Free CISI IAD Derivatives Practice Questions: Introduction to Derivatives

CISI means Chartered Institute for Securities & Investment. IAD means Investment Advice Diploma, and this page is for the Derivatives unit. Use this focused CISI IAD Derivatives page as a short practice test for 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: Introduction to Derivatives

An adviser explains a six-month exchange-traded call option on ABC shares. One contract gives the buyer the right to buy 1,000 shares at £10 per share at expiry. The premium is £0.40 per share, paid upfront. The investor is considering buying one contract; the market maker that sells it will be short the call. Which statement best applies the option payoff principle?

• A. The buyer must buy at £10 at expiry; if the market price is lower, the writer may choose not to trade.
• B. The buyer has the right, not the obligation, to buy at £10; if exercised, the writer must deliver, and the buyer’s maximum loss is the premium.
• C. Both sides have the same open-ended risk because the premium converts the option into a geared forward.
• D. The writer has the right to require exercise above £10; the buyer must accept any loss above the strike.

Best answer: B

What this tests: Introduction to Derivatives

Explanation: A call option has an asymmetric payoff. The long call holder pays a premium for a right, not an obligation, to buy the underlying at the strike price. If ABC is above £10 at expiry, exercising can be valuable. If ABC is at or below £10, the buyer can let the option lapse and the loss is limited to the premium paid. The short call writer receives the premium but takes on the obligation to perform if the holder exercises. For a call over shares, the writer’s loss can grow as the share price rises because delivery at £10 becomes increasingly disadvantageous. This differs from a forward or futures contract, where both parties normally have binding obligations and broadly symmetric price exposure.

• Treating the buyer as obliged to buy confuses an option with a forward or futures contract.
• Giving the writer the exercise right reverses the basic buyer-writer relationship.
• Describing equal open-ended risk ignores the premium-limited downside of the long option holder and the obligation of the writer.

A long call gives the buyer an exercise right, while the short call writer has the corresponding obligation if the option is exercised.

Question 2

Topic: Introduction to Derivatives

A UK portfolio manager holds a £30 million equity portfolio that closely tracks the FTSE 100. The manager wants to reduce broad market exposure for the next two months without selling the shares, and accepts that the hedge may not be perfect. Which action best applies the derivative principle of offsetting exposure?

• A. Enter a forward contract to buy US dollars against sterling in two months.
• B. Buy FTSE 100 index futures with a notional value broadly matched to the portfolio exposure.
• C. Sell FTSE 100 index futures with a notional value broadly matched to the portfolio exposure.
• D. Buy a commodity futures contract with a notional value broadly matched to the portfolio exposure.

Best answer: C

What this tests: Introduction to Derivatives

Explanation: Derivatives can transform risk by creating an exposure that is different from, or opposite to, an investor’s existing position. A portfolio that closely tracks the FTSE 100 has positive exposure to that index: it generally gains when the index rises and loses when it falls. Selling FTSE 100 index futures creates a short index exposure. If the index falls, the short futures position should gain, helping to offset losses on the equity portfolio. The hedge is not guaranteed to be exact because the portfolio may not move perfectly in line with the futures contract, which is a form of basis risk.

• Buying FTSE 100 futures would add more positive equity market exposure rather than reduce it.
• Buying US dollars forward addresses currency exposure, not the UK equity index exposure described.
• Buying commodity futures creates commodity price exposure and does not directly offset FTSE 100 market risk.

A short index futures position creates negative equity index exposure that should partly offset losses on the long equity portfolio if the market falls.

Question 3

Topic: Introduction to Derivatives

A cash-settled equity index call option has the following terms:

Client A buys one contract and Client B writes one identical contract. Overall results include the premium and ignore commission and funding. Which statement is correct?

• A. Client A is obliged to exercise and makes a net profit of £600; Client B has the right to let the option lapse and makes a net loss of £600.
• B. Client A has the right to exercise and makes a net profit of £1,500; Client B is obliged if assigned and makes a net loss of £1,500.
• C. Client A has unlimited downside risk; Client B’s maximum loss is limited to the £900 premium received.
• D. Client A has the right to exercise and makes a net profit of £600; Client B is obliged if assigned and makes a net loss of £600.

Best answer: D

What this tests: Introduction to Derivatives

Explanation: A long call gives the buyer a right, not an obligation. A short call writer receives the premium but must meet the exercise or cash-settlement obligation if the option is exercised or assigned. Here the call is in the money by 150 index points. With a £10 multiplier, the settlement value is £1,500. The buyer paid 90 points, or £900, so the net profit is £600. The writer received the £900 premium but pays the £1,500 settlement amount, giving a net loss of £600. This illustrates the asymmetry of options: the buyer’s maximum loss is the premium paid, while the writer’s potential loss can exceed the premium received.

• Treating the buyer as obliged to exercise reverses the basic legal position of an option contract.
• Using £1,500 as the profit ignores the £900 premium paid by the buyer and received by the writer.
• Saying the buyer has unlimited downside and the writer’s loss is capped reverses the usual payoff asymmetry for a long and short call.

The call finishes 150 points in the money, so the £1,500 settlement value less the £900 premium gives the buyer a £600 profit and the writer a matching £600 loss.

Question 4

Topic: Introduction to Derivatives

A private client holds a diversified UK equity portfolio and wants to reduce exposure for three months without selling the shares. The adviser is considering a short FTSE 100 index futures position. The futures contract is exchange-traded and centrally cleared; the client must post initial margin and meet daily variation margin calls. The portfolio is not identical to the FTSE 100, and the client has limited spare cash and little derivatives experience.

Which statement best applies the risk transformation principle?

• A. The futures hedge may reduce broad equity market exposure, but it introduces basis risk, margin-liquidity risk, operational demands, and client-understanding risk.
• B. Because the client pays only margin rather than the full contract value, the position is not leveraged and losses cannot exceed the initial margin.
• C. Central clearing removes counterparty, liquidity, and operational risk, so the client’s only remaining risk is share-specific performance.
• D. Using an index future eliminates all market risk in the share portfolio until expiry, provided the contract maturity matches the intended hedge period.

Best answer: A

What this tests: Introduction to Derivatives

Explanation: Derivatives often change the type and timing of risk rather than removing it. A short index future can offset some broad equity market falls, but the hedge will not be exact if the client’s portfolio differs from the index. That creates basis risk. The exchange-traded and centrally cleared structure reduces bilateral counterparty exposure compared with an uncleared OTC trade, but it brings daily margining and the need for cash to meet variation margin calls. There are also operational risks, such as monitoring the position, handling expiry or rollover, and ensuring the trade remains suitable. Because the client has little derivatives experience, understanding risk is also important; leverage can produce losses large relative to the initial margin posted.

• Central clearing reduces some counterparty risk, but it does not remove liquidity needs, operational duties, or suitability concerns.
• Margin is not the maximum loss on a futures position; it is collateral for a leveraged exposure.
• Matching the hedge period does not remove basis risk or share-specific risk when the portfolio is not identical to the index.

A derivative hedge can transform rather than eliminate risk, especially where the hedge is imperfect and margin calls require cash and monitoring.

Question 5

Topic: Introduction to Derivatives

An adviser is checking liquidity before recommending an exchange-traded index put to hedge a client’s equity portfolio for about three months. Two put series on the same exchange have the required expiry and similar moneyness:

• 5,900 strike put: today’s volume 1,200 contracts; open interest 8,500 contracts; bid-offer spread 3 ticks.
• 6,100 strike put: today’s volume 2,000 contracts, including one large trade; open interest 120 contracts; bid-offer spread 12 ticks.

Which interpretation is the single best guide to the liquidity comparison?

• A. Volume is the number of contracts still open after trading, while open interest is the number of contracts traded during the day.
• B. The 6,100 strike is clearly more liquid because today’s higher volume proves more contracts will be available to close before expiry.
• C. Volume shows contracts traded during the period, while open interest shows outstanding contracts, so the 5,900 strike has stronger evidence of continuing market depth.
• D. Open interest measures the clearing house’s margin support, so the 5,900 strike is less relevant than the contract with the highest daily turnover.

Best answer: C

What this tests: Introduction to Derivatives

Explanation: For exchange-traded derivatives, volume and open interest measure different things. Volume is the number of contracts traded over a stated period, commonly the day. Open interest is the number of contracts that remain outstanding and have not been closed out, exercised, expired, or otherwise terminated. A single large trade can make daily volume look high without proving that many participants continue to support trading in that series. In this case, the 5,900 strike has lower daily volume than the 6,100 strike, but it has much higher open interest and a tighter bid-offer spread. That combination is better evidence that the client may be able to enter and later close the hedge with less execution difficulty.

• Higher one-day volume can be useful, but it does not by itself prove deeper ongoing liquidity, especially when driven by one large trade.
• Open interest is not a clearing-house margin measure; it reflects outstanding contracts in that series.
• Reversing the meanings of volume and open interest leads to the wrong liquidity assessment.

The higher open interest and tighter spread indicate a larger outstanding market, despite the lower one-day trading volume.

Question 6

Topic: Introduction to Derivatives

A UK importer has a confirmed invoice for €2 million payable in three months. The finance director wants certainty over the sterling cost and is willing to give up any benefit if sterling strengthens before the payment date. A dealer proposes a three-month forward contract to buy €2 million against sterling. Which derivative purpose is most consistent with this transaction?

• A. Arbitraging a price difference between two exchange-traded euro futures contracts
• B. Speculating on a short-term strengthening of sterling against the euro
• C. Creating geared exposure to increase profit from euro volatility
• D. Hedging the euro payable by locking in the future sterling cost

Best answer: D

What this tests: Introduction to Derivatives

Explanation: A derivative used to reduce or transfer an existing exposure is being used for hedging. The importer already has a euro liability, so sterling weakness would make the invoice more expensive in sterling terms. Buying euros forward fixes the exchange rate for the future payment and gives budget certainty. The transaction is not mainly intended to profit from a market view, exploit a pricing anomaly, or create leveraged trading exposure. The client also accepts the main trade-off of a forward hedge: if sterling strengthens, the importer will not benefit from the more favourable spot rate because the forward rate has been locked in.

• Speculation would involve taking a market view for profit rather than covering a confirmed business payable.
• Arbitrage would require exploiting a pricing discrepancy between related instruments, which is not described.
• Geared exposure is inconsistent with the stated objective of reducing uncertainty rather than increasing risk.

The forward matches the known euro liability and transfers the risk of an adverse exchange-rate move.

Question 7

Topic: Introduction to Derivatives

A UK importer wants to hedge a foreign-currency payment due in seven and a half months for an amount that does not match a standard futures contract size. Its adviser is comparing an exchange-traded currency future with quarterly expiries against an OTC forward offered by a bank. Which assessment best applies the main product differences?

• A. The OTC forward is normally more transparent and more liquid because its terms are negotiated directly with a bank, while the future is less transparent because it trades on an exchange.
• B. The OTC forward can be tailored to the exact amount and date, but it is typically less transparent and less liquid, with bilateral counterparty exposure; the future is standardised, exchange-priced, centrally margined and normally more liquid.
• C. The OTC forward removes counterparty exposure through daily exchange margining, while the future creates bilateral counterparty exposure until maturity.
• D. The future can be tailored to the exact amount and broken-date maturity, while the OTC forward must use standard quarterly expiries and contract sizes.

Best answer: B

What this tests: Introduction to Derivatives

Explanation: Exchange-traded derivatives are generally standardised by contract size, expiry, underlying and settlement terms. That standardisation tends to support visible pricing, secondary-market liquidity and central clearing, with initial and variation margin reducing bilateral counterparty exposure. The trade-off is that the hedge may not exactly match the client’s amount or maturity, creating residual exposure or basis risk. OTC derivatives are negotiated directly between counterparties, so they can be designed around a broken date, unusual notional amount or specific cash-flow need. The trade-off is usually lower price transparency, less secondary-market liquidity and greater bilateral counterparty exposure, although collateral and documentation may reduce that risk.

• Negotiated bank terms do not automatically make an OTC derivative more transparent or more liquid than an exchange-traded contract.
• Exchange-traded futures use standard contract specifications, so they do not normally provide exact broken-date and notional tailoring.
• Daily exchange margining and central clearing are features of futures, not ordinary bilateral OTC forwards.

The facts favour an OTC contract for precise hedge tailoring, while the exchange-traded future offers standardisation, transparency, margining and central clearing.

Question 8

Topic: Introduction to Derivatives

An adviser is assessing derivative suitability for a private client. The client holds a £600,000 UK equity tracker that they do not wish to sell, wants protection against a market fall over the next four months while retaining long-term equity exposure, has limited derivative experience, can afford a one-off premium from surplus cash, but cannot meet unpredictable margin calls because £70,000 is needed for a house deposit in two months. Which is the single best suitability conclusion?

• A. Sell uncovered index calls because the premium income improves liquidity and the client already owns equities.
• B. Use a leveraged long index CFD because it preserves equity market exposure without selling the tracker.
• C. Use a short index future for the full portfolio value because it avoids paying a premium and gives immediate downside protection.
• D. Consider a bought index put sized to the portfolio and protection period, provided the client understands the premium, payoff and expiry.

Best answer: D

What this tests: Introduction to Derivatives

Explanation: Derivative suitability depends on matching the product to the client’s objective, existing exposure, risk capacity, liquidity position, leverage tolerance and understanding. Here, the objective is short-term downside protection on a UK equity holding without selling the long-term investment. The client can afford a known premium but cannot meet uncertain margin calls. A bought put or put-based protection strategy is therefore the most suitable route to consider, subject to clear explanation of premium loss, expiry and payoff. It transforms the risk by setting protection against market falls while leaving the client invested. Strategies that create daily margin calls, add leverage, or pursue income rather than protection do not fit the client’s liquidity constraint or objective.

• A short index future can hedge market falls, but daily variation margin creates liquidity risk and may remove upside during the hedge period.
• Selling uncovered calls seeks income rather than downside protection and can create leveraged loss exposure if the market rises.
• A leveraged long CFD increases equity exposure, which conflicts with the protection objective and the client’s limited capacity for margin calls.

A bought put aligns with the hedge objective and exposure while limiting the cash risk to a known premium rather than margin calls.

Question 9

Topic: Introduction to Derivatives

An adviser is reviewing whether a retail client understands the risk effect of using an exchange-traded equity index future instead of buying £6,000 of an index tracker. The proposed future has these terms:

• Index level at trade: 7,500
• Futures multiplier: £10 per index point
• Initial margin to open one contract: £6,000
• The contract is centrally cleared and marked to market daily in cash
• A one-day adverse move of 4% is being stress-tested

Using these figures, which risk assessment is most accurate?

• A. The future creates about £75,000 of exposure, but central clearing means counterparty, liquidity, operational, legal, and understanding risks can be treated as negligible.
• B. The future creates only £6,000 of market exposure; a 4% adverse move would be about £240, so the client’s losses and liquidity needs are broadly capped by the margin paid.
• C. The future creates £6,000 of exposure until expiry and then converts into about £75,000 of exposure only if physical delivery occurs.
• D. The future creates about £75,000 of market exposure; a 4% adverse move would be about £3,000 of cash variation margin, so leverage, liquidity-call, operational, legal, and understanding risks need review, while central clearing reduces bilateral counterparty risk.

Best answer: D

What this tests: Introduction to Derivatives

Explanation: A derivative can transform risk rather than simply reduce it. Here, the initial margin is not the amount of market exposure. One futures contract gives exposure of \(7,500 \times £10 = £75,000\). A 4% adverse move is therefore \(£75,000 \times 4\% = £3,000\), settled through daily variation margin. The client has used a relatively small cash outlay to control a much larger position, so market risk and short-term liquidity risk are amplified compared with a £6,000 tracker purchase. Central clearing reduces bilateral counterparty exposure, but it does not remove the need to understand margin calls, broker close-out rights, daily settlement, expiry, and contract documentation. These features create operational, legal, and client-understanding risks that must be assessed before the position is suitable.

• Treating initial margin as the amount at risk ignores the contract notional and daily variation margin.
• Central clearing mitigates bilateral counterparty exposure, but it does not remove market losses, margin calls, or documentation risk.
• Exposure does not arise only at delivery; futures positions are marked to market throughout their life.

The notional exposure is \(7,500 \times £10 = £75,000\), so a 4% adverse move is about £3,000 and creates cash-margin, contractual, operational, and understanding issues despite central clearing.

Question 10

Topic: Introduction to Derivatives

A UK manufacturer has agreed to pay a US supplier $2 million in six months. Its accounts are in sterling, and the finance director is worried that sterling may weaken against the dollar before payment is due. The company wants to fix the sterling cost of the invoice and does not want to pay an option premium. Which action is the single best way to offset the exposure?

• A. Enter a six-month forward contract to sell $2 million and buy sterling.
• B. Buy a six-month sterling call option against dollars for a premium.
• C. Enter a six-month forward contract to buy $2 million and sell sterling.
• D. Sell short a sterling interest rate future expiring in six months.

Best answer: C

What this tests: Introduction to Derivatives

Explanation: A derivative offsets an exposure when its payoff or delivery obligation moves in the opposite direction to the risk being hedged. The manufacturer will need dollars in six months, so its risk is that dollars become more expensive in sterling terms. A forward contract to buy dollars and sell sterling creates a matching long dollar position at the payment date. This transforms an uncertain future sterling cost into a fixed sterling cost, assuming the forward is for the invoice amount and maturity. The stated preference not to pay an option premium also points to a forward rather than an option-based hedge.

• Selling dollars forward would add to the problem, because the company already needs to obtain dollars for the invoice.
• A sterling call against dollars benefits from sterling strength and also involves a premium, so it does not meet the stated hedge objective.
• A sterling interest rate future changes exposure to interest rates, not to the dollar/sterling exchange rate on the supplier payment.

Buying dollars forward matches the dollar payable and fixes the sterling cost at the six-month payment date.

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