✔ Why correct: A basis swap exchanges one floating rate for another (e.g., SOFR for Fed Funds). It is ideal for eliminating basis risk between two floating-rate instruments with different reference rates. ✘ Why others are wrong: A is an equity swap. C is an interest rate swap function. D is FX speculation.
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Question 336
A portfolio manager can use interest rate futures to adjust portfolio duration by:
Select an option first.
Correct answer: C — Buying bond futures to lengthen duration and selling to shorten duration
Explanation: ✔ Why correct: Long bond futures increase duration (adds rate sensitivity). Short bond futures decrease duration. The number of contracts is calculated from the target vs. current duration and portfolio size. ✘ Why others are wrong: A and B are each half-right but reversed relative to each other. D is incorrect; futures are widely used for duration management.
Question 337
The concept of 'cheapest to deliver' is most relevant in which type of derivative?
Select an option first.
Correct answer: C — Treasury bond futures
Explanation: ✔ Why correct: T-bond futures allow the short to choose which eligible bond to deliver. The short selects the cheapest-to-deliver bond, which is the one that minimizes the delivery cost after conversion factor adjustment. ✘ Why others are wrong: A uses cash settlement. B is a specific currency, not a basket. D does not involve physical delivery.
Question 338
An inflation swap is used to:
Select an option first.
Correct answer: A — Convert fixed nominal cash flows into inflation-linked cash flows
Explanation: ✔ Why correct: In an inflation swap, one party pays a fixed rate and receives a payment linked to an inflation index (like CPI). It allows parties to exchange fixed and inflation-linked exposures. ✘ Why others are wrong: B is equity derivatives. C is FX derivatives. D is a plain vanilla IRS.
Question 339
A company issues floating-rate debt and simultaneously enters a pay-fixed, receive-floating swap. The company's all-in cost is:
Select an option first.
Correct answer: C — The fixed swap rate (the floating legs cancel out)
Explanation: ✔ Why correct: Debt: pay floating. Swap: pay fixed, receive floating. The floating receipts from the swap cancel the floating debt payment, leaving only the fixed swap rate as the net cost. ✘ Why others are wrong: A ignores the swap overlay. B incorrectly subtracts rates. D is wrong; there is still a cost equal to the swap rate.
Question 340
A hedge fund sells protection in a CDS on a corporate bond. If the bond issuer defaults, the hedge fund:
Select an option first.
Correct answer: B — Must make a payment to the protection buyer equal to the loss on the bond
Explanation: ✔ Why correct: As protection seller, the hedge fund must compensate the buyer for the credit loss upon a credit event (default). The payment is typically par minus recovery value. ✘ Why others are wrong: A reverses the cash flow. C is wrong; default triggers payment, not cancellation. D is partly true (physical vs. cash settlement), but B accurately describes the obligation. Credit Derivatives
Question 341
Recovery rate in a CDS refers to:
Select an option first.
Correct answer: B — The percentage of face value that bondholders receive in a default/restructuring
Explanation: ✔ Why correct: Recovery rate = what creditors recover per dollar of face value in the event of default (e.g., 40 cents on the dollar = 40% recovery). Loss given default = 1 − recovery rate. ✘ Why others are wrong: A is not a standard term. C is bond restructuring. D is return on investment.
Question 342
The protection seller in a CDS is effectively:
Select an option first.
Correct answer: B — Long the credit risk of the reference entity
Explanation: ✔ Why correct: The protection seller takes on default risk in exchange for premium — equivalent to investing in the reference bond. They are long credit risk. ✘ Why others are wrong: A is the protection buyer's exposure. C is wrong; the premium rarely fully offsets the risk. D is a bond decomposition, not CDS seller exposure.
Question 343
A naked CDS position is one where the buyer:
Select an option first.
Correct answer: A — Does not hold the underlying reference bond and is speculating on credit deterioration
Explanation: ✔ Why correct: A naked CDS buyer does not own the reference bond. They are speculating that credit quality will deteriorate or that the entity will default. ✘ Why others are wrong: B is a free position, which does not exist. C is a hedged position. D is a naked short.
Question 344
A credit-linked note (CLN) combines:
Select an option first.
Correct answer: B — A regular bond with an embedded CDS where the investor takes on credit risk
Explanation: ✔ Why correct: A CLN is a bond issued by a special purpose vehicle that embeds a CDS. The investor earns a higher coupon but loses principal if a credit event occurs on the reference entity. ✘ Why others are wrong: A is not a standard structure. C is a synthetic floating-rate note. D is a dual-currency bond.
Question 345
Which of the following is an advantage of a CDS over selling the reference bond?
Select an option first.
Correct answer: B — CDS can efficiently express a short credit view without short-selling bonds
Explanation: ✔ Why correct: Short-selling a bond requires borrowing and returning it, which can be costly and difficult. A CDS allows a party to take a short credit view (buy protection) directly and efficiently. ✘ Why others are wrong: A is not always true. C is false. D is incorrect; CDS expose the seller to credit risk.
Question 346
An index CDS (such as CDX or iTraxx) allows investors to:
Select an option first.
Correct answer: B — Buy or sell protection on a portfolio of reference entities simultaneously
Explanation: ✔ Why correct: Index CDS products (CDX in North America, iTraxx in Europe) provide diversified credit exposure. One trade hedges or speculates on the credit quality of a basket of issuers. ✘ Why others are wrong: A is a single-name CDS. C is an equity swap. D is a rate derivative.
Question 347
A collateralized debt obligation (CDO) is related to derivatives because:
Select an option first.
Correct answer: B — It is structured using the cash flows from a pool of assets, with credit risk distributed across tranches
Explanation: ✔ Why correct: A CDO pools credit-risky assets and issues securities in tranches with varying risk/return profiles. Junior tranches absorb first losses; senior tranches are protected. CDS are often used within synthetic CDOs. ✘ Why others are wrong: A describes a feature of some CDOs but not the primary description. C and D are incorrect.
Question 348
The term 'upfront payment' in a CDS relates to:
Select an option first.
Correct answer: B — A one-time payment at CDS initiation when the standard running spread differs from the contract spread
Explanation: ✔ Why correct: Standardized CDS (e.g., 100 bps or 500 bps coupons) use an upfront payment to compensate for the difference between the standardized coupon and the fair-value spread at inception. ✘ Why others are wrong: A is variation margin. C is initial margin. D is bond coupon.
Question 349
The 'cheapest to deliver' option in CDS physical settlement gives the protection buyer:
Select an option first.
Correct answer: B — The right to deliver any eligible defaulted bond, and will choose the cheapest one
Explanation: ✔ Why correct: In physical settlement, the protection buyer delivers eligible defaulted obligations. They will rationally select the one trading at the lowest price (cheapest to deliver), maximizing the recovery from the seller. ✘ Why others are wrong: A is backward. C is an alternative settlement method. D is not eligible delivery.
Question 350
A protection buyer in a CDS is similar in risk profile to a:
Select an option first.
Correct answer: B — Short seller of the reference entity's bonds
Explanation: ✔ Why correct: The protection buyer profits when the reference entity's credit deteriorates (spreads widen) or default occurs. This is economically similar to being short the credit/bonds. ✘ Why others are wrong: A is the protection seller's profile. C is equity risk, different from credit risk. D is interest rate risk.
Question 351
Counterparty risk in a CDS is unique because:
Select an option first.
Correct answer: B — The counterparty is most likely to fail when the credit event also occurs (wrong-way risk)
Explanation: ✔ Why correct: CDS counterparty risk is especially severe because sellers of protection may be financially stressed during the same credit crises that trigger payments. This concentration amplifies systemic risk. ✘ Why others are wrong: A is exchange-traded derivatives. C daily MTM reduces but doesn't eliminate risk. D is wrong; sellers face substantial risk.
Question 352
A credit spread option gives the holder:
Select an option first.
Correct answer: B — The right to receive a payment if the credit spread exceeds (or falls below) a specified level
Explanation: ✔ Why correct: A credit spread option is an option on the credit spread. A call on the spread pays when spreads widen (credit deteriorates); a put pays when spreads tighten. ✘ Why others are wrong: A is a CDS option / swaption. C is an obligation (forward). D is a CLN coupon.
Question 353
A 'first-to-default' basket CDS provides protection on:
Select an option first.
Correct answer: B — Only the first default that occurs among a specified basket of reference entities
Explanation: ✔ Why correct: A first-to-default CDS pays when the first credit event occurs in the basket and then terminates. It is cheaper than individual CDSs but leaves the buyer exposed to subsequent defaults. ✘ Why others are wrong: A would be much more expensive. C is a specific selection, not first-to-default. D is time-restricted, not event-restricted.
Question 354
Sovereign CDS are used to:
Select an option first.
Correct answer: B — Hedge or speculate on the default or restructuring risk of a national government
Explanation: ✔ Why correct: Sovereign CDS reference the debt of a national government. They are used to hedge or speculate on a country's ability to service its public debt. ✘ Why others are wrong: A is corporate CDS. C is unrelated. D is FX forward/swap.
Question 355
If a trader expects corporate credit spreads to widen (credit quality to deteriorate), they would most likely:
Select an option first.
Correct answer: B — Buy CDS protection
Explanation: ✔ Why correct: Buying protection profits when the reference entity's credit quality worsens and spreads widen. The long protection position gains value as the CDS spread increases. ✘ Why others are wrong: A loses money when spreads widen. C loses value when spreads widen. D is a rates trade, not credit.
Question 356
In a synthetic CDO, the credit exposure is created through:
Select an option first.
Correct answer: B — Entering into CDS contracts rather than buying the underlying bonds
Explanation: ✔ Why correct: A synthetic CDO uses CDS contracts to replicate the economic exposure to a pool of reference entities without physically owning the bonds, allowing leverage and customization. ✘ Why others are wrong: A is a cash CDO. C describes equity issuance. D is a mortgage-backed securitization.
Question 357
Credit valuation adjustment (CVA) is a derivative pricing adjustment that accounts for:
Select an option first.
Correct answer: B — The possibility that the counterparty will default before the derivative matures
Explanation: ✔ Why correct: CVA reduces the fair value of a derivative by the expected loss due to counterparty default. It is a key component of OTC derivative pricing and risk management. ✘ Why others are wrong: A is interest rate risk. C is a transaction cost. D is a volatility risk metric.
Question 358
A 'nth-to-default' basket CDS pays only when the:
Select an option first.
Correct answer: B — Nth default in the basket occurs (and all prior defaults have already happened)
Explanation: ✔ Why correct: An Nth-to-default CDS pays upon the Nth credit event in the basket. It provides less immediate protection (1st-to-default pays first) but at a lower cost. ✘ Why others are wrong: A is first-to-default. C is a tranche trigger. D is a specific entity rule.
Question 359
Expected shortfall (ES), also called conditional VaR (CVaR), differs from VaR because:
Select an option first.
Correct answer: A — ES measures the average loss when losses exceed the VaR threshold
Explanation: ✔ Why correct: ES is the expected (average) loss in the tail beyond VaR. It is a coherent risk measure that captures the magnitude of extreme losses, not just their probability. ✘ Why others are wrong: B is wrong; ES is always ≥ VaR. C is wrong; ES uses the same confidence level. D is wrong; ES can use various methods.
Question 360
Delta-gamma approximation for a non-linear position (like an option) improves on the delta approximation by:
Select an option first.
Correct answer: A — Accounting for the curvature of the option's value function
Explanation: ✔ Why correct: Delta alone is a linear approximation. The gamma term accounts for the curvature (convexity) of the option price, providing a more accurate estimate for large moves. ✘ Why others are wrong: B is wrong. C is one source of data, not the improvement. D is incorrect.
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