Free CISI IAD Derivatives Practice Questions: OTC 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 OTC Derivatives. The items are original Finance Prep sample exam questions built for scenario-based practice, not trivia, puzzle questions, official CISI questions, copied live-exam content, or exam dumps.

Topic snapshot

How to use this topic drill

Use this page to isolate OTC Derivatives for CISI IAD Derivatives. Work through the 10 questions first, then review the explanations and return to mixed practice in Finance Prep.

Pass	What to do	What to record
First attempt	Answer without checking the explanation first.	The fact, rule, calculation, or judgment point that controlled your answer.
Review	Read the explanation even when you were correct.	Why the best answer is stronger than the closest distractor.
Repair	Repeat only missed or uncertain items after a short break.	The pattern behind misses, not the answer letter.
Transfer	Return to mixed practice once the topic feels stable.	Whether the same skill holds up when the topic is no longer obvious.

Blueprint context: 17.5% of the practice outline. A focused topic score can overstate readiness if you recognize the pattern too quickly, so use it as repair work before timed mixed sets.

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: OTC Derivatives

An investment firm enters into an uncleared OTC interest rate swap with a corporate counterparty under an ISDA master agreement and a credit support annex. The annex requires daily collateral calls based on the previous day’s mark-to-market value, with eligible collateral limited to cash and UK government bonds. After a sharp rate move, the counterparty is downgraded and a collateral transfer is delayed because of a settlement error. The firm’s risk committee asks why exposure limits and monitoring are still required.

Which statement best applies the collateral principle?

• A. Collateral reduces unsecured exposure, but market moves, default timing, enforceability, settlement errors, and the need to liquidate collateral can still create residual risk.
• B. Collateral converts an uncleared OTC swap into an exchange-cleared contract with no need for bilateral credit monitoring.
• C. Collateral removes market risk because the collateral value automatically offsets all future changes in the swap valuation.
• D. Collateral eliminates counterparty risk once a credit support annex is signed, provided daily margin calls are made.

Best answer: A

What this tests: OTC Derivatives

Explanation: Collateral is a credit risk mitigant, not a complete transfer or cancellation of risk. In an OTC derivative, exposure can change between valuations and collateral calls, especially during volatile markets. A counterparty may default before meeting the next call, or there may be a dispute over valuation or close-out amounts. Legal risk remains if documentation, netting, or collateral enforcement is challenged. Operational risk can arise from failed settlement, incorrect calls, or reconciliation breaks. Liquidity risk also remains because collateral may have to be sold quickly, may be subject to haircuts, or may not realise its expected value at the time it is needed. For these reasons, firms still use limits, monitoring, documentation controls, and collateral management even when a credit support annex is in place.

• Treating a signed credit support annex as eliminating counterparty risk ignores timing gaps, disputes, and default before collateral is received.
• Assuming collateral removes market risk confuses credit mitigation with hedging; the derivative’s value can still move.
• Equating bilateral collateralisation with central clearing is incorrect; uncleared OTC trades still rely on bilateral documentation and counterparty performance.

Collateral mitigates counterparty exposure but does not remove market, counterparty, legal, operational, or liquidity risks around valuation changes, default, documentation, processing, and collateral realisation.

---

Question 2

Topic: OTC Derivatives

A portfolio manager wants downside protection for an equity-index exposure and would prefer to avoid bilateral dealer counterparty exposure if possible. The desk provides the following facts:

• Portfolio exposure: £9,900,000
• Current index level: 3,300
• Option multiplier: £10 per index point
• Required strike: 3,175
• Required expiry: 11-month month-end date
• Required settlement: cash
• Standard listed index options: exchange screen market, CCP-cleared, cash settled, strikes every 50 points, quarterly expiries only
• OTC dealer option: any strike and expiry, ISDA master agreement and confirmation, bilateral collateral and settlement, no exchange order-book publication
• FLEX option facility: exchange-traded and CCP-cleared under exchange rules, negotiable strike and expiry, cash settlement available, less screen-price transparency than standard listed options

Use contract exposure as index level × multiplier. Which conclusion is most appropriate?

• A. Use a standard listed option for 300 contracts; it gives screen transparency and also meets the required strike and expiry.
• B. Use a FLEX option for 30 contracts; its customised terms remove the need to match notional through the multiplier.
• C. Use a FLEX option for 300 contracts; it can align the strike and expiry while retaining exchange venue and clearing.
• D. Use an OTC option for 300 contracts; it gives custom terms and avoids bilateral counterparty exposure through exchange clearing.

Best answer: C

What this tests: OTC Derivatives

Explanation: The contract exposure is 3,300 × £10 = £33,000. Dividing £9,900,000 by £33,000 gives 300 contracts. Standard listed options provide the strongest exchange-screen transparency and central clearing, but their standardised strikes and expiries do not match the required 3,175 strike and 11-month month-end expiry. An OTC option could be made fully bespoke, but it would normally be documented bilaterally, such as under an ISDA master agreement and confirmation, with bilateral counterparty exposure rather than exchange clearing. A FLEX option sits between these: it permits negotiated terms within exchange rules while retaining exchange execution and central counterparty clearing, although transparency is generally less than for fully standard listed contracts.

• Standard listed options match the 300-contract calculation but not the required strike or expiry.
• OTC options can provide bespoke economic terms, but they do not remove bilateral counterparty exposure through exchange clearing.
• FLEX customisation affects strike, expiry, and settlement terms; it does not remove the need to size exposure using the contract multiplier.

Each contract represents £33,000, so £9,900,000 requires 300 contracts, and FLEX terms best combine customisation with exchange clearing.

---

Question 3

Topic: OTC Derivatives

A wealth manager is reviewing a bespoke equity option for a client.

• The contract is documented bilaterally under an ISDA confirmation and is not listed as an exchange-traded FLEX contract.
• Underlying: 100,000 shares
• Option: cash-settled call
• Strike: 250p
• Settlement rule: use the arithmetic average of the four month-end closing prices, with automatic settlement at expiry

Which description correctly identifies the distinctive option feature and cash settlement amount?

• A. An OTC American call with a £12,000 cash settlement
• B. An OTC European call with an £8,000 cash settlement
• C. A FLEX Asian call with a £5,000 cash settlement
• D. An OTC Asian call with a £5,000 cash settlement

Best answer: D

What this tests: OTC Derivatives

Explanation: An Asian option is identified by a payoff linked to an average price over specified observations rather than only the spot price at expiry. The average closing price is \((244p + 256p + 262p + 258p) / 4 = 255p\). For a call struck at 250p, the intrinsic value is 5p per share. On 100,000 shares, that equals 500,000p, or £5,000. The contract is OTC because it is bilaterally documented and not an exchange-traded FLEX option. European and American labels describe exercise timing, not an average-price payoff feature.

• The European calculation uses the final observed price of 258p, but the contract requires an average price.
• The American calculation incorrectly assumes the holder can capture the highest observed price of 262p.
• FLEX is not appropriate because the contract is not listed or exchange-traded, even though the payoff amount is otherwise correct.

The bilateral documentation makes it OTC, and the payoff is Asian because it is based on the average price: 255p less 250p, multiplied by 100,000 shares.

---

Question 4

Topic: OTC Derivatives

An adviser is reviewing a 5-year sterling structured note for a client. The note promises 100% repayment of nominal at maturity provided the issuer does not default. Its return is linked to the worst-performing of the FTSE 100, S&P 500, and Euro Stoxx 50. On each annual observation date, if all three indices are at or above their starting levels, the note redeems early at nominal plus 7% for each elapsed year. There is no guaranteed secondary-market exit.

Which statement best describes the structure?

• A. It is a puttable note because the investor can require early redemption whenever the indices are above their starting levels.
• B. It is a covered warrant because the investor pays an option premium and can lose the whole premium if the indices fall.
• C. It is an ordinary fixed-rate bond because nominal capital is protected if the issuer does not default.
• D. It is a capital-protected note with embedded equity basket derivatives and an auto-call feature, with issuer credit and liquidity risk remaining.

Best answer: D

What this tests: OTC Derivatives

Explanation: Structured notes commonly combine a debt component with embedded derivatives. In this case, the promised repayment of nominal at maturity gives the product a capital-protection feature, but only subject to the issuer meeting its obligations. The return is not a normal fixed coupon; it depends on the performance of a worst-of basket of equity indices, which is an exotic equity-linked payoff. The annual early redemption condition is an auto-call feature because redemption occurs automatically if the specified market condition is met. The lack of a guaranteed secondary market also means the investor may face liquidity risk before maturity.

• A puttable note gives the investor a right to demand redemption; here early redemption is triggered by the product terms, not by investor election.
• A covered warrant is a separate securitised derivative exposure; the facts describe a note with embedded derivative payoffs.
• Capital protection does not make the product an ordinary bond, because coupons and redemption timing depend on equity index conditions.

The repayment promise, worst-of index-linked return, and automatic early redemption trigger are characteristic embedded derivative features in a structured note.

---

Question 5

Topic: OTC Derivatives

A company has a £20 million floating-rate loan that pays compounded SONIA plus a 1.50% margin. To hedge the next two years, it enters into a zero-cost interest rate collar with a bank:

• The company buys a SONIA cap with a 5.00% strike.
• The company sells a SONIA floor with a 3.00% strike.
• Settlement is in cash against the same loan notional and benchmark.

Which outcome best describes the effect of the collar on the company’s borrowing cost?

• A. The all-in borrowing cost is fixed at 4.00%, because the cap and floor strikes average out over the collar term.
• B. The benchmark component is effectively limited to a range of about 3.00% to 5.00%, while the 1.50% loan margin still applies.
• C. The company keeps unlimited benefit from falling SONIA while still being protected from SONIA rising above 5.00%.
• D. The collar removes the loan margin as well as the SONIA exposure, because both payments are based on the full loan notional.

Best answer: B

What this tests: OTC Derivatives

Explanation: A borrower with a floating-rate liability is exposed to rising reference rates, so buying an interest rate cap provides protection above the cap strike. To reduce or eliminate the upfront premium, the borrower may sell a floor. That sale gives up the benefit of rates falling below the floor strike, because the borrower must compensate the collar counterparty when the reference rate is below that level. In this case, the derivative affects only the SONIA benchmark component. The loan margin is a contractual credit spread on the borrowing and is not removed by the collar. The likely result is an effective benchmark range of about 3.00% to 5.00%, plus the 1.50% margin, before considering any minor timing or settlement differences.

• A zero-cost collar does not fix the rate at the average of the cap and floor strikes; it creates a protected range.
• Selling the floor means the company does not keep unlimited benefit from falling SONIA.
• The derivative settles on the benchmark exposure, not on the contractual loan margin.

The bought cap offsets SONIA above 5.00%, and the sold floor requires payments below 3.00%, leaving the borrower with a collared benchmark exposure plus the loan margin.

---

Question 6

Topic: OTC Derivatives

An adviser is reviewing a 5-year FTSE 100 structured note for a client who wants equity-linked exposure but wants capital repaid at maturity if the index has not fallen by more than 30%. The client accepts that any gain may be capped.

Product facts:

• Investment amount: £50,000
• Initial FTSE 100 level: 8,000
• Stress-test final level: 5,900
• If the final level is at or above the initial level, the note pays the index gain, capped at 20%.
• If the final level is below the initial level but at least 70% of the initial level, the note repays £50,000.
• If the final level is below 70% of the initial level, repayment is reduced in line with the index fall.

Which structured-product feature is most relevant to the client’s stated risk-return objective?

• A. The absence of periodic income during the term
• B. The 20% cap on the maximum equity-linked gain
• C. The participation in positive FTSE 100 performance
• D. The 70% final-level barrier that determines whether capital protection applies

Best answer: D

What this tests: OTC Derivatives

Explanation: For a structured note with conditional capital protection, the key feature is usually the downside barrier. Here the barrier is 70% of the initial FTSE 100 level: \(8,000 \times 70\% = 5,600\). The stress-test final level is 5,900, so the index has fallen, but not by more than 30%. Under the terms, the note would repay the £50,000 capital at maturity. The cap and participation terms affect the upside if the index rises, but they do not decide whether the client’s capital-repayment condition is met. The absence of income may matter for suitability, but it is not the embedded payoff feature that protects capital in the specified downside scenario.

• The gain cap limits upside, so it is relevant to return potential but not to the client’s downside-protection condition.
• Participation in index growth matters only if the FTSE 100 finishes above its initial level.
• Lack of periodic income affects cash-flow suitability, not whether capital is repaid after a moderate index fall.

The barrier is at 5,600, and the stress-test final level of 5,900 is above it, so this feature directly addresses the client’s capital-repayment condition.

---

Question 7

Topic: OTC Derivatives

An advisory firm arranges an OTC interest rate swap for a corporate client hedging floating-rate borrowing. The internal trade capture shows the client pays 4.20% fixed and receives compounded SONIA on £10 million for five years. The counterparty confirmation received the next day shows the client receives 4.20% fixed and pays SONIA. No payments have yet been made.

Which control process is the best response to this operational break?

• A. Submit an amended transaction report to the regulator showing the counterparty’s version of the trade.
• B. Increase the collateral call under the CSA until the mark-to-market exposure is neutralised.
• C. Perform same-day confirmation matching of the economic terms and escalate the mismatch for counterparty resolution before the trade is allowed to settle.
• D. Wait until the first reset date and reconcile the cashflow difference through the payments process.

Best answer: C

What this tests: OTC Derivatives

Explanation: OTC derivatives rely heavily on accurate trade capture, timely confirmation, and exception management because the contracts are bilateral and bespoke. A mismatch in pay/receive direction on an interest rate swap changes the economic exposure of the hedge. The most relevant control is therefore confirmation matching against the internal trade record, followed by prompt escalation and resolution with the counterparty before settlement or cashflow processing. Collateral, reporting, and payment controls are important, but they do not correct an unresolved disagreement over the contract’s fundamental terms.

• Collateral calls manage counterparty exposure; they do not fix a disagreement over whether the client pays or receives fixed.
• Transaction reporting may be required, but it should not simply adopt one side’s incorrect economics without resolving the trade terms.
• Waiting for the first payment would allow an avoidable operational error to become a cashflow and client-impact problem.

The break is a core economic-term mismatch in an OTC trade, so confirmation matching and exception escalation directly address the processing error.

---

Question 8

Topic: OTC Derivatives

A UK investment firm arranges a 9-month uncleared OTC cash-settled commodity swap for a corporate client hedging copper purchases. The notional is £12 million, the trade is agreed by phone with a dealer, and the client has an ISDA agreement and collateral support annex in place. Operations wants to reduce the risk of mismatched economic terms and maintain accurate records for payment dates, valuations, and collateral calls. Which mechanism is the single best fit?

• A. Enter the trade into the internal trade-capture system and send it to an OTC electronic matching and confirmation service, with matched details feeding settlement and lifecycle systems.
• B. Book the hedge as an exchange-traded copper futures position and rely on the clearing house to calculate all cash flows.
• C. Report the trade to a trade repository and use the repository record as the bilateral confirmation between the client and dealer.
• D. Wait until the first payment date to compare the dealer’s cash-flow notice with the client’s internal trade record.

Best answer: A

What this tests: OTC Derivatives

Explanation: OTC derivatives are often negotiated bilaterally by phone, chat, broker, or an electronic dealing platform, but the operational control does not stop at execution. The trade details should be captured and then matched or affirmed against the counterparty’s record. An electronic confirmation or matching service helps ensure that key terms such as notional, maturity, floating or fixed references, payment dates, and settlement method are aligned. Once confirmed, the trade record can feed downstream processes such as payment settlement, valuation, collateral calls, portfolio reconciliation, and lifecycle event processing. This is especially important for uncleared OTC trades, where the parties do not rely on an exchange clearing house to standardise and process the contract.

• Treating the hedge as an exchange-traded future changes the product structure and relies on exchange clearing rather than bilateral OTC processing.
• Trade repository reporting supports regulatory transparency, but it does not replace bilateral matching and confirmation.
• Waiting until a payment date leaves a trade mismatch unresolved for too long and weakens operational control.

Electronic matching and confirmation compares bilateral OTC terms promptly and creates controlled records for settlement, valuation, collateral, and lifecycle processing.

---

Question 9

Topic: OTC Derivatives

A manufacturer has a £10 million bank loan with five years remaining. The loan interest resets quarterly at 3-month SONIA plus 1.20%. To reduce interest-rate uncertainty, the manufacturer enters into a five-year OTC interest-rate swap with its bank on a £10 million notional. Under the swap, the manufacturer pays a fixed 4.10% quarterly and receives 3-month SONIA quarterly. The collateral agreement requires daily collateral transfers when the swap’s mark-to-market exposure exceeds £250,000. Six months later, market swap rates have fallen materially.

Which statement is the single best assessment of the swap?

• A. It is likely to produce a positive mark-to-market for the manufacturer because the floating receipt resets lower while the fixed payment remains unchanged.
• B. It largely fixes the SONIA element on the £10 million exposure for five years, but the fall in rates is likely to make the pay-fixed swap negative, with potential collateral calls and residual counterparty risk.
• C. It creates its main risk through exchanging the £10 million principal amount with the bank at maturity if SONIA remains below 4.10%.
• D. It removes both interest-rate risk and counterparty credit risk because the notional and maturity match the loan and collateral is exchanged daily.

Best answer: B

What this tests: OTC Derivatives

Explanation: A pay-fixed, receive-floating interest-rate swap can convert the benchmark component of a floating-rate loan into a fixed exposure when the reset basis, notional amount and maturity closely match the borrowing. Here, the manufacturer pays a fixed swap rate and receives 3-month SONIA, which offsets the SONIA element payable on the loan. The 1.20% loan margin remains payable under the loan. The hedge protects against rising SONIA, but if market swap rates fall, the fixed rate the manufacturer has agreed to pay becomes unattractive relative to current market rates. That normally creates a negative mark-to-market and may require collateral to be posted. The collateral agreement reduces replacement-cost exposure, but it does not make the OTC swap free of counterparty, operational, liquidity or termination risk.

• A lower floating receipt does not create a gain for a pay-fixed swap; the fixed payer is generally disadvantaged when market rates fall.
• Matching notional and maturity improves hedge effectiveness, but it does not remove all basis, collateral, liquidity or counterparty risks.
• In a standard interest-rate swap, the notional is used to calculate payments and is not exchanged as principal.

The swap legs, reset basis, notional and maturity match the loan exposure, while falling rates reduce the value of a pay-fixed swap and collateral mitigates rather than removes credit exposure.

---

Question 10

Topic: OTC Derivatives

A dealer is estimating the fair mid-market fixed rate for an OTC 3x6 FRA covering a 90-day sterling borrowing period that starts in 90 days. The following annual simple sterling money-market rates are quoted on an ACT/360 basis. Ignore bid-offer, credit charges and collateral effects.

• 90-day spot rate: 5.00%
• 180-day spot rate: 5.30%

Which conclusion best applies the OTC pricing principle?

• A. A fair FRA fixed rate is 5.30%, because the 180-day spot rate already covers the full period from today to loan maturity.
• B. A fair FRA fixed rate is 5.00%, because the borrower’s cash-flow risk starts only at the 90-day reset date.
• C. A fair FRA fixed rate is approximately 5.53%, because it is the 90-day forward rate implied between the 90-day and 180-day cash flows.
• D. A fair FRA fixed rate is 5.15%, because an FRA is priced by averaging the two spot rates over the borrowing period.

Best answer: C

What this tests: OTC Derivatives

Explanation: An FRA fixed rate is derived from the implied forward money-market rate for the future loan period, not from a simple average or from either spot rate alone. Using simple ACT/360 rates, the 180-day cash flow is compared with rolling a 90-day cash flow into a second 90-day period. The implied annualised rate for that second 90-day period is:

\[ \left(\frac{1 + 0.0530 \times 180/360}{1 + 0.0500 \times 90/360} - 1\right) \div (90/360) \approx 5.53\% \]

This is higher than the 180-day spot rate because the longer-period rate must cover both the first 90 days at 5.00% and the later 90 days at the implied forward rate.

• Averaging the spot rates ignores the cash-flow replication used in no-arbitrage FRA pricing.
• Using the 180-day spot rate treats the whole six-month rate as if it applied only to the forward 90-day period.
• Using the 90-day spot rate ignores the market rate implied for the later 90-day borrowing period.

The fair FRA rate is the implied forward rate that makes the 90-day-to-180-day cash-flow replication consistent with the two spot money-market rates.

Continue in the web app

Use Finance Prep for interactive CISI IAD Derivatives practice with mixed sets, timed mock exams, topic drills, explanations, and progress tracking.

Related focused pages

• Free CISI IAD Derivatives Practice Exam
• Free CISI IAD Derivatives Practice Questions: Introduction to Derivatives
• Free CISI IAD Derivatives Practice Questions: Underlying Assets
• Free CISI IAD Derivatives Practice Questions: Exchange-Traded Futures and Options
• Free CISI IAD Derivatives Practice Questions: Clearing
• Free CISI IAD Derivatives Practice Questions: Delivery and Settlement
• Free CISI IAD Derivatives Practice Questions: Portfolio Research and Construction
• Free CISI IAD Derivatives Practice Questions: Trading, Hedging, and Investment Strategies
• Free CISI IAD Derivatives Practice Questions: Investment Selection and Administration
• Free CISI IAD Derivatives Practice Questions: Regulatory Requirements

Practice next step

Use the Finance Prep web app above when you want interactive practice beyond this static page.