Free CISI Derivatives (CMP Level 3) practice questions

Not quite. The answer is C.

The bond already commits the company to paying a fixed coupon, so what it needs from the swap is to receive fixed, which meets those coupons, and to pay floating on the same notional. Its net cost then becomes SONIA plus or minus the gap between its coupon and the swap rate, so it moves with the market as the company wants. Paying fixed and receiving floating is the hedge the other way round, used to fix the cost of a floating rate loan, and would add a second fixed payment to the one it already has. Paying fixed and receiving fixed exchanges one fixed rate for another and leaves the cost fixed. Paying floating and receiving floating is a basis swap between two reference rates, which would leave the fixed coupon unconverted.

Not quite. The answer is D.

Mining costs differ widely from one deposit to another, so a price that has fallen below the marginal cost bites first on the producers whose costs are highest, and those mines are shut or put on care and maintenance. The loss of that output is what eventually puts a floor under the price, which is why the marginal cost of mining sits among the influences on base metal prices. The lowest cost mines are the last to suffer, and they keep producing at prices that have already driven their dearer rivals out of the market. Destocking releases warehouse stocks onto the market, which adds to supply and presses the price lower still, so it is the opposite of the response to a price that fails to cover costs. Stockpiling withholds stocks from the market, a tactic used to tighten an already short market, and it says nothing about the cost of digging the metal out of the ground.

Not quite. The answer is B.

Derivative trade reporting is two sided. Each counterparty to the contract must send the details, including the parties, the product, the notional, the price and the maturity, to a registered trade repository no later than the working day after the contract is concluded, changed or terminated. A firm may delegate the mechanics of reporting to the other side or to a third party, but the obligation and the liability for a late or wrong report stay with it. Putting the duty on the seller alone borrows a rule from securities transaction reporting and leaves half the market unreported. The clearing house reports the positions it holds once a trade has been novated to it, which does not remove the counterparties' own duty and does not apply at all to an uncleared contract. Naming the financial counterparty singles out one side, which only happens where the other side is a small non-financial counterparty, and both firms here are investment firms.

Not quite. The answer is B.

Put / call parity ties the price of a call and a put sharing one strike and one expiry to the price of the underlying and the cost of funding it to that date. Buying the call and selling the put at that shared strike leaves the holder with the payout of a long forward whichever way the underlying finishes, and the gap between the two premiums reflects the strike discounted at the risk free rate. Where the prices do not line up, an arbitrageur can deal the options against the underlying and take a riskless profit, which is what holds the relationship together. A long call with a long put is a straddle, which pays off on a large move either way and replicates nothing. A short call with a long put gives the payout of a short forward, the mirror image of the parity position. Parity holds only where the strike and the expiry of the two options are the same, so different strikes break the relationship.

Not quite. The answer is B.

A collar is built by buying a cap and selling a floor, which leaves a borrower protected if rates rise above the cap rate but giving up the benefit of any fall below the floor rate. The premium received on the floor pays for part or all of the premium on the cap, and that is why a borrower who baulks at the cost of a cap on its own will take a collar instead. A swaption is an option to enter into a swap at a future date, a single option rather than a pair of interest rate options held in opposite directions. A forward rate agreement fixes one rate for one future period outright, so it removes the benefit of a favourable move altogether rather than leaving a band. A basis swap exchanges one floating rate for another floating rate and gives no protection at all against the level of rates.

Not quite. The answer is D.

A central counterparty can only novate and margin a contract it is able to value and net against every other position in the same pool, so it will accept a swap for clearing only where the maturity, the payment dates, the floating rate index and the day count follow its published standard. That is the trade off for central clearing: the counterparties give up the bespoke terms of the bilateral market and receive daily margining and the removal of each other's credit risk. Terms freely agreed between the two parties describe the uncleared bilateral swap, which is precisely what cannot be put through the clearing house. The executing broker arranges and may guarantee the trade, but it does not set the contract specification, which is the clearing house's own. A cap of one year is invented, as cleared interest rate swaps run out to thirty years and beyond where the clearing house lists them.

Not quite. The answer is B.

A future carried through to delivery is invoiced at the exchange delivery settlement price, applied to the nominal amount changing hands, and the buyer pays that against receipt of the asset. Paying the final settlement price does not leave him better or worse off than the price he originally dealt at, as the movement between the two has already passed backwards and forwards each day as variation margin. Taking the variation margin off the invoice as well would collect the same money twice, and would leave the clearing house short. The price of the original deal, agreed when the position was opened, is the reference for the running profit or loss, not the sum invoiced at delivery. The last trade is a market print that may come from any small bargain late in the session, whereas the exchange delivery settlement price is struck by the exchange for delivery purposes.

Not quite. The answer is C.

A long strangle is built by buying a call and buying a put on the same underlying for the same expiry but at strikes either side of the current price, and it is used when a large move is expected without a view on direction. Because both options start out of the money it costs less than the equivalent straddle, but the underlying has to travel further before the position pays. The most that can be lost is the two premiums together, suffered when the market finishes between the strikes and both legs are abandoned. A long straddle uses the same expiry and the same strike for both legs, which is the single detail that separates the two. A short strangle sells both options instead of buying them, so it profits from a quiet market and carries an open ended loss if the market runs. A bull call spread uses two calls and no put, and it expresses a view that prices will rise modestly. Bought strangles and straddles are positions on volatility rather than on direction, and both bleed value while the market stays still.

Not quite. The answer is A.

An exchange seeking and keeping recognition must satisfy its regulator that business done on its market is conducted in an orderly manner and that investors are given proper protection. Everything else the regulator asks of it follows from that duty: sufficient financial resources, rules on membership and conduct, adequate clearing and settlement arrangements, surveillance of trading, and the power to investigate and discipline members. Liquidity cannot be promised by an exchange, and even where market makers are obliged to quote there is no undertaking that a counterparty will be there at every price. Dealing spreads are the product of competition between members, and a maximum spread obligation is a rule imposed on quote driven market makers rather than the exchange's own primary requirement. Uniform commission rates were once set by exchanges and were abolished as anti-competitive, with fair and open access required of the exchange instead.

Not quite. The answer is B.

The sterling inflation swap market runs off the Retail Prices Index. Index linked gilts pay coupons and redemption money on the RPI, and the pension increases and rent reviews that most users of these swaps are protecting are themselves written by reference to it, so a swap settling on any other measure would leave the hedger carrying the gap between the two indices. An average earnings index tracks pay rather than prices, and while some pension promises are linked to earnings, the swap market quotes and settles on a price index. The Consumer Prices Index is the measure the Bank of England is given a target for, and it is compiled differently and has run below the RPI for many years, so it is not the yardstick this market has settled on. The Producer Price Index covers prices charged at the factory gate rather than prices paid by households, which puts it a step away from the liabilities being hedged.