CISI IoI Derivatives and Alternative Investments 2 — Questions and Answers
Question 1: What is the maximum loss for the buyer of a put option?
- Unlimited
- The premium paid for the option (Correct answer)
- The strike price of the option
- The current market value of the underlying asset
Correct answer: The premium paid for the option
The maximum loss for any option buyer (whether call or put) is limited to the premium paid. If the option expires worthless (out of the money), the buyer simply loses the premium. This is a key advantage of options over futures, where losses can be much larger.
Question 2: Which alternative investment type involves investing in companies that are not listed on a public stock exchange?
- Hedge funds
- Commodities
- Private equity (Correct answer)
- Real estate investment trusts (REITs)
Correct answer: Private equity
Private equity involves investing in companies that are not publicly listed on a stock exchange. This can include venture capital (early-stage companies), buyouts (acquiring established companies), and growth capital. Private equity investments are typically illiquid with long holding periods.
Question 3: An investor sells (writes) a call option. What is their maximum potential loss?
- Limited to the premium received
- Theoretically unlimited (Correct answer)
- Limited to the strike price
- Zero, as the writer always profits
Correct answer: Theoretically unlimited
The writer (seller) of a call option faces theoretically unlimited losses because there is no upper limit to how high the underlying asset's price can rise. If the option is exercised, the writer must sell the asset at the strike price regardless of how much higher the market price has gone.
Question 4: What is the role of a clearing house in derivatives trading?
- To provide investment advice to derivatives traders
- To act as the counterparty to both buyer and seller, reducing counterparty risk (Correct answer)
- To set the prices at which derivatives are traded
- To regulate the derivatives market on behalf of the FCA
Correct answer: To act as the counterparty to both buyer and seller, reducing counterparty risk
A clearing house (such as LCH in London) acts as the central counterparty (CCP) to every trade, becoming the buyer to every seller and the seller to every buyer. This eliminates bilateral counterparty risk, as both parties deal with the creditworthy clearing house rather than directly with each other.
Question 5: Which of the following is a characteristic of investing in physical commodities such as gold?
- They always generate regular income through dividends
- They involve storage and insurance costs and generate no income (Correct answer)
- They can only be accessed through futures contracts
- They are risk-free assets that never lose value
Correct answer: They involve storage and insurance costs and generate no income
Physical commodities like gold do not generate income (no dividends or interest). Holding physical commodities also incurs costs such as storage, insurance, and security. Investors accept these costs because commodities can act as a hedge against inflation and provide portfolio diversification.
Question 6: What is a 'swap' in derivatives terminology?
- An agreement to exchange one security for another of equal value
- A contract where two parties agree to exchange cash flows over a specified period (Correct answer)
- A trade where an investor simultaneously buys and sells the same security
- A type of option that can be exercised at any time before expiry
Correct answer: A contract where two parties agree to exchange cash flows over a specified period
A swap is an OTC derivative contract in which two parties agree to exchange (swap) cash flows over a set period. The most common type is an interest rate swap, where one party exchanges fixed interest payments for floating rate payments. Currency swaps and credit default swaps are other common examples.
CISI IoI Derivatives and Alternative Investments 2
What is the maximum loss for the buyer of a put option?