CIRE practice questions: derivatives (Element 8)

10 free questions

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1. 1

   A mining company executive knows that an internal assay report confirming a major ore discovery has not yet been publicly released. She calls her registrant and places a large buy order in the company's shares. Under Canadian securities law, which of the following is most accurate?

   Outcome 8.1 · click for answer

   A.The trade is permissible because the executive's account is at an arm's-length dealer and the order was placed verbally.

   B.The prohibition applies only if the executive is a director or officer of a reporting issuer; a senior employee does not qualify as an insider.

   C.The trade is permissible because the executive is buying, not selling, her own company's shares.

   D.The executive is trading on material non-public information and the trade is prohibited under insider trading provisions of applicable securities legislation; the registrant who knowingly facilitates such a trade may also face liability.Correct

   Insider trading prohibitions under provincial securities legislation apply to any person in a special relationship with a reporting issuer who trades with knowledge of a material fact or material change that has not been generally disclosed. Senior employees such as executives fall squarely within this definition. The prohibition applies equally to purchases and sales. A registrant who knowingly facilitates insider trading may be found to have tipped or assisted the insider, attracting their own regulatory and civil liability.

2. 2

   A trader enters a series of buy and sell orders for a thinly traded security using two accounts he controls, creating the appearance of active trading and causing other investors to buy at an inflated price. He then sells his position at the higher price. Which market integrity violation does this most clearly describe?

   Outcome 8.2 · click for answer

   A.Wash trading paired with a pump-and-dump, using related accounts to inflate the price before exitingCorrect

   B.Late trading, since the offsetting orders were booked after the market officially closed

   C.Front-running, since he traded in his own accounts ahead of a client order he knew about

   D.Spoofing, since the orders were entered with intent to cancel before any execution occurred

   The described scheme involves wash trading, executing offsetting buy and sell orders between related accounts to create the illusion of genuine market activity, combined with a pump-and-dump strategy designed to attract other buyers at an artificially inflated price. Both UMIR and provincial securities legislation prohibit these activities. Front-running involves trading ahead of known client orders, and spoofing involves placing orders with intent to cancel before execution, neither of which is the primary characterization here.

3. 3

   A client buys one call option on shares of a Canadian bank with a strike price of $130 and an expiry of three months. The current share price is $128. Which statement correctly describes the client's position at expiry if the shares are trading at $125?

   Outcome 8.1 · click for answer

   A.The client is obligated to buy the shares at $130 since call buyers must exercise at expiry

   B.The call expires worthless since $125 is below the $130 strike, capping the loss at the premiumCorrect

   C.The call is in the money here and the client collects $5 per share at settlement

   D.The position converts automatically into shares because this is an American-style option

   A call option gives the holder the right; not the obligation; to buy the underlying at the strike price. At expiry with the stock trading at $125, exercising the call to buy at $130 would be economically irrational (the client could buy shares in the market for $125). An out-of-the-money call expires worthless. The buyer's maximum loss is the premium paid. A call buyer has the right to buy; a call seller (writer) has the obligation to sell. Automatic conversion to shares occurs only for deep-in-the-money options under some brokerage exercise-by-exception rules, which does not apply here.

4. 4

   A call option on a Canadian bank stock has a strike price of $110 and a premium of $4.50. The option expires in 60 days. What is the break-even price for the option buyer at expiry, and under what condition does the buyer profit?

   Outcome 8.1 · click for answer

   A.Break-even is $114.50, strike plus premium, and profit needs the stock above $114.50 at expiryCorrect

   B.Break-even is $110, the strike itself, with loss capped at the stock price minus $110 at expiry

   C.Break-even is $105.50, strike minus premium, and profit needs the stock below that level at expiry

   D.Break-even is $110, the strike price, and profit begins the moment the stock passes $110

   For a call option buyer, the break-even price at expiry equals the strike price plus the premium paid: $110 + $4.50 = $114.50. At expiry, if the stock price equals $114.50, the buyer's profit from exercising (or selling) the option exactly offsets the premium paid. The buyer profits when the stock price exceeds $114.50 because intrinsic value > premium paid. The maximum loss for the buyer is the premium paid ($4.50 per share), regardless of how far the stock falls.

5. 5

   Which of the following best describes a key difference between an exchange-listed futures contract and an over-the-counter (OTC) forward contract?

   Outcome 8.2 · click for answer

   A.Futures are standardized, clearinghouse-settled daily, forwards are custom deals with mutual credit exposureCorrect

   B.Futures and forwards carry equal counterparty risk, since both bind two parties to a future trade

   C.Futures are privately negotiated on size and delivery terms, the same way forward contracts are

   D.Forwards settle daily through clearinghouse margining, just as exchange-listed futures do

   Futures contracts traded on exchanges (such as the Montréal Exchange) are standardized as to contract size, delivery dates, and specifications, and are centrally cleared by a clearing house (CDCC in Canada). Central clearing substitutes the clearing house for both counterparties, eliminating bilateral credit risk. Daily mark-to-market settlements ensure that gains and losses are settled each day through the margin system. OTC forward contracts are bilateral, customized agreements between two counterparties with no central clearing; each party bears the other's credit risk for the life of the contract.

6. 6

   A portfolio manager holds 10,000 shares of a Canadian resource company currently trading at $45. The manager buys put options at a strike of $42 (1 contract = 100 shares, premium = $1.80 per share) as a hedge. What is the maximum loss on the hedged position per share if the stock falls to $30 at expiry?

   Outcome 8.2 · click for answer

   A.Maximum loss equals $3 per share, the gap between the $45 entry and the $42 strike price

   B.Maximum loss equals $4.80 per share, the $45 entry minus the $42 strike net of the $1.80 premiumCorrect

   C.Maximum loss equals $1.80 per share, since exercising the put at $42 fully offsets any price decline

   D.Maximum loss equals $15 per share, since the put cannot be exercised below the strike price

   The put option grants the right to sell at $42. If the stock falls to $30, exercising the put yields $42 per share regardless of the market price. Net proceeds per share after paying the premium = $42 - $1.80 = $40.20. The loss relative to the original $45 purchase price = $45.00 - $40.20 = $4.80 per share. The put effectively sets a floor: no matter how far below $42 the stock falls, the manager receives $42 from exercise. The premium ($1.80) represents the cost of the insurance and is the additional loss beyond the $3 in-the-money gap.

7. 7

   A Canadian wheat farmer expects to harvest 50,000 bushels in four months and is concerned that wheat prices may fall before harvest. Which derivative strategy would most directly hedge this risk?

   Outcome 8.3 · click for answer

   A.Sell short wheat futures now to lock in today's price and offset a spot price decline at harvestCorrect

   B.Enter an interest rate swap now to convert fixed-rate debt into floating-rate debt exposure

   C.Buy call options on wheat futures now to profit if wheat prices rise before the harvest

   D.Buy put options on wheat futures, which obligates the farmer to sell at the strike price

   A producer holding physical inventory who fears a price decline uses a short hedge: selling futures contracts at today's price to lock in a forward sale price. If the spot price falls by harvest, the futures position will have gained in value, offsetting the lower cash price received for the physical wheat. Buying call options would profit from a price increase; the opposite of what the farmer fears. Buying put options would give the right to sell at the strike price, which is a different hedging mechanism more suitable for an investor, and not an obligation as stated in option C. Interest rate swaps are unrelated to commodity price risk.

8. 8

   An investor buys a call option on shares of a company when the share price is $50, the strike price is $52, and the premium is $3.00. What is the investor's break-even share price at expiry?

   Outcome 8.4 · click for answer

   A.$47.00, found by subtracting the premium paid from the current share price

   B.$52.00, the strike price alone, ignoring the premium the investor paid upfront

   C.$50.00, the original share price at the moment the call option was purchased

   D.$55.00, found by adding the premium paid to the strike price ($52 + $3)Correct

   For a call option buyer, the break-even point at expiry is the strike price plus the premium paid. Here, the investor needs the stock to be above $52 (strike) by enough to recover the $3 premium; a total of $55. Below $55, the investor has a net loss on the position. At exactly $55, the intrinsic value ($55 - $52 = $3) exactly offsets the premium. Above $55, the investor profits on a dollar-for-dollar basis with each additional point of stock appreciation. The current stock price ($50) and its relationship to the strike ($52) indicate the option is currently out-of-the-money.

9. 9

   A client wants to hedge their Canadian equity portfolio against a broad market decline using derivatives. They are choosing between listed index put options and an OTC equity swap. Which key difference should the registrant highlight?

   Outcome 8.5 · click for answer

   A.OTC equity swaps trade under UMIR marketplace rules, which lowers their counterparty risk enough to make them as safe as exchange-cleared options for retail clients.

   B.Listed puts require the writer to post exchange margin against losses, while OTC equity swap counterparties are exempt from any margin or collateral obligations.

   C.Exchange rules generally bar retail investors from listed index options, so OTC equity swaps are the standard hedging vehicle registrants offer retail clients.

   D.Listed index puts are standardized and centrally cleared with no counterparty credit risk, in fixed contract sizes. OTC swaps are customizable but carry bilateral counterparty risk.Correct

   Exchange-listed options are standardized contracts cleared through a central counterparty (CDCC), eliminating bilateral credit risk, and trade in defined contract sizes. OTC derivatives like equity swaps are bilaterally negotiated under ISDA master agreements, allowing customization of notional, term, and underlying exposure, but they expose each party to the other's ability to perform (counterparty credit risk). UMIR governs trading conduct on Canadian equity marketplaces, not OTC swap risk, and does not make OTC products "as safe" as centrally cleared ones. OTC counterparties are not exempt from margin/collateral — they typically post it under an ISDA Credit Support Annex. Both listed options and OTC swaps are available to qualifying retail and institutional clients, so access is not restricted to one product type.

10. 10

    A trader sells a straddle on a stock trading at $50. She sells a call with strike $50 at a premium of $4 and a put with strike $50 at a premium of $3.50. What is the maximum profit and the two break-even points at expiry?

    Outcome 8.5 · click for answer

    A.Maximum profit is the combined premium of $7.50 with break-evens at $42.50 and $57.50Correct

    B.Maximum profit is the call premium of $4 alone with break-evens at $46 and $54

    C.Maximum profit is unlimited since it gains from a large move in either direction

    D.Maximum profit is $7.50 but the break-evens round to $43 and $57 near the strike

    A short straddle earns the combined premium when both options expire worthless: $4 + $3.50 = $7.50 maximum profit, achieved when the stock closes exactly at $50 at expiry. Break-even (upside) = $50 + $7.50 = $57.50. Break-even (downside) = $50 - $7.50 = $42.50. Below $42.50, the short put produces losses; above $57.50, the short call produces losses. The maximum loss is theoretically unlimited on the upside (from the short call) and substantial on the downside (from the short put, capped at $42.50 if the stock goes to zero). Short straddles profit from low volatility; the stock staying near $50.

FAQ

How much math is on Element 8?

Less than candidates expect. The CIRE tests payoff direction and option-strategy logic more than precise option pricing. Memorize: long call = unlimited upside / max loss is the premium, long put = max gain is K minus premium, put-call parity (C minus P equals S minus PV(K)), futures cost of carry (F equals S times e to the (r minus q) t). With those, you can reason through most questions.

Do I need to know Black-Scholes?

You do not need to compute a Black-Scholes price on the CIRE. You should know the qualitative effect of each Greek (delta, gamma, vega, theta) and the inputs that move option premiums (strike, time to expiry, volatility, risk-free rate, dividend yield).

Are options on individual stocks tested differently from index options?

The mechanics are the same. The CIRE tests cash-settled vs physically settled, American vs European exercise, and the practical implications for retail clients. Cash-settled index options never deliver the underlying. American options can be exercised early. European options cannot.

What about futures and basis?

Basis equals spot price minus futures price. A widening basis means the spot is moving up relative to the future, or the future is moving down relative to spot. For a hedger, basis risk is the residual risk after the hedge is on. Hedge ratio (h-star) for minimum variance is rho times sigma S divided by sigma F.

Can I get more derivatives questions?

Yes. Registrant Prep includes 71 published questions on Element 8, plus an AI tutor that walks through every wrong-answer payoff diagram. After 30 questions on the element, most candidates report the diagrams stop feeling intimidating.

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