CFA® Derivative Investments
Summary, Syllabus, Topics, and Sample Questions (L1, L2, L3)
Derivative Investments are financial instruments that derive their value from another asset. The underlying asset could be a stock, currency, commodity, or interest rate. Derivative Investments were initially used to hedge commodity risk, but their usefulness has grown over the years to help investors mitigate various types of risk and earn higher returns than traditional investments. Generally, Derivative Investments can be classified as forward commitments and contingent claims. The forward commitment sets an obligation between the parties to engage in a transaction at a future date on terms agreed upon in advance. In contrast, contingent claims give one party the right but not the obligation to engage in a prospective transaction on set terms.
Derivative Investments are either exchange-traded or traded over-the-counter (OTC). Exchange-traded Derivative Investments offer standardized terms and conditions, whereas OTC-based Derivative Investments are customizable.
The most common Derivative Investments used by investors are:
- Future Contracts
- Options (call and put)
- Forward Contracts
- Swaps
- Credit Default Swaps
What is the CFA® Level 1 Derivative Investments Topic?
The Derivative Investments curriculum has a similar weighting to that of alternative investments and portfolio management. Around 3% of Level 1 readings are dedicated to the topic, which introduces Derivative Investments.
Candidates will study various derivative instruments classified as forward commitments and contingent claims and see how these instruments derive their value and are traded in different settings.
Exam Weighting
The CFA Level 1 Derivative Investments has a weighting of 5-8% which implies that around 9-14 out of 180 CFA Level 1 exam questions focus on this topic.
| Topic Weight | No. of Readings | No. of Formulas | No. of Questions |
| 5-8% | 02 | Around 12 | 9-14 |
Syllabus, Readings & Changes Overview
The weighting of the Derivative topic will not increase in 2022. Since 2021, weighting has fluctuated between 5-8%.
| 2018 | 2019 | 2020 | 2021 | 2022 |
|---|---|---|---|---|
| 5% | 6% | 6% | 5-8% | 5-8% |
Material in the Derivative Investments topic area of the 2022 curriculum remains unchanged from 2020.
Key Changes to CFA Level 1 Derivative Investments:
| Derivative Investments Level 1 Changes | |
|---|---|
| Derivative Markets and Instruments | No Changes |
| Basics of Derivative Pricing and Valuation | No Changes |
There are a total of 60 readings and 19 study sessions for CFA Level I in 2022. Out of these, 2 readings under 1 study session are devoted to Derivative Investments. The following table provides a brief description of the study session:
| Study Session | No. of Readings | No. of LOS |
|---|---|---|
| 15 | 02 | 21 |
|
Summary
Discusses the fundamentals of derivative instruments including forward commitments (e.g. futures, forwards, swaps) and contingent claims (e.g. call and put options) and derivative markets such as exchange-traded and over-the-counter derivative markets. It further explains the derivative pricing and valuation along with the introduction of the principle of arbitrage. |
||
Derivative Markets and Instruments
This reading provides an overview of derivative instruments and markets, distinguishing characteristics of forward commitments and contingent claims, and the underlying of Derivative Investments. It also covers the purpose, benefits, and risks of Derivative Investments, as well as criticism and potential misuse of Derivative Investments.
Basics of Derivative Pricing and Valuation
This reading focuses mainly on the pricing and valuation of derivative instruments such as futures contracts, forward contracts, swaps, and contingent claims, including call or put options. It also introduces the principle of arbitrage. Characteristics of the European and American-style call options are also discussed.
CFA Derivative Investments Level 1 Sample Questions and Answers
The sample questions are typical of the probing multiple-choice questions on the L1 exam. During the exam, you have about 90 seconds to read and answer each question, carefully designed to test knowledge from the CFA Curriculum. UWorld’s question bank is built to expose you to exam-like questions and illustrate and explain the concepts tested thoroughly.
An analyst observes the following market data for one American put option:
| Selected Data (in CAD) | |
|---|---|
| Stock price | 48 |
| Strike price | 50 |
| Option premium | 4 |
- in the money.
- at the money.
- out of the money.
An increase in which of the following is most likely to cause the value of both puts and calls to increase?
- Volatility
- Strike price
- Interest rate
Which of the following best replicates the cash flows of an interest rate swap? A series of:
- interest rate futures.
- interest rate call options.
- forward rate agreements.
Copyright © UWorld. All rights reserved.
Study Tips for the CFA L1 Derivative Investments
Here are some tips for studying Derivative Investments:- Make sure that you have got some understanding of concepts related to equity, fixed income, and alternative investments before starting with Derivative Investments.
- Focus on each LOS explicitly and make sure that the information under each LOS is completely understood.
- Memorize formulas: Spend some time comprehending formulas.
- Practice from examples and practice problems from the CFA Institute’s official curriculum.
- Visit our Level 1 study guide for more details.
FAQs
Is the CFA Level 1 Derivative Investments topic hard?
How can I study L1 Derivative Investments for the CFA exam?
How do I practice CFA L1 Derivative Investments questions?
What are Derivative Investments for the CFA exam?
How do I practice the CFA L1 Derivative Investments formulas?
What is the CFA Level 2 Derivative Investments topic?
The CFA Level 2 test’s Derivative Investments portion is one of the most dreaded since exam applicants are familiar with forwards, futures, swaps, and options. Candidates have trouble navigating the subject when there are complicated notations in the curriculum.
Exam Weighting
The CFA Level 2 Derivative Investments topic has a weight of 5-10% which implies that around 4-9 out of 88 CFA Level 2 exam questions focus on this topic.
| Topic Weight | No. of Readings | No. of Formulas | No. of Questions |
|---|---|---|---|
| 5-15% | 02 | Around 20 | 4-9 |
Syllabus, Readings and Changes Overview
The weighting of Derivative Investments was between 5-15% in 2018 which has reduced to 5-10% in 2019 and remained the same till 2022.
| 2018 | 2019 | 2020 | 2021 | 2022 |
|---|---|---|---|---|
| 5-15% | 5-10% | 5-10% | 5-10% | 5-10% |
Key Changes to CFA Level 2 Derivative Investments:
| Derivative Investments Level 2 Changes | |
|---|---|
| Pricing and Valuation of Forward Commitments | Major Revisions |
| Valuation of Contingent Claims | No Changes |
A condensed version of the “Pricing and Valuation of Forward Commitments” reading provides more details on the concepts for pricing and valuing forwards, futures, and swaps while increasing clarity for learners through the use of understandable images and graphics. The pricing and valuation of futures are demonstrated, for instance, using the arbitrage-free approach and offsetting bond portfolios.
For specialists who utilize forwards and swaps to handle a variety of market risks, the “Pricing and Valuation of Forward Commitments” reading clarifies a useful strategy. Anyone who wants to understand the work of, for example, a private wealth manager who uses futures to hedge clients’ equity risk, a pension scheme manager who uses swaps to hedge clients’ interest rate risk, or a manager of a university endowment who uses Derivative Investments for tactical asset allocation and portfolio rebalancing, will find the content useful.
There are a total of 47 readings and 17 study sessions for CFA Level 2 in 2022. Out of these, 2 readings under 1 study session are devoted to Derivative Investments. The following table provides a brief description of the study session:
| Study Session | No. of Readings | No. of LOS |
|---|---|---|
| 15 | 02 | 21 |
|
Summary
Introduces key pricing and valuation concepts of forward commitments including forwards, futures, and swaps as well as valuation of contingent claims, that is, options. ‘Greeks’ which measure the effects on the value of small changes in underlying asset value, time, volatility, and the risk-free rate is also discussed. |
||
Pricing and Valuation of Forward Commitments
This reading focuses on the pricing and valuation for forward and futures contracts including equity forwards, bond forward contracts, currency forward, and forward rate agreements. Calculations of no-arbitrage valuation for derivative instruments are also covered here.
Valuation of Contingent Claims
Binomial option valuation model, alternative calculations of no-arbitrage values of European and American options, and valuation of interest rate options are covered in this study. The Black-Scholes-Merton option model and its application along with option Greeks are also discussed in detail.
CFA Derivative Investments Level 2 Sample Questions and Answers
The sample questions here are typical of the L2 exam’s complexity and depth: formatted as item sets, with a vignette to deliver a scenario that tests the CFA L2 Curriculum. (On the actual exam, each vignette applies to four questions; we’ve thrown in a couple extra to get a bit more learning in). And be sure to review the illustrated explanations we’ve provided for each question: UWorld’s question bank is designed to expose you to exam-like questions and explain the concepts tested thoroughly.
Passage
Herman Schmidt is a fund manager working at Rosige Zukunft LLC (RZ), a derivatives trading firm. RZ uses the carry arbitrage model to assess the value of bond forward contracts. Exhibit 1 contains information on several German government bonds that pay coupons once per annum and have five years remaining until maturity. Schmidt directs Hedwig Meyer, an RZ analyst, to price forward contracts on Bond A, Bond B, and Bond C. The 6-month risk-free rate is 1.50% and the 1-year risk-free rate is 2.00%.
| Exhibit 1 5-Year German Government Bonds | |||
|---|---|---|---|
| Bond | Coupon rate | YTM | Price |
| Bond A | 0.00% | 3.00% | 86.261 |
| Bond B | 3.00% | 2.80% | 100.921 |
| Bond C | 5.00% | 2.85% | 109.889 |
Schmidt and Meyer discuss different methods for valuing interest rate and currency swaps. Exhibit 2 contains information on at-market EUR and CHF interest rate swaps, and the CHF/EUR exchange rate.
| Exhibit Selected Data Related to 3-Year EUR and CHF Interest Rate and Currency Swaps | |||
|---|---|---|---|
| Spot CHF/EUR currency exchange rate | 1.0500 | ||
| Fixed rate on fixed-for-floating EUR interest rate swap | 1.80% | ||
| Fixed rate on fixed-for-floating CHF interest rate swap | 1.20% | ||
Schmidt has RZ initiate a fixed-for-fixed EUR/CHF currency swap, agreeing to pay 1.20% in CHF and receive 1.80% in EUR. RZ exchanges the swap notional with the counterparty at contract initiation, paying EUR 10 million and receiving CHF 10.5 million. Six months later, at-market 2.5-year fixed-for-fixed EUR/CHF currency swaps are quoted at 1.60% EUR for 1.40% CHF and the spot CHF/EUR exchange rate is 1.1000.
Schmidt anticipates that the equity of Dash Haber Ltd., a UK clothing retailer, will outperform versus expectations. He decides to use a 1-year, quarterly settled, equity-return-for-fixed-interest rate swap to gain long exposure to Dash Haber equity. Exhibit 3 contains information related to the swap:
| Exhibit 3 Selected Data Related to Dash Harber Equity Swaps % | |
|---|---|
| Equity dividend yield | 0.00 |
| 90-day reference interest rate | 2.52 |
| 180-day reference interest rate | 3.07 |
| 270-day reference interest rate | 3.62 |
| 360-day reference interest rate | 4.12 |
| 1-year expected return on commo | 3.85 |
All interest rates are annual compound rates and are based on a 360-day year.
Based on Exhibit 1, the no-arbitrage 6-month forward price of Bond A is most likely:
- less than its spot price.
- equal to its spot price.
- greater than its spot price.
Based on Exhibit 1, the no-arbitrage 1-year forward price of Bond B is closest to:
- 99.880
- 99.939
- 102.939
RZ goes long a 1-year forward contract on Bond C at the no-arbitrage forward price of 107.087. On the following day, the German government bond yield curve steepens, with the 1-year rate declining to 1.00% and Bond C’s YTM increasing to 3.85%. Based on its no-arbitrage value immediately after the yield curve shift, the value of RZ’s forward contract is most likely:
- negative.
- zero.
- positive.
Copyright © UWorld. All rights reserved.
Study Tips for the CFA L2 Derivative Investments
- CFA Level 2 Derivative Investments is heavily concentrated on numerical calculations.
- Make sure to understand and try to memorize all formulas and practice all practice problems of the CFA Institute official curriculum.
- Try to grasp all concepts clearly and cover all LOS.
- Try to do practice problems from UWorld QBank (available September 2022).
- Visit our Level 2 study guide for more information.
FAQs
Is the CFA Level 2 Derivative Investments topic hard?
How can I study Level 2 Derivative Investments for the CFA exam?
How do I practice CFA Level 2 Derivative questions?
What are Derivative Investments for the CFA exam?
How do I practice CFA Level 2 Derivative Formulas?
What is CFA Level 3 Derivative Investments?
The CFA Level 3 Derivative Investments covers how Derivative Investments, particularly options, can be used to establish positions and obtain exposure to instruments without directly investing in those instruments. CFA Level 3 Derivative Investments is more focused on the strategies behind using Derivative Investments and how to adjust a portfolio accordingly to hedge or generate additional returns.
Exam Weighting
The CFA Derivative Investments have a weight of 5-10%, meaning that approximately 3-5 of the CFA Level 3 exam questions focus on this topic.
| Topic Weight | No. of Readings | No. of Formulas | No. of Questions |
|---|---|---|---|
| 5-10% | 03 | 31 | 3-5 |
Syllabus, Readings and Changes Overview
The weight of the Derivative Investments remains unchanged for 2022.
| 2018 | 2019 | 2020 | 2021 | 2022 |
|---|---|---|---|---|
| 5-15% | 5-10% | 5-10% | 5-10% | 5-10% |
The three readings in the Derivative Investments and Currency Management topic area remain unchanged for 2022.
Key Changes to Level 3 Derivative Investments:
| Derivative Investments Level 3 Changes | |
|---|---|
| Options Strategies | No Changes |
| Swaps, Forwards, and Futures Strategies | No Changes |
| Currency Management: an Introduction | No Changes |
The CFA Level 3 includes 35 total readings for 2022, of which 3 (9%) of these readings are devoted to Derivative Investments (Reading 8-10) and are divided into the following study sessions:
| Study Session | No. of Readings | No. of LOS |
|---|---|---|
| 04 | 03 | 24 |
Summary CFA Level 3 Derivative Investments deal with the payoffs and profits associated with holding positions. It also covers the use of future, forward contract, and currency management | ||
For a more comprehensive discussion of the LOS visit the official CFA Level 3 syllabus page and select the desired session under “2022 Level 3 study sessions”
Derivative Investments is one of the fundamental building blocks of finance and also one of the most technical topics of the CFA exam. Candidates should have a strong knowledge of Derivative Investments from Level 1 and Level 2 to understand Level 3 Derivative Investments better.
- Reading 8: Option Strategies by Adam Schwartz, PhD, CFA, and Barbara Valbuzzi, CFA
- Reading 9: Swaps, Forwards, and Futures Strategies by Barbara Valbuzzi, CFA
- Reading 10: Currency Management: An Introduction by William A. Barker, PhD, CFA
Options Strategies
The first reading of CFA Level 3 Derivative Investments includes the topics covered during CFA Level 1 and 2 such as value and profit at expirations, as well as important Derivative Investments strategies like covered calls, protective puts, straddles, spreads, volatility skews, and volatility smiles.
Swaps, Forwards, and Futures Strategies
The second reading of CFA Level 3 Derivative Investments focuses on the use of Derivative Investments to change the beta of an equity portfolio or the duration of the bond portfolio, to change portfolio exposure to the various asset classes, to hedge interest rate risk, and to create a synthetic position.
Currency Management: An Introduction
This reading of Derivative Investments deals with different management tools and techniques of currency management, the effect of currency on portfolio risk and return, and active strategies like carry trade and volatility trading.
CFA Derivative Investments L3 Study Tips
At Level 3, Derivative Investments is more about the practical implication of Derivative Investments contracts and strategies, so candidates must have knowledge of Level 1 and Level 2 Derivative Investments. This will help candidates to grasp the basic concepts and move on to the more complex areas covered in CFA Level 3.
- Understand the constructed response format and its implications
- Don’t underestimate your fatigue
- Do lots of mock exams under real test parameters
- Level 3 is similar to Level 2, but with some differences
- Use – and know – the CFA curriculum
- Learn to skip questions to maximize your score
FAQs
Is the CFA Level 3 Derivative Investments topic hard?
In contrast to CFA Level 1 and Level 2 Derivative Investments, CFA Level 3 Derivative Investments focus on strategic implications rather than lengthy calculations and, like all topic areas, is harder than both prior levels because of the essay format. Level 3 emphasizes portfolio management, so having the L1 and L2 knowledge of portfolio management along with Derivative Investments is a key to grasping the Derivative Investments topic.
How can I study L3 Derivative Investments for the CFA exam?
The best way to study for the exam is to practice with a Qbank across all chapters and readings. UWorld is releasing its CFA Level 3 test prep in 2023. Until then, candidates should review the requisite Qbanks offered by the CFA Institute. We also suggest candidates do the examples along with practice problems from the CFA official curriculum for Level 3.
How do I practice CFA L3 Derivative Investments questions?
After moving through a Qbank, the best method to monitor your current understanding of the content is to take mock exams. UWorld is releasing its CFA Level 3 test prep in Q4 2023, which will closely replicate the actual CFA Level 3 exam experience. Candidates should practice with the CFA Institute’s mocks until then.