Free CISI CMP Sec/Deriv Practice Questions: Derivatives: Introduction to Derivatives

CISI means Chartered Institute for Securities & Investment. CMP means Capital Markets Programme, and this page is for the Securities/Derivatives unit. Use this focused CISI CMP Securities/Derivatives page as a short practice test for Derivatives: Introduction to Derivatives. The items are original Finance Prep sample exam questions built for scenario-based practice, not trivia, puzzle questions, official CISI questions, copied live-exam content, or exam dumps.

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These are original Finance Prep practice questions aligned to this topic area. They are not official CISI questions, copied live-exam content, or exam dumps. Use them to preview question style and explanation depth before continuing with topic drills, mixed sets, and timed mock exams in Finance Prep.

Question 1

Topic: Derivatives: Introduction to Derivatives

A derivatives desk reviews this new trade record for a client that has no physical position in the underlying index.

What is the best supported interpretation of the main risk exposure created by the position?

• A. The client’s maximum loss is limited to the initial margin lodged with the clearing member.
• B. The client is mainly exposed to the risk that an option premium expires worthless.
• C. The client is mainly exposed to losses if the equity index rises above the trade price.
• D. The client is mainly exposed to losses if the equity index falls below the trade price.

Best answer: C

What this tests: Derivatives: Introduction to Derivatives

Explanation: A futures position creates directional exposure to movements in the underlying market. A short futures position benefits when the underlying price falls and suffers when it rises. Because the trade is cash-settled with daily variation margin, an adverse rise in the index would normally require cash payments as the futures position is marked to market. Initial margin supports performance of the contract, but it is not the maximum loss. The record also does not describe an option, so premium decay or expiry of a premium is not the relevant exposure.

• Falling index prices would generally help, not hurt, a short equity index futures position.
• Initial margin is collateral for performance and can be topped up; it does not cap losses on a futures trade.
• Option premium risk applies to purchased options, not to the short futures position shown in the trade record.

A short futures position loses when the underlying index rises, creating adverse daily variation margin movements.

Question 2

Topic: Derivatives: Introduction to Derivatives

A UK corporate treasurer is choosing how to hedge a foreign-currency receivable.

Hedge facts:

• Amount and date: €18.7 million receivable in 73 days.
• Hedge aim: match the exact cash flow rather than approximate it with rounded contract sizes.
• Dealing preference: negotiate directly with the bank under existing ISDA documentation.
• Board concern: understand transparency and counterparty-risk trade-offs.

Which route is most appropriate and why?

• A. Use an OTC forward because it is exchange-standardised and publicly order-book traded, giving the treasurer the best price transparency.
• B. Use an exchange-traded futures contract because standard contract terms are more flexible than OTC terms and require no clearing-house involvement.
• C. Use an exchange-traded futures contract because it can be privately negotiated for any notional and maturity while eliminating counterparty risk without margining.
• D. Use an OTC forward because it can be tailored to the exact notional and maturity, but it will have less market transparency and bilateral counterparty exposure than an exchange-traded contract.

Best answer: D

What this tests: Derivatives: Introduction to Derivatives

Explanation: Exchange-traded derivatives are normally standardised by the exchange, traded on transparent venues, and supported by a clearing house that reduces bilateral counterparty risk through novation, margining, and default-management arrangements. Their weakness for a corporate hedge is that contract size, expiry dates, and other terms may not precisely match the exposure. OTC derivatives are privately negotiated, so they can be tailored to the exact notional, maturity, underlying, and settlement needs. That flexibility is useful for a receivable of €18.7 million due in 73 days. The trade-off is that OTC trading is generally less transparent than exchange trading and leaves the parties focused on counterparty exposure, usually managed through documentation, collateral, credit limits, or central clearing where applicable.

• Private negotiation for any notional and maturity describes OTC dealing, not exchange-traded futures.
• Exchange-standardised and publicly order-book traded describes exchange-traded derivatives, not a bilateral OTC forward.
• Standard contract terms are less flexible than bespoke OTC terms, and exchange-traded derivatives typically involve clearing arrangements.

The exact amount, maturity, and bilateral ISDA dealing preference point to an OTC derivative, with the usual trade-off of lower transparency and higher counterparty-risk focus.

Question 3

Topic: Derivatives: Introduction to Derivatives

An investor pays a premium of £0.30 per share for a standardised exchange-traded contract over 1,000 XYZ plc shares. The contract is written by another market participant, not by XYZ plc, and gives the investor the right, but not the obligation, to buy the shares at £8.00 per share at expiry.

At expiry, XYZ plc shares are trading at £8.75. The investor exercises only if it is profitable to do so. Ignore dealing costs.

Which classification and net result is correct?

• A. It is a call option; the investor has a right rather than an obligation and makes a net profit of £450.
• B. It is a warrant issued by XYZ plc; the investor has a right rather than an obligation and makes a net profit of £450.
• C. It is a futures contract; the investor has an obligation to buy and makes a net profit of £750.
• D. It is a forward contract; the investor has a right rather than an obligation and makes a net profit of £450.

Best answer: A

What this tests: Derivatives: Introduction to Derivatives

Explanation: A call option gives the holder the right, but not the obligation, to buy the underlying at the strike price. The holder will exercise when the market price is above the strike. Here, the gross payoff is £8.75 minus £8.00, or £0.75 per share. The premium paid must then be deducted, so the net profit is £0.45 per share. For 1,000 shares, that is £450. Futures and forwards create obligations for both parties, producing a linear gain or loss against the agreed price. A warrant can also give a right rather than an obligation, but it is typically issued by a company or financial institution rather than simply written by another exchange participant.

• A futures contract would impose an obligation and normally has no option-style premium deducted from an exercise payoff.
• A forward contract is an obligation between counterparties, not a right to walk away if exercise is unfavourable.
• A warrant can resemble an option in payoff, but the facts state that the contract was not issued by XYZ plc.

The intrinsic value is £0.75 per share, less the £0.30 premium, giving £0.45 per share across 1,000 shares.

Question 4

Topic: Derivatives: Introduction to Derivatives

A derivatives operations analyst is asked to classify an issue before escalating it to the correct team.

OTC confirmation excerpt:

Product: Total return swap on an equity index
Trade execution: Bilateral OTC trade arranged by voice broker
Documentation: ISDA master agreement and trade confirmation
Clearing status: Not submitted to a central counterparty
Collateral: Daily variation margin under a CSA
Issue raised: Client requests early termination, but the confirmation lists
only scheduled maturity and mandatory termination events.

Which interpretation is best supported?

• A. The issue is mainly about contract terms, because the right to terminate early depends on the confirmation and governing documentation.
• B. The issue is mainly about clearing, because the trade was not submitted to a central counterparty.
• C. The issue is mainly about counterparty exposure, because daily variation margin is exchanged under a CSA.
• D. The issue is mainly about trading venue, because the trade was arranged through a voice broker rather than on an exchange order book.

Best answer: A

What this tests: Derivatives: Introduction to Derivatives

Explanation: A derivatives issue should be classified by the fact that drives the decision. Here, the client is asking to end the swap before scheduled maturity, and the concern is that the confirmation does not state an optional early termination right. That makes the issue primarily contractual. The relevant review is the trade confirmation, ISDA master agreement, schedule, and any termination provisions. The execution method, collateral arrangement, and clearing status are relevant background, but they do not decide whether the client has a contractual right to terminate early.

• Voice-brokered OTC execution describes how the trade was arranged, not whether early termination is allowed.
• Daily variation margin under a CSA manages counterparty exposure, but collateral does not create an early termination right.
• Absence of central clearing affects counterparty structure and processes, but the stated problem is a missing or unclear contractual term.

The disputed point is whether early termination is permitted under the agreed contractual documentation.

Question 5

Topic: Derivatives: Introduction to Derivatives

A UK importer must hedge a USD payment due in just over four months.

Hedge requirement:

• Amount: USD 7.3 million
• Date: 17 September
• The treasury policy permits either an OTC bank forward or exchange-traded currency futures.
• The exchange contract is a standardised USD/GBP futures contract with fixed contract sizes and quarterly delivery months.
• The bank forward can be written for the exact amount and date under bilateral documentation.
• The broker has reminded the importer that futures positions require initial margin and daily variation margin.

Which statement is the single best comparison of the two alternatives?

• A. The futures contract can be privately tailored to the exact amount and date, while the forward must use standard contract sizes and exchange delivery months.
• B. The forward should have daily variation margin and central clearing, while the futures contract normally creates direct bilateral exposure to the trading counterparty.
• C. The forward can match the exact amount and date, but it is an OTC bilateral contract with more counterparty exposure and typically less secondary-market liquidity than a centrally cleared futures contract.
• D. Both contracts are equally standardised and equally liquid because both create a binding obligation to exchange currency at a future date.

Best answer: C

What this tests: Derivatives: Introduction to Derivatives

Explanation: Forwards and futures both lock in a future price or rate, but their contract features differ. A forward is normally an OTC agreement between two counterparties, so it can be tailored to the exact notional amount and settlement date. That flexibility comes with bilateral counterparty exposure and often less ability to close or transfer the position in a deep secondary market. A futures contract is standardised by the exchange, traded on an exchange or trading facility, and centrally cleared. The clearing house becomes the counterparty through novation, and the position is supported by initial margin and daily variation margin. Futures are usually more liquid, but their fixed contract sizes and delivery months can create a mismatch against an exact commercial exposure.

• Treating futures as privately tailored reverses the key distinction: futures are standardised, while forwards are customisable.
• Assigning daily variation margin and central clearing to the forward reverses the normal operational structure.
• Saying both are equally standardised and liquid ignores the exchange-traded, centrally cleared nature of futures and the bilateral OTC nature of forwards.

A forward is customisable and bilateral, while a futures contract is standardised, exchange-traded, centrally cleared, margined daily, and usually more liquid.

Question 6

Topic: Derivatives: Introduction to Derivatives

A trader buys one equity index futures contract on margin.

Ignoring commissions and funding costs, which result best shows the effect of gearing relative to the initial margin?

• A. £1,200 loss, equal to a 30% loss on the initial margin
• B. £1,200 profit, equal to a 30% gain on the initial margin
• C. £120 profit, equal to a 3% gain on the initial margin
• D. £1,200 profit, equal to a 3% gain on the initial margin

Best answer: B

What this tests: Derivatives: Introduction to Derivatives

Explanation: Gearing means the trader controls a larger market exposure with a smaller initial margin. The contract’s notional exposure at entry is 4,000 × £10 = £40,000, while the initial margin is only £4,000. The futures price rises by 120 points, so the profit is 120 × £10 = £1,200. Compared with the initial margin, the return is £1,200 ÷ £4,000 = 30%. The futures price itself rose only 3% from 4,000 to 4,120, but the return on margin is magnified because the margin is only a fraction of the full contract exposure.

• Treating the result as a 3% gain on margin confuses the futures price movement with the return on the cash initially committed.
• Using £120 ignores the £10 contract multiplier.
• A long futures position gains, rather than loses, when the futures price rises.

The futures gain is 120 index points times £10, so £1,200 represents 30% of the £4,000 initial margin.

Question 7

Topic: Derivatives: Introduction to Derivatives

A portfolio manager is deciding how to hedge a UK equity portfolio for the next two months. Review the trading note.

Trading note:

• Exposure: broadly tracks the FTSE 100.
• Purpose: reduce market beta quickly, not obtain a bespoke payoff.
• Contract fit: listed FTSE 100 index futures have an acceptable contract size and nearby expiry.
• Operational constraint: no new bilateral OTC documentation can be approved this week.
• Operations: existing clearing broker can process exchange margin.
• Preference: transparent pricing and central counterparty clearing.

Which trading mechanism is the best supported action?

• A. Enter a bespoke OTC equity swap with an investment bank under a new ISDA agreement.
• B. Trade a contract for differences with a dealer account to create short index exposure.
• C. Negotiate a bilateral OTC forward on the index with a dealer for the exact hedge dates.
• D. Sell listed FTSE 100 index futures on a regulated derivatives exchange through the existing clearing broker.

Best answer: D

What this tests: Derivatives: Introduction to Derivatives

Explanation: Exchange-traded futures are designed for standardised exposures where the contract size, expiry, and underlying are acceptable. They trade on regulated derivatives exchanges and are cleared through a central counterparty, normally via a clearing member or broker. That fits a quick beta hedge on a portfolio that broadly tracks the FTSE 100, especially where the desk already has operational access to exchange margin processing. OTC mechanisms are more useful when the hedge must be tailored by date, notional, underlying basket, or payoff. Here, the note says a standard listed contract is acceptable and that new bilateral OTC documentation cannot be approved in time, so the exchange-traded route is the better fit.

• Bespoke OTC swaps can tailor exposure, but they require bilateral documentation and counterparty arrangements that the note says cannot be approved this week.
• A bilateral OTC forward could provide exact dates, but exact customisation is not required and the operational constraint points away from OTC dealing.
• A CFD may create short exposure, but it is typically a dealer-facing arrangement rather than a centrally cleared exchange-traded futures mechanism.

Listed index futures match the standardised hedge, use existing exchange-clearing arrangements, and avoid new bilateral OTC documentation.

Question 8

Topic: Derivatives: Introduction to Derivatives

A company has a £20 million floating-rate bank loan and wants to reduce its exposure to rising short-term interest rates. It enters into a sterling interest rate swap with the following terms:

Which statement correctly describes the next swap cash flow and the main reason for using the swap?

• A. The company receives £75,000 net, and the swap helps convert floating-rate borrowing exposure into fixed-rate exposure.
• B. The company pays £400,000 net, and the swap removes all credit risk on the bank loan.
• C. The company pays £75,000 net, and the swap helps increase its benefit from rising floating rates.
• D. The company receives £150,000 net, and the swap creates a direct exchange of principal amounts.

Best answer: A

What this tests: Derivatives: Introduction to Derivatives

Explanation: In a plain vanilla interest rate swap, the parties exchange interest cash flows calculated on a notional principal. The notional is used for calculation only and is normally not exchanged. Here, the six-month fixed cash flow is £20 million × 4.00% × 6/12 = £400,000. The floating cash flow is £20 million × 4.75% × 6/12 = £475,000. Because the swap is net-settled and the company receives floating while paying fixed, it receives £75,000. This floating receipt can offset higher floating interest on the company’s bank loan, leaving it economically closer to paying a fixed rate, plus any loan margin outside the swap.

• A net payment by the company reverses the cash-flow direction; the floating leg is larger than the fixed leg for this period.
• Doubling the £75,000 difference ignores that the quoted rates are annual rates applied to a six-month period.
• The notional principal is not normally exchanged in an interest rate swap, and the swap does not eliminate the borrower’s loan credit risk.

For six months, the floating receipt is £475,000 and the fixed payment is £400,000, so the company receives £75,000 net.

Question 9

Topic: Derivatives: Introduction to Derivatives

A proprietary trading desk enters the following exchange-traded derivatives position:

• Buys 20 June FTSE 100 index futures at 8,000.
• Posts initial margin equal to a small percentage of the contract value.
• The contracts are marked to market daily through the clearing house.
• The desk holds no offsetting cash equity portfolio.
• The trade was entered to profit from a short-term rise in UK equities.

What is the single best description of the main risk exposure created by this position?

• A. A loss limited to the initial margin paid when the trade was opened
• B. A primary exposure to issuer credit risk from companies in the index rather than market price risk
• C. A physical delivery obligation to buy all constituent shares in the FTSE 100 index
• D. A geared exposure to losses and variation margin calls if the FTSE 100 index falls

Best answer: D

What this tests: Derivatives: Introduction to Derivatives

Explanation: A long futures position gives positive exposure to the underlying market: it benefits when the underlying rises and loses when the underlying falls. Because only margin is posted rather than the full notional value, the position is geared. A relatively small move in the index can create a large gain or loss compared with the cash committed. Exchange-traded futures are also marked to market daily, so adverse movements can require variation margin payments before the contract expires. In this case, the desk has no offsetting equity position, so the futures are a directional long exposure to UK equity market prices.

• Initial margin is collateral, not the maximum loss on a futures contract.
• Index futures are normally cash-settled, so the key risk is not taking delivery of every index constituent.
• Company-specific credit risk may affect shares, but the futures position mainly creates geared equity index price exposure.

A long futures position gains from a rise in the underlying index and loses from a fall, with margining creating cash-flow pressure as losses are marked to market.

Question 10

Topic: Derivatives: Introduction to Derivatives

A UK airline treasury desk is reviewing fuel-price hedges for the next planning cycle.

Hedge need:

• Forecast purchases are uneven by calendar quarter, totalling 18.6 million litres.
• The board wants the hedge to reference a Northwest Europe jet-fuel assessment rather than Brent crude.
• The protection should cap prices above budget while allowing participation in lower prices, subject to an agreed floor.
• The final exposure date is 14 months away.
• The airline can trade bilaterally with an approved bank under an ISDA agreement and collateral support annex.

Which structure is most appropriate?

• A. A strip of exchange-traded Brent futures with standard delivery months, whole contract sizes and a rolling programme
• B. An OTC fixed-for-floating Brent swap for the total volume with one bullet settlement at the 14-month date
• C. Listed Brent call options using the closest exchange expiries, standard strike intervals and standard contract sizes
• D. A bespoke cash-settled OTC jet-fuel collar referencing the selected jet-fuel assessment, with tailored quarterly notionals and a 14-month final maturity

Best answer: D

What this tests: Derivatives: Introduction to Derivatives

Explanation: OTC derivatives are commonly preferred when a hedge needs terms that standard exchange-traded contracts cannot provide. Exchange-traded products offer liquidity, transparent pricing and central clearing, but their underlyings, contract sizes, expiries and payoff structures are standardised. The airline’s exposure is to jet fuel, not simply Brent crude, and the forecast purchases are uneven across quarters. It also needs a collar payoff rather than a purely linear futures or swap hedge. A bespoke OTC collar can specify the reference index, settlement dates, notional schedule, maturity and cap/floor levels. The ISDA and collateral documentation supports the bilateral credit and legal framework needed for the trade.

• Brent futures are liquid, but they create crude-oil basis risk and use standardised months and contract sizes.
• Listed Brent calls provide upside price protection, but they do not fully match the jet-fuel underlying, uneven volumes or bespoke maturity.
• A Brent swap is OTC, but a single bullet, fixed-for-floating structure does not match the quarterly schedule or collar payoff.

The OTC collar can be customised for the exact underlying, uneven notional profile, maturity and cap/floor payoff required by the airline.

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