Free CISI CMP Sec/Deriv Practice Questions: Derivatives Trading and Hedging

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 Trading and Hedging. 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: Trading, Hedging and Investment Strategies

A derivatives desk holds £25 million of UK mid-cap equities during a five-day client transition. It proposes a temporary hedge using listed equity index futures. Review the hedge memo excerpt.

Hedge memo excerpt:

• Objective: Reduce broad equity market exposure for five trading days.
• Hedge: Sell FTSE 100 index futures with notional close to the portfolio market value.
• Portfolio: UK mid-cap shares; historical beta to the FTSE 100 is 0.82 and sector weights differ materially from the index.
• Liquidity and cash: Futures are exchange-traded and liquid, but variation margin must be paid in cash each morning if the short futures position moves against the desk.
• Process: Contract expiry falls during the transition; the roll is to be instructed manually by one operations analyst.

Which interpretation is best supported by the memo?

• A. The hedge should be rejected because a futures hedge cannot reduce risk unless the index exactly matches every share in the portfolio.
• B. The futures position can reduce broad equity exposure, but it introduces basis risk, cash funding pressure from variation margin and operational risk around the manual roll.
• C. The main new risk is bilateral counterparty credit risk because the futures contract is an OTC derivative.
• D. The hedge eliminates equity price risk because the futures notional is close to the portfolio market value.

Best answer: B

What this tests: Derivatives: Trading, Hedging and Investment Strategies

Explanation: A hedge can reduce one exposure while creating or revealing other risks. Selling equity index futures is likely to reduce broad equity market exposure during the transition, but the hedge is imperfect because the portfolio is made up of mid-cap shares with different sector weights and a beta that is not one-for-one with the FTSE 100. That mismatch creates basis risk: the portfolio and the futures may not move together. Listed futures are usually liquid, but daily variation margin can create cash funding pressure if the futures position loses money before the cash portfolio is sold. The expiry and manual roll also add operational risk, because an instruction error or missed roll could leave the desk under-hedged or over-hedged.

• Matching notional value does not eliminate risk when the hedge instrument tracks a different index and beta.
• Bilateral OTC counterparty credit risk is not the main issue shown because the hedge uses listed equity index futures.
• An exact share-by-share match is not required for a hedge to reduce risk; imperfect hedges can still lower broad market exposure while leaving residual risk.

The memo supports a partial market hedge, while the index mismatch, daily cash margining and manual roll create basis, funding/liquidity and operational risks.

Question 2

Topic: Derivatives: Trading, Hedging and Investment Strategies

A derivatives trader expects a moderate rise in a share price and enters a bull call spread using options on the same share and expiry.

Premiums are quoted per share. Ignore fees and financing. What is the net premium paid, maximum profit per share at expiry, and breakeven share price?

• A. Net premium paid £5; maximum profit £5; breakeven £55
• B. Net premium received £3; maximum profit £3; breakeven £57
• C. Net premium paid £3; maximum profit unlimited; breakeven £53
• D. Net premium paid £3; maximum profit £7; breakeven £53

Best answer: D

What this tests: Derivatives: Trading, Hedging and Investment Strategies

Explanation: A bull call spread is created by buying a lower-strike call and selling a higher-strike call with the same expiry. The short higher-strike call helps fund the long call, so the net premium is £4 paid less £1 received, or £3 paid. The maximum payoff occurs when the share price is at or above the higher strike. The long £50 call is then worth £10 more than the short £60 call, so the maximum profit is the £10 spread width less the £3 net premium, giving £7 per share. The breakeven is the lower strike plus the net premium paid: £50 + £3 = £53.

• Treating the trade as costing £5 adds both premiums instead of netting the premium received on the short call.
• A net credit result reverses the cash flow; this position pays more premium for the long lower-strike call than it receives for the short higher-strike call.
• Unlimited profit applies to an uncovered long call, not to a bull call spread where the short higher-strike call caps the upside.

The spread costs £3, caps upside at the £10 strike difference, and breaks even at the lower strike plus the net premium.

Question 3

Topic: Derivatives: Trading, Hedging and Investment Strategies

A derivatives desk has the following open positions after trade registration:

• Bought 50 FTSE 100 index futures.
• Entered a three-month FX forward to deliver USD 5 million and receive GBP at an agreed forward rate.
• Bought exchange-traded Brent crude call options.
• Entered an OTC interest rate swap under ISDA terms to pay a fixed rate of 4.20% and receive three-month SONIA.

Assume there are no offsetting positions. Which statement is the single best summary of the desk’s exposures?

• A. The desk is short the FTSE index and Brent crude price, long USD and short GBP under the forward, and positioned to benefit if SONIA falls relative to the fixed swap rate.
• B. The desk is long the FTSE index and Brent crude price, short USD and long GBP under the forward, and positioned to benefit if SONIA rises relative to the fixed swap rate.
• C. The desk has directional exposure only through the futures and call options, because the forward and swap do not create exposure until final cash settlement.
• D. The desk is long the FTSE index, long USD and short GBP under the forward, short Brent crude through the call options, and positioned to benefit if SONIA falls.

Best answer: B

What this tests: Derivatives: Trading, Hedging and Investment Strategies

Explanation: A long futures position gives direct positive exposure to the underlying: if the FTSE 100 rises, the bought futures should gain. A bought call option also gives positive exposure to the underlying price, although the payoff is non-linear and the maximum loss is generally the premium paid. In the FX forward, the desk has agreed to deliver USD and receive GBP, so it is short USD and long GBP for that contract. In a pay-fixed, receive-floating interest rate swap, the desk benefits when the floating reference rate, here SONIA, rises relative to the fixed rate it pays. These exposures exist as market values change, not only at final settlement.

• Buying a futures contract is long exposure to the underlying, not short exposure because settlement occurs later.
• A forward to deliver USD and receive GBP is short USD and long GBP, not the reverse.
• A bought call has positive price exposure to Brent crude; it is not short Brent merely because exercise is optional.
• Forwards and swaps create market exposure before maturity because their values change as rates, currencies, or prices move.

Buying futures and calls gives positive underlying exposure, delivering USD makes the desk short USD, and paying fixed while receiving floating benefits from higher SONIA.

Question 4

Topic: Derivatives: Trading, Hedging and Investment Strategies

Sterling exchange rates are quoted as USD per £1.

A UK exporter will receive $5,000,000 in three months and wants to remove uncertainty over its sterling cash receipt.

Ignoring fees, credit risk, and discounting, which description best fits the exporter’s derivative use and the approximate effect versus converting at the maturity spot rate?

• A. Corporate hedger; about £186,000 higher sterling proceeds
• B. Arbitrageur; about £186,000 risk-free profit
• C. Market maker; about £186,000 lower sterling proceeds
• D. Speculator; about £186,000 higher sterling proceeds

Best answer: A

What this tests: Derivatives: Trading, Hedging and Investment Strategies

Explanation: A corporate hedger uses derivatives to reduce uncertainty in an underlying business exposure. Here, the exporter already has a future USD receipt, so the forward is used to lock in the sterling value. At the forward rate, the sterling proceeds are approximately $5,000,000 ÷ 1.2400 = £4,032,258. If the exporter waited and converted at the maturity spot rate, the proceeds would be $5,000,000 ÷ 1.3000 = £3,846,154. The forward therefore produces about £186,000 more than spot conversion in this scenario. The purpose is not to create a standalone trading profit, quote prices to others, or exploit a pricing mismatch; it is to manage currency risk on a commercial cash flow.

• Speculation would involve taking a derivative position mainly to profit from an expected price move, not offsetting an existing export receivable.
• Arbitrage requires exploiting a pricing inconsistency with little or no market risk; the facts show a hedge against FX exposure instead.
• A market maker quotes buy and sell prices to facilitate client trading; the exporter is entering one forward to manage its own cash flow.

The exporter is hedging a commercial USD receivable, and the forward converts $5,000,000 at 1.2400 rather than the less favourable 1.3000 spot rate.

Question 5

Topic: Derivatives: Trading, Hedging and Investment Strategies

A derivatives trader expects the FTSE 100 to rise moderately over the next three months, but wants both the initial cost and downside risk to be limited.

The trader uses exchange-traded FTSE 100 index options with the same expiry and a contract multiplier of £10 per index point:

• Buys a 7,500 call for a premium of 180 points
• Sells a 7,900 call for a premium of 70 points
• Ignore commissions, interest, and tax

Which statement best describes the risk, reward, and breakeven at expiry?

• A. It is a bull call spread with a £1,100 maximum loss, a £2,900 maximum profit, and a 7,610 breakeven index level.
• B. It is a long call with a £1,800 maximum loss, unlimited profit above a 7,680 breakeven index level.
• C. It is a bull call spread with a £700 maximum loss, a £3,300 maximum profit, and a 7,570 breakeven index level.
• D. It is a bear call spread with a £1,100 maximum profit, a £2,900 maximum loss, and a 7,610 breakeven index level.

Best answer: A

What this tests: Derivatives: Trading, Hedging and Investment Strategies

Explanation: Buying the lower-strike call and selling the higher-strike call with the same expiry creates a bull call spread. The trader pays a net premium of 110 index points: 180 paid less 70 received. With a £10 multiplier, the maximum loss is therefore £1,100, occurring if the index finishes at or below 7,500. The maximum value of the spread is the 400-point difference between the strikes, so the maximum profit is 400 less the 110-point net premium, or 290 points. Multiplied by £10, that is £2,900. The breakeven level is the lower strike plus the net premium paid: 7,500 + 110 = 7,610. Gains are capped because the sold 7,900 call offsets further upside above that level.

• Treating the trade as a single long call ignores the premium received and the upside cap created by selling the higher-strike call.
• Calling it a bear call spread reverses the strategy; this position is entered for a moderate rise and is a net debit.
• Using only the 70-point premium received understates the net cost and gives the wrong breakeven and maximum profit.

The net debit is 110 points, the spread width is 400 points, and the short 7,900 call caps the upside.

Question 6

Topic: Derivatives: Trading, Hedging and Investment Strategies

A UK equity fund holds a large position in a listed share currently trading at 420p.

Portfolio objective:

• Keep the shares because a takeover approach is possible within the next three months.
• Limit the downside if a trading update disappoints the market.
• Retain upside participation if the bid emerges.
• The fund is willing to pay an upfront premium for defined protection.
• Exchange-traded three-month equity options on the share are available.

Which strategy best fits the objective?

• A. Sell equity futures against the full value of the shareholding.
• B. Buy three-month put options on the shares and retain the shareholding.
• C. Sell three-month call options on the shares and retain the shareholding.
• D. Buy three-month call options on the shares and retain the shareholding.

Best answer: B

What this tests: Derivatives: Trading, Hedging and Investment Strategies

Explanation: The stated objective is protection with continued upside participation. Buying puts against an existing long equity position is a protective put strategy: if the share price falls, the put gains value and provides a floor related to the strike price; if the takeover bid emerges and the share rises, the fund still owns the shares and can benefit from the increase, reduced by the premium paid. The willingness to pay an upfront premium supports this approach. The strategy does not generate income, but income is not the priority. It also avoids creating a hedge that would largely neutralise the desired upside exposure.

• Selling calls generates premium income, but it caps upside if the share rises after a takeover approach.
• Selling equity futures gives downside hedging, but it also largely offsets gains on the existing shares.
• Buying calls creates leveraged upside exposure, but it does not protect the current shareholding from a fall.

A protective put gives defined downside protection while allowing the fund to keep the shares and participate in upside above the premium cost.

Question 7

Topic: Derivatives: Trading, Hedging and Investment Strategies

A derivatives trader is hedging a long position in exchange-traded equity index call options with index futures.

Position and market move:

• Calls: strike 7,500, expiry in one week.
• At trade date: index at 7,460; call delta estimated at 0.46.
• Today: index at 7,535; implied volatility has risen; three trading days remain.
• The desk wants to know why the futures hedge should be recalculated rather than kept at the original delta.

Which is the single best explanation?

• A. Delta is a local hedge ratio for a nonlinear payoff; the index move changes moneyness, and volatility and remaining time change the probability distribution of expiry outcomes.
• B. Delta is fixed by the exchange contract specification, so only the number of futures changes when contracts are opened or closed.
• C. Delta will automatically fall towards zero as expiry approaches, regardless of whether the call is in or out of the money.
• D. Delta changes only because implied volatility has risen; the index level and time to expiry do not affect a call’s hedge ratio.

Best answer: A

What this tests: Derivatives: Trading, Hedging and Investment Strategies

Explanation: Delta is not a fixed term of an option contract. It is a model-derived sensitivity and hedge ratio that changes as the underlying price, volatility, and time to expiry change. When the index moves from below the strike to above it, the call becomes more in the money, so its delta would generally rise. A change in implied volatility alters the distribution of possible expiry prices, so it can also change delta. As expiry approaches, clearly in-the-money calls tend towards a delta of +1 and clearly out-of-the-money calls tend towards 0, while near-the-money options can have rapidly changing delta. The original 0.46 hedge ratio is therefore stale.

• Treating delta as an exchange contract specification confuses standardised contract terms with a changing valuation sensitivity.
• Attributing the change only to volatility ignores the effect of moneyness and the shortening time to expiry.
• Saying delta always falls to zero with time is wrong; an in-the-money call’s delta tends towards +1 as expiry nears.

The call’s hedge ratio changes because the payoff is nonlinear and delta depends on moneyness, implied volatility, and time to expiry.

Question 8

Topic: Derivatives: Trading, Hedging and Investment Strategies

A metals producer will sell 10,000 units in three months and is worried the cash price will fall. It enters a short futures hedge using 10 futures contracts of 1,000 units each.

Basis is defined as cash spot price minus futures price.

Ignoring commissions and margin interest, what is the effective sale price and what does it show about the hedge?

• A. £102.00 per unit; matching the contract size to the exposure removes both price risk and basis risk.
• B. £100.50 per unit; the basis narrowed from £2.00 to £0.50, leaving £1.50 per unit less than the opening cash price.
• C. £95.50 per unit; the hedge result is measured by the closing futures price rather than by cash proceeds plus futures profit or loss.
• D. £100.00 per unit; the initial futures price is fixed once the number of contracts exactly matches the cash exposure.

Best answer: B

What this tests: Derivatives: Trading, Hedging and Investment Strategies

Explanation: A short futures hedge offsets a fall in the cash price with a gain on the futures position. Here, the futures price falls from £100.00 to £95.50, so the short futures gain is £4.50 per unit. The producer sells the inventory for £96.00 per unit, giving an effective sale price of £100.50 per unit. The hedge did not lock in the opening cash price of £102.00 because the basis changed. The basis was £2.00 when the hedge opened and £0.50 when it closed. That £1.50 narrowing is the residual basis risk. Even with the directional exposure broadly offset and the contract size matched to the quantity sold, the cash and futures prices did not move by exactly the same amount.

• Matching the contract size reduces directional exposure, but it does not remove basis risk.
• Treating £100.00 as locked ignores the closing basis, which affects the final effective price.
• Using the closing futures price ignores the cash sale and the gain on the short futures position.

The cash sale at £96.00 plus the short futures gain of £4.50 gives an effective sale price of £100.50, with the residual difference caused by basis narrowing.

Question 9

Topic: Derivatives: Trading, Hedging and Investment Strategies

A derivatives trader is reviewing a hedge note for an equity holding. Which strategy is the best supported action?

• A. Sell a three-month straddle using at-the-money options.
• B. Write three-month call options with a strike above 520p.
• C. Write three-month put options with a strike near 480p.
• D. Buy three-month put options with a strike near 480p.

Best answer: D

What this tests: Derivatives: Trading, Hedging and Investment Strategies

Explanation: The objective is downside protection on an existing long share position while retaining upside. Buying put options creates a protective put: if the share price falls below the strike, the put gains value and offsets part of the loss on the shares. If the share price rises, the investor can still benefit from the shareholding, although the net return is reduced by the premium paid. This matches the stated willingness to pay a premium. Writing calls would generate income but cap upside. Writing puts increases downside exposure rather than protecting the existing holding. Selling a straddle is an income strategy that benefits from low realised volatility but creates significant risk if the price moves sharply.

• A covered call suits an income objective, but it gives up some upside above the call strike.
• A short put produces premium income, but it adds exposure to a falling share price.
• A short straddle is a volatility-income trade, not a hedge for a long equity position.

A long put protects the existing long share position below the strike while preserving upside participation, at the cost of the premium.

Question 10

Topic: Derivatives: Trading, Hedging and Investment Strategies

A trader reviews the following payoff note for a package consisting of one long European call, one short European put, and a risk-free bill. The call and put are on one ABC plc share, have the same £100 strike and expiry, and premiums, dividends, and transaction costs are ignored.

Which interpretation is best supported by the payoff note?

• A. The full package replicates a short position in one ABC plc share at expiry.
• B. The full package replicates a fixed £100 cash repayment at expiry.
• C. The full package replicates a long forward only, leaving no cash component.
• D. The full package replicates a long position in one ABC plc share at expiry.

Best answer: D

What this tests: Derivatives: Trading, Hedging and Investment Strategies

Explanation: A long call and a short put with the same strike and expiry create a synthetic long forward: the combined option payoff rises or falls with the underlying relative to the strike. Adding a risk-free bill that repays the strike amount at expiry completes the replication of the underlying share’s terminal value. Here, the total payoff is £80, £100, or £120 when the share is £80, £100, or £120, respectively. That is exactly the payoff pattern of holding one ABC plc share at expiry, ignoring dividends, premiums, and costs.

• The long forward interpretation describes the option package alone, not the full package once the bill repayment is included.
• A short share position would gain when the share price falls; the displayed total payoff increases with the share price.
• A fixed cash repayment would stay at £100 in every share-price outcome, but the total payoff varies with the share price.

The total payoff moves one-for-one with the ABC share price, matching the payoff from holding one share at expiry.

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