How to Pass the CISI IAD Derivatives Exam

Derivatives is the technical unit of the CISI Level 4 Investment Advice Diploma that most candidates arrive at with the least working knowledge, because most advisers do not trade futures and options day to day. It is not the Level 3 Capital Markets Programme paper of the same name, which is a different level with a different syllabus lineage and a different workbook, and which catches a steady stream of candidates out before they have opened a book. This paper is 80 questions across ten elements, from what a derivative is through to the rules around selling one, and three of those ten elements carry 42 of the 80 marks.

The exam is 80 multiple-choice questions in two hours, with a 70% pass mark, which means 56 correct answers. It is computer based and there is no negative marking, so answer every question, including the ones you are guessing. The current workbook is Edition 16, written against syllabus version 16. The weightings below are the exam specification rather than anybody's estimate, so the shape of the paper is settled before you sit it and you can plan your revision against it.

Candidates are usually trainee or newly qualified advisers, paraplanners moving into advice, private client and wealth staff, and people coming across from operations or banking who need a Level 4 technical unit on record. Passkey covers the other Investment Advice Diploma units too: Securities, UK Regulation and Professional Integrity, Investment Risk and Taxation and Financial Planning and Advice.

Know the weightings before you revise

Eighty questions across ten elements, and the spread is lopsided. Three elements are 14 marks each, Underlying Assets is 10, and the remaining six share 28 between them.

Exchange Traded Futures and Options, OTC Derivatives and Trading, Hedging and Investment Strategies are 14 marks each, 42 between them and more than half the paper. Underlying Assets follows at ten, then Clearing at seven, then Delivery and Settlement and Portfolio Research and Construction at five apiece. The tail is thin: Introduction to Derivatives and Investment Selection and Administration are four each and Regulatory Requirements is three. Those three smallest elements are eleven marks between them, and they are the cheapest eleven marks on the syllabus.

What each element tests

Introduction to Derivatives (4 questions)

Four marks on the vocabulary the rest of the paper assumes. What a derivative is and how its value is taken from something else, the difference between a future, a forward, an option and a swap, and the three uses the syllabus keeps returning to: hedging, speculation and arbitrage. Exchange traded against over the counter is introduced here and examined everywhere else.

Underlying Assets (10 questions)

Ten marks, and the largest element outside the top three. The markets derivatives are written on: equities and equity indices, bonds and interest rates, currencies, commodities from metals and energy to soft and agricultural products, and credit. What is examined is how each cash market behaves, because that drives the contract: storage and carry for a commodity, coupon and accrued interest for a bond, dividends for a share.

Exchange Traded Futures and Options (14 questions)

The first of the three heavy elements. Contract specifications and why they are standardised: contract size, delivery months, tick size and tick value, and the arithmetic of turning a price move into money. Futures pricing, cost of carry, fair value and basis. Then options: calls and puts, buying against writing, strike price, premium, intrinsic and time value, and what moves a premium. Exchange trading, position limits, and how a position is opened and closed.

OTC Derivatives (14 questions)

Equal in weight to exchange traded and far less familiar. Forwards, including forward rate agreements, and how they differ from a future in standardisation, credit exposure and settlement. Swaps are the substance: interest rate swaps and the fixed against floating exchange, currency swaps, and credit default swaps and what the protection buyer is buying. Then documentation, the counterparty risk an OTC contract carries, collateral, and the clearing and reporting obligations that now reach much of the market.

Clearing (7 questions)

Seven marks on what happens once the trade is done. The central counterparty and novation, why a clearing house standing between the two sides removes counterparty risk, and the difference between a clearing member and a client. Margin is the heart of it: initial against variation margin, what each is for, and how an open position is marked to market daily.

Delivery and Settlement (5 questions)

Five marks on how a contract ends. Closing out before expiry, which is what happens to most positions, against physical delivery and cash settlement. Delivery mechanics and the delivery month, notice and assignment for an option, exercise style and the difference between American and European exercise, and how an expiry or settlement price is arrived at.

Portfolio Research and Construction (5 questions)

Five marks that sit closer to the Securities unit than to the rest of this one. Risk and return, correlation and diversification, and client objectives. Fundamental and technical analysis in outline, asset allocation and benchmarks, and how a derivative overlay changes a portfolio's exposure without the underlying holdings being bought or sold.

Trading, Hedging and Investment Strategies (14 questions)

The third heavy element and the one candidates find hardest, because everything earlier has to be put to work rather than recalled. Hedging with futures: long and short hedges, hedge ratios and basis risk. Option strategies and their payoffs, from covered calls and protective puts to straddles, strangles, spreads and collars, each with a maximum profit, a maximum loss and a break-even. Then speculation, arbitrage, spread trading, and what gearing does to both sides of a position.

Investment Selection and Administration (4 questions)

Four marks on the practical end: choosing a suitable contract for a stated client objective, the suitability work that goes with recommending a geared product, and the account opening, record keeping, valuation and reporting that follow. Small, quick to learn, and near the back of the workbook, which is where it usually gets skipped.

Regulatory Requirements (3 questions)

The smallest element at three marks. The framework around derivatives business: the conduct rules that apply when a geared product is sold to a client, client money and client asset protections, reporting obligations, and market abuse and the controls run against it. Three marks is still three marks, and it is one evening's reading.

Where people slip

The first and largest problem is revising ten elements as though they were ten equal chapters. Exchange Traded Futures and Options, OTC Derivatives and Trading, Hedging and Investment Strategies are 42 of the 80 marks between them, and the other seven elements share 38. Read the weighting table before you build a timetable rather than after.

The second is Trading, Hedging and Investment Strategies, the element candidates find hardest. Nothing in it is new, which is the problem: every earlier concept has to be put to work at once. A hedge ratio or a collar means nothing until contract specifications, swaps and margin are solid. Revise it late, and revise it twice.

The third is margin, and specifically initial against variation margin. The two are examined by being swapped over: which is posted when the position opens, which is called after a daily mark to market, and which comes back at the close. It is a reliable source of lost marks, and one table fixes it.

The fourth is option payoffs learned as definitions. A covered call is easy to describe and no use described, because the question gives you a strike, a premium and an underlying price and asks for the break-even or the maximum loss. Draw the payoffs and drill the arithmetic until it is automatic.

The fifth is revising from the wrong workbook entirely. Both the Level 4 Investment Advice Diploma and the Level 3 Capital Markets Programme have a unit called Derivatives, and the mix-up is common enough to cost people a sitting. Before you read a page, check the cover says Investment Advice Diploma and Edition 16.

How long it takes to prepare

Nobody can tell you how many hours you need, because it turns on how much of this you already meet at work, and for most advisers the honest answer is very little. The more useful question is where the hours go, and on this paper the weightings answer it unusually clearly.

More than half of them belong to the three 14-mark elements, and of those three, Trading, Hedging and Investment Strategies should come last, because it only works once the other two are solid. Give Underlying Assets an eighth, Clearing a little less, and an evening apiece to Delivery and Settlement, Portfolio Research and Construction, Introduction to Derivatives, Investment Selection and Administration and Regulatory Requirements. That still leaves room for two full timed mocks at the end, which is where the format rehearsal happens rather than the learning.

How to revise it

Work in syllabus order, which is better advice here than on most papers. Contract size, tick value, basis and premium come from Exchange Traded Futures and Options and are used by everything after it. Swaps and counterparty risk come next, then clearing and margin, then the strategies element that leans on all three.

Work the numbers with a pen. Tick value and the money value of a price move, a hedge ratio, and the break-even, maximum profit and maximum loss of each option strategy: do each enough times that the method is automatic, because 90 seconds a question leaves no room to reconstruct it.

Build a one-page table of the option strategies with their payoffs, and a second of initial margin against variation margin. Most of the marks in the heavy elements turn on keeping similar things apart, and a table you have drilled beats a chapter you have read.

Then revise by being tested rather than by rereading. The gap between recognising a term and knowing it cold shows up only under a clock, so finish with timed 80-question mocks weighted like the real paper, and use repeated results alongside your timetable and remaining weak areas when deciding whether to book. No mock score can predict an individual result. If you are not sure where to start, the Introduction diagnostic will tell you which elements are costing you most.

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