Free CISI IAD Derivatives Practice Questions: Investment Selection and Administration

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 Investment Selection and Administration. 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: Investment Selection and Administration

A retired client holds £500,000 in a FTSE 100 tracker as a long-term investment. They are concerned about a possible market fall over the next three months but do not want to sell the holding. They have a low-to-medium risk profile, want to keep most upside participation, and will not accept margin calls or losses beyond a known initial cash outlay. Which strategy is the single best recommendation?

• A. Sell FTSE 100 futures with a notional amount close to £500,000.
• B. Buy three-month FTSE 100 put options with a notional amount close to £500,000.
• C. Buy three-month FTSE 100 call options with a notional amount close to £500,000.
• D. Sell three-month FTSE 100 call options with a notional amount close to £500,000.

Best answer: B

What this tests: Investment Selection and Administration

Explanation: A strategy can be mechanically possible but still unsuitable if it conflicts with the client’s risk profile, cash-flow capacity, or objective. Here the client wants temporary downside protection, continued ownership, upside participation, and no margin calls or open-ended derivative losses. Buying put options is the closest fit: the premium is paid upfront, the loss on the derivative is limited to that premium, and the option can gain value if the index falls. The hedge need not be perfect, but matching the notional exposure reasonably to the tracker is consistent with the stated aim.

• Selling calls may generate premium, but it caps upside and gives only limited downside cushioning.
• Selling futures can hedge market falls, but it removes upside and creates daily variation margin exposure.
• Buying calls has limited loss, but it benefits from a rising market rather than protecting against a fall.

A protective put gives downside protection while keeping upside potential, and the maximum derivative loss is the known premium paid.

Question 2

Topic: Investment Selection and Administration

An advisory client held a £600,000 UK equity portfolio hedged with short FTSE 100 index futures. At a portfolio review, the adviser finds that the client sold the equity portfolio last week to raise cash, but the futures position remains open with one month to expiry and has generated variation margin calls. The client’s mandate permits derivatives only for hedging and gives no discretionary dealing authority. What is the single best administration and communication action?

• A. Close the futures immediately without contacting the client because margin calls show the position is unsuitable.
• B. Leave the futures open until expiry because they were originally entered as a hedge against the equity portfolio.
• C. Contact the client promptly, explain that the futures are now an uncovered short exposure, recommend closing them, and record the instruction.
• D. Roll the futures into the next expiry month to maintain continuous downside protection.

Best answer: C

What this tests: Investment Selection and Administration

Explanation: Portfolio monitoring should identify when a derivative no longer matches the exposure it was intended to hedge. A short equity index future can be suitable as a hedge while the client owns a correlated equity portfolio, but after the portfolio has been sold it becomes a standalone short market position. That conflicts with a mandate permitting derivatives only for hedging and exposes the client to further variation margin movements. Because the account is advisory and gives no discretionary dealing authority, the adviser should not simply trade without client instruction. The proper administration and communication response is to contact the client promptly, explain the change in risk, recommend closing or otherwise reducing the position, obtain the client’s instruction, and keep an adequate record.

• Keeping the futures open ignores that the original hedged asset has been sold.
• Rolling the futures would extend an uncovered short exposure rather than maintain a valid hedge.
• Closing without client contact may be appropriate only with authority or an agreed procedure; this client has an advisory mandate with no discretionary dealing authority.

Once the underlying equities have been sold, the short futures no longer hedge the client’s portfolio and require prompt client communication and an instructed action.

Question 3

Topic: Investment Selection and Administration

An adviser is reviewing a client’s £400,000 portfolio. The client holds a low-cost UK equity tracker fund, has £50,000 in cash, and plans to use £150,000 in six months for a property purchase. She wants to stay invested because she is concerned about missing a market recovery, but she has low capacity for a large loss before the purchase. She can pay an upfront cost for protection, but she does not want any arrangement that could require uncertain margin payments. After discussion, she understands the basic payoff of a plain-vanilla listed put. Which recommendation is most suitable?

• A. Sell the tracker fund and buy a concentrated portfolio of large UK shares to remove derivative risk while keeping equity exposure.
• B. Retain the tracker fund and sell index futures against the full portfolio to remove market exposure until the property purchase.
• C. Retain the tracker fund and buy a six-month put on a closely matched UK equity index for the amount needing protection.
• D. Switch the equity exposure into leveraged index CFDs so less cash is tied up before the property purchase.

Best answer: C

What this tests: Investment Selection and Administration

Explanation: Suitability depends on matching the instrument to the client’s objective, risk capacity, liquidity needs, and ability to tolerate derivative obligations. Here, the client wants to remain invested but limit a near-term fall on the amount needed for a property purchase. Buying a put over a closely matched index is a defined-risk overlay: the maximum cost is the premium, the client keeps upside exposure in the tracker, and there are no uncertain margin calls for the put buyer. The adviser would still need to explain basis risk, strike selection, expiry, premium cost, and what happens if the hedge does not exactly match the fund.

• A concentrated direct-share portfolio may reduce fund-product complexity, but it increases stock-specific risk and does not address the short-term downside concern.
• A futures hedge can reduce market exposure, but it may create daily variation margin cash flows and could remove the upside participation the client wants.
• Leveraged CFDs increase leverage, financing exposure, and margin risk, which conflicts with the client’s low loss capacity and liquidity need.

A protective put overlay preserves upside participation while giving defined downside protection for a known premium and no variation margin calls for the buyer.

Question 4

Topic: Investment Selection and Administration

A private client holds £800,000 of one FTSE 100 share and has a large unrealised gain. Selling now would crystallise gains earlier than desired. For the next nine months, the client wants protection against a fall of more than about 10%, is willing to give up gains above about 10%, wants a low net premium, and will not accept uncovered option exposure or speculative leverage. The existing shares can be used to cover any written call. Which strategy is the single best fit?

• A. Write nine-month puts 10% below the current share price to earn premium income.
• B. Buy nine-month puts 10% below the current share price and write nine-month covered calls 10% above the current share price over the holding.
• C. Sell nine-month equity futures or CFDs over the full value of the holding.
• D. Buy nine-month calls 10% above the current share price over the same notional amount.

Best answer: B

What this tests: Investment Selection and Administration

Explanation: The client needs a hedge that preserves the shareholding, limits downside, keeps initial cost low, and avoids uncovered exposure. A collar does this by buying a protective put and writing a covered call. The put creates protection below the chosen floor, while the call premium helps fund the put. The trade-off is that gains above the call strike are given up, which the client has expressly accepted. Because the client already owns the shares, the written call is covered rather than naked. The position would still need administration, including checking contract size, liquidity, expiry date, corporate-action treatment, assignment risk, costs, and tax advice on the derivative transactions.

• Buying calls adds upside exposure and premium cost but does not protect the existing shareholding against a fall.
• Selling futures or CFDs may hedge downside, but it largely removes equity upside and can create margin or financing cash-flow demands.
• Writing puts earns income but increases downside exposure, which is the opposite of the client’s protection objective.

A collar provides downside protection, reduces the net premium, and caps upside in a way the client has accepted.

Question 5

Topic: Investment Selection and Administration

A client with a £4 million UK equity portfolio wants to reduce market risk on roughly half of the portfolio for three months while a property purchase is pending. The adviser implements a short FTSE 100 futures overlay with an initial notional exposure of about £2 million. The client’s objective is capital protection, not speculation, and the futures position is subject to daily variation margin. After the FTSE 100 rises 6%, the futures position shows cash losses while the equity portfolio has gained. Which maintenance control is the single best way to keep the strategy aligned with the client’s objective and risk tolerance?

• A. Rely on the initial suitability assessment until expiry unless the client asks for a review.
• B. Add extra short futures after market rises to recover variation margin losses if the market later falls.
• C. Monitor only the standalone futures profit or loss and close the hedge after any daily variation margin outflow.
• D. Maintain trigger-based reviews of hedge ratio, margin cash, expiry or roll actions, and client reporting against the stated risk-reduction objective.

Best answer: D

What this tests: Investment Selection and Administration

Explanation: Maintenance controls keep a derivative strategy aligned after it has been implemented. For a futures hedge, the adviser should monitor whether the notional exposure still matches the client’s underlying portfolio exposure, whether margin cash remains adequate, whether expiry or roll decisions are approaching, and whether the client needs an update or revised recommendation. A short futures hedge can lose cash through variation margin when the market rises, but that may be offset by gains on the equities being hedged. The control should therefore assess the combined hedge position against the client’s capital-protection objective and risk tolerance, not treat the futures as a speculative standalone trade.

• Standalone futures profit or loss can give the wrong signal because hedge losses may be offset by gains on the protected portfolio.
• An initial suitability assessment is not enough because exposure, margin capacity, expiry, and client circumstances can change.
• Adding extra short futures to recover losses changes a risk-reduction hedge into a more speculative leveraged position.

This control monitors whether the derivative remains a suitable hedge, rather than judging it as a standalone trade.

Question 6

Topic: Investment Selection and Administration

A private client holds a £800,000 UK equity portfolio and wants protection against a possible market fall over the next six months without selling the shares. An adviser is considering a short FTSE 100 futures overlay with a notional amount close to the portfolio value. The client has only £15,000 readily available outside the portfolio, needs regular income withdrawals, and has a moderate risk profile. The futures position would be subject to daily variation margin. What is the single most important suitability factor to address before recommending the strategy?

• A. The client’s capacity and willingness to meet variation margin calls if the equity market rises during the hedge period.
• B. Whether the futures trade has lower explicit dealing costs than buying index put options.
• C. Whether the client can defer all portfolio income withdrawals until after the futures hedge expires.
• D. Whether the selected futures contract has sufficient exchange trading volume for institutional hedging.

Best answer: A

What this tests: Investment Selection and Administration

Explanation: A derivative-based strategy must be suitable not only for the investment objective but also for the client’s ability to bear the product’s risks and cashflow demands. A short index futures overlay may hedge downside exposure in the share portfolio, but it is leveraged and marked to market. If the market rises, the futures position loses money and daily variation margin may need to be paid, even though the underlying portfolio is gaining value. A client with limited spare cash and ongoing withdrawal needs may be unable or unwilling to meet those calls without forced sales. That liquidity and risk-capacity issue should be resolved before cost, contract convenience, or market-volume points.

• Lower dealing cost is not enough to make a leveraged margined strategy suitable.
• Deferring income withdrawals may help cashflow, but the core issue is whether margin calls can be met when they arise.
• Exchange liquidity is relevant, but client suitability and liquidity capacity come first for a retail derivatives recommendation.

A short futures hedge can create daily cash outflows in a rising market, so liquidity and risk capacity are decisive suitability considerations.

Question 7

Topic: Investment Selection and Administration

A grain producer used exchange-traded wheat futures to hedge the expected sale price of a September harvest. The client sold 20 September futures contracts, each for 50 tonnes, to hedge an expected crop of 1,000 tonnes. After a weather event, the latest agronomist report reduces the expected harvest to 600 tonnes. The futures position is currently showing a gain. What is the single best action for the adviser to recommend?

• A. Retain all 20 September futures contracts because the position is currently profitable.
• B. Review the hedge with the client and buy back 8 September futures contracts to reduce the hedge to 600 tonnes.
• C. Sell 8 additional September futures contracts to lock in more of the lower expected production value.
• D. Roll all 20 September futures contracts into a later delivery month until the harvest uncertainty is resolved.

Best answer: B

What this tests: Investment Selection and Administration

Explanation: A hedge should be monitored against the client’s current underlying exposure, not just its current profit or loss. The producer originally had a short futures hedge for 1,000 tonnes: 20 contracts multiplied by 50 tonnes. The revised expected harvest is only 600 tonnes, so only 12 contracts are needed. Keeping all 20 contracts would leave 400 tonnes over-hedged. That excess short futures exposure could create losses if wheat prices rise and there is no matching physical crop to sell at the higher price. The appropriate administration response is to review the changed exposure, explain the over-hedge to the client, and close the excess 8 contracts.

• Keeping all contracts focuses on current profit but ignores the reduced physical exposure.
• Selling more contracts would increase the over-hedge and create more speculative short exposure.
• Rolling the full position changes the maturity but does not correct the excessive hedge size.

The expected physical exposure has fallen by 400 tonnes, so 8 contracts should be closed to avoid an unintended speculative short position.

Question 8

Topic: Investment Selection and Administration

An advisory client holds a £900,000 UK equity portfolio. Three months ago the adviser recommended selling FTSE 100 index futures with an initial notional of £850,000 to provide temporary downside protection. The client’s mandate permits derivatives only for hedging, and the futures expire in two weeks. The equity portfolio has fallen to £810,000, the short futures position has generated variation margin gains, and the client has limited spare cash if margin calls arise after a market rebound. The adviser is preparing the client review and considering whether to roll the hedge.

Which is the best next step?

• A. Roll the short futures automatically because the original recommendation was suitable and the hedge has made a profit.
• B. Close the futures immediately and report only the realised futures gain because the hedge has achieved its purpose.
• C. Increase the short futures notional to recover the equity loss more quickly, provided the additional contracts are liquid.
• D. Review hedge effectiveness, current hedge ratio, expiry and margin capacity; report the equity and futures results together; then obtain and document the client’s instruction before any roll or rebalance.

Best answer: D

What this tests: Investment Selection and Administration

Explanation: Derivative positions used in client portfolios require ongoing monitoring, not a one-off suitability assessment. A compliant review should consider whether the derivative still matches the client’s objective, mandate and risk capacity. Here, the position was permitted only as a hedge, the futures are near expiry, the portfolio value has changed, and margin capacity is limited. The adviser should assess hedge effectiveness and the current hedge ratio, explain the combined effect of the cash portfolio and futures position, and address expiry, roll risk and potential margin calls. Because the relationship is advisory, any roll, rebalance or closure should be recommended clearly and documented with the client’s instruction.

• Automatic rolling ignores the need to reassess current suitability, hedge size, expiry and margin capacity.
• Reporting only the futures gain is incomplete because the client needs the combined portfolio and derivative outcome.
• Increasing the short futures notional would move beyond the stated hedging mandate and introduce speculative exposure.

This applies ongoing suitability, risk monitoring, full reporting and documented client communication before changing an advisory derivative position.

Question 9

Topic: Investment Selection and Administration

An adviser is reviewing whether to recommend maintaining an exchange-traded fuel futures hedge for a small transport company. The company must buy physical fuel in three months. The hedge direction is appropriate for a fuel consumer, but the futures position is marked to market daily.

• Current hedge: long 8 fuel futures
• Contract size: 1,000 barrels
• Broker’s short-term stress move for cash planning: $5 adverse move per barrel before the physical fuel is bought
• Immediately available treasury cash: $72,000
• Board minimum working-cash reserve: $50,000
• Assume the variation margin from the stress move is payable in cash and there are no offsetting receipts before the margin call.

The stress margin call would be 8 × 1,000 × $5 = $40,000, reducing cash to $32,000.

Which suitability factor should the adviser treat as most important before recommending that the hedge is maintained?

• A. The expected offset between futures losses and cheaper physical fuel.
• B. Lower counterparty exposure from exchange clearing of the futures.
• C. Lower upfront premium cost than buying an option hedge.
• D. Liquidity to fund variation margin without breaching the working-cash reserve.

Best answer: D

What this tests: Investment Selection and Administration

Explanation: A derivative strategy can be economically sensible but still unsuitable if the client cannot meet the cash-flow demands that arise before the hedge benefit is realised. Futures are marked to market, so adverse price moves can require immediate variation margin. Here, the stressed margin call is $40,000. Paying it would reduce available cash from $72,000 to $32,000, which is below the company’s $50,000 working-cash reserve. That makes liquidity capacity the key suitability factor before maintaining the hedge. The adviser should consider whether the hedge size, instrument choice, or collateral arrangements need to change so the commercial hedge does not create an unacceptable short-term funding strain.

• Exchange clearing reduces counterparty credit risk, but it does not remove daily margin cash flows.
• Avoiding an option premium may reduce upfront cost, but futures can create substantial variation margin calls.
• A cheaper physical fuel purchase may economically offset a futures loss, but that benefit may not provide cash in time for the margin call.

The stressed margin call would leave only $32,000, below the $50,000 reserve, so cash-flow capacity is the decisive suitability issue.

Question 10

Topic: Investment Selection and Administration

An adviser is comparing implementation routes for a small charity that has just received £1,600,000. The trustees want passive FTSE 100 exposure now, but the permanent custody account for fund purchases will not be ready for one month.

• Investment policy permits derivatives only for efficient portfolio management or transition hedging, not for permanent gearing.
• Trustees want low ongoing administration and no stock-by-stock portfolio management.
• Cash can be held on deposit during the transition.
• FTSE 100 index future: index level 8,000, multiplier £10 per index point.
• Assume no beta adjustment and round to the nearest whole contract.

Which implementation is most suitable?

• A. Hold cash for one month and buy a tracker only after custody opens, leaving the charity without interim equity exposure.
• B. Hold the cash on deposit, buy 20 FTSE 100 futures for the transition, then close the futures and invest in a low-cost FTSE 100 tracker when custody is available.
• C. Hold the cash on deposit and buy 200 FTSE 100 futures as the ongoing equity exposure.
• D. Use £1,600,000 to buy individual FTSE 100 constituents directly and maintain the basket in-house.

Best answer: B

What this tests: Investment Selection and Administration

Explanation: The futures notional is the index level multiplied by the contract multiplier: 8,000 × £10 = £80,000 per contract. To obtain £1,600,000 of temporary FTSE 100 exposure, the adviser needs £1,600,000 ÷ £80,000 = 20 contracts. The client’s facts point to a combination approach: cash remains available while custody is being arranged, the futures provide a short-term derivative overlay for transition hedging, and the permanent solution is a low-administration indirect holding such as a tracker fund. A permanent futures position would introduce rolling, margin, and leverage management inconsistent with the policy. A direct basket of shares would create unnecessary administration and stock-level management.

• Waiting entirely in cash avoids derivative use but fails to meet the trustees’ wish for market exposure now.
• Direct constituent holdings conflict with the stated preference for passive exposure and low administration.
• Buying 200 futures gives £16,000,000 of notional exposure and would also make the derivative position an unsuitable ongoing implementation route.

Each future gives £80,000 of notional exposure, so 20 contracts provide the intended £1,600,000 temporary overlay before moving to the suitable indirect holding.

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