Free CISI IAD Derivatives Practice Questions: Underlying Assets

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 Underlying Assets. 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: Underlying Assets

A UK cereal manufacturer plans to hedge its next purchase of 1,200 tonnes of milling wheat. Its supplier prices the purchase as the relevant Euronext milling wheat futures price plus a fixed €14 per tonne basis. FX and basis are assumed unchanged.

For the relevant input, cost change = tonnes × change in price per tonne. Which market factor is most relevant to the manufacturer’s stated exposure?

• A. Euronext milling wheat futures price
• B. UK natural gas futures price
• C. EU Allowance futures price
• D. LME aluminium price

Best answer: A

What this tests: Underlying Assets

Explanation: For a commodity user, the most relevant market factor is the price driver that directly affects the physical input being bought or sold. Here, the manufacturer’s supplier prices the wheat purchase from Euronext milling wheat futures plus a fixed basis. Because the basis and FX are unchanged, the relevant change is the futures price movement from €226 to €244 per tonne. For 1,200 tonnes, that is a €21,600 increase in the expected input cost. Other quoted markets may be important to different businesses, but they do not directly drive this stated milling wheat purchase price.

• Natural gas may affect general production costs, but the stated exposure is the wheat purchase formula.
• Aluminium is a metals exposure and has no stated link to cereal input costs.
• EU Allowances relate to emissions pricing, not the quoted wheat purchase price.

The purchase formula is directly linked to milling wheat futures, and the input cost change is 1,200 × (€244 - €226) = €21,600.

Question 2

Topic: Underlying Assets

A derivatives desk holds several debt instruments and wants to reduce price sensitivity to changes in conventional sterling government bond yields for the next two months. The exchange’s Long Gilt futures contract has a deliverable basket of sterling, fixed-coupon UK government gilts with 8.75 to 13 years remaining to maturity. The desk intends to sell the futures as the hedge. Which holding would normally create the lowest basis risk against this futures contract?

• A. A sterling UK index-linked gilt, inflation-indexed coupon and principal, 10 years remaining, high investment-grade sovereign credit.
• B. A sterling supranational floating-rate note, quarterly benchmark reset, 5 years remaining, AAA credit.
• C. A sterling conventional UK Treasury gilt, fixed coupon, 10 years remaining, high investment-grade sovereign credit.
• D. A sterling public-authority fixed-rate bond, 10 years remaining, A credit.

Best answer: C

What this tests: Underlying Assets

Explanation: Basis risk in a bond futures hedge is lowest when the cash holding behaves like the futures contract’s deliverable assets. The relevant comparisons are not just maturity, but also issuer type, coupon structure, indexation, currency, and credit quality. A conventional UK Treasury gilt with 10 years remaining sits inside the stated deliverable maturity range and shares the fixed-coupon sovereign sterling exposure of the Long Gilt futures contract. The other holdings may still be debt instruments, but their prices respond to additional or different risk drivers such as inflation indexation, floating-rate resets, supranational credit spreads, or public-authority credit spreads. Those differences weaken the relationship between the futures price and the cash bond price.

• An index-linked gilt has sovereign credit and a similar term, but inflation-linked cash flows introduce real yield and indexation risk.
• A supranational floating-rate note has different issuer exposure, a shorter term, and coupon resets that reduce fixed-rate duration.
• A public-authority fixed-rate bond has a similar term and coupon style, but its credit spread risk is not the same as conventional UK sovereign gilt risk.

This holding most closely matches the futures deliverable profile by issuer, currency, coupon type, maturity range, and credit quality.

Question 3

Topic: Underlying Assets

A cereal manufacturer expects to buy 1,000 tonnes of local milling wheat for delivery to its factory. No liquid futures contract exists for that exact grade and location, so it buys 10 exchange-traded feed wheat futures contracts as a hedge.

• Physical requirement: local milling wheat delivered to the factory
• Physical price: £252 per tonne when the hedge is opened; £278 per tonne when it is closed
• Futures contract: feed wheat, approved warehouse delivery, November month
• Futures size: 100 tonnes per contract
• Futures price: £230 per tonne when bought; £248 per tonne when closed
• Local cash-market depth is poor during harvest, and transport restrictions can widen the milling wheat premium

The physical price increase is \(1,000 \times (£278 - £252)\). The futures gain is \(10 \times 100 \times (£248 - £230)\).

Which interpretation is most accurate?

• A. The hedge matched the tonnage, but the £18,000 futures gain did not fully offset the £26,000 physical price increase because the contract did not match the local grade, delivery point, and seasonal market conditions.
• B. The manufacturer should have sold futures, because a buyer of the physical commodity is exposed to rising spot prices.
• C. The hedge was precise because 10 contracts covered 1,000 tonnes, so the futures gain should be treated as a full offset to the physical purchase cost.
• D. The shortfall arose only because the futures contract was exchange-traded; an OTC contract would always remove quality, delivery, and liquidity risk.

Best answer: A

What this tests: Underlying Assets

Explanation: For many non-financial underlyings, the quoted derivative may be based on a standard grade, delivery location, contract month, or settlement process that differs from the actual exposure. Here, the manufacturer’s physical cost rose by £26,000, while the futures position gained £18,000, leaving an £8,000 adverse residual. The contract count matched the tonnage, but the hedge was still imperfect because milling wheat at a factory is not the same exposure as feed wheat deliverable at approved warehouses in a later month. Storage constraints, transport restrictions, seasonality, regulation, and thin local trading can all cause the cash price to move differently from the derivative price.

• Matching tonnage alone does not make a commodity hedge precise; basis can change because the deliverable asset is not identical.
• A buyer normally uses a long futures hedge to protect against rising prices, not a short futures hedge.
• OTC terms may be customised, but they do not automatically remove pricing, liquidity, counterparty, or delivery risks.

The residual £8,000 exposure reflects basis risk caused by differences in quality, location, delivery terms, seasonality, and market depth.

Question 4

Topic: Underlying Assets

A wealth manager is assessing a cash-settled total return swap that would give a client synthetic long exposure to a corporate bond. The client would receive the bond’s total return and pay a floating financing leg. If market credit spreads widen, which reference bond would create the greatest adverse mark-to-market exposure for the client?

• A. An A-rated 5-year fixed-rate bond with a 5% coupon trading at gilts +90 bps
• B. A BBB-rated 10-year fixed-rate bond with a 1% coupon trading at gilts +220 bps
• C. A AAA-rated 7-year covered floating-rate note trading at gilts +30 bps
• D. An AA-rated 2-year floating-rate note paying quarterly SONIA plus a margin and trading at gilts +45 bps

Best answer: B

What this tests: Underlying Assets

Explanation: For a synthetic long position in a debt underlying, a widening in the bond’s spread over the benchmark normally reduces the bond’s price and therefore harms the receiver of total return. Spread sensitivity is generally greater for lower credit quality and longer maturity debt. A low fixed coupon also tends to increase duration compared with a higher-coupon bond of similar maturity, increasing price sensitivity. Floating-rate notes usually have lower interest-rate duration, so their prices are typically less sensitive to benchmark yield changes, although they can still be affected by credit spread changes.

• The BBB 10-year low-coupon fixed-rate bond combines weaker credit quality, long maturity, high spread and high duration.
• The AA 2-year floating-rate note has stronger credit quality, short maturity and low spread, limiting spread and rate sensitivity.
• The A-rated 5-year fixed-rate bond has some spread exposure, but its shorter maturity, higher coupon and lower spread reduce sensitivity.
• The AAA covered floating-rate note has strong credit quality and floating-rate coupons, so it is not the highest-risk spread exposure despite its 7-year final maturity.

Lower credit quality, longer maturity, low fixed coupon and a wider benchmark spread make this bond the most sensitive to spread widening.

Question 5

Topic: Underlying Assets

A derivatives adviser is reviewing a next-quarter UK baseload power forward. The demand forecast is unchanged, there are no reported generator outages, and gas-fired generation is expected to set the marginal price. Political concerns about gas supply have already been reflected in the gas forward price.

Using these figures, which interpretation is most supportable?

• A. The power forward mainly reflects cheap electricity storage and falling holding costs into the next quarter.
• B. The power forward mainly indicates a demand shock, because the stated marginal production and delivery costs are well below the forward price.
• C. The power forward is broadly explained by marginal gas-fired production cost, carbon cost, and delivery/balancing cost.
• D. The power forward is materially below marginal cost, so the figures imply generators would be loss-making at the quoted price.

Best answer: C

What this tests: Underlying Assets

Explanation: Power prices are often strongly influenced by the marginal generating technology. If gas-fired plant is expected to be marginal, the relevant cost includes the fuel needed to produce one MWh of electricity, emissions cost, and delivery or balancing costs. Here the implied cost is £60.80 for gas, £27.00 for carbon, and £4.20 for delivery/balancing, giving £92.00/MWh. That equals the quoted power forward price. The unchanged demand forecast and absence of outage news make a demand or physical supply shock less persuasive from the facts given. Electricity is also not normally priced like an easily storable commodity, so holding cost is less relevant than marginal production and network-related costs.

• A demand shock is not supported because the provided marginal-cost calculation already reconciles to the forward price.
• Cheap storage and falling holding costs are weak explanations for power, which is difficult and costly to store at scale.
• A below-cost interpretation fails because the calculated marginal cost equals, rather than exceeds, the quoted forward price.

The implied marginal cost is £32.00 × 1.90 + £75.00 × 0.36 + £4.20 = £92.00/MWh, matching the forward price.

Question 6

Topic: Underlying Assets

An adviser reviews a client holding a UK large-cap equity tracker. Over the last two trading sessions:

• Trading volume in the tracker and related index futures has risen sharply, but quoted bid-offer spreads have widened.
• Several analysts have cut sector earnings forecasts after companies warned of weaker order books.
• Equity index futures fell before the cash market opened after a poorer GDP forecast.
• A scheduled central bank rate decision is due tomorrow.

The client asks whether selling index futures would be an appropriate temporary response. Which statement best applies a derivatives principle to these market signals?

• A. Analyst downgrades and economic forecasts affect only cash shares, so index futures should be ignored until the cash index re-prices.
• B. A short index-futures hedge could reduce broad equity exposure, but event risk, revised valuation expectations, liquidity conditions and basis risk may affect hedge effectiveness.
• C. Rising trading volume confirms strong liquidity, so a futures hedge should remove timing and execution risk.
• D. Because futures require margin rather than full payment, selling futures creates a low-risk way to profit from the expected fall.

Best answer: B

What this tests: Underlying Assets

Explanation: Equity index futures often react quickly to changes in expected earnings, economic outlook and scheduled events such as central bank decisions. Analyst downgrades and weaker GDP forecasts can reduce valuation expectations, while a known policy announcement can increase uncertainty and volatility before it occurs. Higher trading volume does not automatically mean better liquidity; widened bid-offer spreads suggest execution may be more costly or uncertain. Selling index futures can hedge a tracker holding by reducing broad market exposure, but the result may not exactly match the tracker because of basis risk, timing differences and liquidity conditions around the event.

• Higher volume can occur during stressed trading; widened spreads are a warning that liquidity may be weaker, not stronger.
• Futures prices can incorporate analyst opinion, economic outlook and timed events before the cash market fully reflects them.
• Margin creates leverage and funding efficiency, but it does not make a short futures position low risk or guarantee a profit.

The signals indicate broad equity-market risk, so short index futures can reduce directional exposure while liquidity and basis risk prevent a perfect hedge.

Question 7

Topic: Underlying Assets

An adviser is comparing three possible debt underlyings for an OTC total return swap. The client would receive the total return on the selected debt instrument, with the same notional amount and collateral terms in each case.

• 5-year AA-rated sovereign bond, fixed 4% coupon, benchmark spread +30bp
• 12-year BBB-rated corporate bond, fixed 2% coupon, benchmark spread +240bp
• 12-year BBB-rated corporate floating-rate note, coupon 3-month SONIA +240bp, reset quarterly

Which assessment best applies to the derivative exposure?

• A. The floating-rate note removes both interest-rate exposure and issuer credit exposure because its coupon resets quarterly.
• B. The 5-year AA-rated sovereign bond has the highest credit derivative exposure because its benchmark spread is the tightest.
• C. All three underlyings have the same exposure because the total return swaps have the same notional and collateral terms.
• D. The 12-year BBB fixed-rate corporate bond gives the greatest combined exposure to benchmark yield changes and credit spread widening.

Best answer: D

What this tests: Underlying Assets

Explanation: Debt-related derivative exposure depends on the characteristics of the referenced debt, not just the derivative notional. Lower credit quality and a wider benchmark spread indicate greater credit risk and greater sensitivity to spread widening. Longer maturity generally increases price sensitivity to yield and spread movements. A lower fixed coupon also tends to increase duration because more value is concentrated in later cash flows. A floating-rate note normally has lower sensitivity to benchmark rate changes because the coupon resets, but it still carries issuer credit and spread exposure. Here, the 12-year BBB fixed-rate corporate bond combines weaker credit quality, a much wider spread, longer maturity, and a low fixed coupon, making it the most exposed of the three to adverse movements in yields and credit spreads.

• Quarterly reset reduces benchmark rate duration, but it does not eliminate issuer credit or spread exposure.
• Equal notional and collateral terms do not make the underlying debt exposures equivalent.
• A tight spread on a high-quality short sovereign bond usually indicates lower, not higher, credit spread risk.

Its lower credit quality, wider spread, longer maturity, and low fixed coupon all increase sensitivity to adverse debt-market movements.

Question 8

Topic: Underlying Assets

A portfolio manager is considering receiving the total return on one of four corporate bonds through a total return swap with a £10 million reference notional. Ignore movements in the government yield curve, accrued interest, coupons during the day, and the financing leg. Estimate the immediate mark-to-market effect of the stated issuer spread stress on the receiver of total return.

Use: approximate price change = -spread duration × spread change, with spread change in decimal form.

Which reference bond would create the largest loss?

• A. BBB, 12-year, 2.5% fixed, with an approximate loss of £552,000
• B. BBB, 7-year, 5.0% fixed, with an approximate loss of £348,000
• C. BB, 5-year, 7.0% fixed, with an approximate loss of £312,000
• D. AA, 3-year, 4.5% fixed, with an approximate loss of £81,000

Best answer: A

What this tests: Underlying Assets

Explanation: For a receiver of total return, a fall in the reference bond price is a loss. Credit spread widening reduces the price of a fixed-rate bond, and the effect is larger when spread duration is higher. Longer maturity and lower coupon structures typically increase spread duration, while weaker credit quality may be associated with larger spread moves. Here, the stressed spread change for the 12-year BBB bond is 60 bp, or 0.006. Multiplying by its spread duration of 9.2 gives an approximate price change of -5.52%. On a £10 million notional, that is a loss of about £552,000, which is larger than the losses on the other reference bonds.

• The AA 3-year bond has a modest 30 bp spread widening and low spread duration, so the estimated loss is only £81,000.
• The BBB 7-year bond has a 60 bp widening, but its spread duration is materially lower than the 12-year low-coupon bond.
• The BB 5-year bond has poorer credit quality and an 80 bp widening, but its shorter maturity and higher coupon reduce the spread-duration impact.

The 60 bp spread widening gives a price fall of about 9.2 × 0.006 = 5.52%, or £552,000 on £10 million.

Question 9

Topic: Underlying Assets

A derivatives desk is structuring a cash-settled option on a government bond. The settlement value is based on the bond’s inflation-adjusted redemption amount.

• Nominal principal referenced by the option: £5,000,000
• Inflation index ratio at valuation: 1.08
• Redemption amount used for settlement: £5,000,000 × 1.08 = £5,400,000

Which type of debt is the relevant underlying?

• A. Convertible debt
• B. Zero-coupon debt
• C. Floating-rate debt
• D. Index-linked debt

Best answer: D

What this tests: Underlying Assets

Explanation: Index-linked debt has cash flows that are adjusted by reference to an index, commonly an inflation index. In the scenario, the derivative settlement amount is calculated by multiplying the bond’s nominal principal by an inflation index ratio, increasing the redemption amount from £5,000,000 to £5,400,000. That makes index-linked debt the relevant underlying. Floating-rate debt would involve coupon payments resetting by reference to a money-market or other interest rate. Zero-coupon debt would be issued at a discount and redeemed at maturity without periodic coupons. Convertible debt would include a right to convert into shares or another equity-linked exposure.

• Floating-rate debt is linked to resetting interest coupons, not inflation-adjusted principal.
• Zero-coupon debt focuses on discount-to-redemption mechanics, not indexation.
• Convertible debt involves conversion into equity, which is not part of the settlement basis here.

The settlement amount is based on principal adjusted by an inflation index ratio, which is characteristic of index-linked debt.

Question 10

Topic: Underlying Assets

A derivatives adviser is reviewing eligible money-market underlyings for a client that will hold surplus sterling cash for three months while using short-term rate futures to manage reinvestment risk. The proposed instrument is a UK Treasury bill with £1,000,000 nominal, issued through the government tender process and maturing in 91 days. The client asks how the bill is normally issued and what cash flows to expect. Which is the single best description?

• A. It is a bank deposit receipt, issued directly by a commercial bank in small retail denominations, with interest paid periodically until redemption.
• B. It is a corporate money-market note, issued at a premium through a dealer programme, with its return coming mainly from a final capital loss.
• C. It is a coupon-bearing government bond, sold at par by syndication, with semi-annual interest and capital repaid at the next coupon date.
• D. It is a short-term government borrowing instrument, issued by tender in large nominal denominations, sold below par, paying no coupon, and redeemed at par at maturity.

Best answer: D

What this tests: Underlying Assets

Explanation: A Treasury bill is a short-term government money-market instrument used to raise or manage government cash over short periods. It is normally issued through a tender or auction process in large nominal amounts, has a maturity typically measured in weeks or months rather than years, and carries no periodic coupon. Instead, it is issued or traded at a discount to its face value and redeemed at par on maturity. The investor’s return is therefore the difference between the discounted purchase price and the redemption amount. For a derivatives adviser considering short-term-rate exposure, a Treasury bill is a short-dated government cash instrument, not a coupon-paying gilt, bank deposit, or corporate commercial paper.

• A coupon-bearing government bond describes a gilt-style instrument, not a short-term zero-coupon Treasury bill.
• A bank deposit receipt points to a bank-issued instrument, whereas a Treasury bill is issued by the government.
• A corporate money-market note has the wrong issuer, and a Treasury bill’s return comes from buying below par and receiving par, not from a premium issue and capital loss.

Treasury bills are short-term zero-coupon government money-market instruments whose investor return is the discount between issue price and par redemption.

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