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CFA Level III Derivatives and Risk Management Practice Questions

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CFA Institute Level III exam topics and pathways
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7
Updated
Nov 3, 2026

  1. Question 1, medium

    Ayesha holds a share priced at USD 100.00. She buys a 95-strike put for USD 2.00 and sells a 110-strike call for USD 3.00, all with the same expiration. What is her maximum loss per share at expiration?

    • A.USD 5.00
    • B.USD 6.00
    • C.USD 1.00
    • D.USD 4.00
    Show answer and explanationHide answer

    Correct answer: D. USD 4.00

    A collar's floor is set by the put strike, adjusted for net premium. Net premium = +3.00 received - 2.00 paid = +1.00 credit. Maximum loss = (100.00 - 95.00) - 1.00 = USD 4.00. Maximum gain = (110.00 - 100.00) + 1.00 = USD 11.00.

    • A. Drop to the put strike only; ignores the net credit from the premiums.
    • B. Adds the net credit to the loss instead of subtracting it.
    • C. Reports the net premium credit itself rather than the maximum loss.
    • D. Correct: the 5.00 drop to the put strike is partly offset by the 1.00 net credit.

  2. Question 2, hard

    A five-year CDS on a corporate issuer is quoted at a spread of 400 bps while the standard fixed coupon is 100 bps. The CDS has a spread duration of about 4.0. For a USD 10 million notional, what is the approximate upfront payment and who pays it?

    • A.The protection seller pays about USD 1.20 million
    • B.The protection buyer pays about USD 1.60 million
    • C.The protection buyer pays about USD 0.40 million
    • D.The protection buyer pays about USD 1.20 million
    Show answer and explanationHide answer

    Correct answer: D. The protection buyer pays about USD 1.20 million

    Upfront premium is about (credit spread - fixed coupon) x spread duration = (4.00% - 1.00%) x 4.0 = 12% of notional = USD 1.20 million. Because the market spread exceeds the coupon, the buyer is paying too little through coupons and compensates the seller upfront.

    • A. Right amount but wrong payer; the seller receives the upfront here.
    • B. Uses the full 400 bps instead of the difference from the coupon.
    • C. Uses only the 100 bps coupon instead of the spread difference.
    • D. Correct: 3% spread difference x 4.0 duration = 12%.

  3. Question 3, easy

    Luis owns a share bought at USD 60.00 and buys a put with a strike of USD 55.00 for USD 2.50. Ignoring transaction costs and dividends, what is the maximum loss per share on this protective put at expiration?

    • A.USD 5.00
    • B.USD 7.50
    • C.USD 2.50
    • D.USD 62.50
    Show answer and explanationHide answer

    Correct answer: B. USD 7.50

    Maximum loss on a protective put = (stock price - strike) + put premium = (60.00 - 55.00) + 2.50 = USD 7.50. The put sets a floor under the share's value at the strike, but the premium is an added cost. The 62.50 figure is the breakeven price, not a loss.

    • A. Counts the decline to the strike but leaves out the premium paid for protection.
    • B. Correct: the 5.00 of stock decline down to the strike plus the 2.50 premium.
    • C. Counts only the premium, as if the stock could not lose value before the put pays off.
    • D. Gives the breakeven stock price (cost plus premium) instead of a loss per share.

  4. Question 4, easy

    A pension plan's policy allows tactical shifts between equities and bonds. The CIO wants to move 5% of assets toward equities for three months without disrupting the external managers' holdings. What is the best reason to use a derivatives overlay?

    • A.It guarantees a higher return because futures carry a built-in risk premium over cash
    • B.It changes asset class exposure quickly and cheaply without trading the underlying portfolios
    • C.It removes counterparty and basis risk because exchange-traded contracts replicate cash holdings exactly
    • D.It avoids the need for a policy benchmark because derivative exposure is excluded from asset allocation
    Show answer and explanationHide answer

    Correct answer: B. It changes asset class exposure quickly and cheaply without trading the underlying portfolios

    Overlays adjust exposures with futures or swaps, avoiding transaction costs, market impact and disruption to the underlying managers. They do not guarantee return, still carry basis and tracking risk, and the exposure is still part of the asset allocation measured against policy.

    • A. Futures do not add a guaranteed premium; fair pricing offsets cash plus the financing.
    • B. Correct: speed, lower cost and no disruption to managers.
    • C. Basis and tracking error versus the cash market remain, so the replication is not exact.
    • D. Overlay exposure counts toward actual allocation versus the policy benchmark.

  5. Question 5, hard

    A USD-based investor holds euro assets and hedges by selling EUR forward each month. USD interest rates are about 4% and EUR rates are about 1%. Assuming the spot rate is unchanged, what is the approximate effect of rolling this hedge over a year?

    • A.A positive roll yield of about 3% because the EUR is sold forward at a premium to spot
    • B.A hedging cost of about 3% because the investor must buy the higher-yielding USD forward
    • C.No gain or cost because covered interest rate parity makes the hedge neutral over time
    • D.A hedging cost of about 1% because the investor gives up the EUR yield on the hedged assets
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    Correct answer: A. A positive roll yield of about 3% because the EUR is sold forward at a premium to spot

    With USD rates above EUR rates, EUR trades at a forward premium. Selling EUR forward at the premium and having it converge to spot yields roughly the rate differential, about 3%, as a positive roll yield. The hedged return is approximately the local EUR return plus this differential.

    • A. Correct: selling the currency at a forward premium earns the differential.
    • B. Reverses the roll yield sign; hedging here earns, not costs.
    • C. Parity prices the forward but the hedger still earns the differential relative to an unchanged spot.
    • D. Uses the EUR rate alone, not the interest rate differential.

  6. Question 6, hard

    A defined benefit plan has assets of USD 500 million with a duration of 7.0 and liabilities with a present value of USD 500 million and a duration of 11.0. The sponsor worries about a surplus loss if rates fall, and wants to close the gap without selling any bonds. Which action is best?

    • A.Enter pay-fixed swaps to reduce the effective duration of the assets
    • B.Sell bond futures to reduce the effective duration of the assets
    • C.Shorten the bond portfolio's maturities to match the shorter duration
    • D.Use receive-fixed swaps or long bond futures to add asset duration
    Show answer and explanationHide answer

    Correct answer: D. Use receive-fixed swaps or long bond futures to add asset duration

    Liabilities are more rate-sensitive than assets, so a rate decline raises liabilities more than assets. The plan needs more duration on the asset side; receive-fixed swaps or long bond futures add duration without trading the physical bonds. Pay-fixed swaps and short futures do the opposite and widen the gap.

    • A. Pay-fixed swaps behave like short bond positions and would widen the gap.
    • B. Selling futures cuts duration further, increasing the exposure to falling rates.
    • C. Shortening maturities lowers asset duration, which moves it away from the liability duration.
    • D. Correct: adding duration synthetically moves assets toward the 11.0 liability duration.

  7. Question 7, easy

    A treasurer will borrow USD 10 million at a floating rate in three months for a three-month period and fears rates will rise. Which forward rate agreement (FRA) position hedges this exposure?

    • A.Buy a 3x6 FRA, paying the fixed rate and receiving the floating rate
    • B.Sell a 3x6 FRA, receiving the fixed rate and paying the floating rate
    • C.Buy a 6x9 FRA, paying the fixed rate and receiving the floating rate
    • D.Sell a 3x9 FRA, receiving the fixed rate and paying the floating rate
    Show answer and explanationHide answer

    Correct answer: A. Buy a 3x6 FRA, paying the fixed rate and receiving the floating rate

    A borrower fixes its cost by paying the fixed FRA rate and receiving the floating reference rate, which offsets higher borrowing costs. The FRA must start when the loan starts (3 months) and end when it ends (6 months), so a 3x6 FRA matches. The long (buy) side is the fixed-rate payer.

    • A. Correct: long 3x6 FRA gains if rates rise, offsetting the higher loan cost.
    • B. This is the lender's hedge; the receive-fixed side loses if rates rise.
    • C. Right direction but the dates are wrong; it covers months 6 to 9, not the loan period.
    • D. Wrong direction and wrong tenor; a 3x9 FRA covers a six-month rate.

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