JAIIB Paper 3 • Accounting & Financial Management for Bankers (AFM) âââââ
Derivatives
Financial instruments that derive their value from something else â and the closing topic of Module C. This guide covers the Characteristics & Functions of Derivatives, their Users, Futures, Forward Rate Agreements, Swaps, and Options â with 50 exam-style MCQs with hidden answers.
đ Updated: September 2026 • 27 min read
1 Characteristics and Functions of Derivatives
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Definition
A Derivative is a financial instrument whose value is derived from an underlying asset â equity, a bond, a currency, a commodity, or an interest rate â rather than having intrinsic value of its own.
Price Discovery
Derivatives markets help reveal the market's consensus expectation of future prices.
Risk Management (Hedging)
Allow businesses and investors to offset exposure to adverse price movements.
Speculation
Enable traders to take a view on future price direction, seeking profit.
Arbitrage
Allow riskless profit from price discrepancies between related markets.
2 Users of Derivatives
Hedgers
Use derivatives to reduce or eliminate an existing risk exposure.
Speculators
Deliberately take on risk, betting on the direction of future price movements.
Arbitrageurs
Exploit price differences for the same or related asset across markets, for a near risk-free profit.
3 Futures
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Definition
A Futures contract is a standardised, exchange-traded agreement to buy or sell an underlying asset at a predetermined price on a specified future date â marked-to-market daily, and backed by an exchange-mandated margin.
JAIIB tip: Unlike a Futures contract, a Forward contract is an OTC (over-the-counter), customised agreement â with no daily mark-to-market, no exchange guarantee, and therefore higher counterparty risk.
4 Forward Rate Agreement (FRA)
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Definition
A Forward Rate Agreement (FRA) is an OTC agreement between two parties to fix an interest rate for a future period on a notional principal â settled purely in cash (the difference between the agreed and actual reference rate), with no exchange of the underlying principal.
FRAs are used primarily to hedge interest rate risk on a known future borrowing or investment.
5 Swaps
Interest Rate Swap (IRS)
Two parties exchange fixed-rate for floating-rate interest payments on the same notional principal, without exchanging the principal itself.
Currency Swap
Two parties exchange both principal and interest payments denominated in different currencies.
JAIIB tip: India's OTC derivatives market, including Swaps, is RBI-regulated and predominantly cleared through the CCIL (Clearing Corporation of India Ltd), the same institution central to forex market settlement.
6 Options
Call Option
Gives the holder the right, but not the obligation, to buy the underlying at a specified strike price on/before expiry.
Put Option
Gives the holder the right, but not the obligation, to sell the underlying at a specified strike price on/before expiry.
JAIIB tip â the key asymmetry: The option buyer pays an upfront premium, and their maximum loss is limited to that premium. The option writer (seller) receives the premium but faces potentially unlimited loss â a sharp contrast to Futures/Forwards, where both parties carry a symmetric, unlimited obligation.
â Key Takeaways
Derivatives serve four functions: price discovery, hedging, speculation, and arbitrage.
Futures are standardised, exchange-traded and marked-to-market daily; Forwards are OTC, customised, with higher counterparty risk.
An FRA settles purely in cash on a notional principal, hedging future interest rate risk.
Interest Rate Swaps exchange fixed for floating interest only; Currency Swaps exchange both principal and interest across currencies.
Options carry an asymmetric payoff â the buyer's loss is capped at the premium, while the writer's loss can be unlimited.
đ Top 50 JAIIB-Style MCQs on Derivatives
Test your understanding with these 50 practice MCQs, closely modelled on the pattern expected in the JAIIB AFM exam â including combination-answer questions. Each question has 5 options â the correct answer is hidden by default; tap "Show Answer" to reveal it along with a short explanation.
đ Characteristics and Functions of Derivatives
1 A Derivative's value is:
A. Entirely independent of any other asset
B. Derived from an underlying asset
C. Always equal to its face value
D. Set arbitrarily by the government
E. Fixed permanently at issuance
Answer: B. A derivative's value derives from an underlying asset.
2 Which of these can serve as an underlying for a derivative? (i) Equity (ii) Currency (iii) Interest rate
A. (i) only
B. (i) and (ii) only
C. (iii) only
D. All of (i), (ii) and (iii)
E. None of these
Answer: D. Equity, currency and interest rates can all underlie derivatives.
3 Price discovery, as a derivatives function, refers to:
A. Hiding the market's price expectations
B. Revealing the market's consensus expectation of future prices
C. Fixing prices permanently by law
D. Eliminating all price volatility
E. Setting the GST rate
Answer: B. Price discovery reveals market price expectations.
4 Which of these are recognised functions of derivatives? (i) Hedging (ii) Speculation (iii) Arbitrage
A. (i) only
B. (i) and (ii) only
C. (iii) only
D. All of (i), (ii) and (iii)
E. None of these
Answer: D. Hedging, speculation and arbitrage are all key functions.
5 Arbitrage, as a derivatives function, seeks to:
A. Increase risk deliberately with no expected profit
B. Exploit price discrepancies for a near risk-free profit
C. Eliminate all trading activity
D. Fix exchange rates permanently
E. Avoid any use of derivatives
Answer: B. Arbitrage exploits price discrepancies for near risk-free profit.
đĨ Users of Derivatives
6 Hedgers use derivatives to:
A. Increase their risk exposure deliberately
B. Reduce or eliminate an existing risk exposure
C. Speculate purely for profit with no underlying exposure
D. Avoid all financial markets
E. Guarantee a profit with no risk consideration
Answer: B. Hedgers reduce existing risk exposure.
7 Speculators, unlike hedgers, typically:
A. Have no existing exposure and deliberately take on risk for profit
B. Always avoid any market participation
C. Only trade government securities
D. Never use derivatives
E. Are prohibited from trading in India
Answer: A. Speculators take on risk deliberately, without prior exposure.
8 Arbitrageurs profit by:
A. Betting on long-term price direction
B. Exploiting price differences between related markets
C. Hedging an existing exposure only
D. Avoiding all trading activity
E. Holding assets indefinitely with no trading
Answer: B. Arbitrageurs exploit price differences across markets.
9 An exporter using a forward contract to lock in a future exchange rate is acting as a:
A. Speculator
B. Hedger
C. Arbitrageur
D. Notary Public
E. None of these
Answer: B. Locking in a rate to manage risk is hedging.
10 A trader with no underlying exposure who buys futures purely betting prices will rise is a:
A. Hedger
B. Speculator
C. Arbitrageur
D. Regulator
E. Auditor
Answer: B. Betting on price direction with no exposure is speculation.
đ Futures
11 A Futures contract is:
A. Customised and OTC
B. Standardised and exchange-traded
C. Never marked-to-market
D. Free of any margin requirement
E. Identical to a savings account
Answer: B. Futures are standardised and exchange-traded.
12 Futures contracts are marked-to-market:
A. Never
B. Daily
C. Only once at expiry
D. Only once a year
E. Only when the RBI directs
Answer: B. Futures are marked-to-market daily.
13 A Forward contract, compared to a Futures contract, is:
A. Standardised and exchange-traded
B. OTC and customised
C. Identical in every respect
D. Always marked-to-market daily
E. Guaranteed by an exchange, exactly like futures
Answer: B. Forwards are OTC and customised, unlike Futures.
14 Counterparty risk is generally:
A. Higher in Forwards than in exchange-traded Futures
B. Higher in Futures than in Forwards
C. Identical in both, always
D. Non-existent in Forwards
E. Non-existent in Futures and Forwards both
Answer: A. Forwards carry higher counterparty risk than Futures.
15 Futures contracts require participants to post:
A. No collateral whatsoever
B. A margin
C. Full face value in cash upfront always
D. Only a verbal promise
E. A bank guarantee equal to 200% of exposure always
Answer: B. Futures require posting a margin.
đ Forward Rate Agreement (FRA)
16 An FRA fixes:
A. An interest rate for a future period on a notional principal
B. The price of gold permanently
C. A company's share price
D. The GST rate
E. A fixed deposit's maturity date
Answer: A. An FRA fixes a future interest rate on a notional principal.
17 An FRA is settled:
A. Through physical exchange of the principal amount
B. Purely in cash, based on the rate difference
C. Never settled at all
D. Only through equity conversion
E. Only after 10 years
Answer: B. FRAs settle in cash, based on the rate difference.
18 FRAs are primarily used to hedge:
A. Interest rate risk
B. Equity price risk exclusively
C. Weather risk
D. Tax risk
E. GST compliance risk
Answer: A. FRAs hedge interest rate risk.
19 FRAs are traded:
A. On a formal exchange, exactly like Futures
B. Over-the-counter (OTC)
C. Only through the RBI directly
D. Only by individuals
E. Never in India
Answer: B. FRAs are OTC instruments.
20 The "notional principal" in an FRA is used:
A. Only as a reference amount for calculating settlement, not exchanged
B. As the actual amount physically transferred
C. To determine the GST rate
D. To set the exchange rate
E. To calculate dividend payments
Answer: A. Notional principal is a reference, not exchanged.
đ Swaps
21 An Interest Rate Swap (IRS) typically exchanges:
A. Fixed-rate for floating-rate interest payments
B. Two different currencies' principal amounts
C. Equity shares for bonds
D. Gold for currency
E. Nothing at all
Answer: A. IRS exchanges fixed for floating interest.
22 A Currency Swap exchanges:
A. Only interest payments, never principal
B. Both principal and interest in different currencies
C. Only equity shares
D. Only commodities
E. Nothing at all
Answer: B. Currency Swaps exchange both principal and interest.
23 In an IRS, the underlying notional principal is:
A. Physically exchanged between parties
B. Not exchanged; only interest payment differences are settled
C. Converted into equity
D. Deposited with the RBI permanently
E. Irrelevant to the swap
Answer: B. IRS principal is not exchanged.
24 India's OTC derivatives market, including Swaps, is regulated by:
A. RBI
B. SEBI exclusively
C. IRDAI
D. ICAI
E. FEDAI exclusively
Answer: A. RBI regulates India's OTC derivatives market.
25 Swaps in India are predominantly cleared through:
A. CCIL
B. FEDAI
C. ICAI
D. IRDAI
E. NPCI
Answer: A. CCIL predominantly clears Indian swaps.
âī¸ Options
26 A Call Option gives the holder the right to:
A. Sell the underlying
B. Buy the underlying at a specified strike price
C. Neither buy nor sell
D. Force the writer to buy the underlying
E. Receive a fixed dividend
Answer: B. A Call Option gives the right to buy.
27 A Put Option gives the holder the right to:
A. Buy the underlying
B. Sell the underlying at a specified strike price
C. Neither buy nor sell
D. Force the writer to sell
E. Receive a fixed coupon
Answer: B. A Put Option gives the right to sell.
28 The option holder's obligation to exercise the option is:
A. Mandatory in every case
B. Optional â it is a right, not an obligation
C. Enforced by the RBI directly
D. The same as a Futures obligation
E. Irrelevant to the contract
Answer: B. Exercising an option is optional, not mandatory.
29 The option buyer's maximum possible loss is limited to:
A. The premium paid
B. Unlimited amounts
C. Zero, always
D. The strike price only
E. The underlying's full market value
Answer: A. The buyer's loss is capped at the premium paid.
30 The option writer's (seller's) potential loss on a Call Option is:
A. Limited to the premium received
B. Potentially unlimited
C. Always zero
D. Fixed at the strike price only
E. Identical to the buyer's loss always
Answer: B. A Call writer's loss can be unlimited.
đ Comprehensive Review
31 The premium in an options contract is paid by the:
A. Writer to the buyer
B. Buyer to the writer, upfront
C. Government to the writer
D. RBI to the buyer
E. No premium is ever paid
Answer: B. The buyer pays the premium upfront to the writer.
32 Compared to Futures/Forwards, Options have a payoff structure that is:
A. Symmetric, with both parties bearing equal, unlimited obligation
B. Asymmetric â buyer's risk is capped, writer's can be unlimited
C. Identical in every respect
D. Non-existent, with no payoffs at all
E. Determined solely by the RBI
Answer: B. Options have an asymmetric payoff, unlike Futures/Forwards.
33 A bank hedging its floating-rate loan book against rising interest rates would most likely use:
A. An Interest Rate Swap, receiving fixed and paying floating
B. A Currency Swap only
C. No hedging instrument at all
D. Only equity options
E. Only Public Deposits
Answer: A. An IRS receiving fixed/paying floating hedges rising-rate risk.
34 A company with foreign currency debt seeking to hedge both currency and interest rate exposure would consider:
A. A Currency Swap
B. Only a domestic FRA
C. No derivative instrument exists for this
D. Only a Put Option on equity
E. Only Trade Credit
Answer: A. A Currency Swap addresses both currency and interest rate exposure.
35 A firm expecting to borrow in 3 months and wanting to lock in today's interest rate, without an exchange transaction, would use a/an:
A. Forward Rate Agreement
B. Currency Swap
C. Equity Option
D. Sale and Leaseback
E. Public Deposit
Answer: A. An FRA locks in a future interest rate.
36 Which derivative would be most appropriate for a farmer wanting to lock in a sale price for a crop to be harvested in 6 months?
A. A Futures contract on the commodity
B. An Interest Rate Swap
C. A Currency Swap
D. An FRA
E. None of these
Answer: A. A commodity Futures contract locks in a future sale price.
37 Margin requirements and daily mark-to-market in Futures contracts exist primarily to:
A. Increase counterparty risk deliberately
B. Reduce counterparty/default risk by settling gains/losses daily
C. Eliminate the need for an exchange
D. Guarantee a profit to all participants
E. Replace the need for any regulation
Answer: B. Daily mark-to-market/margin reduces default risk.
38 An investor buying a Put Option on a stock they own is primarily seeking to:
A. Hedge against a potential fall in the stock's price
B. Speculate on an unrelated commodity
C. Guarantee unlimited upside with zero cost
D. Convert the stock into a bond
E. Eliminate the need to ever sell the stock
Answer: A. A protective Put hedges against a price fall.
39 Which of these is NOT a standard derivative instrument discussed in this module?
A. Futures
B. Swaps
C. Options
D. Forward Rate Agreement
E. Public Deposit
Answer: E. A Public Deposit is not a derivative instrument.
40 Options, Futures, Forwards and Swaps collectively represent instruments used mainly for:
A. Long-term equity fundraising only
B. Managing/transferring various forms of financial risk
C. Only accounting record-keeping
D. Only tax computation
E. Only statutory audit
Answer: B. These instruments primarily manage/transfer financial risk.
41 The "underlying" of a derivative contract refers to:
A. The asset from which the derivative's value is derived
B. The regulator overseeing the contract
C. The clearing house only
D. The tax rate applicable
E. The premium paid
Answer: A. The underlying is the reference asset for value derivation.
42 A bank offering a customer a forward exchange contract, as covered in the Forex Arithmetic module, is providing a form of:
A. Equity financing
B. OTC derivative (forward) hedging tool
C. Fixed deposit product
D. Public Deposit scheme
E. Statutory reserve requirement
Answer: B. A forward exchange contract is an OTC derivative hedging tool.
43 Which of these is a genuine risk of using derivatives, if mismanaged?
A. Guaranteed elimination of all financial risk
B. Amplification of losses due to leverage, if positions move adversely
C. Automatic profit in every scenario
D. No risk exists whatsoever
E. Complete immunity from counterparty default
Answer: B. Leverage can amplify losses if mismanaged.
44 A speculator who is proven wrong about future price direction will typically:
A. Always profit regardless
B. Incur a loss
C. Be automatically reimbursed by the exchange
D. Face no consequence at all
E. Be exempted from margin calls
Answer: B. A wrong speculative bet results in a loss.
45 An arbitrageur's profit opportunity typically disappears once:
A. The price discrepancy between markets is corrected by trading activity
B. The RBI bans all trading permanently
C. Prices become infinitely volatile
D. No one else ever trades the asset
E. The government nationalises the exchange
Answer: A. Arbitrage opportunities vanish once prices converge via trading.
46 An FRA and an Interest Rate Swap both share the common feature of:
A. Settling based on interest rate differentials on a notional principal, without physical exchange of that principal
B. Requiring physical delivery of currency
C. Being exchange-traded and standardised
D. Being used only for equity hedging
E. Having no relation to interest rates
Answer: A. Both settle on interest differentials without exchanging principal.
47 Which statement about Futures vs Options is correct?
A. Futures impose a symmetric obligation; Options give an asymmetric right
B. Both impose an identical symmetric obligation
C. Options impose a symmetric obligation; Futures give a right only
D. Neither instrument involves any obligation or right
E. Both are identical to a Public Deposit
Answer: A. Futures are symmetric obligations; Options are asymmetric rights.
48 A bank's Treasury department using Swaps to manage its overall interest rate exposure is engaging in:
A. Speculative trading only, with no risk management purpose
B. Hedging, a core function of derivatives
C. An illegal activity
D. A form of tax evasion
E. An activity unrelated to derivatives
Answer: B. Using swaps to manage exposure is hedging.
49 "Strike Price" in an Options contract refers to:
A. The premium paid
B. The specified price at which the underlying may be bought/sold
C. The market price at expiry only
D. The GST rate on the transaction
E. The clearing house's fee
Answer: B. Strike Price is the specified buy/sell price.
50 For JAIIB purposes, the single most important reason bankers study derivatives is to:
A. Understand how corporate clients and the bank itself manage financial risk
B. Eliminate the need for any credit appraisal
C. Replace the need for KYC compliance
D. Avoid ever dealing with foreign exchange
E. Guarantee risk-free profits for every client
Answer: A. Understanding risk management for clients and the bank is the core purpose.
Disclaimer: This article is prepared for educational and exam-preparation purposes only, as of September 2026. Candidates should cross-check the latest official IIBF syllabus and current notifications before the exam.