Free CFA Level III: Private Wealth Derivatives & Risk Management Practice Questions

A is correct. A calendar spread (also called a time spread or horizontal spread) involves options at the same strike but different expirations. The long position is in the farther-dated option, and the short position is in the nearer-dated option. The strategy benefits from time decay because the shorter-dated option loses value faster.

B is incorrect. Buying and selling options at different strikes with the same expiration describes a vertical spread (such as a bull spread or bear spread), not a calendar spread.

C is incorrect. Buying a call and a put at the same strike and expiration describes a long straddle, which profits from large price movements regardless of direction.

B is correct. A covered call is primarily a yield enhancement (income) strategy. The writer earns premium income in exchange for capping the upside at the strike price. It works best when the writer expects the stock to remain flat or rise slightly, as the premium provides additional return above the stock's performance.

A is incorrect. Covered calls are conservative, not speculative. The strategy limits upside, making it unsuitable for maximizing capital gains. Speculative strategies would involve buying options or taking leveraged positions.

C is incorrect. Covered calls do not eliminate downside risk. The short call provides only limited downside protection (equal to the premium received). Below the breakeven point ($S_0 - c_0$), the position incurs losses.

Variance notional = vega notional / (2 * strike vol) = $200{,}000 / (2 \times 18) = 5{,}555.56$. Payoff = variance notional $\times$ (realized variance - strike variance) = $5{,}555.56 \times (22^2 - 18^2) = 5{,}555.56 \times (484 - 324) = 5{,}555.56 \times 160 = 888{,}889$.

C is correct. The variance swap pays on the difference in squared volatilities (variance), scaled by the variance notional derived from the vega notional.

B is incorrect. $800{,}000$ may result from using the simple volatility difference: $200{,}000 \times (22 - 18) = 800{,}000$. This treats the instrument as a volatility swap rather than a variance swap, ignoring the convexity effect.

A is incorrect. $1{,}600{,}000$ may result from using the full vega notional as the variance notional: $200{,}000 \times (484 - 324)/100$ or a similar scaling error.