Derivatives
Derivatives questions test whether you understand that these instruments derive value from an underlying asset, that they are zero-sum contracts rather than assets, and that leverage cuts both ways.
The four families
Forwards are bespoke OTC contracts to trade at a future date; futures are standardised, exchange-traded and centrally cleared, marked to market daily with initial and variation margin. Options give the buyer a right, not an obligation, for which the buyer pays a premium to the writer. Swaps exchange cash flows - an interest rate swap exchanges fixed for floating, a credit default swap transfers credit risk.
Options mechanics
A call gives the right to buy at the strike; a put the right to sell. Buyers risk only the premium; writers receive the premium but carry the obligation, and a naked call writer faces theoretically unlimited loss. Intrinsic value is the amount in the money; time value erodes toward expiry. European options exercise only at expiry; American options any time before it.
Hedging with futures
Exchange-traded index futures carry contract specifications: the FTSE 100 future is £10 per index point. To hedge an equity portfolio, divide portfolio value by contract value (index × £10) and sell that many contracts, adjusting for portfolio beta. Over-hedging means the residual position is short.
Regulation
Derivatives business sits under FCA rules with onshored MiFID II conduct requirements and EMIR obligations for clearing and reporting. Retail restrictions apply to contracts for difference and binary options.
Worked example
You buy one call with a 500p strike for a 20p premium, contract size 1,000 shares, so the cost is £200. At expiry the share price is 560p. Intrinsic value = 60p, so the payoff is £600 and the net profit is £400. Breakeven is 520p; below 500p the option expires worthless and the entire £200 premium is lost. Note the writer's mirror image: they keep £200 but pay out £600.
Traps that cost marks
Believing a premium is refundable or that buyers can lose more than the premium. Forgetting that futures require daily margin, so a correct long-term hedge can still force a cash call. Confusing the contract's notional value with the margin required. Assuming OTC and exchange-traded derivatives carry the same counterparty risk.