CISI IAD Derivatives – Options and Futures 2 — Questions and Answers
Question 1: What is 'hedging' with derivatives and why do investors use it?
- Using derivatives to speculate on price increases
- Using derivatives to reduce or offset the risk of adverse price movements in existing portfolio positions, protecting against losses while retaining upside potential (Correct answer)
- Using derivatives to increase portfolio leverage and amplify returns
- Using derivatives to avoid paying stamp duty on share purchases
Correct answer: Using derivatives to reduce or offset the risk of adverse price movements in existing portfolio positions, protecting against losses while retaining upside potential
Hedging involves taking an offsetting derivative position to protect against adverse price movements. For example, buying put options on an equity portfolio protects against a market fall. It is analogous to insurance — paying a premium (cost) to limit potential losses.
Question 2: What is a 'contract for difference' (CFD)?
- A bond contract that specifies the exact coupon payment dates
- A derivative allowing traders to speculate on price movements of an underlying asset without owning it, settling the difference in price between opening and closing the contract (Correct answer)
- A foreign exchange forward contract used to hedge currency risk
- A regulated savings contract offered by banks
Correct answer: A derivative allowing traders to speculate on price movements of an underlying asset without owning it, settling the difference in price between opening and closing the contract
A CFD is an OTC derivative where the parties agree to exchange the difference in the value of an underlying asset between the contract's opening and closing. CFDs allow leveraged exposure to equities, indices, commodities, and currencies without physical ownership, but carry significant risks.
Question 3: What is 'margin' in futures trading?
- The profit earned from a futures position
- A deposit of good faith (initial margin) placed with the exchange by both buyer and seller, and daily variation margin calls to cover any losses on the position (Correct answer)
- The fee charged by a broker for executing a futures trade
- The price differential between two futures contracts of different maturities
Correct answer: A deposit of good faith (initial margin) placed with the exchange by both buyer and seller, and daily variation margin calls to cover any losses on the position
Futures trading requires both parties to post initial margin as security. Daily mark-to-market means if the position moves against a party, they receive a variation margin call requiring them to post additional funds. Failure to meet a margin call results in the position being closed.
Question 4: What is an 'interest rate swap' and what is it used for?
- A contract to exchange one currency for another at a fixed rate
- An agreement between two parties to exchange interest rate cash flows — typically one party pays a fixed rate and receives a floating rate (or vice versa) — used to manage interest rate risk (Correct answer)
- A derivative that allows investors to swap equity exposure for bond exposure
- A government bond exchange programme run by the Bank of England
Correct answer: An agreement between two parties to exchange interest rate cash flows — typically one party pays a fixed rate and receives a floating rate (or vice versa) — used to manage interest rate risk
In an interest rate swap, one party pays a fixed interest rate and receives a floating rate (e.g., SONIA), or vice versa, on a notional principal amount. Corporations use them to convert fixed-rate debt to floating (or vice versa), managing interest rate exposure cost-effectively.
Question 5: What does it mean for a call option to be 'in the money'?
- The option has been exercised and profit has been received
- The current market price of the underlying asset is above the option's strike price, so the option has intrinsic value (Correct answer)
- The option premium has been fully recovered through trading profits
- The option is about to expire and must be exercised immediately
Correct answer: The current market price of the underlying asset is above the option's strike price, so the option has intrinsic value
A call option is in the money (ITM) when the underlying asset's market price is above the strike price — meaning the holder could profit by exercising (buying at strike and selling at market price). The intrinsic value is market price minus strike price.
Question 6: What is 'theta' in options pricing?
- The sensitivity of an option's price to changes in the underlying asset's price
- The rate at which an option's time value decays as it approaches expiry — also known as time decay (Correct answer)
- The sensitivity of an option's price to changes in implied volatility
- The change in delta for a one-unit change in the underlying price
Correct answer: The rate at which an option's time value decays as it approaches expiry — also known as time decay
Theta measures the time decay of an option's premium — as the option approaches its expiry date, all else being equal, its time value diminishes. Theta is negative for option buyers (their option loses value with time) and positive for option writers.
CISI IAD Derivatives – Options and Futures 2
What is 'hedging' with derivatives and why do investors use it?