Derivatives Foundation interview preparation

Questions

100

Traced to a firm

29

Firms

19

Updated

September 2026

Asked at

All firmsMSMorgan Stanley4Nomura4Akuna Capital2Amundi2HSBC2PIMCO2Bank of America1Barclays1Citadel1DRW1Goldman Sachs1Jane Street1Millennium Management1Mizuho1Old Mission Capital1RCRBC Capital Markets1Scotiabank1UBS1Wells Fargo Securities1

Topic

All topicsForwards and futures10Options basics8Option pricing7The Greeks10Volatility7Option strategies9Swaps and rates7Credit derivatives4Market structure and clearing6Indian derivatives8Trading and markets9Brainteasers6Fit9

Level

AnyCoreIntermediateHard

Type

AnyTechnicalCaseMarket viewBrainteaserFit

1. 057How does a currency swap differ from an interest rate swap, and who uses one?Swaps and ratesIntermediatetechnicalFX derivativesCorporate treasury

   Say this

   In a currency swap the notionals are in two different currencies and they are exchanged — at the start, at the end, or both — and the interest payments are made in their own currencies. That makes it a funding instrument as much as a rate instrument, and it carries principal risk that a plain rate swap does not.

   Then walk it

   1. Structure: you pay rupee interest on a rupee notional and receive dollar interest on a dollar notional, with the two notionals exchanged at the outset at spot and re-exchanged at maturity at the same rate. So you have both rate and currency exposure managed in one trade.
   2. The classic use: an Indian company issues a dollar bond because the market is deeper and cheaper, then swaps it into rupees so its liability matches its rupee revenues. It has raised offshore and ends up with a domestic-currency obligation.
   3. The reverse flow is what drives the market: foreign issuers raising in a currency because the swap back to their home currency is cheap. That relative cheapness is the cross-currency basis, and it is a funding indicator, not just a spread.
   4. Cross-currency basis is worth naming. In theory covered interest parity should hold and the basis should be zero. Since 2008 it has been persistently negative for dollar funding, because of balance sheet constraints on dealers and structural dollar demand. That persistent deviation is one of the clearest post-crisis examples of an arbitrage that is not arbitragable.
   5. Risk profile: because principal is exchanged, the credit exposure is far larger than on a rate swap of the same notional. A currency swap can be deeply in the money on the principal leg alone, which is why they carry heavier collateral and capital treatment.
   6. The limitation to say: the hedge is only clean if the maturity matches the exposure. Companies that rolled short-dated currency hedges against long-dated dollar debt have been caught by both the basis widening and the rupee depreciating at the same moment, which is precisely the correlation a short hedge fails to capture.

   Where candidates lose it

   Saying the difference is 'two currencies' without noting that principal is exchanged, which is the reason the credit exposure is much larger. And if you are interviewing anywhere India-facing, have the Indian issuer swapping dollar debt back into rupees as your example, plus the cross-currency basis.

   Expect next

   • What is the cross-currency basis and why is it not zero?
   • Why is the credit exposure bigger than on a rate swap?
   • How would an Indian corporate hedge a ten-year dollar bond?
2. 058Walk me through the move from LIBOR to SOFR. What actually changed, and what broke?Swaps and ratesIntermediatetechnicalRates derivativesCorporate treasury

   Say this

   LIBOR was a survey of what banks said they could borrow at unsecured; SOFR is a volume-weighted average of actual overnight repo transactions secured by Treasuries. So the benchmark moved from judgement to data, and from unsecured term lending to secured overnight. The two hardest consequences were the loss of credit sensitivity and the absence of a forward-looking term rate.

   Then walk it

   1. Why LIBOR had to go: it was a submission, not a transaction. After the 2012 manipulation scandals and the collapse of real unsecured interbank lending, the rate was being set on a market that barely existed. Regulators ended it rather than patch it.
   2. What SOFR is: roughly a trillion dollars a day of actual repo transactions, secured, overnight. Essentially unmanipulable because of the volume, which was the whole design goal.
   3. First problem — no credit spread. LIBOR rose when bank funding stress rose, so a bank lending at LIBOR was naturally hedged to its own funding cost. SOFR is secured, so in a crisis it falls while bank funding costs rise. That is a real basis risk for lenders, and it is why credit-sensitive alternatives like BSBY and AMERIBOR appeared, and mostly failed to gain traction.
   4. Second problem — no term structure. LIBOR was quoted for three and six months in advance; SOFR is an overnight rate you only know in arrears. The market solved it with compounded-in-arrears conventions, plus CME Term SOFR for loan markets where borrowers need to know the coupon at the start of the period.
   5. Transition mechanics: ISDA's 2020 fallbacks protocol amended existing contracts to fall back to compounded SOFR plus a fixed credit adjustment spread — 26 basis points for three-month USD. That spread number is worth knowing, because it is the price the industry put on the credit component.
   6. India ran a parallel version. MIBOR-based products and the shift to overnight-indexed benchmarks, with the RBI pushing users off LIBOR references in external commercial borrowings by mid-2023. The same two issues appeared: no credit sensitivity and the need for a term rate. The unfinished part everywhere is the long tail of legacy contracts — loans, securitisations and bonds with fallbacks that were drafted for a temporary LIBOR outage, not a permanent end.

   Where candidates lose it

   Describing the change as 'LIBOR was manipulated so they replaced it'. The interviewer wants the two structural consequences: no credit sensitivity and no forward term rate. Knowing the credit adjustment spread exists, and roughly what it was for three-month USD, is what marks this out as real knowledge.

   Expect next

   • Why does the loss of credit sensitivity matter to a bank lender?
   • How does a compounded-in-arrears coupon work in practice for a borrower?
   • What happened to legacy contracts with no proper fallback language?
3. 059Explain how a credit default swap works.Credit derivativesIntermediatetechnicalCredit tradingRisk management

   Say this

   It is insurance on a borrower. The buyer pays a periodic spread on a notional; if a defined credit event happens, the seller makes them whole on the loss. Buying protection is economically short the credit, and you can do it without owning the bond, which is what makes CDS a trading instrument rather than just a hedge.

   Then walk it

   1. Cash flows: the protection buyer pays a running spread quarterly — say 150 basis points a year on 10 million, so 37,500 a quarter — until maturity or a credit event.
   2. On a credit event, settlement is now almost always by auction. The market determines a recovery price for the reference obligation and the protection seller pays notional times one minus recovery in cash. Physical delivery was the old convention and it broke when notional outstanding exceeded the deliverable bonds.
   3. What counts as a credit event is contractual, not intuitive: bankruptcy, failure to pay, and for some entities restructuring. A Determinations Committee at ISDA rules on it, and the rulings have been contested — the Greek restructuring and several cases of manufactured defaults are why the definitions were tightened in 2014 and again on narrowly tailored credit events.
   4. Uses: a bank hedges a loan book without selling the loans and damaging the client relationship; a fund expresses a negative view where the bonds are impossible to borrow; an investor buys a bond and sells protection to create synthetic exposure where no cash bond exists at that maturity.
   5. Index CDS matters more than single name now. CDX and iTraxx are standardised baskets that trade with far more liquidity than individual names, and they are how most macro credit risk is expressed and hedged.
   6. The limitations to name. It is a bilateral contract, so you are exposed to the seller — the 2008 lesson, where protection bought from AIG was worth what AIG was worth. And jump-to-default risk means the mark moves smoothly and the payoff does not, which is exactly the risk profile that looks harmless in a value-at-risk model right up until it isn't.

   Where candidates lose it

   Describing CDS as a bond short and stopping. Get the auction settlement and the contractual definition of a credit event in, because that is where the real disputes and losses happen. And name counterparty risk on the protection seller — the buyer is only hedged if the seller survives.

   Expect next

   • Who decides whether a credit event occurred?
   • Why did the market move from physical to auction settlement?
   • How is buying index protection different from shorting a basket of bonds?
4. 060A five-year CDS trades at 400 basis points. What does that tell you about the probability of default?Credit derivativesHardsuperdayCredit tradingRisk management

   Say this

   Roughly a 6 to 7 percent annual risk-neutral default probability, using the rule of thumb that spread equals default probability times loss given default. At a 40 percent recovery, 400 over 0.6 is about 667 basis points a year, so around 28 percent cumulative over five years. But that is a risk-neutral number, and it is meaningfully higher than the real-world probability.

   Then walk it

   1. The approximation: spread is approximately the hazard rate times one minus recovery. Invert it — hazard rate equals spread over loss given default. With 40 percent recovery assumed, 400 basis points implies about 6.7 percent a year.
   2. Cumulative over five years, compounding the survival probability: 0.933 to the fifth is about 0.71, so roughly a 29 percent chance of default over the life.
   3. The recovery assumption does a lot of work here. Assume 20 percent recovery instead and the implied hazard rate drops to 5 percent. So you cannot read a default probability out of a spread without a recovery view, and the two are jointly unidentified from the spread alone.
   4. The bigger point: this is a risk-neutral probability, which embeds a risk premium. Empirically risk-neutral default probabilities run perhaps two to three times realised default rates for investment grade credits, because investors demand compensation for default risk being correlated with bad times. Quoting 29 percent as the actual chance the company fails would be wrong.
   5. The spread also contains things that are not default risk: liquidity premium, the cost of dealer balance sheet, and for index CDS, the demand for macro hedges. In a stress event, spreads widen more than any credible reassessment of default odds justifies.
   6. So how I would use the number: as a market-implied ranking and a hedging cost, not as a forecast. If I wanted the real-world probability I would look at rating agency transition matrices or a structural model like Merton, and I would expect a considerably lower figure — and the gap between the two is itself the credit risk premium I might want to harvest.

   Where candidates lose it

   Quoting the risk-neutral number as the probability of default. The whole test is whether you know that the spread contains a risk premium, a liquidity component and a recovery assumption. Do the arithmetic, then correct it out loud.

   Expect next

   • How sensitive is your answer to the recovery assumption?
   • How would you get a real-world default probability instead?
   • Why do risk-neutral and real-world probabilities differ by so much?
5. 061What is the CDS-bond basis, and what does it mean when it goes negative?Credit derivativesHardsuperdayCredit tradingHedge funds

   Say this

   The basis is the CDS spread minus the bond's credit spread on the same issuer and maturity. In theory it should be near zero, because buying the bond and buying protection creates a near-riskless position. A negative basis — CDS cheaper than the cash bond spread — means the cash market is under stress and nobody has the balance sheet to arbitrage it.

   Then walk it

   1. The arbitrage in principle: buy the bond, buy CDS protection to the same maturity, and you have hedged default risk. The residual spread you earn should be roughly the risk-free rate, so a large positive residual is a negative basis trade.
   2. Why it does not get arbitraged away: the trade needs funding for the bond position and balance sheet at a dealer. In a crisis funding is expensive or unavailable, so the trade is theoretically profitable and practically impossible. That is why the basis went to hundreds of basis points negative in late 2008 and again in March 2020.
   3. So a deeply negative basis is a funding stress indicator, not a credit signal. It measures the scarcity of balance sheet rather than the probability of default.
   4. Structural reasons for a non-zero basis in normal times: the cheapest-to-deliver option in CDS makes protection worth slightly more than a specific bond's spread; CDS is unfunded so it attracts different investors; and CDS documentation covers restructuring events that a bond spread does not price identically.
   5. A positive basis usually reflects demand for protection that cannot easily be expressed in cash — for example when bonds are impossible to borrow, so the negative view has to be taken in CDS.
   6. The limitation for anyone thinking of the trade: it is not riskless. You carry the counterparty on the protection leg, you carry funding and margin risk that can force you out, and you carry basis risk on the exact maturity and deliverable. The 2008 version of this trade destroyed funds who were right about the convergence and could not survive the path.

   Where candidates lose it

   Calling a negative basis an arbitrage. The point is precisely that it is not — it persists because funding and balance sheet are the binding constraint, and that is why the size of the basis is a stress gauge. Say that, and name March 2020.

   Expect next

   • So why does the arbitrage not close?
   • What does a persistently positive basis tell you?
   • How would you fund and size a negative basis trade?
6. 063When would a client want an exchange-traded derivative and when an OTC one?Market structure and clearingCorephone / first roundSell-side sales and trading

   Say this

   Exchange-traded when they want liquidity, price transparency and no counterparty risk, and they can live with standardised terms. OTC when the exposure they are hedging does not match any listed contract — an odd maturity, an odd notional, a bespoke underlying — and they are willing to pay a wider spread and take credit risk for the precision.

   Then walk it

   1. Exchange: standard size, standard dates, central clearing, continuous two-way prices, and margin set by the exchange. You can get out by trading, not negotiating.
   2. OTC: any terms you can agree. A corporate hedging a 47 million dollar payable on the 14th of March cannot do that with 1,000-lot standard contracts without leaving a residual.
   3. The cost of precision is the spread and the credit. An OTC trade is priced with CVA and funding charges built in, and you are exposed to the dealer — collateralised under a CSA, but exposed between margin calls.
   4. Hedge accounting pushes corporates to OTC too. A precise hedge that matches the exposure qualifies for hedge accounting and avoids profit and loss volatility; a proxy hedge with basis risk may not.
   5. Since 2009 the line has blurred. Standardised OTC products — most vanilla interest rate swaps and index CDS — are now centrally cleared and often traded on electronic platforms, so they have exchange-like credit and margin with OTC-like flexibility on terms.
   6. The practical rule I would give a client: start with the listed market, and only go OTC for the residual you genuinely cannot hedge there. Most treasurers who ended up in trouble had a bespoke structure where a plain vanilla listed hedge would have covered 90 percent of the exposure at a fraction of the cost and with none of the complexity.

   Where candidates lose it

   Presenting it as a two-column comparison table with no judgement. The interviewer wants you to pick, and the answer that lands is 'listed by default, OTC only for the residual you cannot hedge there'. Mention that cleared OTC now sits in between.

   Expect next

   • What does a corporate give up by using a listed contract?
   • How has clearing changed the distinction since 2009?
   • Why does hedge accounting push clients towards OTC?
7. 064What does a central counterparty actually do, and does it eliminate risk?Market structure and clearingIntermediatetechnicalClearing and riskRisk management

   Say this

   A CCP interposes itself between the two sides of every trade, so each party faces the clearing house instead of each other. It does not eliminate risk — it mutualises and concentrates it. Bilateral credit risk becomes a single, heavily collateralised exposure to an institution that is now systemically critical.

   Then walk it

   1. Novation is the mechanism: one trade becomes two, buyer to CCP and CCP to seller. The CCP is flat in market terms and long credit risk to everyone.
   2. It manages that with a default waterfall: the defaulter's initial margin first, then their default fund contribution, then the CCP's own skin in the game, then the surviving members' mutualised default fund, and in the extreme, assessment rights or variation margin haircutting.
   3. Multilateral netting is the underrated benefit. Ten dealers with offsetting positions net down to a fraction of the gross notional, which cuts collateral and systemic exposure far more than any single risk transfer.
   4. But the risk did not vanish. It concentrated. A handful of CCPs now sit at the centre of the global derivatives market, they are all members of each other's ecosystems through the same dealers, and a CCP failure is close to unthinkable in the way that made pre-2008 assumptions dangerous.
   5. The procyclicality problem is the live one. Margin models raise requirements when volatility rises, so the CCP demands cash from everyone exactly when cash is scarce. March 2020 and the 2022 UK gilt and European energy episodes were all liquidity events driven substantially by margin calls.
   6. So my honest summary: clearing turned an opaque web of bilateral credit exposures into a transparent, collateralised, procyclical liquidity demand. That is a better trade-off than 2008, and it is a different risk, not the absence of one. The nickel squeeze on the LME in 2022 — where the exchange cancelled trades to protect itself and its members — showed the governance question is unresolved.

   Where candidates lose it

   Saying a CCP removes counterparty risk. It transforms credit risk into liquidity risk and concentrates it, and the procyclical margin point is the sophisticated answer. Naming a specific episode — March 2020, the gilt crisis, LME nickel — is what makes it credible.

   Expect next

   • Walk me through the default waterfall.
   • Why is CCP margin procyclical, and can that be fixed?
   • What went wrong at the LME in the 2022 nickel episode?
8. 065Distinguish initial margin from variation margin in the OTC world, and tell me why initial margin rules changed.Market structure and clearingIntermediatetechnicalClearing and riskRisk management

   Say this

   Variation margin covers the loss that has already happened — the daily mark-to-market. Initial margin covers the loss that might happen between a counterparty defaulting and you closing out the position, typically over a ten-day horizon at a 99 percent confidence level. Before 2016, uncleared OTC trades exchanged variation margin but almost no initial margin at all, and that gap is what the Uncleared Margin Rules closed.

   Then walk it

   1. The conceptual split: variation margin is a settlement of value that has moved and it is netted against your exposure. Initial margin is a buffer against future moves and it must be segregated, held by a third party, and not rehypothecated.
   2. That segregation requirement is the operationally expensive part. You cannot use the initial margin you received, so it is a genuine drag on balance sheet, unlike variation margin which offsets an exposure.
   3. Why it changed: in 2008 the uncollateralised and under-collateralised bilateral book was the transmission mechanism. AIG's positions had variation margin obligations that exploded and no meaningful initial margin buffer. The Basel and IOSCO framework from 2013, phased in from 2016 to 2022, required two-way initial margin on uncleared derivatives above declining notional thresholds.
   4. How it is calculated: either a regulatory schedule based on notional and asset class, which is crude and punitive, or ISDA SIMM, a standardised sensitivity-based model that everyone uses so that both sides compute the same number and disputes stay manageable.
   5. The threshold mechanic is worth knowing: a 50 million euro or dollar initial margin threshold per counterparty group means smaller relationships never actually post, which is why the final phases mostly captured buy-side firms rather than dealers.
   6. The honest consequence: the rules made uncleared derivatives materially more expensive, which was the intent — it pushed volume into clearing. The cost is that bespoke hedges are now expensive for exactly the end users who need them most, and some corporates responded by hedging less rather than differently. That is the unintended outcome regulators are still arguing about.

   Where candidates lose it

   Mixing the two up, or describing initial margin as 'a deposit'. The distinction is backward-looking versus forward-looking, and the key operational fact is that initial margin must be segregated while variation margin is not. Naming SIMM and the notional phase-in shows you know the actual regime.

   Expect next

   • Why must initial margin be segregated?
   • What is SIMM and why did the industry standardise on one model?
   • Did the rules push business into clearing, and at what cost to end users?
9. 066What is an ISDA Master Agreement and what does the CSA do?Market structure and clearingIntermediatetechnicalDerivatives operationsRisk management

   Say this

   The ISDA Master is the contract that governs all trades between two counterparties, so each new deal is a short confirmation under one legal framework rather than a fresh negotiation. Its most important function is close-out netting: on a default, all trades collapse into a single net amount. The Credit Support Annex is the collateral schedule bolted onto it — what you post, when, in what form, and with what thresholds.

   Then walk it

   1. Structure: the Master Agreement, a Schedule with the negotiated elections, definitions booklets by asset class, the CSA for collateral, and then individual trade confirmations. The confirmation for a swap can be a page because everything else is upstairs.
   2. Close-out netting is the commercial heart of it. Without it, a defaulting counterparty's administrator could cherry-pick — enforce the trades in their favour and disclaim the rest. Netting is why gross notional figures overstate real exposure by an order of magnitude, and why the enforceability opinion in each jurisdiction matters so much.
   3. Events of default and termination events are the other core: failure to pay, bankruptcy, cross-default, and negotiated ones like a ratings downgrade trigger or a NAV decline clause for a fund.
   4. The CSA sets the collateral mechanics: threshold, which is the unsecured amount you tolerate before any collateral moves; minimum transfer amount, to avoid moving trivial sums; eligible collateral and haircuts; and the valuation and dispute process.
   5. Those parameters are a real negotiation, not boilerplate. A high threshold means less operational friction and more credit exposure. Asymmetric thresholds, where the weaker credit posts and the dealer does not, were standard before the crisis and are much rarer now.
   6. India-specific note: the enforceability of close-out netting was genuinely uncertain here until the Bilateral Netting of Qualified Financial Contracts Act 2020, which is why bilateral derivative activity with Indian counterparties was constrained and priced accordingly. That legislation is one reason the onshore OTC market has been able to develop.

   Where candidates lose it

   Calling the ISDA Master 'the derivatives contract' without naming close-out netting. Netting is the reason the document exists and the reason gross notional is a misleading number. For an India-facing interview, knowing the 2020 netting legislation is a genuine differentiator.

   Expect next

   • Why is close-out netting so important to a dealer's capital?
   • What is the difference between a threshold and a minimum transfer amount?
   • How did the Indian netting legislation change the market here?
10. 067What did post-2008 regulation actually change about the derivatives market?Market structure and clearingHardsuperdayRisk managementClearing and risk

    Say this

    Four things: standardised OTC derivatives must be centrally cleared, uncleared ones must exchange two-way margin, everything must be reported to a trade repository, and dealer capital charges for derivatives rose sharply. The combined effect was to make bespoke and long-dated derivatives much more expensive and to shrink dealer balance sheets.

    Then walk it

    1. The clearing mandate under Dodd-Frank in the US and EMIR in Europe: interest rate swaps in major currencies and index CDS have to go to a CCP. That converted the most systemic part of the OTC market into a margined, netted, reported system.
    2. Execution moved too. Swap Execution Facilities in the US and the trading obligation in Europe pushed the standardised flow onto platforms with pre-trade transparency, which compressed dealer spreads on vanilla products considerably.
    3. Uncleared margin rules put two-way initial margin on the rest, phased in from 2016. Reporting to trade repositories gave regulators — for the first time — a picture of who held what.
    4. Capital is the underrated piece. The leverage ratio, the credit valuation adjustment capital charge, and SA-CCR for counterparty exposure all raised the balance sheet cost of a derivative. That is why dealers price CVA, FVA and capital into a quote now, and why a long-dated uncollateralised swap with a corporate can be startlingly expensive.
    5. Volcker and the ring-fencing rules changed who provides liquidity. Dealers stopped warehousing risk in size, and a meaningful share of market making in derivatives migrated to non-bank firms — which is one reason prop shops and electronic market makers matter more now than in 2007.
    6. The honest assessment: the reforms genuinely reduced the risk of a bilateral credit cascade, which was the 2008 failure mode. They introduced a new one — synchronised margin-driven liquidity demand — which showed up in March 2020, in the 2022 UK LDI crisis and in European energy. Regulators fixed the problem they had and created the problem they now study, which is roughly what you should expect from any reform of this scale.

    Where candidates lose it

    Listing acronyms. The strong answer groups the changes into four buckets, names the capital piece — which most candidates omit — and closes by saying which risk was reduced and which was created. Naming LDI 2022 or March 2020 as the new failure mode is what shows judgement.

    Expect next

    • Which reform had the biggest effect on dealer pricing?
    • Why did market making migrate to non-bank firms?
    • What is the new systemic risk the reforms created?

Firm tags come from public, anonymous candidate reports on Wall Street Oasis: strong signal, not sworn testimony. Firms are named as the places a question was reported, not as partners of Fin Maverick. Answers are written for this page to show how to think out loud; they are not scripts to recite.