Free CISI Intro Practice Questions: Derivatives
Practice 10 free CISI Intro sample exam questions on Derivatives, with answers, explanations, practice tests, topic drills, and the Finance Prep next step.
Use this focused CISI Intro page as a short practice test for 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
| Field | Detail |
|---|---|
| Exam route | CISI Intro |
| Issuer | CISI |
| Topic area | Derivatives |
| Blueprint weight | 8% |
| Page purpose | Focused sample questions before returning to mixed practice |
How to use this topic drill
Use this page to isolate Derivatives for CISI Intro. 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: 8% 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: Derivatives
A company has a floating-rate bank loan and wants to reduce its exposure to rising interest rates. It enters into an interest-rate swap with the same notional principal.
| Notional principal | Fixed leg paid by company | Floating leg received by company |
|---|---|---|
| £2,000,000 | 5.0% p.a. | 4.4% p.a. |
Assume a one-year period, annual interest, no fees, and no exchange of principal. Which statement correctly describes the swap cash flow for the year?
- A. It is an exchange of principal amounts, with the company paying £12,000 net under the swap.
- B. It is an option to borrow at a fixed rate, with the company paying £100,000 net under the swap.
- C. It is an exchange of interest payment streams, with the company receiving £12,000 net under the swap.
- D. It is an exchange of interest payment streams, with the company paying £12,000 net under the swap.
Best answer: D
What this tests: Derivatives
Explanation: An interest-rate swap is a derivative contract in which two parties exchange one stream of interest payments for another, typically fixed-rate payments for floating-rate payments. The calculation is based on a notional principal amount, but that notional principal is not normally exchanged. Here, the company pays fixed interest of 5.0% on £2,000,000, which is £100,000. It receives floating interest of 4.4% on £2,000,000, which is £88,000. The net swap cash flow is therefore a payment of £12,000. The broad purpose is to change the company’s interest-rate exposure, for example by combining a floating-rate loan with a pay-fixed, receive-floating swap.
- Treating the swap as an exchange of principal confuses the notional amount with an actual cash transfer.
- Receiving £12,000 reverses the direction of the net payment; the fixed leg is higher than the floating leg.
- Calling the arrangement an option is incorrect; a swap is an agreement to exchange payment streams, not a right that may simply be exercised or ignored.
The fixed payment is £100,000 and the floating receipt is £88,000, so the company pays £12,000 net while only interest streams are exchanged.
Question 2
Topic: Derivatives
An investor already holds a portfolio of UK shares and sells call options over those shares mainly to receive option premiums, accepting that gains may be capped if prices rise strongly. Which derivatives use is being described?
- A. Arbitrage
- B. Speculation
- C. Income enhancement
- D. Hedging
Best answer: C
What this tests: Derivatives
Explanation: Derivatives can be used for different purposes depending on the investor’s objective and exposure. In this case, the investor already owns the shares and sells call options to generate extra income from option premiums. This is commonly associated with income enhancement, because the premium improves return if the shares do not rise above the option’s exercise price. The trade-off is that the investor may give up some upside if the share price rises strongly and the calls are exercised. Hedging would focus mainly on reducing an existing risk. Speculation would involve taking a position to profit from an expected market move. Arbitrage would seek to exploit a price difference between related markets or instruments.
- Hedging is tempting because the investor has an existing exposure, but selling calls mainly caps upside rather than directly protecting against a fall.
- Speculation involves taking risk to profit from a market view; the main stated aim here is earning premium income.
- Arbitrage requires exploiting a pricing discrepancy, which is not indicated by the facts.
Selling options over an existing holding to earn premium income is an income enhancement strategy.
Question 3
Topic: Derivatives
A UK investor already owns 1,000 shares in ABC plc. She sells call options on those shares and receives an option premium. Which term best matches her role on the option contract?
- A. Premium payer
- B. Covered writer
- C. Naked writer
- D. Option holder
Best answer: B
What this tests: Derivatives
Explanation: In an option contract, the writer is the seller and receives the premium. If that writer already owns the underlying shares, the position is described as covered because the shares are available if the option is exercised. In this case, the investor owns the ABC plc shares before selling the call, so she is a covered writer.
A naked writer also sells the option and receives the premium, but does not own the underlying asset or have an offsetting position. The holder is the buyer of the option and pays the premium for the contractual right. The key point is that selling the option makes her the writer, and owning the shares makes that writing covered.
- Naked vs covered: a naked writer has sold the option without owning the underlying shares or another suitable offsetting position.
- Holder: the holder is the buyer of the option and has the right under the contract, not the obligation to write it.
- Premium flow: the premium is paid by the buyer and received by the writer, so premium payer does not fit these facts.
She has written the call and already owns the underlying shares, so the position is covered.
Question 4
Topic: Derivatives
A UK investor owns shares in a FTSE 100 company. She is worried about a short-term fall in the share price but wants to keep any gain if the shares rise. She buys a put option on the shares and pays a premium. Which principle does this strategy best illustrate?
- A. An asymmetric hedge that limits downside while retaining upside potential
- B. Immediate removal of market exposure by selling the shares
- C. A symmetric contract that fixes the future sale price with no upside
- D. Diversification by spreading money across different assets
Best answer: A
What this tests: Derivatives
Explanation: An option gives its buyer a right, not an obligation, to buy or sell an asset at an agreed price. Here, the investor already owns the shares and buys a put option, which gives her the right to sell at the strike price if the market falls. That helps manage downside risk.
The key pattern is asymmetric payoff:
- losses are limited or reduced by the put
- upside on the shares is still available
- the premium is the cost of that protection
This differs from a futures or forward-style position, which is more symmetric and can lock in a price without preserving the same upside flexibility.
- The idea of fixing the future sale price with no upside better matches a more binding contract pattern, such as a forward or futures exposure, not a purchased option.
- Selling the shares would remove market exposure straight away, but the investor in the stem keeps the shares and adds protection instead.
- Diversification reduces risk by holding different assets, whereas this strategy changes the payoff profile of one existing holding.
Buying a put while holding the shares creates protection against a fall, but the investor can still benefit from a rise apart from the premium cost.
Question 5
Topic: Derivatives
A UK food manufacturer expects to buy wheat in three months and wants protection if wheat prices rise. It buys exchange-traded wheat futures that match the expected purchase date and quantity.
| Detail | Figure |
|---|---|
| Contract size | 10 tonnes |
| Number of contracts bought | 10 |
| Futures price | £210 per tonne |
Ignoring costs and basis risk, which statement best describes what this futures position is being used to do?
- A. It is hedging the future purchase by locking in about £2,100 in total.
- B. It is buying the wheat immediately for £210 per tonne rather than entering a derivative contract.
- C. It is hedging the future purchase by locking in about £21,000 in total.
- D. It is speculating on a fall in wheat prices by locking in about £21,000 in total.
Best answer: C
What this tests: Derivatives
Explanation: A futures contract is a standardised derivative agreement to buy or sell an asset at a set future date and price. In this case, the manufacturer expects to buy wheat later, so buying futures helps protect against a price rise before the purchase date. The position covers 10 contracts × 10 tonnes = 100 tonnes. At £210 per tonne, the approximate price level being locked in is 100 × £210 = £21,000. This is a hedging use of futures because the contract is intended to reduce uncertainty over a future input cost, not to make a standalone bet on price movements.
- Speculating on a fall is the wrong direction: buying futures generally benefits from a rise in the futures price.
- £2,100 uses only one 10-tonne contract rather than all 10 contracts.
- A futures contract does not normally mean immediate ownership of the underlying asset; it is a derivative agreement for future settlement or delivery.
Buying 10 contracts for 10 tonnes each covers 100 tonnes, and 100 tonnes at £210 per tonne gives an approximate locked-in value of £21,000.
Question 6
Topic: Derivatives
An investor receives the following derivative contract note:
Premium: paid by the investor today
Underlying: ABC plc ordinary shares
Exercise price: 420p per share
Investor's entitlement: may buy ABC shares at 420p before expiry
Exercise: not compulsory
Which derivative term best describes the investor’s position?
- A. A long call option
- B. A short call option
- C. A futures contract
- D. A long put option
Best answer: A
What this tests: Derivatives
Explanation: A call option gives its holder the right, but not the obligation, to buy the underlying asset at a specified exercise price. Because the investor has paid the premium and holds the entitlement, the investor is long the option. The right is to buy ABC shares, so the derivative is a call rather than a put. The absence of a compulsory exercise obligation also distinguishes it from a futures contract, where both parties are committed to transact under the contract terms.
- A short call option would involve granting someone else the right to buy and receiving the premium, not paying it.
- A long put option would give the right to sell the underlying shares, not buy them.
- A futures contract creates an obligation to transact, whereas the exhibit says exercise is not compulsory.
Paying a premium for the right, but not the obligation, to buy the shares is a long call option position.
Question 7
Topic: Derivatives
A UK retail investor has a three-month view that crude oil prices will rise and wants maximum market exposure for a small initial outlay. He buys an exchange-traded oil futures contract using margin. What is the single best description of the main benefit and main risk of this choice?
- A. Oil exposure with a small cost, but losses stop at the margin.
- B. Leveraged oil exposure, but losses can exceed the margin paid.
- C. Direct physical oil ownership, but value changes only at expiry.
- D. Lower counterparty risk, but little exposure to oil price swings.
Best answer: B
What this tests: Derivatives
Explanation: The core concept is leverage in commodity derivatives. A futures contract derives its value from the underlying oil price, and the investor only posts margin rather than the full contract value. That small initial outlay increases exposure, which is attractive for a short-term view on rising oil prices. However, commodity prices can be very volatile, and futures are marked to market, so adverse movements can trigger margin calls and total losses greater than the original margin deposit.
Exchange trading can reduce counterparty risk compared with some over-the-counter contracts, but it does not remove market risk. The key takeaway is that futures offer efficient exposure, but leverage magnifies both upside and downside.
- Limited-loss trap: A small initial margin does not cap losses; further margin may be required if the market moves against the investor.
- Ownership trap: A futures contract gives price exposure to oil rather than the same thing as holding physical barrels of oil.
- Risk trap: Exchange trading can reduce counterparty risk, but the investor still has full exposure to oil price volatility.
A futures contract uses margin to create leverage, so oil price moves can produce losses greater than the initial deposit.
Question 8
Topic: Derivatives
A trainee analyst is reviewing two derivative contract descriptions before a client meeting.
| Contract | Description |
|---|---|
| Alpha | Traded on a recognised exchange, with fixed contract sizes, set expiry months, daily margining, and a central clearing house between buyers and sellers. |
| Beta | Negotiated directly with a bank for a bespoke notional amount and maturity date, with performance dependent on that bank under a bilateral agreement. |
Which conclusion is best supported by the descriptions?
- A. Both contracts should have the same liquidity because both are derivatives.
- B. Alpha is exchange-traded and Beta is over-the-counter.
- C. Alpha is over-the-counter because daily margining increases counterparty risk.
- D. Beta is exchange-traded because the maturity date can be tailored to the user.
Best answer: B
What this tests: Derivatives
Explanation: Exchange-traded derivatives are usually standardised contracts traded through an exchange, with a clearing house standing between buyers and sellers. This structure generally improves transparency and liquidity and reduces direct counterparty risk, although it does not remove all risk. Over-the-counter derivatives are privately negotiated between parties, so they can be tailored to a user’s needs, such as a specific notional amount or maturity date. The trade-off is that they are generally less standardised and may have higher bilateral counterparty risk and lower secondary-market liquidity.
- Daily margining and central clearing point towards an exchange-traded structure, not an OTC contract.
- A tailored maturity is a sign of a bespoke OTC arrangement, not a standardised exchange contract.
- Being a derivative does not mean the contracts have equal liquidity; trading venue, standardisation, and clearing arrangements matter.
Alpha has standardised exchange terms and central clearing, while Beta is bespoke and bilateral.
Question 9
Topic: Derivatives
Which derivative is designed to transfer the credit risk of a named borrower or bond issuer, usually by exchanging regular premium payments for protection if a credit event occurs?
- A. Currency swap
- B. Interest rate swap
- C. Total return swap
- D. Credit default swap
Best answer: D
What this tests: Derivatives
Explanation: The core concept is credit-risk transfer. In a credit default swap, one party buys protection on a named reference entity and pays regular premiums to the protection seller. If that borrower or issuer suffers a defined credit event, such as default, the seller makes a payment intended to offset the loss on the debt exposure. This lets an investor hedge default risk without necessarily selling the underlying bond or loan.
Other swaps serve different purposes. Interest rate swaps manage exposure to changing interest rates, and currency swaps manage exposures between currencies. A total return swap is the closest alternative, but it transfers the full economic return of an asset, including income and price movements, rather than specifically providing default protection.
- Interest-rate exposure: An interest rate swap exchanges cash flows linked to fixed and floating rates; it does not insure against a borrower failing to pay.
- Currency exposure: A currency swap is used to exchange cash flows in different currencies, so its main function is FX and funding management, not credit protection.
- Broader asset exposure: A total return swap passes the asset’s overall performance to another party, which is wider than the targeted default-risk hedge provided by a CDS.
A credit default swap transfers credit-risk exposure by having a protection buyer pay premiums for compensation if the reference entity suffers a credit event.
Question 10
Topic: Derivatives
A UK investment manager has £5 million of cash that is due to be invested in a fund tracking the FTSE 100 next week. The manager is concerned that the index may rise before the shares can be bought and wants temporary exposure that moves broadly in line with the market. What is the most appropriate next step using a derivative?
- A. Sell FTSE 100 index futures and close the futures position when the shares are purchased.
- B. Wait until the shares are available and leave the cash without market exposure until then.
- C. Buy FTSE 100 put options to benefit from a rise in the index before next week.
- D. Buy FTSE 100 index futures and close the futures position when the shares are purchased.
Best answer: D
What this tests: Derivatives
Explanation: Derivatives can be used to manage exposure without immediately buying or selling the underlying assets. Here, the manager wants temporary exposure to the FTSE 100 because the cash will not be invested until next week. Buying index futures creates a long position that should gain if the index rises, broadly offsetting the opportunity cost of waiting to buy the underlying shares. Once the shares are purchased, the futures position should be closed so the manager is not doubling the market exposure. This is an exposure-management use of derivatives, not simply a speculative trade.
- Selling index futures would reduce or hedge market exposure, which is the wrong direction when the risk is missing out on a rise.
- Put options are generally used to protect against, or profit from, a fall in the underlying index.
- Waiting leaves the manager exposed to the risk of the market rising before the cash is invested.
Buying index futures gives temporary long market exposure and can be unwound once the physical investment is made.
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