CFA Level III Derivatives and Risk Management Practice Questions
Question 1
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 explanation
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.
Question 2
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 explanation
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%.
Question 3
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 explanation
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.
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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 explanation
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.