Free CISI CWM PCT Practice Questions: Portfolio Derivatives and Hedging

CISI means Chartered Institute for Securities & Investment. CWM means Chartered Wealth Manager, and this page is for the Portfolio Construction Theory paper. Use this focused CISI CWM Portfolio Construction page as a short practice test for Portfolio Derivatives 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: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

A UK discretionary portfolio uses equity-index futures only under an approved overlay policy.

Client and mandate:

• Moderate-risk client seeking long-term real growth in GBP.
• Strategic equity weight: 55%.
• Permitted effective equity range: 45% to 60% of portfolio value.

Current derivative review:

• Current physical global equity exposure before the overlay: 52%.
• A short global equity futures position, equivalent to 13% of portfolio value, was added to reduce equity risk before a planned business-sale cash reserve was established.
• The cash reserve has now been established and no further near-term liquidity risk is expected.
• The futures expire in 12 business days.
• Recent variation-margin calls have reduced the available collateral buffer to 3%; the overlay policy minimum is 5%.

Which action should the investment committee approve now?

• A. Increase the short futures notional so the established cash reserve is protected if global equities fall before the next review.
• B. Close or substantially reduce the short futures position now, restoring effective equity exposure to the permitted range and removing the collateral pressure.
• C. Roll the short futures at the same notional because the contract is close to expiry and the client remains a moderate-risk investor.
• D. Allow the futures to expire without action because the remaining term is short and the underlying physical portfolio is diversified.

Best answer: B

What this tests: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

Explanation: Derivative overlays should be monitored against the reason they were introduced, the portfolio’s agreed risk limits, expiry timing, and collateral or margin capacity. Here, the short futures hedge was linked to a temporary liquidity-related risk that has now been resolved. Keeping it creates an effective equity exposure of 39% (52% physical equity less 13% short futures), below the agreed 45% to 60% range. The collateral buffer is also below the policy minimum, so waiting for expiry is not prudent governance. The appropriate response is to close or reduce the overlay promptly, rather than roll it or maintain an unnecessary hedge.

• Rolling unchanged would continue a hedge whose original purpose has ended and would leave the portfolio outside its agreed exposure range.
• Waiting for expiry leaves 12 business days of underexposure and does not address the collateral-buffer breach.
• Increasing the short futures would move the portfolio further away from its strategic allocation and does not protect an already established cash reserve from equity risk.

The hedge purpose has ended, effective equity exposure is below the mandate range, and the collateral buffer has breached the policy minimum.

Question 2

Topic: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

A GBP-based family office plans to fund a £2 million property purchase in six months but does not want to sell its global equity portfolio today.

Case extract:

• Current global equity holding: £2.1 million, benchmarked to a broad developed-market equity index.
• Main concern: a sharp equity-market fall before the purchase date.
• Proposed overlay: either sell equity index futures for six months or buy six-month index put options.
• Liquidity policy: derivatives may be used only where the committee understands collateral, margin, and premium effects.

“If the hedge protects the portfolio value, why would we not hedge the whole exposure immediately?”

Which response best explains the portfolio-construction trade-off?

• A. A futures hedge can offset losses if equities fall, but it can also offset gains if equities rise; an option hedge can retain more upside, but the premium is an explicit cost.
• B. The hedge is unnecessary because diversification across developed-market equities removes the risk of a short-term market fall.
• C. The hedge should be judged only against the equity benchmark because the property purchase is outside the investment portfolio.
• D. The hedge should increase expected return because it adds a second source of performance without changing the portfolio’s equity exposure.

Best answer: A

What this tests: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

Explanation: A hedge is designed to reduce the effect of a specified adverse movement, not to create cost-free protection. A short equity futures position can gain when the equity portfolio falls, helping to preserve value for the planned property purchase. However, if markets rise, losses on the futures can offset some or all of the portfolio’s gains, so upside participation is reduced. A put option can provide downside protection while allowing more participation in a rising market, but the option premium reduces return and may be lost if the option expires out of the money. Collateral, margin calls, liquidity, and implementation costs also matter. The right hedge size depends on the client’s cash-flow need, risk capacity, and willingness to trade upside for greater certainty.

• Treating the hedge as an added return source misunderstands its purpose; it changes the risk exposure rather than creating free performance.
• Diversification does not remove broad equity-market risk, especially over a short six-month horizon.
• Benchmark-relative assessment is incomplete because the client’s known cash need is a central portfolio objective.

The hedge reduces exposure to the adverse market move, but futures give up favourable participation and options require a premium for asymmetric protection.

Question 3

Topic: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

A wealth manager is reviewing inflation protection for a UK retired couple whose portfolio funds most of their spending.

Client circumstances:

• Portfolio value: £1.8 million, GBP base currency.
• Required withdrawals: £55,000 a year, intended to rise with UK CPI for at least 25 years.
• Capacity for loss is limited in the first decade of retirement.
• The clients prefer transparent holdings and want to avoid forced sales to meet collateral calls.

Current positioning and proposal:

• Current portfolio: high allocation to nominal sterling bonds and cash, with only a small allocation to index-linked gilts and real assets.
• Reference portfolio: materially higher allocation to index-linked gilts, infrastructure, and long-lease property.
• Overlay proposed: a 7-year RPI inflation swap using cash or gilts as collateral.
• Stress note: a fall in expected inflation could require a £55,000 collateral top-up within two business days.

Manager note: “The inflation risk is a permanent feature of the spending objective, not a temporary mismatch.”

Which action is most appropriate?

• A. Implement the RPI swap overlay because it provides inflation exposure without changing the current portfolio holdings.
• B. Use commodity futures as the main inflation hedge because they can respond quickly to inflation surprises.
• C. Rebalance the strategic allocation towards index-linked gilts and diversified real assets rather than implement the swap overlay.
• D. Keep the asset allocation unchanged and rely on active nominal bond managers to adjust duration as inflation expectations change.

Best answer: C

What this tests: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

Explanation: Inflation protection should usually come from asset allocation when the inflation exposure is long term, recurring, and embedded in the client’s objectives. Here, the withdrawals are intended to rise with inflation over a 25-year retirement horizon, so the issue is strategic rather than a short-term hedge. Index-linked gilts and diversified real assets can be built into the reference portfolio and reviewed through normal rebalancing. A derivative overlay may be useful for a specific temporary mismatch or where the client can support collateral, margin, liquidity, and counterparty risks. Those conditions are weak here: the proposed swap is shorter than the liability horizon and could create a collateral call that conflicts with the clients’ liquidity and forced-sale constraints.

• The RPI swap preserves current holdings, but it adds collateral and liquidity risk and does not match the permanent nature of the inflation exposure.
• Commodity futures may react to some inflation shocks, but they are volatile, collateral-intensive, and an imprecise hedge for CPI-linked retirement spending.
• Active nominal bond management addresses interest-rate and credit positioning, not a reliable structural hedge against real spending erosion.

The clients have a long-term structural inflation-linked spending need and limited capacity to manage collateral calls, so inflation protection is better embedded in asset allocation.

Question 4

Topic: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

A discretionary manager is considering a three-month short equity-index futures overlay for a sterling-based charity. The investment committee wants to know whether the overlay genuinely reduces risk or mainly moves it elsewhere.

Current portfolio and proposed hedge:

Assume posted initial margin cannot be used to meet variation margin. Use:

• residual beta = portfolio beta − (futures notional ÷ portfolio value) × futures beta
• variation margin loss on short futures = futures notional × market rise

Which conclusion best describes the proposed hedge?

• A. It reduces equity beta risk from 0.85 to 0.10, but it introduces margin-liquidity risk because a £270,000 variation loss exceeds the £210,000 cash left after initial margin.
• B. It eliminates equity-market risk because the short futures cover 75% of the portfolio, leaving only cash-management risk.
• C. It merely changes the source of risk without reducing market exposure because the futures notional is smaller than the portfolio value.
• D. It increases equity-market beta to 1.60 because the portfolio beta and futures notional ratio should be added together.

Best answer: A

What this tests: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

Explanation: A hedge should be assessed by the risk exposure it offsets and by the new risks it creates. Here, the short futures position reduces the portfolio’s beta exposure by 0.75, calculated as £9,000,000 ÷ £12,000,000 × 1.00. Residual beta is therefore 0.85 − 0.75 = 0.10, so the overlay materially reduces equity market risk. However, futures are marked to market, so a 3% market rise creates a variation margin loss of £9,000,000 × 3% = £270,000. After posting £540,000 initial margin, only £210,000 of the original cash reserve remains. The hedge has not removed risk; it has reduced one source of risk while adding a cashflow and liquidity risk that must be managed.

• Treating 75% notional coverage as full protection ignores the portfolio beta, residual exposure, basis risk, and stock-specific risk.
• Adding the futures exposure to beta uses the wrong sign for a short hedge; the position is intended to offset market exposure.
• Saying there is no market-risk reduction ignores the residual beta calculation, which shows a substantial reduction from 0.85 to 0.10.

The short futures reduce residual market beta to 0.10, while the margin stress shows a new liquidity exposure from daily cash settlement.

Question 5

Topic: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

A wealth manager runs a £12 million discretionary portfolio for a UK family trust.

Mandate and powers:

• Balanced mandate benchmarked to 55% global equities, 35% investment-grade bonds, and 10% cash.
• Client risk profile is medium, with no borrowing or gearing permitted.
• £900,000 must remain available for a property purchase in four months.
• Derivatives are permitted only if exchange-traded and used for hedging or efficient portfolio management.
• Uncovered written options and OTC derivatives are prohibited.
• Responsible-investment exclusions prohibit new economic exposure to thermal coal producers.

Current issue: Equity allocation is close to target, but the investment committee is concerned about a short-term equity market fall before the liquidity event. There is sufficient non-earmarked cash to pay an option premium without reducing the property reserve.

Which derivative action is the single best fit with the portfolio mandate and investment powers?

• A. Enter an OTC total return swap on a basket of thermal coal equities as an inflation hedge.
• B. Sell uncovered index call options to generate premium income for the property purchase reserve.
• C. Increase developed-market equity exposure by buying equity index futures, lifting total equity exposure materially above the strategic allocation.
• D. Buy exchange-traded equity index put options sized to hedge part of the current equity exposure, with the premium paid from non-earmarked cash.

Best answer: D

What this tests: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

Explanation: Derivative use must be authorised by the mandate and investment powers before expected return or market view is considered. Here, derivatives are allowed only when exchange-traded and used for hedging or efficient portfolio management. The client has a medium risk profile, no gearing permission, a near-term liquidity need, and a responsible-investment exclusion. Buying exchange-traded equity index puts sized against existing equity exposure is consistent with those constraints: the purpose is downside protection, maximum loss is the premium, and the property reserve remains intact. By contrast, using futures to increase equity exposure would be a geared tactical risk position. Uncovered option writing is expressly prohibited and may create material obligations. An OTC coal equity swap breaches both the derivative power and the responsible-investment restriction.

• Buying equity futures fails because it increases risk and equity exposure above the strategic allocation rather than hedging existing exposure.
• Selling uncovered calls may raise premium income, but it breaches the prohibition on uncovered written options.
• The OTC coal swap fails the permitted-instrument rule and creates prohibited responsible-investment exposure.

A purchased listed put is a protective hedge of existing exposure, does not create gearing, and uses surplus cash without affecting the liquidity reserve.

Question 6

Topic: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

A UK wealth manager reviews a sterling-based client’s portfolio before a planned property purchase in 10 months.

Key facts:

• The client has low capacity for a short-term loss because £250,000 will be needed in cash for the purchase.
• The portfolio remains above its long-term strategic equity allocation after a strong rally.
• Selling the equity funds immediately would create transaction costs and crystallise taxable gains.
• The manager sells equity index futures against part of the portfolio’s equity exposure and holds cash collateral for margin.

Which portfolio risk is the derivative overlay primarily intended to control?

• A. Sterling cash-flow risk caused by uncertainty over the property purchase price
• B. Short-term systematic equity market risk from the portfolio’s excess equity beta
• C. Stock-specific risk arising from individual company selection within the equity funds
• D. Counterparty default risk created by the client’s underlying collective funds

Best answer: B

What this tests: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

Explanation: An equity index futures overlay is normally used at portfolio level to adjust market exposure quickly and efficiently. Here, the client has a near-term liquidity need and low capacity for a short-term drawdown, while the portfolio is temporarily overweight equities. Selling index futures reduces exposure to broad equity market movements, often described as systematic risk or beta risk, without requiring an immediate sale of the underlying funds. It does not remove all portfolio risk, and it introduces overlay risks such as margin and collateral management, but the intended control is the portfolio’s sensitivity to a general equity market fall.

• Stock-specific risk is not the main target because an index future hedges broad market exposure, not individual security selection inside the funds.
• The property purchase creates a liquidity need, but selling equity futures does not fix uncertainty in the house price itself.
• Counterparty default risk may be relevant to derivative implementation, but it is not the underlying portfolio risk the hedge is designed to reduce.

Selling equity index futures reduces the portfolio’s market beta and limits exposure to a broad equity market fall without immediately selling the underlying funds.

Question 7

Topic: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

A wealth manager is reviewing a proposed six-month hedge for a UK charity portfolio.

Portfolio facts:

• Base currency is sterling and the portfolio value is £42 million.
• The strategic allocation includes 28% in global small-cap and emerging-market equities, selected partly for responsible-investment exclusions.
• The charity expects a £6 million grant payment in nine months and has low tolerance for a drawdown that would force equity sales.
• A risk model suggests a near-perfect hedge using a short derivative on the portfolio’s custom equity basket.
• In practice, only broad developed-market index futures are liquid in the required size; the closer OTC basket hedge has wide spreads, limited counterparties, and restrictive collateral terms.

What is the single best conclusion for the investment committee?

• A. The theoretically precise hedge may be unsuitable in practice; use a liquid proxy or partial hedge, and document the basis risk, liquidity risk, cost, and collateral implications.
• B. The custom OTC hedge should be executed because matching the portfolio basket is more important than liquidity, spreads, or collateral terms.
• C. The broad index futures hedge will eliminate the portfolio’s equity risk if the number of contracts is beta-adjusted correctly.
• D. The committee should avoid hedging until a liquid custom derivative becomes available, because any proxy hedge would be unacceptable.

Best answer: A

What this tests: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

Explanation: A theoretically correct hedge assumes that a suitable derivative exists, can be traded in the required size, and can be adjusted or closed without excessive cost. Here, the model’s preferred derivative tracks the custom equity basket closely, but the practical market for that hedge is weak: wide spreads, few counterparties, and restrictive collateral terms create execution, valuation, counterparty, and liquidity concerns. Liquid broad-market futures may reduce part of the equity exposure, but they introduce basis risk because the portfolio includes global small-cap, emerging-market, and responsible-investment exclusions. The committee should therefore treat the hedge as a governance decision, not just a model output: choose an executable hedge or physical risk reduction, quantify residual exposures, and monitor collateral and liquidity demands.

• Prioritising the custom OTC hedge ignores the decisive liquidity, spread, counterparty, and collateral constraints.
• A beta-adjusted broad-index futures position can reduce market sensitivity, but it cannot eliminate risk when the underlying exposures differ.
• Refusing any proxy hedge may leave the charity exposed despite a known liquidity need and low drawdown tolerance.

Derivative availability and market liquidity can make a modelled exact hedge impractical, so governance should focus on executable risk reduction and residual-risk monitoring.

Question 8

Topic: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

A UK-based family endowment funds annual grants in sterling and wants to keep its long-term strategic asset allocation unchanged.

Case extract:

• Portfolio: 55% global equities, 25% bonds, 10% property, 10% cash.
• Overseas assets: mostly USD, EUR, and JPY exposure; currently unhedged.
• Risk report: a sterling appreciation would materially reduce the GBP value of the overseas holdings.
• Benchmark: the policy benchmark hedges 50% of developed-market currency exposure back to sterling.
• Fund-manager review: stock selection and tracking error are within agreed ranges.
• Proposed overlay: use rolling forward foreign exchange contracts to hedge about half of the main overseas currency exposures, funded from the existing cash collateral reserve.

Which portfolio risk is the proposed derivative overlay primarily intended to control?

• A. Foreign-currency translation risk and benchmark-relative currency mismatch for a sterling-based portfolio
• B. Strategic asset allocation risk from holding too much global equity exposure
• C. Property liquidity risk caused by the 10% allocation to real assets
• D. Stock-specific risk arising from poor security selection by the equity managers

Best answer: A

What this tests: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

Explanation: A derivative overlay is often used to adjust a portfolio-level exposure without selling the underlying holdings. Here, the endowment’s spending needs and reporting currency are sterling, while much of the portfolio is exposed to USD, EUR, and JPY movements. Rolling FX forwards would reduce the effect of exchange-rate movements on the sterling value of overseas holdings and reduce mismatch against a benchmark that is partly currency hedged. The overlay is not designed to improve manager skill, sell illiquid assets, or change the strategic mix. It changes the currency exposure layered on top of the existing portfolio.

• Stock-specific risk is not the main issue because the fund-manager review says stock selection and tracking error are within agreed ranges.
• Property liquidity risk is unrelated to an FX forward overlay and is driven by the nature and allocation of the real-asset holdings.
• Strategic asset allocation risk would be addressed by changing target weights, not by hedging overseas currencies while keeping the asset mix unchanged.

Rolling FX forwards hedge part of the overseas currency exposure back to sterling without changing the underlying asset allocation.

Question 9

Topic: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

A UK discretionary portfolio has a strategic allocation to global equities and reports risk in sterling.

Review notes:

• The client has moderate risk tolerance and a £900,000 cash reserve for annual withdrawals.
• The portfolio has 28% exposure to US equities, all currently unhedged into GBP.
• The benchmark hedges 50% of developed-market currency exposure.
• The proposed overlay is to sell USD forward quarterly, hedging 100% of the US equity currency exposure.
• The risk report estimates annualised GBP volatility would fall from 10.1% to 9.6%, but a USD rally could create short-term collateral calls of up to £1.3 million.

Which is the single best conclusion for the committee?

• A. The hedge eliminates the portfolio’s US equity risk because the USD exposure is fully hedged into sterling.
• B. The hedge reduces sterling currency volatility, but it also introduces liquidity, collateral, roll and benchmark-relative risks that must be assessed against the client’s objectives.
• C. The hedge should be rejected because derivatives can only add risk and cannot reduce total portfolio volatility.
• D. The hedge is automatically suitable because the estimated portfolio volatility falls after the currency overlay is added.

Best answer: B

What this tests: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

Explanation: A hedge should be judged by the client’s relevant risk objective, not by the label “hedged” alone. In this case, selling USD forward can reduce sterling currency volatility from the US equity allocation. However, it does not remove the underlying US equity market risk, and it creates other exposures: collateral calls, cash-management pressure, roll risk, counterparty exposure and tracking error versus a benchmark that only hedges 50% of the currency exposure. The estimated volatility reduction is relevant, but it is not sufficient when a plausible collateral call exceeds the client’s cash reserve. A partial hedge or different hedge ratio may reduce the desired risk while staying within liquidity and benchmark-risk constraints.

• Treating the lower volatility estimate as decisive ignores collateral liquidity and benchmark-relative risk.
• Saying derivatives can only add risk is too absolute; derivative overlays can reduce specific portfolio risks when properly sized and controlled.
• A currency hedge does not eliminate US equity market risk; it mainly changes the currency component of the return and risk profile.

The proposed hedge lowers one measured source of risk but replaces part of it with operational, liquidity and tracking-risk exposures that may be unsuitable given the cash reserve.

Question 10

Topic: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

A UK wealth manager oversees a £24 million UK equity sleeve. The investment committee wants to reduce broad equity market exposure for the next two months without selling the underlying shares.

Overlay facts:

• Current portfolio beta to the FTSE 100: 1.20
• Target beta during the overlay period: 0.80
• FTSE 100 futures price: 6,000
• Futures contract multiplier: £10 per index point
• Treat the futures beta as 1.0 and ignore basis risk, tax, and transaction costs.

Which derivative overlay is most consistent with the risk-control objective?

• A. Buy £9.6 million notional of FTSE 100 call options.
• B. Sell 160 FTSE 100 futures contracts.
• C. Buy 160 FTSE 100 futures contracts.
• D. Sell 320 FTSE 100 futures contracts.

Best answer: B

What this tests: Portfolio-Level Derivatives, Hedging, Collateral, Margin, and Risk Control

Explanation: A futures overlay can adjust market beta without selling the underlying portfolio. The portfolio needs a beta reduction of 0.40, from 1.20 to 0.80. The beta-adjusted exposure to remove is £24,000,000 × 0.40 = £9,600,000. Each futures contract has a notional value of 6,000 × £10 = £60,000. The required number of contracts is £9,600,000 ÷ £60,000 = 160. Because the objective is to reduce equity market exposure, the manager should sell, not buy, the futures. This creates a short index exposure that offsets part of the portfolio’s broad market sensitivity while leaving the physical holdings in place.

• Buying futures would increase equity market exposure rather than reduce it.
• Selling 320 contracts uses the target beta as the amount to hedge, which would reduce exposure too far.
• Buying call options gives additional upside exposure and does not implement the stated beta-reduction overlay.

Selling 160 contracts removes £9.6 million of beta-adjusted exposure, reducing the portfolio beta from 1.20 to about 0.80.

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