Derivatives — CFA Level I practice questions

The forward price on a non-dividend-paying stock is MOST closely linked to the spot price by:

1. F0 equals S0 multiplied by (1 + r)^T
2. F0 equals S0 divided by (1 + r)^T
3. F0 equals S0 plus the fixed coupon rate
4. F0 equals S0 whenever markets are efficient

Answer: A — F0 equals S0 multiplied by (1 + r)^T

A) Correct — no-arbitrage cost-of-carry gives F0 = S0 (1 + r)^T. B) Discounting reverses the sign of the carry and creates arbitrage. C) Coupons apply to bonds, not equity forwards. D) Efficiency does not eliminate the time value of money in the carry.

A bull call spread is established by:

1. Long higher-strike call, short lower-strike call
2. Long lower-strike put, short higher-strike put
3. Long both a call and put at the same strike
4. Long lower-strike call, short higher-strike call

Answer: D — Long lower-strike call, short higher-strike call

A) Reversing the strikes gives a bear call spread, not bullish. B) Long lower / short higher puts creates a bull put spread using puts, not calls. C) Same-strike long call + long put is a straddle. D) Correct — buying the cheaper low-strike call and selling the pricier high-strike call caps upside for reduced premium.

An Investment Policy Statement (IPS) prepared for an institutional client typically documents the:

1. Specific individual stock and bond selections and the exact rebalancing dates over the next several years
2. Objectives and constraints along with asset-allocation, rebalancing, and benchmark selection policy overall
3. Every day-to-day portfolio trade, including counterparties, execution venues, and commissions per trade
4. Quarterly earnings forecasts for each of the individual companies held within the client's investment portfolio

Answer: B — Objectives and constraints along with asset-allocation, rebalancing, and benchmark selection policy overall

A) Individual security selection sits below the IPS level. B) Correct — objectives, constraints, and policy is the IPS core. C) Trade-level detail belongs in execution records. D) Earnings forecasts are not IPS content.

In a one-period binomial option model, the call is priced using:

1. Historical probability of the up-move occurring
2. The investor's subjective risk preferences
3. Risk-neutral probabilities and the risk-free rate
4. Weighted expected payoff at the required return

Answer: C — Risk-neutral probabilities and the risk-free rate

A) The real-world probability is not the pricing measure. B) Preferences vanish under no-arbitrage pricing. C) Correct — π = (R−d)/(u−d), discount at Rf. D) That is the discounted expected value under CAPM instead.

The Markowitz efficient frontier is best described as the set of feasible portfolios that offer the:

1. All possible combinations of risky assets, including combinations that are strictly dominated by other choices
2. A completely random selection of feasible portfolios chosen without regard to any mean-variance efficiency
3. Maximum expected return for each level of risk, or equivalently, the minimum risk for each level of return
4. Portfolios that hold only publicly traded common stocks and explicitly exclude every fixed-income position

Answer: C — Maximum expected return for each level of risk, or equivalently, the minimum risk for each level of return

A) The frontier excludes dominated portfolios. B) Random draws are not the frontier. C) Correct — mean-variance-efficient set. D) The frontier spans asset classes, not just equities.

For a defined-benefit (DB) pension plan, the primary investment consideration is:

1. Maximizing risk-taking so as to raise the sponsor's expected surplus above the accrued benefit obligations
2. Maximizing portfolio liquidity so that beneficiaries can be paid instantly at any point in the future timeline
3. Minimizing corporate taxes paid by the plan sponsor over each of its own accounting reporting periods each year
4. Matching asset characteristics (duration, expected return, liquidity) to the plan's projected liability streams

Answer: D — Matching asset characteristics (duration, expected return, liquidity) to the plan's projected liability streams

A) DB plans manage to a liability stream, not max risk. B) Extreme liquidity is unnecessary given predictable benefit payments. C) Tax minimization is secondary. D) Correct — asset-liability management is the discipline.

A trader is short an equity index future. If the index rises 2% by close, the margin account is:

1. Credited as short positions gain from a rise
2. Debited via daily mark-to-market losses
3. Unaffected until final expiration settlement
4. Frozen until initial margin is reposted

Answer: B — Debited via daily mark-to-market losses

A) Shorts lose, not gain, when the underlying rises. B) Correct — futures settle daily via variation margin. C) That describes forwards, not futures. D) Trading continues; only maintenance triggers a call.

A futures contract differs from a forward contract because futures are:

1. Customized over-the-counter contracts by nature
2. Standardized exchange-traded and marked-to-market
3. Privately negotiated without any clearinghouse
4. Always physically settled at contract expiry

Answer: B — Standardized exchange-traded and marked-to-market

A) That describes forwards, not futures. B) Correct — standardized exchange product with daily mark-to-market. C) Forwards lack clearinghouses; futures use them. D) Many futures settle in cash, not physically.

Put-call parity for European options on a non-dividend-paying stock is expressed as:

1. C plus P equals S, adding call and put prices directly to the current spot price of the underlying asset
2. C minus P equals S minus K times e raised to (minus r T), the standard European put-call parity identity
3. C times P equals S, multiplying the call and put prices together to obtain the spot price of the underlying
4. C divided by P equals K, dividing the call price by the put price to obtain the strike price value directly

Answer: B — C minus P equals S minus K times e raised to (minus r T), the standard European put-call parity identity

A) Dimensionally inconsistent, no arbitrage interpretation. B) Correct — standard parity identity. C) Multiplying option prices is meaningless. D) The ratio of option prices does not equal the strike price.

An interest rate swap involves:

1. Exchanging currencies between counterparties
2. Exchanging options for futures contracts
3. Exchanging equity shares for bonds
4. Exchanging fixed for floating payments

Answer: D — Exchanging fixed for floating payments

A) Describes a currency swap. B) Not a defined derivative product. C) Describes a debt-equity swap in restructuring. D) Correct — standard interest-rate swap definition.

What is a forward rate?

An expected future interest rate implied by current spot rates. Used to determine the market's expectation of future rates.

What is the price of a forward contract at initiation?

Zero — the forward price is set so the contract has no value at inception. Value changes over the life of the contract as the underlying price moves.

What is a credit default swap (CDS)?

Derivative where buyer pays periodic premiums for compensation if a credit event (default) occurs. Acts as credit insurance.

What is a currency forward?

Agreement to exchange currencies at a specified rate on a future date. Used for hedging or speculation on exchange rate movements.