CISI Derivatives (CISI) common mistakes
CISI Derivatives · Understand the traps and how to avoid them.
Confusing the roles of clearing house, exchange and broker when asked who bears counterparty risk after a trade is novated, and answering that the original counterparties remain exposed to each other.
Candidates learn 'clearing reduces counterparty risk' as a slogan and never trace the novation step, so they miss that the CCP becomes buyer to every seller and seller to every buyer, with the clearing member standing between the client and the CCP.
What to do instead
Draw the post-trade chain once: client to clearing member (give-up/novation), clearing member to CCP. Then state for each link who is exposed if the other defaults, and note that initial margin and daily variation margin sit at the CCP and clearing member levels. Practise three scenarios: bilateral OTC trade, exchange-traded future, and a client defaulting on a margin call.
Treating the notional principal of an interest rate swap as an amount exchanged at maturity, or as the figure on which credit exposure is measured.
The word 'principal' suggests a loan, and candidates carry over bond intuition. They also assume exposure scales with notional rather than with the net present value of future cash flows.
What to do instead
State explicitly that only net interest differences change hands in a plain vanilla swap and that notional is a calculation base. For credit exposure, remember it is the cost of replacing the swap (positive mark-to-market plus potential future exposure), which is a small fraction of notional. Work one numeric example: fixed 4% versus floating, notional 100 million, one period, and compute the single net payment.
Getting the direction of the futures-versus-forward rate relationship backwards, or asserting that futures and forwards always price identically.
The convexity adjustment is counterintuitive: daily settlement means gains are received early and losses paid early, which benefits the long when rates and the futures price are positively correlated. Candidates memorise 'futures are different' without the mechanism.
What to do instead
Anchor on one sentence: futures price equals forward price minus a convexity adjustment when rates are positively correlated with the underlying, so futures trade below forwards for interest rate contracts. Then reason from margining cash flows rather than memorising the sign, and check the sign against a simple two-day example.
Mixing up intrinsic value and time value when valuing an option, for example saying a deep in-the-money European option has large time value or that an out-of-the-money option has negative intrinsic value.
Textbook definitions are known but not applied. Candidates also forget that intrinsic value is floored at zero for both calls and puts, and that time value can be large even when intrinsic value is zero.
What to do instead
Use the identity option premium equals intrinsic plus time value, and compute intrinsic as max(S minus K, 0) for a call and max(K minus S, 0) for a put. Drill five positions across moneyness and check each answer against the boundary conditions: premium at least intrinsic for a European call, and at least K discounted minus S for a European put.
Applying put-call parity without adjusting for dividends, the risk-free rate, or the European exercise restriction, and then being surprised when the relationship fails for an American option.
The parity formula is memorised as C minus P equals S minus K, which only holds for non-dividend-paying European options with the strike discounted. Candidates then use it to 'prove' arbitrage where none exists.
What to do instead
Write parity in full: C plus K times the discount factor equals P plus S, adjusted for the present value of dividends. State the assumptions before using it. For American options, use the inequality version rather than the equality, and test whether early exercise of the put is optimal when it is deep in the money.
Confusing delta, gamma, theta, vega and rho, particularly describing gamma as the rate of change of an option's value with respect to time or vega as volatility of the underlying.
The Greek names are learned as a list rather than as partial derivatives, and delta and gamma are both described loosely as 'sensitivity to the underlying'.
What to do instead
Build a one-line definition table: delta is change in option value per one unit change in underlying, gamma is change in delta per unit change in underlying, theta is change per day of passage of time, vega is change per one percentage point change in implied volatility, rho is change per change in interest rates. Then attach a sign and a magnitude intuition to each for a long call and a long put.
Describing a short straddle or short strangle as a low-risk income strategy without identifying the unlimited loss on the call leg and the margin consequences.
Candidates focus on the premium received and the high probability of profit, forgetting that the payoff profile is the mirror image of a long straddle and that losses are unbounded above for the short call.
What to do instead
Always draw the payoff diagram before answering. For any short option position, state the maximum loss explicitly: unlimited for a naked short call, strike minus premium for a short put. Then note the margin requirement and the gamma risk near expiry when the underlying is at the strike.
Misidentifying which party pays which leg in a total return swap or a credit default swap, for example saying the protection buyer pays the premium only on default.
The cash flow direction is easy to invert, and candidates conflate the roles of protection buyer and seller with the roles of fixed and floating payer, which are analogous but not identical.
What to do instead
Write the two legs as sentences. In a CDS, the protection buyer pays a periodic spread and receives a contingent payment on a credit event; the protection seller receives the spread and pays on the event. In a total return swap, the total return payer passes price appreciation and income to the receiver and receives a funding leg. Test yourself by asking who profits if the reference entity improves.
Confusing initial margin with variation margin and treating variation margin as a buffer held against future default rather than settlement of today's mark-to-market movement.
Both are called margin and both are cash, so candidates treat them as interchangeable collateral. The distinction between performance bond and settlement payment is lost.
What to do instead
Define initial margin as collateral posted to cover potential future exposure over the close-out period, returnable when the position closes, and variation margin as the daily cash settlement of gains and losses that extinguishes the day's exposure. Then apply it: if the market moves against you, which one is called, and is it returned later?
Assuming a hedge eliminates risk entirely, and failing to identify basis risk, rollover risk or the mismatch between the hedging instrument and the exposure.
The word hedge implies safety. Candidates overlook that a futures hedge on a different grade, location or maturity leaves residual risk, and that a short-dated future must be rolled, each roll carrying cost and uncertainty.
What to do instead
For every hedging question, name the exposure, the instrument, and the residual risk. Quantify basis as spot minus futures and explain that basis converges to zero only at delivery of the specific contract. State that a cross hedge leaves basis risk and that a stack-and-roll hedge leaves roll risk, then say which one dominates for the position described.