CFA Level I Exam · Derivative Benefits, Risks, and Issuer and Investor Uses

How Investors Use Derivatives: CFA Level I Guide

Updated 7 October 2026 · Fact-checked

Investors use derivatives to change risk exposure quickly and cheaply. They hedge to reduce risk, speculate to take risk, adjust asset allocation or duration, enhance returns, and build synthetic positions that copy another asset. To solve a question, find the exposure the investor has, the exposure wanted, and the position that closes the gap.

Understand Investor Uses of Derivatives

A derivative gets its value from an underlying asset, rate or index. For an investor, this means you can change your exposure without buying or selling the underlying. You trade a contract instead, which is often faster, cheaper and more liquid than trading the physical securities.

The uses fall into a few groups. Risk management (hedging) reduces an existing exposure, such as selling futures against a stock portfolio. Speculation takes on risk in the hope of profit and does not offset any existing exposure. Gaining exposure means adding a market or risk factor you do not hold, such as buying equity index futures with spare cash. Reducing exposure means cutting a risk you hold without selling the assets.

A key idea is asset allocation adjustment. A manager who wants to move from 60% equity to 50% equity can sell index futures instead of selling shares. This avoids high transaction costs, taxes and market impact, and the shares stay in place. The same logic applies to duration. To lengthen duration, you take on more interest rate exposure, for example by buying bond futures or by receiving fixed and paying floating in a swap. To shorten it, you do the opposite: sell bond futures, or pay fixed and receive floating in a swap.

Synthetic positions use derivatives to copy the payoff of another asset. A long position in the underlying can be mimicked with a long forward contract plus a risk-free bond worth the present value of the forward price. The forward gives the exposure to the underlying, and the bond grows to the amount needed to pay the forward price at expiry. For futures, daily settlement (marking to market) means this equivalence holds only approximately. This works because of replication and the law of one price.

Derivatives can also enhance returns. Examples are selling covered calls to earn premium, or exploiting small price gaps between the derivative and the underlying (arbitrage). The premium comes with a cost: you give up upside above the strike. On the exam, always ask whether the trade lowers risk, raises risk, or just moves it.

Key formulas to remember

Synthetic long asset: Long underlying ≈ Long forward + risk-free bond; The bond is worth the present value of the forward price, so it funds delivery at expiry.
Synthetic risk-free asset: Long underlying + short forward ≈ risk-free bond; A full hedge locks in the risk-free return, so the hedged position earns the risk-free rate if there is no arbitrage.
Futures contracts to change duration: Number of contracts = (target MD − current MD) ÷ futures MD × (portfolio value ÷ futures price); MD is modified duration. Futures MD is the modified duration of the futures contract (for bond futures, based on the cheapest-to-deliver bond). A positive result means buy, a negative result means sell. Treat as an approximation and match each duration to the same units.
Futures contracts to change equity exposure: Contracts = (target beta − current beta) ÷ futures beta × (portfolio value ÷ futures contract value); Futures on an index have beta of about 1. Positive means buy, negative means sell.
Covered call payoff and profit at expiry: Payoff = S_T − max(0, S_T − X); Profit = S_T − S_0 − max(0, S_T − X) + c_0; S_T is the stock price at expiry, S_0 the purchase price, X the strike and c_0 the call premium received. Upside is capped at the strike, and the premium is added to profit as a small cushion.

How to solve Investor Uses of Derivatives questions

Use this approach for any question about why or how an investor uses a derivative.

1Identify the investor's current exposure: long or short, which asset, which risk (price, rate, currency, credit).
2Identify the goal: reduce risk (hedge), take risk (speculate), add exposure, change allocation or duration, or earn extra income.
3Choose the position that moves the exposure toward the goal: sell forwards or futures to cut long exposure, buy them to add exposure.
4Check the direction. Rates rising hurts bond prices, so shortening duration means selling bond futures or paying fixed and receiving floating in a swap. Lengthening duration means buying bond futures or receiving fixed and paying floating.
5Ask whether the investor still holds the underlying. Hedging offsets an existing risk, while speculating creates a new one.
6Note the cost or trade-off: capped upside, premium paid, margin and counterparty risk, or basis risk.
7Eliminate the two options that reverse the direction or confuse hedging with speculation.

Quickest way: Exposure gap check

When to use it: Use when a question asks which derivative position achieves a stated goal and you have under 90 seconds.

Write the current exposure and the target exposure in one line each.
Find the gap: more or less of the risk.
More exposure means buy (long). Less exposure means sell (short).
Cross out any option that moves the exposure the wrong way.
Of the remaining options, drop the one that adds an unrelated risk or ignores a stated constraint.

Common mistakes in Investor Uses of Derivatives

Calling every derivatives trade a hedge.
Students link derivatives with risk reduction.
Fix: A hedge offsets an existing exposure. If there is no underlying exposure, the trade is speculation or exposure gain.
Choosing the wrong direction when changing duration.
Duration and rate direction get mixed up.
Fix: Longer duration means more sensitivity to rates, so you add rate exposure (buy bond futures, or receive fixed and pay floating). If you expect rates to rise, shorten duration (sell bond futures, or pay fixed and receive floating).
Thinking synthetic positions need the underlying.
Replication is treated as owning a copy of the asset.
Fix: Synthetic means built from derivatives and bonds or cash, such as a forward plus a risk-free bond to copy a long asset.
Saying a covered call removes all downside risk.
The premium looks like protection.
Fix: The premium only offsets losses by the amount received. The investor still bears the stock's downside below S0 minus the premium, and gives up gains above the strike.
Ignoring that derivatives let you change allocation without trading the assets.
Students assume rebalancing means selling securities.
Fix: Futures and swaps can shift exposure with lower transaction costs, less market impact and no disturbance to the underlying holdings.

Worked examples

Example 1

A fund holds €80 million of equities with a portfolio beta of 1.0 and wants to cut market exposure to a beta of 0.6 for three months without selling shares. An equity index futures contract has a beta of 1.0 and a value of €200,000. What should the fund do?
A. Buy 160 contracts
B. Sell 160 contracts
C. Sell 400 contracts

Show the solution

Current beta is 1.0 and target beta is 0.6, so the fund must cut exposure. That means selling futures, which removes A.
Contracts = (0.6 − 1.0) ÷ 1.0 × (€80,000,000 ÷ €200,000).
€80,000,000 ÷ €200,000 = 400.
−0.4 × 400 = −160, so sell 160 contracts.
Option C is the trap: selling 400 contracts is (0 − 1.0) × 400 = −400, which takes beta to 0 (a full hedge), not to 0.6.

Answer: B. Sell 160 contracts

Example 2

A portfolio manager holds USD 50 million of bonds with a modified duration of 6.0 and expects interest rates to fall. Which action is most consistent with this view?
A. Sell bond futures to shorten duration
B. Buy bond futures to lengthen duration
C. Enter a swap to pay fixed and receive floating

Show the solution

If rates fall, bond prices rise, and longer duration gains more.
So the manager wants more interest rate exposure, which means lengthening duration.
Buying bond futures adds long bond exposure and raises portfolio duration.
Selling bond futures (A) and paying fixed in a swap (C) both reduce interest rate exposure, which goes against the view.

Answer: B. Buy bond futures to lengthen duration

Exam tips

Start every question by naming the current exposure. Most wrong options reverse the direction.
Know the difference between hedging and speculating. A hedge needs an existing exposure to offset.
Remember that using derivatives to adjust allocation or duration avoids trading the underlying securities, which saves cost and time.
For synthetic positions, recall: long forward plus a risk-free bond worth the present value of the forward price equals long asset; long asset plus short forward equals risk-free bond. With futures, daily settlement makes these equivalences approximate.
Expect conceptual three-option items. Eliminate any option that adds risk when the goal is to reduce it.

Practice questions from Derivative Benefits, Risks, and Issuer and Investor Uses

Investor Uses of Derivatives in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

NISM CertificationsInvestor Rights and Obligations in Derivatives Trading

Investor Uses of Derivatives: frequently asked questions

What is the difference between hedging and speculating with derivatives?

Hedging uses derivatives to offset a risk the investor already holds, so the combined position is less risky. Speculating uses derivatives to take on risk with no offsetting exposure, aiming to profit from a view. The same contract can be either one, depending on what else the investor holds.

How do derivatives adjust asset allocation?

An investor can buy or sell futures or swaps to raise or cut exposure to an asset class while leaving the physical holdings alone. For example, selling equity index futures reduces equity exposure. This is often cheaper and faster than selling the underlying securities.

What is a synthetic position?

A synthetic position uses derivatives, often with cash or bonds, to copy the payoff of another asset. A long forward plus a risk-free bond behaves like owning the underlying. It rests on replication and the law of one price.

How do investors change portfolio duration using derivatives?

They take positions in interest rate derivatives. To lengthen duration, buy bond futures or receive fixed and pay floating in a swap, which raises interest rate exposure. To shorten duration, sell bond futures or pay fixed and receive floating in a swap.