Free CISI IAD Derivatives Practice Questions: Portfolio Research and Construction

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

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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: Portfolio Research and Construction

An adviser is reviewing a one-year performance report for a cautious client whose UK equity portfolio used a short FTSE 100 futures overlay to reduce downside exposure. The report shows:

The risk-free return for the same period was 2.0%. Using excess return per unit of volatility, which is the single best interpretation?

• A. The benchmark had the better risk-adjusted result because its total return was 1.0 percentage point higher.
• B. The hedged portfolio had the better risk-adjusted result, with 0.50 excess return per unit of volatility versus 0.40 for the benchmark.
• C. The two results were equivalent because both portfolios produced positive returns above the risk-free return.
• D. The hedged portfolio had the worse risk-adjusted result because the futures overlay reduced participation in the market rise.

Best answer: B

What this tests: Portfolio Research and Construction

Explanation: A risk-adjusted return measure based on excess return per unit of volatility compares reward after deducting the risk-free return with the amount of variability taken to achieve it. The hedged portfolio earned 6.0%, so its excess return was 4.0%. Dividing by 8.0% volatility gives 0.50. The benchmark earned 7.0%, so its excess return was 5.0%. Dividing by 12.5% volatility gives 0.40. Although the benchmark delivered the higher absolute total return, it did so with materially higher volatility. For a cautious client using a short futures overlay to reduce downside exposure, the hedged portfolio therefore produced the stronger risk-adjusted outcome on the stated measure.

• Looking only at total return ignores the volatility component of the stated risk-adjusted measure.
• Assuming the futures overlay made the result worse confuses lower upside capture with poorer risk-adjusted performance.
• Positive excess return for both portfolios does not make the outcomes equivalent; the comparison depends on excess return divided by volatility.

The hedged portfolio’s measure is \((6.0\%-2.0\%)/8.0\%=0.50\), which is higher than the benchmark’s \((7.0\%-2.0\%)/12.5\%=0.40\).

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Question 2

Topic: Portfolio Research and Construction

An adviser is comparing sector index futures for a short-term portfolio overlay. The client mandate permits a sector future only if:

• 20-day realised volatility is not more than 22%.
• Estimated bid-offer cost is not more than 0.10% of notional.

Estimated bid-offer cost is calculated as:

\(\frac{\text{bid-offer spread in index points}}{\text{futures level}} \times 100\)

Among contracts that pass both screens, the adviser will shortlist the one with the highest average daily volume.

Which sector future should be shortlisted?

• A. Healthcare
• B. Energy
• C. Technology
• D. Utilities

Best answer: A

What this tests: Portfolio Research and Construction

Explanation: The screen combines risk, liquidity, and trading activity. Energy has an estimated bid-offer cost of 4.0 / 5,000 × 100 = 0.08%, but its 24% volatility breaches the 22% limit. Technology has acceptable volatility at 21%, but its bid-offer cost is 12.0 / 8,000 × 100 = 0.15%, above the 0.10% limit. Healthcare has a cost of 3.0 / 4,000 × 100 = 0.075% and volatility of 19%, so it qualifies. Utilities also qualifies with 1.0 / 2,500 × 100 = 0.04% and volatility of 16%. Between the eligible Healthcare and Utilities contracts, Healthcare has the higher average daily volume, indicating stronger trading activity for the mandate’s shortlist.

• Energy is sufficiently tight on bid-offer cost, but its realised volatility exceeds the mandate’s risk limit.
• Technology has the highest volume, but it fails the bid-offer cost screen.
• Utilities passes the risk and cost screens, but its trading volume is lower than Healthcare’s.

Healthcare passes both the volatility and bid-offer cost screens, and has the highest volume among the eligible contracts.

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Question 3

Topic: Portfolio Research and Construction

An advisory team is reviewing a sterling fixed income portfolio held for a charity. The charity has a contractual £10 million payment due in five years. Its high-quality bond portfolio is diversified by issuer, but its modified duration is about two years, while the liability’s duration is about five years. The mandate permits derivative overlays only for risk reduction and efficient portfolio management. The trustees do not want to sell the bonds. Which action best applies a portfolio risk tool to this situation?

• A. Switch from active bond selection to a passive bond index while leaving the portfolio duration unchanged.
• B. Sell gilt futures to reduce the portfolio duration further while retaining the existing bond holdings.
• C. Enter a receive-fixed sterling interest rate swap with appropriate notional to raise the portfolio duration toward five years.
• D. Add equity index futures exposure because lower correlation improves the match to a fixed sterling liability.

Best answer: C

What this tests: Portfolio Research and Construction

Explanation: Diversification by issuer can reduce specific credit risk, but it does not necessarily protect a portfolio against a known liability. Immunisation focuses on matching the interest rate sensitivity of assets and liabilities, commonly by aligning duration and monitoring the match over time. Here, the assets have a much shorter duration than the five-year liability, so their value is less sensitive to interest rate changes than the liability. A receive-fixed sterling interest rate swap can add positive fixed-rate duration without selling the existing bonds. Active versus passive management is a separate implementation choice and does not solve the duration gap by itself.

• Selling gilt futures would normally reduce duration, moving the portfolio further away from the liability profile.
• Equity index futures may add market exposure or diversification, but they do not directly hedge a fixed sterling payment liability.
• Moving to a passive bond index can change manager style and costs, but leaving duration unchanged leaves the main risk mismatch unresolved.

A receive-fixed swap adds fixed-rate exposure and can increase duration, helping immunise the portfolio against the liability’s interest rate sensitivity.

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Question 4

Topic: Portfolio Research and Construction

A UK food manufacturer plans to buy 2,000 tonnes of wheat in six months and is considering increasing an exchange-traded wheat futures hedge from 50% to 80% after drought headlines. The board wants a recommendation supported by current market information, official supply data, contract suitability, and a clear audit trail. Which research approach is the best basis for the recommendation?

• A. Use only government agricultural statistics because official data is more reliable than market news or broker research.
• B. Use live news services for weather and export developments, government statistics for crop and stock data, broker research for futures and basis analysis, distributor or exchange information for contract terms, and desk research to reconcile the evidence.
• C. Rely mainly on broker research because it provides the most direct view of likely futures price direction and recommended hedge ratios.
• D. Base the recommendation on the futures distributor’s product brochure because it explains the available contracts and margin requirements.

Best answer: B

What this tests: Portfolio Research and Construction

Explanation: Derivative hedge decisions should be supported by several research sources, each serving a different role. News services help identify fast-moving events such as weather shocks, export restrictions, strikes, or geopolitical developments. Government resources and statistics provide more authoritative supply, demand, inventory, crop, or economic data, but may be less timely. Broker research can add market interpretation, basis analysis, hedge-ratio views, and sector commentary, but it should not be treated as independent proof. Distributor or exchange information is useful for product terms such as contract size, delivery months, margin, and settlement rules. Desk research ties these sources together, tests consistency, and creates a documented basis for the advice.

• Broker research alone may be useful, but it can reflect house views and does not replace official data or product due diligence.
• Government statistics are authoritative, but they may lag current events and do not confirm contract suitability by themselves.
• Distributor or exchange documents explain contract mechanics, but they do not provide a complete market or hedge recommendation.

This combines timely information, official data, market interpretation, product details, and independent analysis needed for a documented derivative hedge decision.

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Question 5

Topic: Portfolio Research and Construction

A derivatives adviser is preparing a brief for a UK food manufacturer that expects to buy cocoa over the next three months. The adviser’s desk research pack contains the following:

The firm’s policy is to hedge 50% of the identified physical exposure at this stage. Which conclusion is best supported?

• A. Buy 60 cocoa futures contracts, because the broker forecast applies to the whole three-month cocoa requirement.
• B. Buy 30 cocoa futures contracts, using the distributor data for exposure size and the market research as supporting evidence of price risk.
• C. Buy 800 cocoa futures contracts, because government stocks are 8,000 tonnes below the five-year average.
• D. Sell 30 cocoa futures contracts, because the news and broker research indicate a likely rise in cocoa prices.

Best answer: B

What this tests: Portfolio Research and Construction

Explanation: Research inputs support different parts of a derivative decision. Distributor information is client-specific and is the best source for the quantity to be hedged. Contract specifications from desk research convert that exposure into contract numbers. News services, government statistics, and broker research help form a market view, but they do not replace the client’s own exposure data. Here, the manufacturer is exposed to higher cocoa prices because it will need to buy cocoa. A futures hedge against rising input prices is normally a long futures position. Applying the 50% hedge policy gives 300 tonnes to hedge, and each contract covers 10 tonnes, so the appropriate number is 30 contracts.

• Selling futures would suit a producer or holder exposed to falling prices, not a manufacturer needing to buy cocoa.
• Hedging 60 contracts ignores the stated 50% hedge policy and hedges the full 600 tonnes.
• Using the 8,000-tonne stock shortfall as the client’s hedge volume confuses market-wide statistics with the client’s physical exposure.

The hedge size is 600 tonnes × 50% ÷ 10 tonnes per contract = 30 contracts, and a buyer of cocoa hedges rising prices by buying futures.

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Question 6

Topic: Portfolio Research and Construction

A UK balanced fund holds a £30 million passive FTSE 100 allocation as its strategic equity exposure. The investment committee wants to keep the underlying tracker holdings but apply a one-month active timing view that UK large-cap equities may fall. The fund may use exchange-traded derivatives and can meet daily variation margin calls. Which implementation best applies the derivative principle for this passive-active combination?

• A. Buy FTSE 100 index futures for approximately the desired temporary reduction in equity exposure.
• B. Sell FTSE 100 index futures for approximately the desired temporary reduction in equity exposure.
• C. Buy long-dated FTSE 100 call options to replace the passive tracker holdings permanently.
• D. Sell covered calls over the FTSE 100 exposure to fully protect the portfolio from a market fall.

Best answer: B

What this tests: Portfolio Research and Construction

Explanation: A passive-active combination often keeps a strategic index holding and uses derivatives to make a tactical overlay. Selling index futures is a standard way to reduce market exposure for a short period without selling the underlying tracker. The futures position gains if the index falls, offsetting some losses on the passive holding. It is not a perfect hedge because the futures price and the fund’s actual holdings may not move identically, creating basis or tracking risk. The fund must also manage margin cash flows. Buying futures would increase equity exposure, not reduce it. Covered calls can generate income but cap upside and do not provide full downside protection. Long call options create leveraged upside exposure and are not the natural tool for a temporary underweight.

• Buying index futures would add long market exposure and increase sensitivity to a fall.
• Covered calls are a yield-enhancement strategy; the premium gives limited cushion but does not fully hedge the index holding.
• Long calls suit growth or leveraged upside participation, not a one-month tactical reduction in beta.

Short index futures can reduce market beta temporarily while leaving the passive cash portfolio in place, subject to margin and basis risk.

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Question 7

Topic: Portfolio Research and Construction

A discretionary manager runs a derivative-enhanced mandate for a client who wants exposure to UK-listed mining companies but with lower equity-market participation than an unhedged sector fund. The portfolio holds £20 million of mining shares and regularly sells sector index futures so that target net equity exposure is 70% of fund value. Futures gains and losses, collateral income, and share dividends are included in reported performance. Which benchmark is most suitable for assessing the mandate?

• A. A cash benchmark only, because the futures overlay is designed to reduce market risk
• B. A 100% UK mining sector equity index, because the physical holdings are mining shares
• C. The FTSE 100 Index, because it is the most liquid UK equity futures reference point
• D. A composite of 70% relevant UK mining sector equity index and 30% cash or collateral-rate benchmark

Best answer: D

What this tests: Portfolio Research and Construction

Explanation: A suitable benchmark should match the mandate being assessed, not simply the most familiar index or the physical holdings in isolation. Here, the client wants sector-specific mining exposure, but the manager deliberately reduces net equity participation to 70% using short sector index futures. Performance includes derivative gains and losses as well as collateral income, so the benchmark should also include a cash or collateral-rate component for the unexposed portion. A composite benchmark gives a fairer basis for judging whether returns and risk are consistent with the agreed strategy.

• A broad UK equity index fails because it does not match the mining sector exposure.
• A 100% mining sector index ignores the stated futures overlay and would overstate the intended equity risk.
• A cash-only benchmark ignores the continuing 70% net exposure to mining equities.

This reflects both the sector-specific exposure and the reduced net equity exposure created by the futures overlay.

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Question 8

Topic: Portfolio Research and Construction

A wealth manager is considering a three-month derivative overlay for a £25 million equity portfolio measured against a broad global equity benchmark. The client wants protection against a material fall in equity markets but wants to retain most upside if markets rise.

Research summary:

• Portfolio annualised volatility: 15%; benchmark annualised volatility: 14%.
• Portfolio beta to the benchmark: 1.08.
• Correlation between the portfolio and benchmark index derivatives: 0.95.
• Current tracking error against the benchmark: 3.0%.
• Technology sector index options have 32% implied volatility and a 0.48 correlation with the portfolio.
• Government bond futures have a -0.25 correlation with the portfolio.

Which action best applies the relationship between volatility, correlation, and benchmark-relative risk?

• A. Sell government bond futures because their negative correlation with equities should protect the portfolio with no option premium.
• B. Sell benchmark index futures for the full portfolio market value because high correlation makes the beta adjustment and upside objective irrelevant.
• C. Buy three-month put options on the benchmark index, using a notional broadly adjusted for the portfolio beta.
• D. Buy three-month put options on the technology sector index because its higher implied volatility should produce the strongest protection.

Best answer: C

What this tests: Portfolio Research and Construction

Explanation: For a benchmarked portfolio, hedge selection should start with the risk being hedged and the benchmark-relative effect. The portfolio is highly correlated with the benchmark and has a beta of 1.08, so benchmark index derivatives are the closest match and reduce basis risk. Because the client wants downside protection while retaining most upside, put options are more suitable than a linear futures sale, although the premium must be considered. Higher implied volatility in the technology sector makes those options more expensive and does not overcome their low correlation with the portfolio. Government bond futures may have diversification value, but they do not directly hedge the benchmarked equity exposure and could introduce additional tracking risk.

• Technology sector puts focus on a lower-correlation exposure and higher implied volatility usually increases premium cost.
• Government bond futures are not a close hedge for the benchmarked equity risk, despite the negative correlation.
• A full-notional benchmark futures sale ignores the beta estimate and conflicts with the client’s wish to retain most market upside.

Benchmark index puts align with the portfolio’s main benchmark exposure, reduce basis risk through high correlation, and preserve upside better than a linear futures hedge.

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Question 9

Topic: Portfolio Research and Construction

A discretionary manager runs a £50 million UK equity portfolio benchmarked to the FTSE 100. The manager wants to reduce the portfolio’s benchmark beta to 1.00 while retaining the underlying stock positions.

Risk analysis:

Use the implied beta formula:

\[ \beta = \rho \times \frac{\sigma_{portfolio}}{\sigma_{benchmark}} \]

For the futures overlay, use:

\[ \text{contracts} = \frac{(\beta_{current} - \beta_{target}) \times \text{portfolio value}}{\text{futures notional}} \]

Ignore transaction costs, dividends, and basis risk, and round to the nearest whole contract. Which overlay is most appropriate?

• A. Sell 625 FTSE 100 futures contracts
• B. Sell 713 FTSE 100 futures contracts
• C. Buy 88 FTSE 100 futures contracts
• D. Sell 88 FTSE 100 futures contracts

Best answer: D

What this tests: Portfolio Research and Construction

Explanation: The portfolio’s volatility is higher than the benchmark’s and its correlation with the FTSE 100 is high, so FTSE 100 futures are a suitable benchmark-related overlay. The implied beta is \(0.95 \times 18\% / 15\% = 1.14\). The manager does not want to remove all market exposure, only to reduce beta from 1.14 to 1.00. The excess beta to hedge is therefore 0.14. The futures exposure needed is \(0.14 \times £50,000,000 = £7,000,000\). Dividing by £80,000 per futures contract gives 87.5 contracts, rounded to 88. Because the objective is to reduce equity beta, the overlay should be a short futures position.

• Buying 88 futures would increase benchmark beta rather than reduce it.
• Selling 625 futures would hedge roughly the portfolio’s full notional value, not just the excess beta.
• Selling 713 futures would hedge approximately the whole implied beta exposure of 1.14, moving the portfolio close to market-neutral rather than benchmark beta 1.00.

The implied beta is 1.14, so selling about 88 contracts reduces only the excess benchmark beta above 1.00.

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Question 10

Topic: Portfolio Research and Construction

A derivatives adviser is reviewing a possible hedge for a UK food manufacturer that must buy 2,000 tonnes of wheat over the next six months. The near-month wheat futures price rose from £206 to £218 per tonne in one trading session. No forward-curve, cash-market, liquidity, or crop-supply information has yet been reviewed. The client wants to reduce input cost uncertainty and does not want a speculative position.

Which response best applies a sound derivatives principle?

• A. Treat the price rise as a prompt to review the hedge, then assess the forward curve, cash wheat basis, liquidity, supply news, and the client’s purchase schedule before selecting contract size and maturity.
• B. Take no action until wheat futures fall back because a one-day rise is usually temporary and hedging after a rise locks in a loss.
• C. Buy near-month wheat futures immediately for the full six-month requirement because the price rise proves that input costs will continue to increase.
• D. Sell wheat futures to profit from an expected correction, then use any trading gains to offset the client’s future wheat purchases.

Best answer: A

What this tests: Portfolio Research and Construction

Explanation: Derivative decisions should be supported by market information that explains the relevance of the price move to the client’s actual exposure. A one-day rise in a futures contract may reflect temporary order flow, short covering, liquidity conditions, or news that affects only part of the curve. For a wheat buyer, the adviser should review factors such as the forward curve, the basis between futures and the client’s cash purchase price, contract liquidity, supply and weather information, hedge horizon, and contract matching. This helps determine whether a hedge is needed, which maturity is appropriate, and how much exposure should be covered. Acting solely on the price movement risks creating an over-hedge, a maturity mismatch, or an unintended speculative position.

• Buying the full near-month hedge assumes the price rise predicts future prices and ignores maturity matching and basis risk.
• Waiting for a fall assumes mean reversion without evidence and may leave the client’s input cost risk unmanaged.
• Selling futures would be speculative for a wheat buyer and could increase risk if wheat prices continue to rise.

A derivative hedge should be based on relevant market information and the client’s exposure, not on a single isolated futures price movement.

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