CISI IoI Derivatives and Alternative Investments — Questions and Answers
Question 1: What is the key difference between a futures contract and an options contract?
- Futures are traded on exchanges while options are only traded over-the-counter
- A futures contract obliges both parties to transact, whereas an option gives the holder the right but not the obligation (Correct answer)
- Options are always more expensive than futures
- Futures can only be used for commodities while options are used for equities
Correct answer: A futures contract obliges both parties to transact, whereas an option gives the holder the right but not the obligation
The fundamental difference is that a futures contract creates an obligation for both buyer and seller to complete the transaction at expiry, while an option gives the holder (buyer) the right, but not the obligation, to buy or sell. The option writer (seller) has an obligation if the holder exercises.
Question 2: An investor buys a call option on shares with a strike price of GBP 5.00 and pays a premium of GBP 0.50. At what share price does the investor break even?
- GBP 5.00
- GBP 5.50 (Correct answer)
- GBP 4.50
- GBP 0.50
Correct answer: GBP 5.50
The break-even point for a call option buyer is the strike price plus the premium paid. Strike price (GBP 5.00) + Premium (GBP 0.50) = GBP 5.50. The share price must exceed GBP 5.50 for the investor to make a profit.
Question 3: What is the primary purpose of using derivatives for hedging?
- To maximise speculative profits from market movements
- To reduce or offset the risk of adverse price movements in an existing position (Correct answer)
- To avoid paying capital gains tax on investments
- To increase the leverage of a portfolio
Correct answer: To reduce or offset the risk of adverse price movements in an existing position
Hedging uses derivatives to protect an existing position against adverse price movements. For example, a fund manager holding UK equities might buy put options or sell futures to protect against a market fall. The hedge reduces potential losses but may also limit potential gains.
Question 4: Which of the following is classified as an alternative investment?
- UK government gilts
- Ordinary shares listed on the LSE
- A hedge fund using a long/short equity strategy (Correct answer)
- An OEIC investing in FTSE 100 companies
Correct answer: A hedge fund using a long/short equity strategy
Hedge funds are classified as alternative investments, along with private equity, property, commodities, and infrastructure. They differ from traditional investments (equities, bonds, cash) by often using complex strategies such as long/short positions, leverage, and derivatives.
Question 5: What does 'gearing' or 'leverage' mean in the context of derivatives?
- The ability to gain large exposure to an asset for a relatively small initial outlay (Correct answer)
- The process of converting one currency into another
- The requirement to hold derivatives until their expiry date
- The obligation to pay dividends on underlying shares
Correct answer: The ability to gain large exposure to an asset for a relatively small initial outlay
Gearing (leverage) in derivatives means that an investor can gain a large exposure to the price movements of an underlying asset by committing only a fraction of its full value (e.g., a margin deposit or option premium). This amplifies both potential gains and losses.
Question 6: What is a 'contract for difference' (CFD)?
- A contract to exchange one currency for another at a future date
- An agreement to exchange the difference in value of an asset between the opening and closing of the contract (Correct answer)
- A type of government bond with a variable coupon rate
- A legally binding agreement to purchase physical commodities
Correct answer: An agreement to exchange the difference in value of an asset between the opening and closing of the contract
A CFD is a derivative contract where two parties agree to exchange the difference in the value of an underlying asset between the opening and closing of the contract. The investor does not own the underlying asset but profits or loses based on price movements. CFDs are leveraged products and carry significant risk.
CISI IoI Derivatives and Alternative Investments
What is the key difference between a futures contract and an options contract?