Free CISI CMP Sec/Deriv Practice Questions: Derivatives: OTC 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: OTC 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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Sample questions

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: OTC Derivatives

A buy-side firm agrees an uncleared OTC equity total return swap with a dealer.

Trade facts:

• The parties have a signed ISDA Master Agreement and a CSA.
• The swap is bilateral and will not be submitted to a clearing house.
• The agreed notional is £25 million, with quarterly resets and cash settlement.
• The trader’s blotter records the underlying as UK Renewable Infrastructure Basket.
• The dealer’s draft confirmation refers to Basket as defined in Annex A, but Annex A is not attached.
• The confirmation states that the dealer is calculation agent.

Which is the single best assessment of the confirmation risk?

• A. The confirmation should not be affirmed until the basket constituents are agreed, because the missing annex leaves the economic underlying undefined for legal, valuation, and processing purposes.
• B. The confirmation can be affirmed because the ISDA Master Agreement and CSA are already signed and will override any missing economic detail.
• C. The operations team can book the notional and quarterly reset schedule now because the calculation agent can select the basket constituents when the first reset occurs.
• D. The main issue is that the trade is uncleared, so it should be sent to a clearing house before the confirmation is matched.

Best answer: A

What this tests: Derivatives: OTC Derivatives

Explanation: An OTC derivatives confirmation records the specific economic terms of the transaction under the broader ISDA documentation. The master agreement and CSA provide the contractual framework, close-out and collateral mechanics, but they do not normally define the unique commercial details of each trade. For an equity total return swap, the underlying basket is a core economic term. If the confirmation refers to an annex that is missing, the parties may not have an enforceable or operationally usable definition of what performance is being transferred. That affects legal certainty, independent valuation, collateral exposure calculations, resets, dispute handling, and final settlement. The correct response is to resolve and match the missing basket terms before affirmation or downstream processing.

• Signed ISDA and CSA documentation does not cure a missing transaction-level economic term.
• Central clearing is not the issue because the facts state the swap is bilateral and uncleared.
• Letting the calculation agent decide the basket later would not resolve the need for agreed trade terms at confirmation.

Without the basket definition, the parties cannot reliably determine the swap payoff, valuation inputs, reset amounts, or enforceable economic terms.

Question 2

Topic: Derivatives: OTC Derivatives

A UK corporate treasury team hedges floating-rate borrowing with two bilateral OTC sterling interest rate swaps with the same investment bank.

Documentation facts:

• The trades are not exchange-traded and are not centrally cleared.
• The parties have executed an ISDA Master Agreement with a negotiated Schedule.
• Each swap is booked only after a separate confirmation is matched.
• A Credit Support Annex requires collateral when the net mark-to-market exposure exceeds an agreed threshold.
• The bank’s credit officer asks how the documents work together if one party defaults.

Which is the single best explanation?

• A. The confirmation provides the only legally relevant terms, the Schedule records daily valuations, the credit support documentation replaces the need for collateral calls, and netting applies only to coupon payments on each swap separately.
• B. The master agreement provides the umbrella legal terms, the Schedule amends standard elections, confirmations record trade-specific economics, credit support documentation governs collateral, and netting provisions convert covered transactions into one close-out amount after termination.
• C. The master agreement is needed only for exchange-traded derivatives, the Schedule appoints the clearing house, confirmations are internal trade tickets, and netting is performed by the central counterparty.
• D. The master agreement fixes the commercial terms for every future swap, the confirmation sets default rules, the credit support documentation is used only after default, and netting eliminates all market risk on the hedge.

Best answer: B

What this tests: Derivatives: OTC Derivatives

Explanation: OTC derivatives documentation separates recurring legal architecture from trade-specific details. A master agreement, commonly an ISDA Master Agreement, sets the standard relationship terms such as representations, default events, termination events and close-out mechanics. The Schedule customises those standard terms for the parties. A confirmation records the economic and operational terms of a particular transaction, such as notional, dates, fixed rate, floating reference rate and payment frequency. Credit support documentation, such as a Credit Support Annex, sets how collateral is calculated, called, delivered and returned. Netting provisions are important for counterparty exposure because, following an event such as default and early termination, covered transactions can be valued and reduced to a single net amount payable by one party to the other.

• Treating the confirmation as the only legal document ignores the umbrella role of the master agreement and the customising role of the Schedule.
• Referring to a clearing house is inappropriate because the swaps are bilateral OTC trades and are not centrally cleared.
• Netting reduces credit exposure at close-out, but it does not remove the underlying market risk of the hedge.

This correctly matches each OTC document to its purpose and explains how close-out netting reduces counterparty exposure across covered transactions.

Question 3

Topic: Derivatives: OTC Derivatives

A dealer values an OTC interest rate swap each day under a two-way collateral agreement. A positive mark-to-market value is an exposure to the counterparty because the counterparty would owe the dealer if the swap were replaced.

Collateral terms:

Ignore collateral haircuts, interest, and rounding. What collateral call should the dealer make, and what uncollateralised counterparty exposure remains after the call is met?

• A. Call £200,000; residual counterparty exposure £250,000.
• B. Call £900,000; residual counterparty exposure £250,000.
• C. Call £450,000; residual counterparty exposure £0.
• D. No call; residual counterparty exposure £450,000.

Best answer: A

What this tests: Derivatives: OTC Derivatives

Explanation: Mark-to-market valuation determines the current replacement value of an OTC derivative. When the value is positive to the dealer, the dealer has counterparty credit exposure. Under the collateral terms, the counterparty is allowed an unsecured threshold of £250,000, so collateral is required only for the excess over that amount. The exposure of £1,150,000 therefore requires £900,000 of collateral. Since the dealer already holds £700,000, the additional collateral call is £200,000. This exceeds the £100,000 minimum transfer amount, so the call is made. Once paid, the dealer holds £900,000 against a £1,150,000 mark-to-market exposure, leaving £250,000 uncollateralised.

• Calling £450,000 ignores the permitted unsecured threshold and over-collateralises the exposure.
• Calling £900,000 treats the total required collateral as a new call and ignores collateral already held.
• Making no call is incorrect because the collateral shortfall is £200,000, which exceeds the minimum transfer amount.

The required collateral is £900,000 after allowing the £250,000 threshold, so the dealer calls £200,000 more than the £700,000 already held.

Question 4

Topic: Derivatives: OTC Derivatives

An OTC derivatives operations analyst reviews the legal file for a new 5-year GBP fixed-for-floating interest rate swap before booking it.

Legal file extract:

Which interpretation is best supported?

• A. Complete and agree the confirmation; it records the swap economics, while the master agreement, schedule, credit support annex and netting terms cover the wider legal and exposure framework.
• B. Assess exposure on a gross trade-by-trade basis; netting provisions are operational payment instructions rather than close-out protections.
• C. Use the schedule as the collateral document; it customises margin mechanics and replaces credit support documentation for exposure control.
• D. Book the trade from the master agreement alone; it contains the standard legal framework and normally makes transaction confirmations unnecessary.

Best answer: A

What this tests: Derivatives: OTC Derivatives

Explanation: In OTC derivatives, a master agreement avoids negotiating a full legal contract for every trade. It sets standard legal terms, including events of default, termination mechanics and the basis for close-out netting. The schedule customises that master agreement through elections and amendments. A confirmation records the economic terms of a specific transaction, such as notional, rate, index and payment dates, so an unsigned draft should be completed and agreed before the trade is treated as fully documented. Credit support documentation, such as a credit support annex, sets collateral terms, eligible collateral, valuation and transfer mechanics. Netting provisions reduce counterparty exposure by allowing obligations to be combined, particularly on termination, rather than leaving multiple gross claims outstanding.

• A master agreement provides the standard legal framework, but it does not normally remove the need for a transaction confirmation.
• A schedule customises elections and amendments; it is not the same as credit support documentation.
• Credit support documentation covers collateral, not the core trade economics recorded in a confirmation.
• Netting is not merely administrative; it is central to reducing gross counterparty exposure.

The draft confirmation is still needed for the transaction-specific economics, while the other documents set the legal, amended, collateral and netting framework.

Question 5

Topic: Derivatives: OTC Derivatives

A UK infrastructure company wants to hedge the interest-rate risk on a loan.

• Loan amount: £86.4 million, reducing on a scheduled amortisation profile
• Maturity: 7.5 years from drawdown
• Floating reference: compounded SONIA, reset on each interest period
• Cash flows: semi-annual interest payments with larger principal reductions in the final two years
• The treasury team wants the hedge to match the loan rather than roll a series of standardised exchange-traded contracts

Which statement best explains why an OTC derivative is suitable?

• A. An exchange-traded futures contract can be amended by the clearing house to match any borrower’s loan schedule.
• B. A listed option is preferable because its fixed expiry cycle removes the need to specify a maturity or cash-flow structure.
• C. An OTC derivative is suitable because all OTC contracts have identical standard terms and therefore trade with high liquidity.
• D. A bilateral OTC interest rate swap can be negotiated so the notional, final maturity, SONIA reference, and payment profile match the loan.

Best answer: D

What this tests: Derivatives: OTC Derivatives

Explanation: OTC derivatives are agreed directly between counterparties, usually documented under market-standard legal documentation such as an ISDA Master Agreement. Unlike exchange-traded derivatives, they do not have to use a fixed contract size, fixed expiry cycle, or standardised settlement structure. This allows the parties to tailor the notional amount, maturity date, reference underlying, reset dates, payment dates, and cash-flow formula to the commercial exposure. In this case, the company needs a hedge for a 7.5-year amortising SONIA-linked loan with semi-annual cash flows. A bespoke OTC interest rate swap can be structured to mirror those features more closely than a chain of listed contracts.

• Exchange-traded futures are standardised; the clearing house does not rewrite contract terms for each borrower’s loan schedule.
• Standardisation is a feature of listed derivatives, not the main reason for using OTC contracts.
• A listed option’s fixed expiry cycle would make it harder, not easier, to match a bespoke loan maturity and cash-flow profile.

OTC derivatives are privately negotiated, so their economic terms can be tailored to the exposure being hedged.

Question 6

Topic: Derivatives: OTC Derivatives

A collateral operations analyst is reviewing a proposed amendment to the collateral agreement (CSA) for an uncleared OTC derivatives portfolio. Internal policy requires credit-risk review before accepting changes that increase unsecured counterparty exposure.

Which action is best supported by the amendment summary?

• A. Approve because daily collateral calls remove exposure, so threshold, independent amount, MTA, and haircut settings are operational details.
• B. Request a lower threshold only because independent amounts and haircuts reduce operational workload rather than counterparty risk.
• C. Escalate for credit review because the amendment increases unsecured exposure, removes the independent amount buffer, and eliminates the haircut; the MTA only filters small calls.
• D. Approve because keeping the MTA at £250,000 keeps the same overall credit protection even though the threshold and independent amount change.

Best answer: C

What this tests: Derivatives: OTC Derivatives

Explanation: Collateral terms in an OTC derivatives CSA directly affect counterparty credit exposure. Daily margining helps, but it does not eliminate risk if the agreement permits a threshold, because exposure can remain unsecured until the threshold is exceeded. A minimum transfer amount avoids inefficient small transfers, but it can leave small excess amounts uncalled until the amount is large enough. An independent amount is additional collateral, similar in purpose to an initial margin buffer, and helps cover potential future exposure or close-out risk. Haircuts reduce the recognised value of securities collateral to allow for price, liquidity, and sometimes currency risk. Here, the proposed amendment raises the threshold, removes the independent amount, and applies no haircut to gilts, so it should be treated as a credit-risk issue.

• Daily collateral calls reduce exposure but do not override thresholds, MTAs, independent amounts, or haircuts.
• An unchanged MTA does not preserve credit protection when the threshold rises and the independent amount is removed.
• Thresholds, independent amounts, and haircuts are credit-risk terms, not merely operational workload settings.

The proposed terms weaken credit protection by allowing more uncollateralised exposure, removing extra collateral, and giving full value to securities collateral.

Question 7

Topic: Derivatives: OTC Derivatives

A bank is reviewing an OTC interest rate swap after receiving an internal credit update on the counterparty. Which interpretation is best supported by the excerpt?

• A. The bank should increase the counterparty credit adjustment because the positive exposure is now to a lower-quality counterparty.
• B. The bank should leave valuation and exposure reporting unchanged because market rates have not moved.
• C. The bank should reduce counterparty credit risk because the trade is below the collateral threshold.
• D. The bank should mark the swap higher because the counterparty’s downgrade makes the bank’s receivable more valuable.

Best answer: A

What this tests: Derivatives: OTC Derivatives

Explanation: OTC derivatives create counterparty credit exposure when a trade has positive value to one party. Here, the swap is worth +£4.3 million to the bank, so the bank is exposed to the counterparty’s ability to perform. A downgrade and wider CDS spread indicate weaker credit quality and higher default risk. Even though market rates have not moved and the exposure is below the collateral threshold, the risk-adjusted valuation should reflect a higher counterparty credit charge, often through a larger credit valuation adjustment. Collateral terms affect how much exposure is secured, but they do not eliminate the need to assess the counterparty’s credit quality.

• Unchanged market rates do not mean unchanged OTC valuation when counterparty credit risk has deteriorated.
• Being below the collateral threshold may mean no immediate collateral call, but it leaves uncollateralised exposure.
• A weaker counterparty makes the bank’s receivable less valuable on a risk-adjusted basis, not more valuable.

A weaker counterparty increases expected credit loss on the bank’s positive exposure, reducing the risk-adjusted value of the OTC derivative.

Question 8

Topic: Derivatives: OTC Derivatives

An operations analyst is reviewing a draft OTC equity forward confirmation before trade matching. Which action is best supported by the review?

• A. Match the trade because the trade date, underlying, quantity, and forward price agree.
• B. Calculate exposure using the LSE closing price and leave the settlement method for the settlement team to resolve later.
• C. Escalate as an unmatched confirmation and obtain an amended confirmation covering settlement method, final valuation date, and valuation source before matching.
• D. Book the trade as physical delivery because the draft confirmation should override the internal trade capture record.

Best answer: C

What this tests: Derivatives: OTC Derivatives

Explanation: OTC confirmations evidence the agreed economic and settlement terms of a derivative under the wider documentation framework. A trade should not be treated as matched when terms that determine payoff or performance are missing or inconsistent. Here, cash settlement versus physical delivery changes the parties’ legal obligations and the operational settlement process. The missing final valuation date and valuation source also prevent reliable valuation and counterparty exposure measurement. Agreement on headline economics such as quantity and forward price is not enough where core payoff and settlement terms remain unresolved. The appropriate action is to escalate the break and obtain a corrected confirmation before matching the trade.

• Matching on common headline economics is incomplete because settlement method and valuation mechanics are core terms.
• Treating the draft confirmation as automatically overriding trade capture is unsafe while the record is still unmatched and inconsistent.
• Assuming an exposure calculation source does not remove the legal ambiguity or the settlement-processing risk.

The settlement conflict and missing valuation terms are material breaks that affect enforceability, valuation, exposure measurement, and settlement processing.

Question 9

Topic: Derivatives: OTC Derivatives

A derivatives operations team at a UK investment firm receives a collateral notice from a dealer bank.

Trade and documentation:

• Instrument: bilateral OTC equity swap.
• Documentation: ISDA Master Agreement with a Credit Support Annex.
• Clearing: the swap is not centrally cleared.
• Eligible collateral: GBP cash only.
• Minimum transfer amount: £100,000.
• Notice timing: received before the CSA notification deadline; any dispute must be raised today.

Variation margin call: Client to deliver £650,000 by 10:00 London time tomorrow. Portfolio exposure has moved in Dealer Bank’s favour.

No termination, option exercise, coupon payment, or scheduled swap reset is due today.

Which is the best operational interpretation of the notice?

• A. Route the payment to the central counterparty as initial margin because derivative margin calls are handled through clearing houses.
• B. Meet the call with listed equities or government bonds because they are liquid assets commonly used as collateral.
• C. Record it as a final equity swap settlement payment because the dealer’s exposure has moved in its favour.
• D. Treat it as a CSA variation margin call: reconcile the exposure, raise any dispute today, otherwise deliver £650,000 in GBP cash tomorrow.

Best answer: D

What this tests: Derivatives: OTC Derivatives

Explanation: A collateral notice under a Credit Support Annex is an operational instruction linked to current exposure, not a normal swap cashflow or termination payment. Here, the swap is bilateral and uncleared, the call was received within the CSA timing, and the amount is above the minimum transfer amount. The operations team should therefore validate the dealer’s exposure calculation and either dispute it within the required deadline or settle the collateral transfer. Because the CSA restricts eligible collateral to GBP cash, delivering securities would not satisfy the notice unless the parties agreed an amendment or substitution outside these facts.

• Treating the amount as final swap settlement ignores that no termination, reset, exercise, or scheduled payment is due.
• Sending it through a central counterparty ignores that the trade is bilateral and not centrally cleared.
• Delivering securities ignores the CSA’s GBP cash-only collateral eligibility term.

The notice is a timely collateral call under the CSA, and the only eligible collateral is GBP cash.

Question 10

Topic: Derivatives: OTC Derivatives

Review the OTC counterparty exposure note for a 5-year interest rate swap. All amounts are in GBP equivalent.

Which interpretation is best supported by the note?

• A. The £2.4 million positive mark-to-market is replacement cost; current exposure after collateral is £0.8 million; the £3.8 million add-on is potential future exposure; the coupon timing creates settlement exposure.
• B. The £0.8 million after collateral is potential future exposure, and settlement exposure exists only if the counterparty fails after final maturity.
• C. The £100 million notional is the collateralised exposure because collateral is held against the trade, and the £2.4 million mark-to-market is settlement exposure.
• D. The £3.8 million add-on is replacement cost because it is modelled over the trade life, and the coupon timing is unrelated to counterparty exposure.

Best answer: A

What this tests: Derivatives: OTC Derivatives

Explanation: Replacement cost is the amount that would be lost or need to be replaced if the counterparty defaulted now, normally the positive current mark-to-market. Here that is £2.4 million before collateral. Collateralised current exposure reflects the effect of eligible collateral, so the post-haircut collateral of £1.6 million reduces the current exposure to £0.8 million. Potential future exposure is different: it is an estimate of how much exposure could increase over the remaining life of the OTC derivative because market prices move. The £3.8 million model add-on fits that description. Settlement exposure arises around payment or delivery, when one party has made a payment or delivery but has not yet received the corresponding leg. The same-day coupon timing creates that risk window.

• Treating the future exposure add-on as replacement cost confuses current exposure with possible later exposure.
• Using notional as collateralised exposure overstates the credit exposure; notional is a reference amount, not the current loss amount.
• Calling the collateral-reduced amount potential future exposure ignores that it is derived from current mark-to-market less post-haircut collateral.
• Settlement exposure can arise during an interim coupon exchange, not only at final maturity.

Replacement cost is the current positive mark-to-market, collateral reduces that current exposure, PFE is the future-move add-on, and mismatched payment timing creates settlement exposure.

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