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 to Expect in CFA® Level 1 Derivative Investments?
The Derivative Investments curriculum has a similar weighting to that of alternative investments and portfolio management. There are 10 Level 1 learning modules dedicated to the topic. 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 Learning Modules | No. of Formulas | No. of Questions |
|---|---|---|---|
| 5-8% | 10 | Around 12 | 9-14 |
Level 1 Derivative Investments 2023 Syllabus, Readings, & Changes
There are a total of 73 learning modules for CFA Level I in 2023. Out of these, 10 cover the material for Derivative Investments. The key change in the Level 1 Derivative Investments curriculum is that it has been reshaped as 10, shorter learning modules (from two larger readings). The material remains largely unchanged, with minor updates. The following table provides a brief description of the topic curriculum:
| No. of Learning Modules – 10 | No. of LOS – 22 | |
|---|---|---|
|
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. |
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The exam weight for Derivatives will not increase in 2023. Since 2021, weighting has fluctuated between 5-8%.
| 2018 | 2019 | 2020 | 2021 | 2022 | 2023 |
|---|---|---|---|---|---|
| 5% | 6% | 6% | 5-8% | 5-8% | 5-8% |
Basics of Derivative Pricing and Valuation
These learning modules begin with an overview of derivative instruments and markets, of distinguishing characteristics of forward commitments and contingent claims, and of the derivative’s relation to the underlying asset. They then cover the purpose, benefits, and risks of Derivative Investments, as well as criticisms and potential misuse.
The discussion then 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. Along the way, it also introduces the principle of arbitrage and its applications in derivative pricing and valuation, as well as foundational valuation models.
The learning modules for the Derivative Investments are as follows:
- Derivative Instrument and Derivative Market Features
- Forward Commitment and Contingent Claim Features and Instruments
- Derivative Benefits, Risks, and Issuer and Investor Uses
- Arbitrage, Replication, and the Cost of Carry in Pricing Derivatives
- Pricing and Valuation of Forward Contracts and for an Underlying with Varying Maturities
- Pricing and Valuation of Futures Contracts
- Pricing and Valuation of Interest Rates and Other Swaps
- Pricing and Valuation of Options
- Option Replication using Put-Call Parity
- Valuing a Derivative using a One-Period Binomial Model
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 |
This option’s moneyness is best described as:
- 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.
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What to Expect in CFA Level 2 Derivative Investments?
The CFA Level 2 Derivative Investments curriculum picks up where the Level 1 curriculum left off and explores derivatives instruments and markets in more depth. It includes some of the more detailed and “mathy” portions of the curriculum as it dives into derivative pricing and valuation. It is often some of the least familiar material for applicants, and thus a bit more difficult to master.
Exam Weighting
The CFA Level 2 Derivative Investments topic has an exam weight of 5-10% which implies that around 4-8 questions or 1 – 2 items sets will focus on this topic.
| Topic Weight | No. of Readings | No. of Formulas | No. of Questions |
|---|---|---|---|
| 5-10% | 02 | Around 20 | 4-8 |
Level 2 Derivative Investments 2023 Syllabus, Readings, and Changes
There are a total of 49 learning modules for CFA Level 2 in 2023. Out of these, 2 are devoted to Derivative Investments. The following table provides a brief description: Please note that there are no changes in the CFA Level 2 Derivative Investments curriculum.
| No. of Readings – 2 | No. of LOS – 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. |
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The exam weight of CFA Level 2 Derivative Investments was between 5-15% in 2018 which reduced to 5-10% in 2019 and remained the same till 2023.
| 2018 | 2019 | 2020 | 2021 | 2022 | 2023 |
|---|---|---|---|---|---|
| 5-15% | 5-10% | 5-10% | 5-10% | 5-10% | 5-10% |
Pricing and Valuation of Forward Commitments
The “Pricing and Valuation of Forward Commitments” learning module 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” clarifies a useful strategy. This content will be useful 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 university endowment manager who uses Derivative Investments for tactical asset allocation and portfolio rebalancing.
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; in some cases, 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 2 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.
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What to Expect in CFA Level 3 Derivative Investments?
The CFA Level 3 Derivative Investments covers how Derivative Investments, particularly options, can establish positions and obtain exposure to assets without directly investing in those assets. 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%, so that approximately 4-8 of the item set questions or 1-2 item sets and 4-8 essay questions focus on this topic.
| Topic Weight | No. of Readings | No. of Formulas | No. of Questions |
|---|---|---|---|
| 5-10% | 03 | 31 | 1-2 item sets and 4-8 essay questions |
Level 3 Derivative Investments 2023 Syllabus, Readings and Changes
Derivative Investments reflects some of the fundamental theories and tools 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
The CFA Level 3 includes 35 total readings for 2023, of which 3 (9%) of these readings are devoted to Derivative Investments (Reading 8-10) and are divided into the following study sessions:
Due to the latest transition in Level 3 exam windows —despite other major CFA curriculum changes in levels 1 and 2—CFA Institute has decided to freeze changes in CFA Level 3. This means that the CFA Level 3 curriculum will remain the same as it was in 2022.
| Study Session | No. of Readings | No. of LOS |
|---|---|---|
| 04 | 03 | 24 |
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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 |
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The weight of the Derivative Investments remains unchanged for 2023.
| 2018 | 2019 | 2020 | 2021 | 2022 | 2023 |
|---|---|---|---|---|---|
| 5-15% | 5-10% | 5-10% | 5-10% | 5-10% | 5-10% |
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.Study Tips for CFA Derivative Investments
Derivative Investments are dependent on, as opposed to (more or less) correlated with, another asset, and so have a unique role in portfolio construction and management. The Level 3 CFA curriculum is more about the practical implication of Derivative Investments contracts and strategies, so candidates must have the knowledge of Level 1 and Level 2 Derivative Investments: you need to grasp the basic definitions and concepts before moving on to the more complex areas covered in CFA Level 3.
- Make sure that you have got an understanding of the underlying asset classes, that is, equity, fixed income, and alternative investments, before starting with Derivative Investments.
- CFA Level 1 curriculum focuses on what derivatives are, Level 2 on how derivative positions are calculated, and Level 3 on how to use and create positions in strategic portfolio management. And at all levels, Derivative Investments is heavy with numerical calculations.
- Memorize formulas, but as always comprehending their sense will make them easier to remember.
- Do lots of practice problems. Perhaps more than with many topic areas, practice makes the understanding and calculations involved really sink in. Practice from examples and practice problems in the CFA Institute’s official curriculum, and from UWorld’s QBank and Mock Exams.
Visit our Level 1 study guide and Level 2 study guide for more details.
Frequently Asked Questions
The best way to study for the exam is to practice with a QBank across all chapters and readings. UWorld’s CFA Level 2 exam prep allows you to review your progress and acts as a catalyst for expediting your preparation. We also suggest candidates attempt practice problems from the CFA Institute’s official curriculum for Level 2.
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.
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.