Free CISI Derivatives mock exam

Not quite. The answer is A.

An OTC contract is negotiated directly between two counterparties, so both its terms and its price are a private matter between them. Nothing appears on a screen for the rest of the market to read, which suits a large user that would rather not show its hand, and it is why OTC markets are described as less transparent than exchange traded ones. A clearing house sees only the business that is registered with it, and a swap left bilateral between the fund and the bank never reaches one, so it cannot be the party that holds the terms. Publication by the exchange in real time is the feature a listed contract has and this one does not, as dealing on an order book is reported as it happens. Publication at the close would still put the price in front of the whole market, which is exactly what a privately negotiated deal is designed to avoid.

Not quite. The answer is A.

A forward rate is the spot rate adjusted for the difference between the two interest rates over the period to the forward value date. The adjustment is the amount that removes any risk free profit from borrowing in one currency, converting at spot and depositing in the other. Inflation differentials sit behind interest rates over the long run but they are not the input to the calculation. The forward rate is not a forecast of where spot will be, and it will differ from the eventual spot rate in most cases. Forward rates are also not set independently of spot, and a quoted forward that departs from the calculation invites arbitrage.

Not quite. The answer is A.

A give-up agreement is signed by the client, the broker who executes and the broker who clears, and it is the clearing broker that decides whether to take the trade into the client's account. Acceptance is not automatic: a trade that breaches the limits set for that client, or that falls outside the products covered by the agreement, can be rejected. Until it is accepted the trade sits on the executing broker's books, and the executing broker carries the position and funds the margin on it, which is the main risk in the arrangement. The executing broker cannot make the other firm take the trade, so it has no power to accept on its own behalf. The clearing house registers whatever its clearing member presents to it and takes no view on which client account a trade belongs in. Nor is the decision a joint one, as the agreement gives the clearing broker alone the right to refuse and leaves the executing broker to present the trade

Not quite. The answer is C.

Volatility measures how far the underlying price is expected to move, and a wider range of possible outcomes raises the chance that an option finishes in the money before it expires. That works in the same direction for both types of contract, so a rise in implied volatility lifts call premiums and put premiums together. A rise confined to call premiums is the effect of a rise in the underlying price, which helps calls and hurts puts, and the underlying price is a separate input from volatility. A rise confined to put premiums is the same confusion the other way round, as it is a fall in the underlying that lifts puts on their own. Volatility is one of the main inputs to any option pricing model, so a change in it always feeds through to the premium rather than leaving it where it was.

Not quite. The answer is D.

The threshold is the unsecured exposure each party is willing to run before any collateral is called, so only the amount above GBP 2,000,000 is ever collateralised. Here the mark to market of GBP 2,100,000 leaves an excess of GBP 100,000. The minimum transfer amount then blocks any call smaller than GBP 250,000, which keeps small movements from generating a stream of trivial payments, so nothing is delivered on this valuation. Calling the full mark to market ignores the threshold entirely and would collateralise exposure the parties have agreed to leave unsecured. Calling the excess over the threshold gets the method right but forgets that GBP 100,000 falls under the minimum transfer amount. Calling the minimum transfer amount treats that figure as a fixed payment rather than as a floor below which no transfer is made.

Not quite. The answer is A.

The clearing house has a contractual relationship with its clearing members alone, so initial and variation margin are called from those members and must be paid, normally in cash, by an early deadline the following morning. A client's margin is called by its own clearing broker, which then meets its own obligation to the clearing house on the whole of its book, so the clearing house never deals with the underlying client. Margin is called every business day against the daily settlement price, and a further intra-day call can be made when prices move sharply, rather than waiting for a failure to appear. Credit lines and initial margin lines are commercial limits set by the clearing broker for each of its clients, and the clearing house takes no part in setting them. The whole point of the process is that losses are collected as they arise, which is what allows the clearing house to guarantee performance.

Not quite. The answer is B.

The point of the front to back check is to prove that every deal the dealers believe they have done has reached the books at the same terms, and that nothing has been booked which they did not do. Breaks found this way are usually miskeyed prices, wrong sides or missing tickets, and they are corrected before positions and profit and loss are reported. Comparing clearing house margin with margin held from clients is a margin reconciliation, run by the settlements team for a different purpose. Comparing exchange positions with depository holdings is a stock or position reconciliation and does not test what the dealers actually traded. Checking valuation prices against published closing prices is part of price verification, which supports the daily profit and loss rather than the trade record.

Not quite. The answer is A.

An OTC contract is priced by the counterparty and never appears on a public tape, so the user has no independent market price against which to value the position or to test whether the rate it was quoted was a fair one, and it falls back on the dealer's own marks or on a third party valuation. That loss of transparency is what a user pays for the flexibility of dealing away from an exchange. Matching the contract to the exposure is the opposite way round: an exchange contract comes in fixed lot sizes and fixed delivery months and leaves a remainder unhedged, while an OTC contract can be written for the exact amount and date. Initial margin with a clearing house is an exchange traded feature, and although the uncleared margin rules now make large users exchange initial margin bilaterally, that margin is held with a third party custodian and not by a clearing house. Reporting to the exchange is likewise an exchange feature, since an OTC trade is reported to a trade repository rather than to a market that never saw it.