CFA® Derivative Investments
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 | Summary |
|---|---|---|---|
| 15 | 02 | 21 | 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.
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.
FAQs
Is the CFA Level 1 Derivative Investments topic hard?
Derivative Investments is considered to be one of the most difficult topics compared to others and certainly one of the least familiar to most candidates. However, concepts once learned would help in CFA Level 2 as well as in Level 3.
How can I study L1 Derivative Investments for the CFA exam?
The best way to study for the exam is to complement the CFA Institute’s official material with the UWorld QBank for all readings and study sessions. UWorld’s QBank offers more than 2,100 questions and detailed answers, with more than 160 questions focused on Derivative Investments.
How do I practice CFA L1 Derivative Investments questions?
After practicing hard with QBank, the optimal approach to assess your understanding of the content is taking Mock Exams. UWorld’s mock exams closely replicate the actual CFA Level 1 exam to help you prepare and boost your confidence on test day. Like the actual CFA exam, our mock exams consist of two 2-hour and 15-minute sessions (4.5 hours total), each with 90 multiple-choice questions unique to the mock exams. The question topics and the order of the topics follow the CFA exam design to give you a truly exam-like experience.
What are Derivative Investments for the CFA exam?
Derivative Investments are among the least weighted topics in CFA. However, all three levels of CFA contain Derivative Investments. In addition, concepts discussed in Derivative Investments are useful in other sections as well.
How do I practice the CFA L1 Derivative Investments formulas?
Understanding the concept first and then going through the structure of the formula will help you grasp the formula. Think of the formula as the mathematical representation of the concept. As you build this foundation of understanding, reinforce it through repetition and application. Take a look at our CFA L1 Formula sheet for further resources and tips.
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 | Summary |
|---|---|---|---|
| 15 | 02 | 21 | 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.
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).
FAQs
Is the CFA Level 2 Derivative Investments topic hard?
According to many candidates, CFA Level 2 is the toughest of all 3 levels and Derivative Investments is one of the hardest topics in the CFA Level 2 exam. When compared to Level 1, the depth of every topic increases. Calculations in Derivative Investments are lengthy and need a lot of practice and a decent understanding of the concepts.
How can I study Level 2 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 2 test prep in Q4-2022. 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 Institute’s official curriculum for Level 2.
How do I practice CFA Level 2 Derivative questions?
CFA Level 2 Derivative Investments is considered a difficult and time-consuming topic. Practicing from practice problems given at the end of every reading in the CFA Institute official curriculum is not enough: moving through a Qbank of other available resources is also helpful. After practicing, the best way to monitor your current understanding of the content is to take mock exams. UWorld is releasing its CFA Level 2 test prep later this year, which will closely replicate the actual CFA Level 2 exam experience. Candidates should practice with the CFA Institute’s mocks until then.
What are Derivative Investments for the CFA exam?
Derivative Investments are financial instruments that derive their value from an underlying asset such as stocks, currencies, commodities, and interest rates. A derivative can be traded on an exchange or over-the-counter.
How do I practice CFA Level 2 Derivative Formulas?
CFA Level 2 Derivative Investments is heavily sprinkled with complex calculations. That’s why complete knowledge and a lot more practice are the keys to success. Try to memorize formulas while doing practice problems. but see them as a mathematical representation of concepts as well.
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 | Summary |
|---|---|---|---|
| 04 | 03 | 24 | 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.