CMFAS RES6A Quiz 83

The question tests the understanding of Additional Margins and the principle of gross margining for Extended Settlement (ES) contracts under CMFAS Module 6A. Additional Margins are computed daily based on mark-to-market gains and losses. A loss in an ES position increases the Additional Margin requirement, while a profit reduces it. For Customer P, who holds a long position of 800 units initially bought at $7.50, and the current valuation price is $7.30, there is a mark-to-market loss of ($7.50 – $7.30) = $0.20 per unit. This loss increases the Additional Margin requirement for Customer P’s account by $0.20 800 units = $160. For Customer Q, who holds a short position of 600 units initially sold at $7.80, and the current valuation price is $7.30, there is a mark-to-market gain of ($7.80 – $7.30) = $0.50 per unit. A profit in an ES position reduces the Additional Margin requirement for that account. Therefore, Customer Q’s account does not require Additional Margin; in fact, it has a surplus. CDP computes margin requirements on a gross basis. This means that long and short positions belonging to different customers do not cancel each other out in the calculation of a Member’s overall margin requirement. Consequently, the gain from Customer Q’s position cannot be used to offset the Additional Margin required for Customer P’s loss-making position at the Member firm level. The Member firm is responsible for the Additional Margin required by Customer P’s loss. Therefore, the total Additional Margin requirement for the Member firm for these two customers’ positions is solely the amount required for Customer P’s loss, which is $160.

Arbitrageurs are distinct market participants whose primary objective is to generate riskless profits by identifying and exploiting temporary price discrepancies or inefficiencies between related financial instruments or markets. They do not take a directional stance on the market’s future movement. Instead, they rely on sophisticated systems to detect when the implied value of an asset or derivative deviates from its market value, executing simultaneous trades to lock in the profit from this disequilibrium. This activity also plays a crucial role in enhancing market efficiency by ensuring that prices across related markets remain consistent. In contrast, speculators aim to profit from anticipating future price movements, hedgers seek to mitigate risk from existing or anticipated exposures, and market makers provide liquidity by continuously quoting bid and offer prices, profiting from the bid-ask spread.

Hedging is a strategy employed in portfolio management primarily to mitigate risk. The fundamental characteristic of hedging is that it does not eliminate price risks entirely. Instead, it transforms the original price risk associated with an asset or liability into basis risk. Basis risk arises from the potential for the price of the underlying instrument and the hedging instrument to move differently. By converting price risk to basis risk, hedging aims to confine the final price of the hedged item within a determinable range, thereby containing potential losses or protecting existing profits. However, this risk reduction comes with a trade-off: if the market moves favorably, the profits on the hedged position will typically be capped. Hedging is not intended to guarantee fixed returns, enhance profits by leveraging market volatility, or increase speculative exposure; its core purpose is risk management.

The question describes a structured product with an accrual coupon linked to an equity index, subject to a knock-out barrier. The total tenor (N) is 200 trading days. The yield formula is 0.60% + [4.20% x n/N], where ‘n’ is the number of days the index fixes within the accrual range and below the knock-out barrier. The investment amount is SGD 500,000 principal. According to the scenario, the index fixes within the accrual range for the first 120 trading days. On the 121st trading day, the index trades above the knock-out barrier and remains there until maturity. This means that the coupon stops accumulating after 120 days. Therefore, ‘n’ for the yield calculation is 120 days. 1. Calculate the yield: Yield = 0.60% + [4.20% x (120 / 200)] Yield = 0.60% + [4.20% x 0.6] Yield = 0.60% + 2.52% Yield = 3.12% 2. Calculate the accrual coupon: Accrual Coupon = Investment Amount x Yield Accrual Coupon = SGD 500,000 x 3.12% Accrual Coupon = SGD 15,600 3. Calculate the total redemption proceeds: Total Redemption Proceeds = Principal + Accrual Coupon Total Redemption Proceeds = SGD 500,000 + SGD 15,600 Total Redemption Proceeds = SGD 515,600 Analysis of incorrect options: SGD 524,000: This would be the result if the knock-out barrier was ignored, and the coupon accrued for the entire 200 trading days (n=200). In that case, Yield = 0.60% + [4.20% x (200/200)] = 4.80%, leading to a coupon of SGD 24,000 and total proceeds of SGD 524,000. SGD 511,400: This would result from an incorrect calculation of ‘n’, for example, if ‘n’ was taken as the remaining days after the knock-out (200 – 120 = 80 days). In that case, Yield = 0.60% + [4.20% x (80/200)] = 2.28%, leading to a coupon of SGD 11,400 and total proceeds of SGD 511,400. SGD 512,600: This would result if the fixed component of the yield (0.60%) was incorrectly omitted from the calculation, while correctly applying the variable component for 120 days. In that case, Yield = [4.20% x (120/200)] = 2.52%, leading to a coupon of SGD 12,600 and total proceeds of SGD 512,600.

The scenario describes a structured note where the investor’s returns are linked to the credit performance of a ‘reference entity’ and the investor is also exposed to the credit risk of the note’s issuer. The mention of the investor’s capital being used to settle obligations if the reference entity experiences a credit event, reflecting the sale of credit insurance, directly points to a Credit Linked Note (CLN). CLNs embed a credit default swap (CDS) where the investor essentially sells credit protection, receiving a higher yield in return for taking on the credit risk of the reference entity, in addition to the credit risk of the note’s issuer. An Equity Linked Note (ELN) is tied to the performance of an equity or index. A Range Accrual Note (RAN) pays enhanced yield if a reference index stays within a specific range. An Inverse Floater Note has coupons inversely linked to a floating interest rate index. None of these other options involve the dual credit risk and credit insurance mechanism described in the scenario.

The question describes a scenario where a portfolio manager is concerned with the ‘sensitivity of their options portfolio’s delta to movements in the underlying asset price’. This directly refers to Gamma, which measures the rate of change of an option’s delta with respect to changes in the underlying asset’s price. The methods mentioned for restricting this risk – ‘limiting the absolute change in delta’ and ‘applying risk tolerance amounts expressed as a maximum potential loss’ – are also explicitly stated as methods for managing Gamma risk in the CMFAS Module 6A syllabus. Delta measures the sensitivity of the option price to a change in the underlying asset price, not the rate of change of delta itself. Vega measures sensitivity to volatility, and Theta measures sensitivity to time decay.

The scenario describes a financial entity observing a temporary price difference between a futures contract and its underlying asset across different markets and executing simultaneous trades to profit from this imbalance without taking on directional market risk. This activity is the defining characteristic of arbitrage. Arbitrageurs specifically seek to make riskless profits by exploiting temporary price discrepancies or disequilibrium between related markets. They do not take directional bets on the market but rather capitalize on the difference between implied and market values. Hedgers, in contrast, use futures to reduce or limit the risk associated with an adverse price change in an existing underlying position. Speculators aim to profit from anticipating future price movements, taking on directional risk. Market makers provide liquidity to the markets by continually offering both bids and offers, typically profiting from the bid-ask spread rather than exploiting disequilibrium between related markets in a riskless manner.

The structured fund features an auto-redeemable clause that activates after 1.5 years and every six months thereafter. The condition for this early redemption is met if the closing level of any of the underlying indices falls below 75% of its initial level on a specified observation date. In the given scenario, Index C closed at 73% of its initial level, which is below the 75% threshold. Therefore, the auto-redemption condition is triggered. When this occurs, the product is redeemed, and the investor receives 100% of their initial principal value, as stated in the product’s auto-redeemable feature details. The other options are incorrect because the condition for auto-redemption only requires one index to fall below the threshold, and the redemption guarantees 100% principal return.

The put-call parity principle demonstrates how various financial instruments can be replicated using combinations of other instruments. A synthetic long stock position aims to mimic the payoff and risk profile of directly owning the underlying share. According to the CMFAS Module 6A syllabus, this is achieved by combining a long call option with a short put option, provided both options have the same strike price and expiration date. This combination provides unlimited profit potential if the underlying asset’s price rises and unlimited loss potential if it falls, mirroring the characteristics of holding the actual stock. A short call and long put would create a synthetic short stock. A long call and long put creates a long straddle, which profits from high volatility. A short call and short put creates a short straddle, which profits from low volatility.

When an investor writes (sells) a call option, they receive a premium upfront from the buyer. Their objective is for the option to expire worthless, meaning the underlying share price at expiration is at or below the exercise price. If the option expires worthless, the writer keeps the entire premium received, which represents their maximum possible gain. In this scenario, the investor received a premium of $6 per share. Therefore, their maximum gain is $6 per share, which occurs if the share price at expiration is $75 or less, causing the option not to be exercised. If the share price rises above the exercise price, the option will be exercised, and the writer will incur losses beyond the premium received, theoretically unlimited. The unlimited gain mentioned in one of the options is characteristic of a call option buyer, not a writer. The gain is not the exercise price itself, nor is it limited to only the exact exercise price.

Constant Proportion Portfolio Insurance (CPPI) is a trading strategy designed to achieve a fixed minimum return, typically at a future date, by continuously re-balancing the investment portfolio between performance assets and safe assets. A key characteristic of CPPI, as described in the syllabus, is that it is entirely rule-based and non-discretionary. This means the allocation adjustments are made according to a set formula or mathematical algorithm, rather than relying on the fund manager’s subjective judgment or daily market timing decisions. The principal preservation feature is achieved by adjusting the exposure to performance assets such that the portfolio can absorb a defined decrease in value before falling below the required level for capital preservation. While structured funds with capital preservation aim to return the initial investment at maturity, this is subject to conditions such as holding the investment until maturity and the solvency of the guarantor.

Structured funds are fundamentally different from traditional mutual funds in their investment approach and associated risks. Traditional mutual funds typically rely on a manager’s expertise for active allocation directly into underlying assets without the use of derivatives. In contrast, structured funds aim to replicate an underlying asset’s performance or provide a synthetic return by incorporating derivatives, often with static or rule-based allocation. This use of derivatives introduces a wider variety of risks. Specifically, structured funds are noted to have a greater presence of counterparty risk, which is the risk that a party to a financial contract may fail to meet its obligations. They can also involve exposure to other complex risks such as credit risk, equity market risk, foreign exchange risk, interest rate risk, market volatility risk, and political risks, or combinations thereof. Therefore, the increased presence of counterparty risk and other complex risks is a significant distinguishing characteristic of structured funds compared to traditional mutual funds.

The question describes the concept of Gamma risk, which is the rate at which an option portfolio’s delta changes in response to movements in the underlying asset’s price. To manage this specific risk, the syllabus outlines two primary methods. These methods involve setting limits on the absolute change in delta and defining risk tolerance amounts as a maximum potential loss. The other options refer to risk management techniques for different option Greeks (Vega, Theta, Rho) or general market risk controls not specifically tailored to Gamma.

The investor’s primary concern is that the price of ‘Tech Innovations Ltd.’ shares might increase before their funds become available, making the anticipated purchase more expensive. To mitigate this risk and effectively lock in a purchase price for a future acquisition, the most suitable strategy involving Extended Settlement (ES) contracts is to establish a long hedge. This is achieved by buying ES contracts, which secures the current price for the underlying shares for future delivery. This strategy aligns with the concept of a long hedge as described in the CMFAS Module 6A syllabus, where an investor buys ES contracts to protect against a rise in the price of shares they intend to purchase. Initiating a short sale of ES contracts (Option 2) would be a short hedge, which is typically used to protect against a decline in the price of shares an investor already owns or intends to sell in the future. This is contrary to the investor’s objective of purchasing shares and being concerned about a price increase. Placing a limit order (Option 3) does not involve ES contracts and would not guarantee the purchase at the desired price if the market price rises above the limit. If the price increases significantly, the order might not be filled, or only partially filled, leaving the investor exposed to higher prices for the remaining shares. Purchasing call options (Option 4) provides the right, but not the obligation, to buy shares at a specific price. While call options can be used for speculation or hedging, the direct and most effective way to ‘lock in’ a future purchase price for delivery using the instruments discussed in this chapter is through a long ES contract, which creates a firm commitment for future settlement at a predetermined price.

Before deciding whether to implement a hedge, an investor must evaluate several factors to identify and measure the risks involved. The provided syllabus outlines a structured approach, culminating in a comparison between the cost of hedging and the risk value associated with not hedging. This final comparison directly informs the decision to proceed with or forgo the hedge. While factors like historical price correlation, market liquidity, and the probability of price change are crucial considerations in various stages of risk assessment and hedge program development, the ultimate determinant for the decision to hedge, as per the syllabus, is the comparative analysis of the total hedging costs against the identified risk value. If the risk value significantly outweighs the hedging costs, the decision leans towards hedging.

Synthetic replication is a method where an ETF uses derivative instruments, such as swaps, to achieve the performance of an underlying index without directly holding the physical securities. This approach is particularly advantageous when the underlying assets are illiquid, difficult to acquire, or expensive to hold and manage directly. By entering into a swap agreement with a counterparty, the ETF can gain exposure to the index’s return while avoiding the operational complexities and costs associated with physical custody and management of the actual assets. In contrast, direct replication methods (full replication or representative sampling) involve physically holding the underlying securities, which would be impractical or very costly for highly illiquid assets. Cash-based direct replication is specific to cash ETFs and not suitable for tracking an index of illiquid non-cash assets.

To determine the correct asset allocation after the market event and rebalancing, follow these steps: 1. Identify Initial Parameters: Initial Portfolio Value: $100 Floor: 80% of initial portfolio value = 0.80 $100 = $80 Multiplier: 5 Current Risky Assets (before drop): $120 Current Risk-Free Assets (before drop): -$10 (indicating leverage) Current Total Portfolio Value (before drop): $120 + (-$10) = $110 2. Calculate Portfolio Value After Market Drop (Before Rebalancing): The risky asset component declines by 33.33%. New Risky Asset Value = $120 (1 – 0.3333) = $120 (2/3) = $80 Risk-Free Assets remain unchanged at -$10. Total Portfolio Value (after drop, before rebalancing) = $80 (Risky) + (-$10) (Risk-Free) = $70 3. Evaluate Against the Floor: The new Total Portfolio Value ($70) is below the Floor ($80). In a CPPI strategy, especially when leverage is involved, if the portfolio value falls to or below the floor, the typical response is to liquidate all risky assets to protect the remaining capital and cover any outstanding leverage. 4. Perform Rebalancing: Liquidate all risky assets: $80 in proceeds. Use these proceeds to first cover the leverage. The risk-free asset position moves from -$10 to $0 by using $10 of the proceeds. Remaining proceeds from risky asset liquidation = $80 – $10 = $70. Allocate these remaining $70 to risk-free assets. 5. Final Allocation: Risky Assets: $0 Risk-Free Assets: $70 This outcome demonstrates the ‘gap risk’ inherent in CPPI, particularly when leverage is used and a sudden, significant market downturn occurs, causing the portfolio to breach its protective floor before rebalancing can fully prevent the loss.

For an ETF aiming to track a broad, illiquid index while simultaneously minimizing transaction costs and operational complexities, synthetic replication is generally the most suitable approach. This method utilizes derivatives, such as total return swaps, to mirror the performance of the underlying index without requiring the ETF to physically hold all the constituent securities. This significantly reduces the operational burden and transaction costs associated with acquiring and managing a large number of potentially illiquid assets. While synthetic replication introduces counterparty risk, its efficiency in tracking difficult-to-access or illiquid markets often outweighs the challenges of physical replication in such scenarios. Full physical replication, which involves purchasing every security in the index, would be highly impractical and expensive for a broad, illiquid index due to high transaction costs, potential difficulty in sourcing all constituents, and significant operational overhead. Representative sampling, while a more practical physical method for broad indices than full replication, still involves direct physical holdings and associated transaction costs and may struggle with extremely illiquid components. Cash-based replication, on the other hand, refers to ETFs that primarily invest in short-term money market instruments; it is a classification based on asset holdings, not a method for replicating the performance of a broad equity or bond index.

The Product Highlights Sheet (PHS) for structured notes is a critical document designed to provide investors with clear and concise information. According to the guidelines, if there is a risk that an investor may lose all of their principal investment, this fact must be explicitly emphasised within the PHS using bold or italicised formatting. This ensures that investors are fully aware of the most significant risks associated with the product. The PHS is intended to complement, not replace, the full Prospectus, and it must not contain any information that is not also present in the Prospectus. While it aims for simplicity, it cannot introduce new, unverified information. Furthermore, there are specific length requirements: the PHS should not be longer than 4 pages, or 8 pages if it includes diagrams and a glossary, with the core information still limited to 4 pages. The exemption from providing a Prospectus or PHS applies only when structured notes are offered to institutional or accredited investors, not retail investors.

The scenario describes issues arising from a software system glitch and inadequate staff training on new procedures, leading to delayed or incorrect execution of client instructions. This directly aligns with the definition of operational risk, which encompasses risks due to the operations of a business failing as a result of human errors or breakdown of internal procedures and systems. Examples provided in the syllabus include breakdown of computer systems and failure to make timely actions due to cumbersome internal procedures or change of staff. Issuer risk pertains to the risk that the issuer of a financial product cannot fulfill its obligations due to bankruptcy or lack of liquidity. Concentration risk refers to the uneven allocation of funds to a limited number of financial instruments or asset classes, leading to a lack of diversification. Basis risk is specific to futures contracts, representing the difference between the futures price and the cash price, and the risk that these do not move in perfect lockstep.

The question differentiates between physical and synthetic replication ETFs, particularly concerning tracking error and counterparty risk, as outlined in the CMFAS Module 6A syllabus (Chapter 8, paragraphs 22 and 29). Synthetic replication ETFs typically achieve a lower tracking error compared to physical replication ETFs because they use derivatives (like swaps) to replicate index performance, which can be more precise. However, this introduces counterparty risk, as the ETF’s performance depends on the swap dealer’s ability to meet its obligations. Physical replication ETFs, which directly hold the underlying assets, generally face higher transaction costs and logistical challenges, leading to a higher tracking error, especially for volatile or illiquid markets like emerging markets. They do not, however, carry the same direct counterparty risk associated with swap agreements. Therefore, the distinction lies in the trade-off between tracking efficiency and counterparty exposure.

Delta (Δ) is one of the option ‘Greeks’ that quantifies the sensitivity of an option’s price to a change in the price of its underlying asset. It is calculated as the change in the option’s premium divided by the change in the underlying asset’s price. For a call option, delta is a positive value, typically ranging between 0 and 1. A delta of 0.70 indicates that for every $1.00 increase in the underlying share price, the call option’s premium is theoretically expected to increase by approximately $0.70, assuming all other factors remain constant. Therefore, an increase of $1.00 in the underlying share price would lead to an approximate $0.70 increase in the call option’s premium. The other options are incorrect because: a decrease in premium would be expected for a put option with an increase in underlying price, not a call; the premium would not increase by the full $1.00 unless the delta was precisely 1.00; and delta measures sensitivity to the underlying asset’s price, not volatility (which is measured by Vega).

Knock-out options are a type of barrier option designed to terminate, or ‘knock out,’ when the price of the underlying asset reaches a pre-determined barrier level. In this scenario, the investor holds a knock-out call option with a barrier at $65. When the stock price surges to $66, it crosses this barrier. The immediate consequence is that the option ceases to be valid and the investor’s position is closed out. This means the option can no longer be exercised, and the investor typically loses the premium paid, or receives a pre-determined small rebate, depending on the specific terms of the option agreement. The option does not adjust its strike price, lock in its intrinsic value for later exercise, or convert into a different type of option.

When the underlying asset price of a Callable Bull/Bear Contract (CBBC) reaches its pre-determined call price, a ‘Mandatory Call Event’ (MCE) is triggered. This event causes the CBBC to terminate immediately, and its trading ceases. For a Bull CBBC, this occurs when the underlying asset price falls to or below the call price. The investor’s outcome regarding a cash payment depends on the specific type of CBBC: an N-CBBC (No Residual Value) will result in no cash payment, while an R-CBBC (Residual Value) may provide a small residual cash payment. CBBCs do not involve margin requirements, nor do they convert into underlying shares, and their strike prices are not adjusted to prevent early termination upon hitting the call price.

A structured note is defined as a debt instrument or debenture whose return characteristics, such as coupon amount or market value, are linked to the performance of other underlying instruments. It typically combines a straight debt instrument with one or more embedded options or derivatives. A critical aspect is that the principal repayment is often not guaranteed; investors depend on the note issuer for repayment, and the principal’s return can be contingent on the issuer’s creditworthiness or the performance of the underlying assets. Therefore, it is not a pure equity instrument offering direct ownership, nor is it a pure fixed-income security with guaranteed principal and predictable returns irrespective of market fluctuations. It is also not classified as a collective investment scheme in the typical sense, which offers diversified exposure to a managed portfolio with daily liquidity and capital protection.

The question describes a scenario where a market participant expects significant price volatility but is uncertain about the direction. This points towards a neutral options strategy. The additional condition of aiming for a lower initial premium expenditure compared to a strategy using options at the current market price is key. A long strangle involves simultaneously purchasing an out-of-the-money (OTM) call and an out-of-the-money (OTM) put with the same underlying stock and expiration date. OTM options are generally cheaper than at-the-money (ATM) options, thus resulting in a lower initial debit compared to a long straddle. Both long straddles and long strangles are neutral strategies designed to profit from significant volatility. A long straddle, however, involves buying ATM call and put options, which typically have higher premiums. The other options, buying a call option and selling a higher strike call option (bull call spread) or buying a put option and selling a lower strike put option (bear put spread), are directional strategies, not suitable for a neutral outlook on price direction.

The question assesses understanding of the independent oversight mechanisms for structured products, as outlined in the CMFAS Module 6A syllabus. The syllabus explicitly states that most issuers have independent oversight functions to assure investors that their products are managed with due care. This includes a trust arrangement with an independent trustee to hold assets and underlying financial instruments, the engagement of financial auditors to verify financial statements and fair valuation, and for exchange-traded products, compliance with exchange rules which include providing reports and disclosing material information. These are all independent functions contributing to investor assurance regarding product management and transparency. Other options describe internal functions, initial approvals, market analysis, or sales-related responsibilities, which, while important, do not collectively represent the core independent oversight functions for the ongoing management and transparency of the structured product itself.

The question tests the understanding of fundamental differences between Contracts for Differences (CFDs) and equity futures contracts, as outlined in the CMFAS Module 6A syllabus, Chapter 12. Option 1 is correct because the syllabus explicitly states that CFDs have explicitly computed financing costs added for the duration of the holding period, whereas financing costs in futures contracts are implicit and embedded in the quoted price. Option 2 is incorrect; CFDs are mostly OTC and carry counterparty risk, while futures are traded on exchanges with no counterparty risk. Option 3 is incorrect; CFD investors are generally entitled to dividends, while futures contract holders are not. Option 4 is incorrect; CFDs can be extended or rolled over, while futures have fixed maturity dates.

For an investor who has sold a call option within a structured product, the core risk arises from the obligation to pay the option buyer if the underlying asset’s price (in this case, a securities index) rises above the strike price. Since the potential upward movement of a securities index is theoretically unlimited, the financial exposure for the option seller is also theoretically unlimited. The investor must compensate the option buyer for the difference between the market price and the strike price. This contrasts with the fixed premium received, which only provides a limited buffer against losses. The other options describe different scenarios: the premium does not fully cover unlimited losses, the loss is not capped at the initial investment for a naked short call, and the reallocation to risk-free assets is a characteristic risk of Constant Proportion Portfolio Insurance (CPPI) strategies, not directly of shorting a call option.

Extended Settlement (ES) contracts involve a high degree of leverage, which magnifies both potential gains and losses. While an initial margin is required to enter into an ES contract, the investor’s risk is not limited to this amount. If the market moves unfavorably against the investor’s position, they will be subject to margin calls, requiring additional funds. Failure to meet these margin calls empowers the broker to liquidate the position. In such an event, the investor remains liable for any resulting shortfall in the account, meaning their losses can extend beyond the initial margin deposited. This exposes the investor to the full downside of a fall in the value of the underlying share, not just the initial margin. Therefore, the statement that losses can exceed the initial margin and lead to further liability is accurate. The other options incorrectly suggest that losses are capped at the initial margin or that the investor is only responsible for the underlying asset’s percentage change without considering the magnified effect of leverage.