CISI Derivatives (CISI) common mistakes
CISI Derivatives · Understand the traps and how to avoid them.
Calculating a futures or forward price by compounding the spot at the risk-free rate without deducting the income or yield the underlying pays, so an index future on a dividend-paying index is priced too high.
Candidates memorise F = S(1+r)^T and then apply it mechanically to every underlying, forgetting that carry includes both financing cost and income. The dividend yield or storage cost term is the part most often dropped under time pressure.
What to do instead
Before computing, write the full cost-of-carry line: financing cost minus income plus storage, then cancel terms. Practise a three-line template (spot, carry, income) and force yourself to state the dividend yield or coupon explicitly, even when it is zero.
Treating the futures price and the value of a futures contract as the same number when answering questions on daily settlement or contract valuation.
In forwards the two coincide at inception, so candidates transfer that intuition to futures and cannot see why a contract can be worth zero at initiation but have a non-zero price. The distinction between price and value is conceptually thin and rarely drilled.
What to do instead
State the definition aloud: price is the level at which the contract is struck; value is what the position is worth now, zero at inception for both futures and forwards. Then work one example where the futures price moves after trade date and show the variation margin equals the change in value.
Confusing the obligation profile of a futures hedge with the right-but-not-obligation profile of an option, and answering hedging questions as if a long futures hedge caps downside.
Both are described as hedging tools in study material, and the payoff diagrams look similar at a glance. Candidates under exam pressure default to the option intuition that a hedge protects against adverse moves while preserving gains.
What to do instead
Draw the two payoff lines side by side for every hedging question: futures is a straight line through zero, symmetric gains and losses; long put is kinked, paying off only below the strike. Label the premium as the cost that creates the asymmetry.
Valuing an option with the Black-Scholes formula while ignoring that the model assumes European exercise and no dividends, then applying the answer to an American-style equity option question.
The formula is the most rehearsed item on the syllabus, so it becomes a reflex. Candidates rarely check the assumptions against the question's stated exercise style or dividend treatment before substituting numbers.
What to do instead
Before any pricing question, list the four assumptions you will check: European exercise, no dividends, constant volatility, frictionless markets. If any is violated, say so and switch to a binomial tree or adjusted inputs rather than forcing the formula.
Describing delta, gamma and vega as if they were independent risk measures, missing that gamma measures the rate of change of delta and therefore drives rehedging frequency.
Greeks are taught one at a time with separate formulas, so the second-order relationship between delta and gamma is not internalised. Questions that ask why a delta-hedged book still loses money expose this gap.
What to do instead
Build a one-page map: delta to underlying, gamma to delta, vega to volatility, theta to time. For each, write the first-order versus second-order distinction. Then answer one question on why a large gamma position requires more frequent rebalancing.
Explaining an interest rate swap as an exchange of principal amounts rather than an exchange of interest payments on a notional principal that is never exchanged.
The word swap suggests a two-way transfer of assets, and candidates picture loan principal moving between parties. The notional concept is abstract and easily lost in a definition-style answer.
What to do instead
Write the cash-flow schedule for a two-period swap with a notional of 100 and show that only the net interest difference changes hands. Memorise the phrase 'notional is a reference amount, not a payment' and use it in every swap answer.
Treating central clearing as a guarantee that removes counterparty risk entirely, rather than a transformation of bilateral credit risk into exposure to the clearing house plus margin and default-fund obligations.
Textbook phrasing that clearing 'mitigates counterparty risk' is remembered as 'eliminates'. The residual risks, such as mutualised default-fund contributions and basis or liquidity risk on margin calls, are less frequently tested and so less studied.
What to do instead
For any clearing question, name the three residual exposures: clearing house default, margin funding liquidity, and default-fund mutualisation. State that risk is redistributed and standardised, not deleted, and cite variation margin versus initial margin separately.
Assuming that posting initial margin means the position is fully collateralised and that no further cash calls can arise, so variation margin and intraday margin calls are omitted from answers on margin mechanics.
Initial margin is the figure most visible in study notes and is confused with a one-off deposit. The daily mark-to-market flow and the possibility of calls before settlement are operational details that candidates skip.
What to do instead
Trace one position through three days: initial margin at trade, variation margin at each settlement, and a price gap that triggers an intraday call. Distinguish initial margin (cushion against future moves) from variation margin (settlement of past moves).
Answering ethics questions by identifying the rule that was breached but not the underlying standard of conduct, such as client best interests or market integrity, that the rule implements.
Candidates revise the rulebook as a list of prohibitions and treat ethics as a memory test. Exam questions often describe a novel situation with no exact rule match, so rule-spotting produces a technically correct but incomplete answer.
What to do instead
For each scenario, answer in two layers: the specific rule and the principle it serves. Practise with unfamiliar fact patterns where no rule applies directly, and justify the outcome by reference to client interest, integrity and disclosure.
Confusing the roles of the exchange, the clearing house and the regulator, attributing margin-setting or rule-making to the wrong body in market structure questions.
The three institutions are introduced together and their functions overlap in practice, so candidates collapse them into one 'the exchange does it' answer. The distinctions are rarely tested as a standalone topic, so they go unchecked.
What to do instead
Draw a three-column table: exchange sets contract specifications and trading rules; clearing house sets margin and manages default; regulator authorises, supervises and enforces. Then classify five activities into the correct column without notes.