CMFAS RES6A Quiz 85

The question describes a scenario where a portfolio manager uses a government bond futures contract to hedge a corporate debt instrument. The text explicitly states that basis risk arises when the futures contract and its underlying asset do not exactly match the asset being hedged. In this case, a corporate bond is distinct from a government bond, meaning their price movements may not perfectly correlate. This imperfection in the match between the hedged asset and the underlying asset of the futures contract leads to basis risk, which is the risk that the basis (spot price of hedged asset minus futures price of contract used) will change in an unpredictable way, resulting in an imperfect hedge. The other options describe general market risks (market risk, credit risk) or a misunderstanding of liquidity in this context, rather than the specific risk arising from the mismatch in the hedging instrument as defined by the syllabus material.

When the equity in a futures margin account falls below the maintenance margin level, the investor receives an additional margin call. The purpose of this call is not merely to bring the account back up to the maintenance margin level, but specifically to restore it to the initial margin level. If the investor fails to meet this margin call by the stipulated time, the broker may liquidate the position. Therefore, in this scenario, since the account balance of $8,500 has fallen below the maintenance margin of $9,000, the investor is required to deposit funds to bring the balance back to the initial margin level of $12,000.

To determine the Outperformance Payout, first calculate the Weighted Average Return on the Fund (R Fund %). This is done by multiplying each index’s return by its respective weight and summing the results. For Index A (30% weight, 15% return), Index B (40% weight, 12% return), and Index C (30% weight, 5% return), the R Fund % is (0.30 0.15) + (0.40 0.12) + (0.30 0.05) = 0.045 + 0.048 + 0.015 = 0.108, or 10.8%. Next, compare this R Fund % to the Hurdle Rate. Since 10.8% is greater than the 8% Hurdle Rate, an Outperformance Payout occurs. The Outperformance is then calculated using the formula: ([1 + R Fund] – Threshold Level). Given R Fund % is 10.8%, [1 + R Fund] is 1.108. The Threshold Level is 108%, or 1.08. So, the Outperformance is (1.108 – 1.08) = 0.028, or 2.8%. Finally, apply the Participation Rate to this Outperformance. With a Participation Rate of 50%, the Payout (%) is 0.028 0.50 = 0.014, or 1.4%. For a $100 redemption value, the Payout Sum is $100 0.014 = $1.40.

The question tests the understanding of Additional Margins and the principle of ‘Margining on Gross Basis’ as applied by the Central Depository (CDP) for Extended Settlement (ES) contracts. According to the CMFAS Module 6A syllabus, Additional Margins are computed daily, and a loss in an ES position increases the Additional Margin requirement, while a gain reduces it. Crucially, CDP computes margin requirements on a gross basis. This means that long and short positions, or in this scenario, positions belonging to different customers, do not cancel each other out in the calculation of a Member’s overall margin requirement. Therefore, the Additional Margin for Client P (with a loss) would increase, and for Client Q (with a gain) would decrease, but these individual client-level adjustments are then summed up for the Member’s total requirement without any netting between Client P’s and Client Q’s positions. The other options incorrectly suggest netting between clients or waiving requirements, which contradicts the gross margining principle.

The trade involves two distinct commodities: crude oil and heating oil. Therefore, it is an inter-commodity spread. The contracts are traded on different exchanges, NYMEX and ICE Futures Europe, which makes it an inter-market spread. Lastly, the contracts have different delivery months, September and December, classifying it as an inter-delivery spread. All three characteristics apply to this specific futures spread trade.

The ‘premium’ of a structured warrant, as defined in the CMFAS Module 6A syllabus, represents the difference between the warrant’s market price and its intrinsic value. This premium is largely attributed to the time value of the warrant, reflecting the potential for the underlying asset’s price to move favorably before the warrant’s expiry. The option describing the total cost an investor pays, including transaction charges, refers to the overall investment outlay rather than the specific financial definition of warrant premium. Another option incorrectly defines the premium as the amount by which the underlying asset’s market price exceeds the warrant’s exercise price; this describes the intrinsic value of a call warrant. Lastly, the option referring to additional expected return relates to investment yield or performance, not the structural premium component of a warrant.

The daily mark-to-market (MTM) process for Extended Settlement (ES) contracts is a crucial risk management mechanism. At the end of each day, the Central Depository (CDP) revalues all open positions in ES contracts to their respective valuation prices. The fundamental objective of this daily revaluation is to limit the exposure of the CDP to potential price changes and to prevent the accumulation of substantial losses over time, which could otherwise occur if losses were only recognized at the contract’s maturity. This ensures that any gains or losses are accounted for daily, requiring members to maintain sufficient funds or credit facilities to cover MTM losses, thereby mitigating systemic risk. The other options describe related but not primary objectives or misrepresent the function of MTM.

The question describes a situation of abrupt and severe market decline leading to widespread panic and disorderly trading, specifically asking for a measure that temporarily halts trading. According to the CMFAS Module 6A syllabus, ‘Circuit Breakers’ are systems in cash and derivative markets that trigger trading halts to mitigate market disruption risk. ‘Daily price limits’ are designed to limit price volatility without slowing or halting trading activity. ‘Shock absorbers’ slow down trading during significant volatility but do not halt it completely. ‘Capital controls’ are government actions related to country risk, not a direct market mechanism for temporarily halting trading due to price declines and panic.

Extended Settlement (ES) contracts are leveraged financial instruments. This means that an investor can control a larger value of the underlying asset with a relatively smaller initial capital outlay (the initial margin). The primary consequence of this leverage is that any percentage price movement in the underlying security will result in a disproportionately larger percentage change in the investor’s initial capital. This amplification effect applies to both potential gains and potential losses, magnifying the financial exposure. The provided text explicitly states that the loss in percentage terms for ES contracts will be greater than the percentage price movement in the underlying asset. It is incorrect to assume that leverage caps the maximum loss to the initial margin, as the text clarifies that the risk is not limited to the initial margin deposit and there is exposure to the full downside. Furthermore, the percentage gain or loss is not identical to the underlying share’s movement but rather a magnified version. Physical delivery is a settlement method at expiration if the contract is not offset, and its occurrence is not contingent on the contract being profitable.

The scenario describes an investor needing to liquidate a structured product before its maturity, specifically one with a long lock-up period and underlying exotic derivatives that are not actively traded. This situation directly highlights liquidity risk. Liquidity risk in structured products arises from their customized nature, which often leads to a limited secondary market. Lock-up periods restrict early withdrawals, and illiquid underlying components (like exotic options or certain credit default swaps) make it difficult to find buyers for the product before maturity. Consequently, an investor attempting to sell early might face significant price discounts or even be unable to find a buyer, resulting in a substantial loss of principal. Credit risk pertains to the possibility of the issuer or reference entity defaulting, which is a different concern from the ability to sell the product itself. Interest rate risk relates to changes in interest rates affecting the product’s value, while reinvestment risk is the risk that proceeds from an investment cannot be reinvested at a comparable rate, which occurs after the investment has been liquidated, not during the process of liquidation itself.

A Discount Certificate is explicitly defined in the CMFAS Module 6A syllabus as being constructed from a long call (zero strike) and a short call. This composition allows the product to be issued at a discount to face value, as the premium received from selling the call option is greater than the cost of the zero-strike option. It also results in a capped upside performance and exposes the investor to the full decline of the underlying asset, consistent with the product description. The second option describes the composition of a Reverse Convertible, which, while having a similar risk-return profile, is constructed differently using a bond and a short put. The third option represents an incorrect or non-standard combination for the described product. The fourth option typically describes an equity-linked structured note designed for capital preservation with upside participation, which has a different primary objective and risk profile compared to a Discount Certificate.

The question asks for the factor least likely to contribute to tracking error in an Exchange Traded Fund (ETF). Tracking error refers to the disparity in performance between an ETF and its underlying index. 1. Significant costs of rebalancing: The text explicitly states that tracking errors can arise due to factors such as ‘transaction fees and expenses incurred to the ETF’ and ‘index replication costs resulting from liquidity and ownership restrictions on the underlying’. Frequent rebalancing, especially for dynamic or volatile indices, would incur such costs, making this a probable cause. 2. The ETF’s exposure to foreign exchange fluctuations: The text mentions ‘Foreign Exchange Risk’ as a key risk, stating that ‘Currency rate fluctuations can adversely affect the underlying asset value, also affecting the ETF price.’ If the underlying index is denominated in a different currency than the ETF’s reporting currency or the investor’s home currency, or if the ETF’s currency hedging strategy (or lack thereof) differs from the index, this can lead to a performance disparity relative to the benchmark, contributing to tracking error. 3. The ETF manager’s deliberate strategy to actively select securities with the aim of outperforming the benchmark index: ETFs are fundamentally passive instruments designed to replicate the performance of an underlying index, not to outperform it through active security selection. The text states, ‘As ETFs are passive instruments, they aim to replicate the performance of the underlying index one to one.’ If an ETF manager were deliberately engaging in active security selection to outperform, the fund would cease to function as a true ETF, and such a strategy would be contrary to its core mandate. While it would certainly lead to a performance disparity, it is the least probable ‘direct cause’ of tracking error within the operational framework of a legitimate ETF, as it represents a fundamental deviation from the ETF’s nature rather than a challenge in passive replication. 4. The drag on performance caused by a portion of the ETF’s assets being held in cash for operational needs: The text identifies ‘cash drag’ as a factor that can cause tracking errors. ETFs often hold a small portion of their assets in cash for liquidity, to meet redemptions, or for rebalancing purposes. This uninvested cash does not track the index and can cause the ETF to lag the benchmark, especially in rising markets. Therefore, a deliberate active management strategy is the least probable cause of tracking error for an ETF, as it contradicts the passive nature of these investment vehicles.

SGX implements corporate action adjustments for Extended Settlement (ES) contracts to ensure fairness and continuity. The primary objective is to adjust the ES contract’s terms so that its value after a corporate event (like a bonus issue, share split, or rights issue) remains, as far as practicable, equivalent to its value before the event. This prevents either party to the contract from being unfairly disadvantaged or advantaged solely due to the corporate action. Adjustments can involve changing the contract multiplier or the settlement price. Other options describe potential outcomes or related processes, but they do not capture the fundamental goal of maintaining value equivalence.

The product terms state that a Mandatory Call Event (knock-out event) occurs if the closing index level of ANY 4 of the underlying indices on an Early Redemption Observation Date is < 75% of the initial level. In the given scenario, all four indices are at 70% of their initial values on 15 December 2017, which is an Early Redemption Observation Date and is after the 1.5-year call protection period (Initial Date: 16 Dec 2014, First Callable Date: 15 Jun 2016). Therefore, the knock-out event is triggered. When a Mandatory Call Event occurs, the fund terminates, and the investor receives the latest quarterly coupon and the redemption value. The redemption value is explicitly stated as 100% of invested capital. Option 2 is incorrect because the fixed coupon of 6.38% is only for the first year, and the fund terminates upon a knock-out event, so it would not continue. Option 3 is incorrect because the redemption value is 100% of invested capital, not 70%. Option 4 is incorrect because the fund terminates upon a knock-out event; it does not enter a new observation period or continue paying variable coupons.

For an investor who buys a call option, their maximum potential loss is limited to the premium paid for the option. This is because the option holder has the right, but not the obligation, to exercise the option. If the underlying asset’s price at expiration is below the exercise price, the option will expire worthless, and the buyer will simply lose the premium they initially paid. They are not obligated to buy the underlying asset at the exercise price if it’s unprofitable to do so. The total value of the underlying shares at the exercise price (Option 2) represents the cost if the option were exercised, not the maximum loss. The difference between the underlying share price and the exercise price (Option 3) relates to the intrinsic value or payoff, not the maximum loss itself. An unlimited loss (Option 4) is characteristic of selling (writing) a call option, not buying one, as the writer faces potential losses if the underlying asset’s price rises significantly above the exercise price.

The question describes a specific strategy employed by a structured fund tracking a commodity index, where the fund actively manages the rolling of expiring futures contracts. This management involves maximizing returns when forward prices are lower than spot prices (backwardation) and minimizing losses when forward prices are higher than spot prices (contango). The provided syllabus text, under the ‘Formula Fund with a Commodity Index as the Underlying Asset’ example (ABC Fund), explicitly states that ‘the formula-based asset allocation of this fund provides alpha or enhanced return by offering a more efficient roll methodology instead of a fixed roll period.’ This directly identifies the described strategy as a formula-based asset allocation employing an optimal yield rolling mechanism to enhance returns. Option 1 describes an indirect investment policy fund, which uses derivatives for synthetic exposure to an underlying asset, but this does not specifically characterize the described rolling mechanism. Option 2 refers to a capitalized fund, which is defined by the automatic reinvestment of dividends, a different fund structure and objective. Option 4 refers to a distribution fund, which is characterized by periodic payouts of dividends to investors, also a different fund structure and objective. Thus, the correct characterization is a formula-based asset allocation strategy aimed at optimizing roll returns.

A Callable Bull/Bear Certificate (CBBC) is a leveraged product with a built-in ‘knock-out’ feature. When the price of the underlying asset reaches or crosses the specified Call Price, a Mandatory Call Event (MCE) is triggered, and the CBBC is irrevocably terminated. This means that once the MCE occurs, the contract ceases to exist, and the investor cannot benefit from any subsequent recovery or favorable movement in the underlying asset’s price, regardless of how quickly or significantly it rebounds. The payoff for an N-category CBBC investor is zero, while an R-category investor may receive a small residual value, which is determined at the time of the MCE and is not subject to change based on later market movements. Therefore, the investor holding the knocked-out CBBC will have incurred a loss and will not participate in the subsequent recovery.

Gamma measures the sensitivity of an option’s delta to changes in the underlying asset price. For net selling (short) strategies, gamma is negative. A significant negative gamma implies that if the underlying asset price moves unfavorably (e.g., up for a short call or down for a short put), the portfolio’s delta will change rapidly in a direction that exacerbates losses. Specifically, for a net short position, negative gamma means that as the underlying price moves against the position, the delta will become more negative (or less positive) at an accelerating rate, leading to potentially significant and increasing losses. This highlights the dynamic nature of risk for short option positions, where delta hedging needs constant adjustment. The other options are incorrect because: a significant negative gamma does not directly imply minimal time decay (theta) or lowest sensitivity to implied volatility (vega); these are distinct ‘Greeks’. Furthermore, a net short position with negative gamma is generally exposed to greater risk from large movements against the position, not benefits from them.

Principal preservation refers to a structured product component where the issuer invests in underlying fixed income securities, such as zero-coupon bonds, with the aim of redeeming the principal amount at the product’s maturity. However, the full return of the principal is not guaranteed, as the underlying fixed income security may default, impacting the value of the structured product. Such products can still carry high risk depending on the credit quality of the underlying securities. In contrast, principal guarantee is a stronger feature where the investor’s initial investment is explicitly guaranteed, typically by certain collaterals or through a form of investment insurance. This guarantee feature is priced into the structured product, making products with a principal guarantee generally more expensive than those with only a principal preservation feature for the same principal amount. The key difference lies in the certainty of the return of the initial capital: preservation aims for it but does not guarantee it, while guarantee explicitly secures it through additional mechanisms.

The participation rate in an Equity-Linked Structured Note is directly influenced by the relationship between the discount sum generated from the zero-coupon bond component and the total premium required to purchase the equity call options. As outlined in the CMFAS Module 6A syllabus, if the discount sum is greater than the cost of the call option, the product issuer can purchase more option contracts, leading to a participation rate exceeding 100%. Conversely, if the discount sum is less than the call option cost, the participation rate will be less than 100%. Therefore, the primary factor for achieving a participation rate greater than 100% is when the discount sum from the bond component is larger than the total premium needed for the call options. Other options describe related but not directly determining factors: option maturity (option 2) is a characteristic of the option but doesn’t set the participation rate; the present value being lower than face value (option 3) simply defines the existence of a discount sum, not its sufficiency for >100% participation; and immediate market movement (option 4) affects the actual return, not the pre-determined participation rate.

The question describes a scenario where a structured fund seeks to replicate the total return performance of a market index while minimizing the operational complexities of directly managing underlying securities or frequently rolling over futures contracts. A Total Return Swap (TRS) is specifically designed for this purpose. In a TRS, the fund pays a fixed or floating rate (e.g., SIBOR + spread) and in return receives the total return of the underlying index, effectively achieving synthetic exposure without needing to hold the physical assets or actively manage futures positions. The zero-coupon bond combined with a long call option strategy (Zero Plus Option) is primarily used for capital preservation with upside participation, not solely for synthetic total return replication. Directly investing in all constituent shares or continuously rolling over short-term index futures contracts are methods of tracking an index, but they involve significant active management and operational complexities that the question aims to minimize.

When a corporate treasurer expects to receive funds in the future and anticipates a decline in interest rates, their objective is to lock in the current, higher deposit yield. Eurodollar futures contracts are priced based on the implied 3-month LIBOR. A fall in interest rates would lead to an increase in the price of Eurodollar futures contracts (as the implied yield decreases). Therefore, by selling Eurodollar futures contracts now, the treasurer can establish a short position that will profit if interest rates indeed fall. This profit from the futures position will then compensate for the lower interest earned on the actual deposit when the funds become available and are placed at the then-prevailing lower market rates. This strategy effectively hedges against the risk of falling interest rates for a future deposit.

Early termination risk, as defined in the CMFAS Module 6A syllabus, refers to the possibility that if a structured product is withdrawn or liquidated before its maturity date, the underlying assets will likely be sold at a discount. This action directly and adversely impacts the overall value of the structured product for the investor. While other risks like liquidity risk or specific penalties might exist, the core aspect of early termination risk is the potential for a reduced recovery value due to the forced sale of underlying components at a discount.

The question describes an investor selling a call option on a securities index as part of a structured product. When an investor sells a call option, they are essentially selling the right for someone else to buy the underlying asset (in this case, the securities index) at a predetermined strike price. If the securities index price rises significantly above the strike price, the option buyer will exercise their right, and the investor (the option seller) will be obligated to pay out the difference between the current index price and the strike price. Since there is theoretically no upper limit to how high an index can rise, the potential losses for an uncovered short call position are theoretically unlimited. This is a critical risk associated with such structured products. Other options describe risks related to different structured products (like CPPI strategies) or misrepresent the nature of losses or gains from option selling.

The Constant Proportion Portfolio Insurance (CPPI) strategy is designed to protect principal while allowing participation in upside potential. However, it has specific risks, particularly in certain market conditions. As explained in the syllabus, if the underlying risky asset experiences a prolonged period of range-bound trading, especially with minor downward fluctuations, the CPPI strategy can lead to a ‘buy high and sell low’ scenario. This occurs because as the portfolio value declines, the cushion (total portfolio value minus floor value) shrinks, forcing the manager to reduce exposure to the risky asset and increase allocation to the risk-free asset. If this continues, the portfolio value may eventually drop to the floor, at which point the entire fund is allocated to the risk-free asset to preserve principal. This means the investor would miss out on any subsequent appreciation in the underlying asset if the market eventually recovers. Therefore, the portfolio eroding and leading to a full allocation to the risk-free asset is a direct consequence of this market behavior for a CPPI product. The multiplier in CPPI is constant, not variable, so it would not automatically increase. The cushion value would shrink, not expand, if the portfolio value is declining or stagnant. The floor value adjusts based on time to maturity and yield curve, not dynamically upwards to lock in minimal gains in a declining market.

The product terms clearly state that the fund is call protected for an initial 1.5-year period. The Initial Date (Strike Date) is 16 December 2014. Adding 1.5 years to this date brings us to 16 June 2016. The first Early Redemption Observation Date listed, and explicitly stated as the ‘First Callable Date’, is 15 June 2016. Therefore, this is the earliest date a Mandatory Call Event can be observed. The condition for the Mandatory Call Event (knock-out trigger) to occur is specified as the closing index level of ANY 4 of the underlying indices falling below 75% of their initial level on an Early Redemption Observation Date. Other options either state an incorrect earliest observation date (e.g., within the call-protected period) or misrepresent the specific trigger condition, such as requiring ‘all four’ indices to fall below the threshold instead of ‘any four’, or using an incorrect percentage threshold.

When an investor’s Customer Asset Value in an Extended Settlement (ES) contract account falls below the Required Margins, a margin call is issued. The investor is typically given a specific timeframe, often two market days, to deposit additional funds to bring their Customer Asset Value up to at least the sum of the Initial Margins and Additional Margins. If the investor fails to meet this margin call within the stipulated period, a direct consequence is that they will be prohibited from placing new orders for ES contract trades. However, an important exception is made for trades that are considered ‘risk-reducing.’ These specific trades are still permitted, as they help to mitigate the overall risk exposure of the investor’s position and, by extension, the clearing house. This measure is put in place to manage risk effectively and prevent further accumulation of potential losses.

Yield Enhanced Securities, also known as Discount Certificates, have a specific payoff structure at maturity. If the underlying asset’s closing price on the expiration date is at or above the exercise price, the holder receives a cash settlement equal to the exercise price. However, if the closing price is below the exercise price, the holder receives a cash settlement equal to the value of the underlying asset on the expiration date. In this scenario, the underlying asset closed at $50, which is below the exercise price of $55. Therefore, the investor would receive the value of the underlying asset, which is $50.

For Callable Bull/Bear Contracts (CBBCs) linked to equity, issuers typically account for regular share dividends as part of the funding cost when structuring the product. Therefore, the declaration and payment of a regular cash dividend by the underlying company would generally not necessitate an adjustment to the CBBC’s terms. In contrast, corporate actions such as bonus issues, rights issues, share splits, and reverse share splits fundamentally alter the capital structure or the value per share of the underlying asset. These types of events are not typically factored into the initial funding cost and would require adjustments to the CBBC’s strike price, call price, and/or conversion ratio to ensure the contract’s terms remain fair and reflect the changes in the underlying equity.

Index-Linked Notes (ILNs) with principal preservation typically offer a return at maturity that is the greater of a specified minimum total return or the participation in the underlying index’s performance. In this scenario, the investor’s note specifies a minimum total return of 26.68% and a 100% participation in the index’s average performance. Since the calculated average performance resulted in a 20% gain, which is less than the guaranteed minimum total return of 26.68%, the investor would receive the principal amount plus the minimum total return. Therefore, the redemption amount is determined by multiplying the principal by (100% + 26.68%).