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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 181
The 'running spread' in a CDS refers to:
Select an option first.
Correct answer: B — The periodic premium paid throughout the life of the CDS
Explanation: ✔ Why correct: The running spread is the regular periodic payment (usually quarterly) made by the protection buyer, expressed as an annual rate on the notional. It 'runs' over the contract life. ✘ Why others are wrong: A is spread change. C is the CDS-bond basis. D is the contingent payment.
Question 182
The basis between a CDS spread and the bond asset swap spread (ASW) is called:
Select an option first.
Correct answer: B — The CDS-bond basis
Explanation: ✔ Why correct: The CDS-bond basis = CDS spread − asset swap spread. It can be positive or negative and is exploited in basis trades. Divergence from zero creates arbitrage opportunities. ✘ Why others are wrong: A is not a standard term. C is the spread-default probability-recovery relationship. D is a CVA concept.
Question 183
The 'pull to par' effect in CDS pricing refers to:
Select an option first.
Correct answer: A — The tendency for CDS spreads to tighten as the bond approaches maturity
Explanation: ✔ Why correct: As a bond nears maturity, the time during which default can occur shortens. This reduces the CDS spread even if credit quality is unchanged, similar to how bond prices pull toward par. ✘ Why others are wrong: B and C are not standard descriptions. D is related to convergence but not the 'pull to par' term.
Question 184
The benefit of centrally clearing CDS contracts (post-2008) is primarily:
Select an option first.
Correct answer: B — Reducing systemic risk by inserting a clearinghouse between counterparties and requiring margin
Explanation: ✔ Why correct: Central clearing imposes initial and variation margin, reduces bilateral counterparty risk, and provides transparency, reducing the systemic risk highlighted during the 2008 financial crisis. ✘ Why others are wrong: A is unrelated to clearing benefits. C is market-driven, not a clearing outcome. D is wrong; ISDA agreements remain important. Risk Management
Question 185
The Greeks delta, gamma, vega, theta, and rho are used in derivatives risk management to:
Select an option first.
Correct answer: B — Measure the sensitivity of a derivative's value to changes in specific risk factors
Explanation: ✔ Why correct: Each Greek measures sensitivity to one risk factor: delta (underlying price), gamma (delta change), vega (volatility), theta (time), rho (rates). Together they give a comprehensive risk picture. ✘ Why others are wrong: A overstates; Greeks are approximations. C and D are different problems.
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Question 186
Scenario analysis in derivative risk management involves:
Select an option first.
Correct answer: B — Evaluating portfolio performance under specific hypothetical or historical market scenarios
Explanation: ✔ Why correct: Scenario analysis asks: 'What happens to the portfolio if X occurs?' (e.g., rates rise 100 bps, equities fall 20%). It complements VaR by testing specific stress conditions. ✘ Why others are wrong: A is historical VaR. C is Monte Carlo. D is daily mark-to-market.
Question 187
Stress testing in derivatives risk management is designed to:
Select an option first.
Correct answer: B — Evaluate portfolio losses under extreme but plausible market conditions
Explanation: ✔ Why correct: Stress testing examines portfolio behavior in extreme scenarios (e.g., 2008 financial crisis, COVID crash). It identifies vulnerabilities that VaR may miss. ✘ Why others are wrong: A is model validation. C is a daily Greeks calculation. D is performance attribution.
Question 188
The notional value of a derivative is important for risk management because:
Select an option first.
Correct answer: B — It defines the scale of the exposure even though it may not be exchanged
Explanation: ✔ Why correct: Notional value defines the magnitude of risk. A $10 million notional interest rate swap exposes the parties to rate changes on $10 million. The notional itself may never change hands. ✘ Why others are wrong: A is daily trading volume. C is wrong; market value is different from notional. D depends on the contract structure, not just notional.
Question 189
Central clearing of OTC derivatives was mandated primarily as a result of:
Select an option first.
Correct answer: B — Lessons from the 2008 financial crisis, where OTC counterparty risk created systemic risk
Explanation: ✔ Why correct: The collapse of Lehman Brothers and near-failure of AIG highlighted how OTC counterparty risk can cascade into systemic crisis. The 2009 G20 Pittsburgh summit mandated central clearing for standardized OTC derivatives. ✘ Why others are wrong: A is unrelated. C is wrong; retail demand was not the driver. D was not the intent.
Question 190
Initial margin in central clearing is designed to:
Select an option first.
Correct answer: B — Cover the potential future exposure during the close-out period if a member defaults
Explanation: ✔ Why correct: Initial margin (IM) is sized to cover the cost of closing out a defaulted member's positions over the close-out period (usually 2-5 days for swaps), with a high confidence level. ✘ Why others are wrong: A is covered by variation margin. C is the clearinghouse's own capital. D describes the default fund.
Question 191
The Dodd-Frank Act (US) primarily impacted the derivatives market by:
Select an option first.
Correct answer: B — Requiring central clearing and trade reporting for standardized OTC derivatives
Explanation: ✔ Why correct: Dodd-Frank (2010) required standardized swaps to be cleared through CCPs and reported to trade repositories. It also introduced SEF trading and swap dealer registration. ✘ Why others are wrong: A is wrong; OTC trading continues. C partially — both the CFTC and SEC have roles. D is wrong.
Question 192
A 'spread option' pays based on:
Select an option first.
Correct answer: B — The difference between two asset prices or rates
Explanation: ✔ Why correct: A spread option's payoff depends on the difference between two prices or rates (e.g., crude oil crack spread = refining margin; calendar spreads in commodities). These options are common in energy markets. ✘ Why others are wrong: A is a vanilla option. C is bid-ask, not asset spread. D is credit spread derivative.
Question 193
A derivative is best described as a financial instrument whose value:
Select an option first.
Correct answer: A — Depends on the value of some other underlying asset or rate
Explanation: ✔ Why correct: Derivatives derive their value from an underlying asset, index, rate, or commodity — that is the defining characteristic. ✘ Why others are wrong: B is wrong because derivative values fluctuate. C is wrong; most derivatives carry counterparty risk, not government guarantees. D is wrong; that describes a credit instrument, not a derivative.
Question 194
Which of the following is NOT typically classified as an underlying for a derivative contract?
Select an option first.
Correct answer: D — A company's reputation
Explanation: ✔ Why correct: Underlyings must be observable and measurable. Equity indices, commodity prices, and interest rates all qualify. A company's reputation is too subjective and unquantifiable to serve as a derivative underlying. ✘ Why others are wrong: A, B, and C are all standard derivative underlyings used in practice every day.
Question 195
Exchange-traded derivatives differ from over-the-counter (OTC) derivatives primarily because exchange-traded derivatives:
Select an option first.
Correct answer: A — Are standardized and guaranteed by a clearinghouse
Explanation: ✔ Why correct: Exchanges standardize contract terms and route trades through a central clearinghouse that guarantees performance, dramatically reducing counterparty risk. ✘ Why others are wrong: B is incorrect; retail investors can trade many exchange-listed derivatives. C is wrong; all derivatives have defined expiration. D is incorrect; hedging is one of the primary uses of exchange-traded derivatives.
Question 196
The main advantage of OTC derivatives over exchange-traded derivatives is:
Select an option first.
Correct answer: B — Greater customization of contract terms
Explanation: ✔ Why correct: OTC contracts are negotiated bilaterally, allowing the parties to customize notional amount, maturity, settlement terms, and other features to match exact needs. ✘ Why others are wrong: A is wrong; OTC contracts carry more counterparty risk because there is no clearinghouse. C and D are wrong; exchanges generally offer more liquidity and transparency.
Question 197
Which statement best describes the zero-sum nature of most derivative contracts?
Select an option first.
Correct answer: B — One party's gain equals the other party's loss
Explanation: ✔ Why correct: Derivatives are zero-sum: any payoff received by one side comes directly at the expense of the other. There is no net value creation between the two counterparties. ✘ Why others are wrong: A and D are both impossible in a zero-sum game. C describes equal sharing, which is not how derivative payoffs work.
Question 198
Leverage in derivatives refers to:
Select an option first.
Correct answer: A — The ability to control a large notional position with a small initial outlay
Explanation: ✔ Why correct: Derivatives require little or no upfront payment relative to the notional exposure they represent, giving investors amplified gains and losses relative to the capital committed. ✘ Why others are wrong: B confuses leverage with margin lending on stocks. C describes clearinghouse novation. D describes contract rolling.
Question 199
A trader uses an equity futures contract to lock in the current price of a stock index for delivery in 90 days. This use of a derivative is best described as:
Select an option first.
Correct answer: C — Hedging
Explanation: ✔ Why correct: Locking in a future price to eliminate price uncertainty is the classic definition of hedging. ✘ Why others are wrong: A would mean taking on risk deliberately. B involves exploiting price discrepancies simultaneously. D is a feature of derivatives, not a strategy in itself.
Question 200
A trader who has no underlying exposure buys a futures contract hoping the price will rise. This is best described as:
Select an option first.
Correct answer: B — Speculation
Explanation: ✔ Why correct: Speculation involves taking on directional risk for potential profit without an offsetting underlying exposure. ✘ Why others are wrong: A requires an existing risk to offset. C requires simultaneous offsetting trades in different markets. D involves options strategies to protect a portfolio.
Question 201
Arbitrage in derivative markets is best described as:
Select an option first.
Correct answer: B — Simultaneously buying and selling the same or equivalent asset to profit from a price discrepancy
Explanation: ✔ Why correct: Arbitrage exploits price inefficiencies across markets or instruments simultaneously, earning a riskless profit with no net investment. ✘ Why others are wrong: A is speculation. C is hedging. D describes a forward contract, not an arbitrage strategy.
Question 202
The notional principal of a derivative contract refers to:
Select an option first.
Correct answer: B — The face value on which payments or settlement amounts are calculated
Explanation: ✔ Why correct: Notional principal is the reference amount used to compute cash flows. It is rarely exchanged; it is simply the basis for calculations. ✘ Why others are wrong: A is incorrect; little or no cash changes hands at inception for most derivatives. C is the mark-to-market value. D is the option premium (relevant only for options).
Question 203
Which of the following describes physical settlement of a derivative?
Select an option first.
Correct answer: B — The underlying asset is actually delivered from seller to buyer
Explanation: ✔ Why correct: Physical settlement means the actual underlying asset changes hands. This is common in commodity futures. ✘ Why others are wrong: A describes cash settlement. C describes a mutual cancellation. D is not a standard settlement method.
Question 204
Cash settlement of a derivative contract means:
Select an option first.
Correct answer: C — The net gain or loss is paid in cash without transfer of the underlying
Explanation: ✔ Why correct: In cash settlement, only the net difference between the contract price and the market price is transferred. No physical asset changes hands. ✘ Why others are wrong: A describes physical settlement. B describes expiration of an out-of-the-money option. D describes a repo, not derivative settlement.
Question 205
Counterparty risk in a derivative contract is the risk that:
Select an option first.
Correct answer: B — The other party to the contract fails to fulfill its obligations
Explanation: ✔ Why correct: Counterparty risk (also called default risk or credit risk) is the possibility that the other party will not honor the agreement. ✘ Why others are wrong: A is market risk. C is liquidity risk. D is interest rate risk.
Question 206
A clearinghouse reduces counterparty risk primarily by:
Select an option first.
Correct answer: B — Becoming the buyer to every seller and the seller to every buyer
Explanation: ✔ Why correct: Through novation, the clearinghouse inserts itself between the two original parties, guaranteeing performance to each side and eliminating bilateral counterparty risk. ✘ Why others are wrong: A describes position limits (a different risk-management tool). C is unrelated to risk reduction. D would exclude most participants.
Question 207
Initial margin in exchange-traded futures is best described as:
Select an option first.
Correct answer: B — A good-faith deposit required to open a futures position
Explanation: ✔ Why correct: Initial margin is a performance bond deposited when opening a futures position, ensuring the trader can cover potential losses. ✘ Why others are wrong: A is an option premium. C is the mark-to-market variation margin. D is a commission.
Question 208
If a futures trader's account balance falls below the maintenance margin level, the trader will receive:
Select an option first.
Correct answer: B — A margin call requiring additional funds
Explanation: ✔ Why correct: When equity falls below maintenance margin, the broker issues a margin call. The trader must restore the account to at least the initial margin level. ✘ Why others are wrong: A is a corporate action. C and D do not exist in futures markets.
Question 209
Marking to market in futures means:
Select an option first.
Correct answer: B — Daily crediting or debiting of gains and losses to the margin account
Explanation: ✔ Why correct: Each day, futures positions are repriced to the settlement price and the resulting gains or losses are moved between counterparty accounts, keeping risk current. ✘ Why others are wrong: A is convergence at expiration. C is an accounting standard. D is the unbiased expectations hypothesis, not marking to market.
Question 210
Open interest in a futures market refers to:
Select an option first.
Correct answer: B — The number of outstanding contracts not yet closed or delivered
Explanation: ✔ Why correct: Open interest counts contracts with an open obligation — each open long is matched to an open short. It measures market depth and commitment. ✘ Why others are wrong: A is trading volume. C is the bid-ask spread. D describes net positioning, not open interest.
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