CISI IoI Derivatives and Alternative Investments

Question 1

What is the key difference between a futures contract and an options contract?

Accepted Answer

A futures contract obliges both parties to transact, whereas an option gives the holder the right but not the obligation

Answer

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?

Accepted Answer

GBP 5.50

Answer

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?

Accepted Answer

To reduce or offset the risk of adverse price movements in an existing position

Answer

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?

Accepted Answer

A hedge fund using a long/short equity strategy

Answer

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?

Accepted Answer

The ability to gain large exposure to an asset for a relatively small initial outlay

Answer

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.

CISI Introduction to Investment Practice Test

CISI Introduction to Investment Practice Test

CISI IoI Derivatives and Alternative Investments