CFA Level 3 Derivatives and Risk Management: notes and free practice
CFA Level 3 Derivatives and Risk Management uses contracts to reshape portfolio exposures. Specify the exposure, hedge objective, direction and size, then evaluate basis, liquidity and counterparty risks that remain.
The key ideas, at a glance
Sketch the payoff
Read the visual, then follow the worked example below. Use the stated case assumptions.
Illustrative worked case
$ profit per share
- 80
- -8
- 90
- -8
- 95
- -8
- 100
- -3
- 110
- 7
- 120
- 17
Stock costs 100 and the 95-strike put costs 3. Maximum expiration loss is 8 per share, ignoring financing and dividends.
| Concept | Rule or decision | Common mistake |
|---|---|---|
| Sketch the payoff | Payoff excludes premiums; profit includes them. | A protective put limits downside but its premium reduces net return. |
| Size the exposure change | Contracts ≈ (target beta - current beta) × portfolio value / contract notional. | The hedge is approximate; beta and the futures basis can change. |
| Match the rate exposure | Pay fixed to offset floating borrowing; receive fixed to add duration. | A swap does not remove credit, basis or counterparty risk. |
| Hedge the right currency | A future foreign-currency receipt is a long exposure to that currency. | A hedge can create a new exposure if the expected receipt never arrives. |
01Sketch the payoff
Payoff excludes premiums; profit includes them.
Watch for: A protective put limits downside but its premium reduces net return.
02Size the exposure change
Contracts ≈ (target beta - current beta) × portfolio value / contract notional.
Watch for: The hedge is approximate; beta and the futures basis can change.
03Match the rate exposure
Pay fixed to offset floating borrowing; receive fixed to add duration.
Watch for: A swap does not remove credit, basis or counterparty risk.
04Hedge the right currency
A future foreign-currency receipt is a long exposure to that currency.
Watch for: A hedge can create a new exposure if the expected receipt never arrives.
Selected 2026 study concepts. Match your preparation to your registered exam-year curriculum. These notes are not complete curriculum coverage.
Free PDF by email
All 5 CFA practice PDFs, in one email
Enter your email on the PDF page to receive all 5 printable packs, with answers and explanations. Selected level/pathway questions; see the topic mix before requesting.
No account or payment required for the PDFs. Includes the monthly newsletter; unsubscribe anytime.
Common core, for all three pathways. Selected 2026 concepts, not complete curriculum coverage. Choose pathway-specific practice or check 2027 changes.
Put the method to work
One worked example, from facts to answer
Given
Buy stock at 100 and a put with strike 95 for 3. Ignore financing and dividends.
Method
At expiration, stock plus put is at least 95; initial cost is 103.
Answer and interpretation
Maximum loss is 8 per share under these assumptions.
Original independent teaching example. Assumptions are stated above; this is not an official exam question or scoring key.
Try it here - no account needed
10 free Derivatives and Risk Management questions
Five multiple-choice questions and five written prompts. Self-review written answers against teaching rubrics, not official scoring keys. Short independent cases, not a mock or pass prediction.
Saved in this tab when storage is available. Responses are not uploaded.
Completed
0 / 10
MCQ correct
0 / 0
Self-reviewed
0
Completion is not an exam score. Written responses are self-reviewed, not automatically graded.
- Question 1 of 10Level III common-core sampleDerivatives and Risk ManagementMultiple choice
Case facts
An investor buys a share at 80 and a put with strike 75 for a premium of 2. Hold both to expiration; ignore dividends and financing.
What is the maximum loss per share on the combined position?
Answer and explanations
Initial cost is 82 and the expiration floor is 75, so maximum loss is 7 per share.
Review the method- A - correct: Initial cost is 82 and the expiration floor is 75, so maximum loss is 7 per share.
- B: Five is the stock-to-strike difference but omits the put premium.
- C: The option premium alone is not the combined stock-and-put maximum loss.
- Question 2 of 10Level III common-core sampleDerivatives and Risk ManagementMultiple choice
Case facts
A 12 million portfolio has beta 1.1. Target beta is 0.6. Index futures beta is 1 and each contract notional is 150,000.
Which futures position approximately reaches the target beta?
Answer and explanations
(0.6 - 1.1) × 12 million / 150,000 = -40, so sell 40 contracts.
Review the method- A: Buying futures increases rather than reduces the portfolio’s market exposure.
- B - correct: (0.6 - 1.1) × 12 million / 150,000 = -40, so sell 40 contracts.
- C: Selling 88 contracts targets approximately zero beta instead of the stated 0.6.
- Question 3 of 10Level III common-core sampleDerivatives and Risk ManagementMultiple choice
Case facts
A borrower pays reference rate plus 1.2%. A matching swap receives that same reference rate and pays fixed 3.8%. Ignore costs.
What is the combined annual borrowing rate?
Answer and explanations
Reference + 1.2% + 3.8% - reference = 5.0%, assuming matching resets and notionals.
Review the method- A: 3.8% ignores the loan’s 1.2% credit spread.
- B: Subtracting the loan spread reverses its cash-flow direction.
- C - correct: Reference + 1.2% + 3.8% - reference = 5.0%, assuming matching resets and notionals.
- Question 4 of 10Level III common-core sampleDerivatives and Risk ManagementMultiple choice
Case facts
A US investor will receive EUR 3 million and sells exactly that amount forward for USD 1.08 per EUR. Assume timely receipt and settlement.
What USD amount is locked in by the matched forward?
Answer and explanations
EUR 3 million × USD 1.08 per EUR locks in USD 3.24 million when the receipt and hedge match.
Review the method- A - correct: EUR 3 million × USD 1.08 per EUR locks in USD 3.24 million when the receipt and hedge match.
- B: Dividing by 1.08 uses the opposite quote convention.
- C: Three million ignores the specified USD-per-EUR exchange rate.
- Question 5 of 10Level III common-core sampleDerivatives and Risk ManagementMultiple choice
Case facts
An investor buys stock at 50 and writes a call with strike 55, receiving a premium of 2. Hold to expiration; ignore dividends and financing.
What is the maximum profit per share on the covered call?
Answer and explanations
Maximum profit is 55 - 50 + 2 = 7; the short call caps gains above the strike.
Review the method- A: Five captures the stock gain to the strike but omits the premium received.
- B - correct: Maximum profit is 55 - 50 + 2 = 7; the short call caps gains above the strike.
- C: The short call gives away gains above the strike, so profit is capped.
- Question 6 of 10Level III common-core sampleDerivatives and Risk ManagementWritten response
Case facts
A client wants to preserve participation in a stock’s upside while limiting downside over the next six months. The client can afford an option premium.
Recommend a basic option overlay and explain its cost.
Model answer and self-review rubric
Buy a protective put on the existing stock with a suitable strike and maturity. It creates an expiration floor while preserving upside participation, but the premium lowers net profit and the protection is time-limited.
Review the methodTeaching checklist only. No official points or automated grade.
- Question 7 of 10Level III common-core sampleDerivatives and Risk ManagementWritten response
Case facts
A fund uses broad-index futures to hedge a concentrated sector portfolio. The sector unexpectedly diverges from the index.
Explain why the hedge can leave a loss even if the contract count was calculated correctly.
Model answer and self-review rubric
The index does not perfectly track the sector portfolio. Basis or cross-hedging risk and unstable beta can leave residual exposure; correct initial sizing does not guarantee a perfect hedge.
Review the methodTeaching checklist only. No official points or automated grade.
- Question 8 of 10Level III common-core sampleDerivatives and Risk ManagementWritten response
Case facts
A portfolio manager wants to increase interest-rate duration without immediately purchasing additional bonds.
Identify the fixed-rate side of a plain-vanilla swap that generally adds duration, and justify it.
Model answer and self-review rubric
Receive fixed and pay floating. The fixed receipts behave like a longer-duration asset while the floating payments reset, generally adding positive duration; size and monitor the resulting rate and counterparty exposures.
Review the methodTeaching checklist only. No official points or automated grade.
- Question 9 of 10Level III common-core sampleDerivatives and Risk ManagementWritten response
Case facts
An exporter sells EUR 1 million forward to hedge an expected customer receipt. The order is canceled before payment.
Explain the exposure that remains and recommend an immediate review.
Model answer and self-review rubric
The foreign-currency receipt no longer offsets the short-EUR forward, leaving an unhedged derivative exposure. Reassess whether to close or resize the forward, considering costs and remaining cash flows.
Review the methodTeaching checklist only. No official points or automated grade.
- Question 10 of 10Level III common-core sampleDerivatives and Risk ManagementWritten response
Case facts
A 9 million portfolio has beta 1.0. A suitable index future has beta 1 and contract notional 100,000. Target portfolio beta is 0.4.
Calculate the hedge position and state one remaining risk.
Model answer and self-review rubric
Contracts = (0.4 - 1.0) × 9 million / 100,000 = -54: sell 54 contracts. Basis risk, changing beta or margin liquidity can still matter after the initial exposure adjustment.
Review the methodTeaching checklist only. No official points or automated grade.
Four ideas to put to work
Find the method you need
Start with: Option payoffs, futures exposure, duration and currency quote conventions.
METHOD 01
Sketch the payoff
Payoff excludes premiums; profit includes them.
- Identify the stock and option positions.
- Evaluate each leg at expiration.
- Include premiums when the question asks for profit.
Worked example
- Given
- Buy stock at 100 and a put with strike 95 for 3. Ignore financing and dividends.
- Calculate / decide
- At expiration, stock plus put is at least 95; initial cost is 103.
- Result
- Maximum loss is 8 per share under these assumptions.
Watch for: A protective put limits downside but its premium reduces net return.
Practise this ideaMETHOD 02
Size the exposure change
Contracts ≈ (target beta - current beta) × portfolio value / contract notional.
- State current and target exposure.
- Use the current futures contract notional and stated beta assumptions.
- Interpret the sign, round sensibly and monitor basis risk.
Worked example
- Given
- Portfolio 10 million; beta 1.2 to target 0.8; contract notional 200,000; futures beta 1.
- Calculate / decide
- (0.8 - 1.2) × 10 million / 200,000 = -20.
- Result
- Sell 20 contracts, assuming a suitable index hedge.
Watch for: The hedge is approximate; beta and the futures basis can change.
Practise this ideaMETHOD 03
Match the rate exposure
Pay fixed to offset floating borrowing; receive fixed to add duration.
- Identify whether rates rising or falling hurts the exposure.
- Choose swap cash flows that offset the underlying cash flows.
- Check reset dates, reference rate, notional and counterparty risk.
Worked example
- Given
- Borrow at reference + 1%; swap pays fixed 4% and receives the same reference.
- Calculate / decide
- (reference + 1%) + 4% - reference.
- Result
- 5% combined borrowing cost, before other costs and mismatch risks.
Watch for: A swap does not remove credit, basis or counterparty risk.
Practise this ideaMETHOD 04
Hedge the right currency
A future foreign-currency receipt is a long exposure to that currency.
- Write the quote convention explicitly.
- Match the hedge direction to the underlying receipt or payment.
- Check amount, settlement date and overhedging risk.
Worked example
- Given
- Receive EUR 2 million; sell EUR forward at USD 1.10 per EUR.
- Calculate / decide
- EUR 2 million × USD 1.10/EUR.
- Result
- USD 2.20 million at settlement if the receipt and hedge match.
Watch for: A hedge can create a new exposure if the expected receipt never arrives.
Practise this ideaQuestions about this topic
- Does a hedge eliminate every portfolio risk?
- No. It targets a specified exposure. Basis, liquidity, counterparty, timing, valuation and other risks can remain or be introduced by implementation.
- Why must hedge direction be stated explicitly?
- A position offsets risk only if its payoff responds in the required direction to the exposure being hedged. A reversed contract can increase the risk rather than reduce it.
- How do I justify a hedge in a written response?
- Name the exposure and objective, specify the direction and relevant size or ratio, and connect the choice to the case facts. Explain important residual risks where the prompt asks for them.
Sources and curriculum scope
Official outlines establish curriculum scope. The explanations and worked examples are independent teaching material; the sources do not verify or endorse them.
- 2026 Level III common-core outline: Derivatives and Risk Management
- Level III format and common-core versus pathway structure
- 2026 CFA Level 3 portfolio management outline
- 2027 CFA Level 3 portfolio management outline
MiloPrep is an independent study resource, not affiliated with or endorsed by CFA Institute. CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute.