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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 361
A delta hedge becomes less effective as the underlying moves significantly because:
Select an option first.
Correct answer: B — Delta changes as the underlying price changes (gamma effect), requiring rebalancing
Explanation: ✔ Why correct: Delta is not constant (gamma ≠ 0). Large moves change delta, making the initial hedge ratio incorrect. Continuous rebalancing is required in theory, but transaction costs limit frequency. ✘ Why others are wrong: A may be true in some cases but B is the systematic reason. C and D are not fundamental to delta hedging.
Question 362
Which of the following best describes 'pin risk' in options trading?
Select an option first.
Correct answer: B — The risk that the underlying price finishes exactly at the strike at expiration, creating uncertainty about exercise
Explanation: ✔ Why correct: Pin risk occurs when the stock closes at or very near the strike on expiration. Traders do not know whether the option will be exercised, creating uncertainty about their net delta position going into the weekend. ✘ Why others are wrong: A is a neutral delta. C is not a recognized risk term. D is premium loss risk.
Question 363
A variance swap payoff is determined by:
Select an option first.
Correct answer: A — The difference between realized variance and strike variance times the notional
Explanation: ✔ Why correct: Variance swap payoff = notional × (σ²_realized − K²_var). The buyer of variance profits if actual variance exceeds the strike, and loses if variance is lower. ✘ Why others are wrong: B is VIX-based, not a variance swap. C is part of the calculation but not the payoff formula. D describes a volatility spread.
Question 364
Greeks aggregation in a large derivatives portfolio is useful because:
Select an option first.
Correct answer: A — It allows the trader to identify offsetting risks and net exposures across all positions
Explanation: ✔ Why correct: By aggregating Greeks (net delta, net gamma, net vega), a trader can see whether individual position risks cancel out and where residual exposures remain. ✘ Why others are wrong: B is wrong; Greeks vary by position. C is wrong; individual valuation is still needed. D is a risk function but not the purpose of Greek aggregation.
Question 365
A 'gamma scalping' strategy involves:
Select an option first.
Correct answer: A — Buying options with high gamma and trading the underlying to extract profit from delta rebalancing
Explanation: ✔ Why correct: A long gamma position benefits from volatility. By repeatedly delta-hedging, the trader 'scalps' small profits each time the underlying moves, partially offsetting the theta cost. ✘ Why others are wrong: B is short gamma. C is speculative options buying. D is a position management action.
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Question 366
Cross-gamma refers to:
Select an option first.
Correct answer: B — The sensitivity of one position's delta to changes in a different risk factor
Explanation: ✔ Why correct: Cross-gamma measures the second-order effect when two different risk factors move together (e.g., how a position's equity delta changes when rates move). It is important in complex multi-asset portfolios. ✘ Why others are wrong: A is FX option gamma. C is aggregate gamma. D is a specific portfolio state.
Question 367
A portfolio that is long gamma and short theta is expected to:
Select an option first.
Correct answer: A — Gain from large price moves but lose value daily from time decay
Explanation: ✔ Why correct: Long gamma positions profit from large swings; the tradeoff is negative theta (time decay costs). This is the classic long options payoff profile. ✘ Why others are wrong: B is the short gamma, long theta payoff. C is impossible for a standard long option. D is only true for cash.
Question 368
Model risk in derivatives refers to:
Select an option first.
Correct answer: B — The risk of losses from using an incorrect or misspecified pricing model
Explanation: ✔ Why correct: Model risk arises when the pricing model's assumptions don't reflect reality (e.g., constant volatility in BSM). Wrong model → wrong prices → incorrect hedges → potential losses. ✘ Why others are wrong: A is exchange operational risk. C is estimation risk (a subset of model risk). D is operational risk.
Question 369
Basis risk in a hedge arises when:
Select an option first.
Correct answer: B — The derivative used does not perfectly match the risk being hedged
Explanation: ✔ Why correct: Basis risk is the residual risk that the hedging instrument and the exposure being hedged do not move perfectly together. An imperfect correlation creates basis risk. ✘ Why others are wrong: A creates an over-hedge but may not be basis risk. C is a market risk event. D is a hedging process issue.
Question 370
Liquidity risk in derivatives positions refers to:
Select an option first.
Correct answer: D — Both B and C
Explanation: ✔ Why correct: Liquidity risk in derivatives has two dimensions: market liquidity (inability to trade at a fair price) and funding liquidity (inability to meet margin/settlement cash flows). ✘ Why others are wrong: A is time decay risk. B is market liquidity alone. C is funding liquidity alone. D captures both.
Question 371
The 'Greeks limit' framework used by derivative dealers involves:
Select an option first.
Correct answer: B — Setting maximum allowable exposures for each Greek to control risk
Explanation: ✔ Why correct: Dealers set limits on net delta, gamma, vega, theta, and rho to ensure that no single risk factor can create unacceptable losses. Positions approaching limits trigger rebalancing. ✘ Why others are wrong: A would prohibit directional trading. C is one risk metric approach. D is not standard. Exotic Options
Question 372
An Asian option's payoff is based on:
Select an option first.
Correct answer: B — The average price of the underlying over the option's life
Explanation: ✔ Why correct: Asian (average price) options reduce the impact of price manipulation near expiration and are cheaper than standard options because average prices are less volatile. ✘ Why others are wrong: A is a vanilla option payoff. C is a barrier option. D is a lookback option.
Question 373
A lookback option gives the holder:
Select an option first.
Correct answer: A — The right to buy at the lowest price observed during the option's life (for a lookback call)
Explanation: ✔ Why correct: A lookback call allows the holder to buy at the minimum price over the period; a lookback put allows selling at the maximum. They are valuable but more expensive than vanilla options. ✘ Why others are wrong: B is an Asian option. C is a guaranteed structure. D is an extendable option.
Question 374
A compound option is:
Select an option first.
Correct answer: B — An option whose underlying is another option
Explanation: ✔ Why correct: A compound option has an option as its underlying (e.g., a call on a call, or a put on a call). It is useful when future commitment to buy an option depends on uncertain conditions. ✘ Why others are wrong: A is a basket option. C is a straddle. D is a reload/shout option.
Question 375
A quanto option is used when:
Select an option first.
Correct answer: A — The holder wants exposure to a foreign asset but with payoff in the domestic currency at a fixed exchange rate
Explanation: ✔ Why correct: A quanto option eliminates currency risk. The underlying is foreign (e.g., a Japanese stock) but the payoff is made in domestic currency (e.g., USD) at a fixed exchange rate. ✘ Why others are wrong: B is a FX barrier option. C is a standard FX option. D is an Asian FX option.
Question 376
A cliquet option (also called a ratchet option) is characterized by:
Select an option first.
Correct answer: A — Periodic resetting of the strike to the current underlying price, locking in interim gains
Explanation: ✔ Why correct: A cliquet option periodically resets the strike to the current spot, locking in (or offsetting) gains over each period. It captures periodic moves rather than the total change from inception. ✘ Why others are wrong: B is a modified barrier. C is a series of barrier options. D is a deferred-premium option.
Question 377
Structured products in derivatives often use embedded options to:
Select an option first.
Correct answer: B — Provide customized risk/return profiles such as capital protection with limited upside participation
Explanation: ✔ Why correct: Structured products combine bonds with options (e.g., principal-protected note = zero-coupon bond + call option). They create tailored payoffs: capital protection, enhanced yield, or leveraged exposure. ✘ Why others are wrong: A is impossible without sacrifice of return. C is wrong; structured products add complexity. D is wrong; they are used by all investor types.
Question 378
A swap execution facility (SEF) in the United States is designed to:
Select an option first.
Correct answer: B — Provide a regulated platform for the trading of standardized OTC derivatives with pre- and post-trade transparency
Explanation: ✔ Why correct: SEFs were introduced under Dodd-Frank to increase transparency in the OTC swap market. They require pre-trade and post-trade reporting while maintaining flexible trading protocols. ✘ Why others are wrong: A is not the mandate; bespoke OTC transactions still exist. C is the opposite. D is exchange clearing, not SEF.
Question 379
Variation margin in cleared OTC derivatives is:
Select an option first.
Correct answer: B — Daily cash payments reflecting changes in the mark-to-market value of the derivative
Explanation: ✔ Why correct: Variation margin is the daily cash settlement of gains and losses on cleared positions, keeping the exposure between parties current and reducing the buildup of unpaid obligations. ✘ Why others are wrong: A is initial margin (one-time deposit). C is a clearinghouse fee. D describes the margin call trigger, not variation margin.
Question 380
Reporting requirements for OTC derivatives (e.g., EMIR in Europe, Dodd-Frank in the US) require:
Select an option first.
Correct answer: B — Reporting of trade details to a registered trade repository to improve regulatory visibility
Explanation: ✔ Why correct: Trade repositories (like DTCC) collect transaction data, allowing regulators to monitor systemic risk, detect market manipulation, and assess aggregate exposures across the financial system. ✘ Why others are wrong: A is pre-trade approval, not the reporting mandate. C is not required. D is wrong; MTM is typically daily.
Question 381
ISDA (International Swaps and Derivatives Association) is best known for:
Select an option first.
Correct answer: B — Developing standardized legal documentation (Master Agreement) for OTC derivatives
Explanation: ✔ Why correct: ISDA publishes the Master Agreement and Credit Support Annex (CSA), providing the legal backbone for OTC derivative transactions globally. ✘ Why others are wrong: A is LCH or CME Group. C is exchange-level rule-setting. D is done by local regulators.
Question 382
The Credit Support Annex (CSA) in a derivatives agreement governs:
Select an option first.
Correct answer: B — The terms under which collateral (margin) is posted and managed between OTC counterparties
Explanation: ✔ Why correct: The CSA specifies: eligible collateral, minimum transfer amounts, thresholds, and haircuts for collateral. It governs the bilateral margin relationship between OTC counterparties. ✘ Why others are wrong: A is governed by CDS confirmations. C is the ISDA close-out netting provision. D is exchange-defined.
Question 383
Netting provisions in ISDA agreements allow:
Select an option first.
Correct answer: A — Both parties to set off obligations across all transactions under the agreement upon default
Explanation: ✔ Why correct: Close-out netting allows all derivatives under the Master Agreement to be aggregated into a single net amount on default. This prevents 'cherry-picking' and reduces gross exposure significantly. ✘ Why others are wrong: B would be selective default. C is not the netting provision's purpose. D is not allowed.
Question 384
In the context of derivatives, 'novation' refers to:
Select an option first.
Correct answer: B — Replacing an original contract with a new one, typically inserting the clearinghouse as the central counterparty
Explanation: ✔ Why correct: Novation substitutes the clearinghouse as counterparty to each side of the trade. The original bilateral contract is replaced by two new contracts: one between the buyer and CCP, one between the seller and CCP. ✘ Why others are wrong: A is renegotiation. C is rolling. D is migration, not novation.
Question 385
A bilateral OTC derivative that is not centrally cleared relies on which mechanism for risk reduction?
Select an option first.
Correct answer: B — A bilateral margining agreement (CSA) and counterparty credit assessment
Explanation: ✔ Why correct: For non-cleared OTC derivatives, credit risk is managed bilaterally: the parties negotiate margin terms via a CSA, conduct credit due diligence, and may require credit enhancements. ✘ Why others are wrong: A is exchange-related. C is not standard for OTC derivatives. D is not applicable.
Question 386
A derivative trader's 'book' refers to:
Select an option first.
Correct answer: B — The overall collection of derivative positions, including hedges and speculative trades
Explanation: ✔ Why correct: A trader's 'book' is their entire portfolio of derivative positions. Managing the book involves hedging net Greeks, managing cash flows, and monitoring P&L. ✘ Why others are wrong: A is a narrow accounting concept. C is a regulatory filing. D is the order book.
Question 387
The CFTC (Commodity Futures Trading Commission) in the US regulates:
Select an option first.
Correct answer: B — Most futures contracts and many OTC derivatives including interest rate and credit swaps
Explanation: ✔ Why correct: The CFTC has broad jurisdiction over futures and many OTC derivatives (swaps). The SEC regulates equity options and security-based swaps. Banking oversight falls under other regulators. ✘ Why others are wrong: A is SEC jurisdiction. C is banking regulators. D understates CFTC's mandate.
Question 388
Position limits in commodity futures markets are designed to:
Select an option first.
Correct answer: B — Prevent any single trader from accumulating a position large enough to manipulate prices
Explanation: ✔ Why correct: Position limits are anti-manipulation rules. They prevent a single entity from cornering the market or distorting prices in the cash or futures market. ✘ Why others are wrong: A is a minimum limit, which doesn't exist. C is not a regulatory limit. D is a different type of limit.
Question 389
A 'designated contract market' (DCM) is best described as:
Select an option first.
Correct answer: B — A CFTC-regulated exchange where futures and options on futures are traded
Explanation: ✔ Why correct: A DCM is a CFTC-registered futures exchange (e.g., CME, CBOT, ICE). It provides a regulated venue for futures and options trading with pre- and post-trade transparency. ✘ Why others are wrong: A is a SEF or OTC market. C is a trade repository. D is a banking platform.
Question 390
The gross notional outstanding of the global OTC derivatives market far exceeds global GDP primarily because:
Select an option first.
Correct answer: B — Notional amounts are reference amounts for calculation, not actual amounts at risk
Explanation: ✔ Why correct: Notional value is used only to calculate payment streams. The actual credit exposure (market value) and net exposure are far smaller. Large notional figures reflect the scale of financial activity, not actual sums at risk. ✘ Why others are wrong: A is wrong; most are cash-settled. C is an exaggeration. D is wrong.
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