CMFAS RES6A Quiz 71

The question pertains to the specifications of Eurodollar futures contracts, specifically the minimum price fluctuation. According to the provided Appendix C for Eurodollar Futures, the minimum price fluctuation for contract months that are not the spot month is explicitly stated as 0.0050 point, which corresponds to a monetary value of USD 12.50. Option 1 correctly identifies this value. Option 2, USD 6.25, is the minimum price fluctuation for the spot month, not for other contract months. Options 3 and 4 are incorrect values that do not correspond to the stated specifications for Eurodollar futures.

The question describes a scenario where a small company with a high share price has a greater impact on an equity index than a large company with a lower share price. This is a defining characteristic of a price-weighted average index. In a price-weighted index, the magnitude of a security’s price per share directly influences its weight in the index. Therefore, a stock with a higher price, regardless of its market capitalization, will have a larger effect on the index’s movement. In contrast, a market-value-weighted (or capitalization-weighted) average index gives greater weight to companies with larger total market capitalizations. An equally-weighted average index assigns the same weight to all stocks, irrespective of their price or market value. A volume-weighted average is not a standard method of equity index construction discussed in the provided syllabus material.

A Bull Equity-Linked Note (ELN) is a structured product that combines a fixed-income instrument with an embedded short put option. The investor, by purchasing the ELN, effectively sells a put option to the issuer. This means the investor receives an enhanced return (often through a higher yield or a discount on the issue price) compared to a plain vanilla fixed-income note. However, this enhanced return comes with a significant trade-off: the investor assumes the downside risk of the underlying equity. If the underlying share price falls below the strike price of the embedded put option at maturity, the investor will typically be obligated to take delivery of the underlying shares at the strike price, potentially incurring a loss if the market price of the shares is lower than the strike price. Therefore, the investor accepts exposure to the equity’s downside volatility. The note does not guarantee a higher yield, as the equity risk can lead to losses. The maximum potential loss is not limited to the initial discount; it can be substantial if the underlying share price drops significantly. Furthermore, if the put option is exercised (i.e., the share price is below the strike), the settlement is usually in shares, not a cash payment representing the difference between the strike and market price.

The question pertains to the fundamental principle of futures and spot price convergence. As a futures contract reaches its expiry date, the futures price and the spot price of the underlying asset are expected to align. This phenomenon, known as convergence, results in the basis (the difference between the spot price and the futures price) effectively becoming zero at the moment of expiry. This convergence is a crucial aspect of futures markets, ensuring that the contract’s value accurately reflects the underlying asset’s cash market value at settlement. Prior to expiry, the basis can fluctuate due to various factors, including the cost of carry, but the expectation is always for it to narrow and reach zero by the contract’s end.

A Bull Equity-Linked Note (ELN) is a structured product designed to offer investors an enhanced yield compared to a plain vanilla fixed income instrument. This enhanced yield comes with an embedded short put option, meaning the investor effectively takes on the risk of the underlying equity. At the note’s maturity, there are two primary outcomes. If the underlying equity’s market price is at or above the specified strike price, the embedded put option expires worthless, and the investor receives the full face value of the note in cash. However, if the underlying equity’s market price falls below the strike price, the embedded put option is exercised. In this situation, the investor does not receive cash but instead receives a predetermined number of shares of the underlying equity. This number of shares is typically calculated by dividing the note’s face value by the strike price. Since the market price of the shares is now below the strike price (and likely below the effective purchase price for the investor), this outcome often results in a capital loss for the investor, as the value of the received shares is less than the initial investment.

Structured warrants listed on the Singapore Exchange (SGX-ST) are specifically designed with certain operational characteristics. They are always cash-settled, meaning that upon exercise or expiry, the holder receives a cash payment equivalent to the intrinsic value, rather than physical delivery of the underlying asset. Furthermore, these warrants adhere to an ‘Asian style’ expiry settlement. This implies that the last day on which the warrant can be traded in the market is distinct from its actual expiry date, which is a crucial detail for investors to manage their positions effectively. Other settlement and expiry styles, such as physical settlement, European-style (last trading day equals expiry date), or American-style (exercise anytime up to expiry), do not apply to structured warrants on SGX-ST.

The question asks for a common principle in determining the Last Trading Day for Euroyen TIBOR Futures and 3-month Singapore Dollar Interest Rate Futures. According to the provided specifications, the Last Trading Day for Euroyen TIBOR Futures is the ‘2nd Tokyo Financial Exchange (TFX) business day immediately preceding the 3rd Wednesday of the expiring contract month’. Similarly, for 3-month Singapore Dollar Interest Rate Futures, the Last Trading Day is ‘2 business days preceding the 3rd Wednesday of the expiring contract month’. Both contracts share the characteristic of their last trading day being set two business days before the third Wednesday of the expiring contract month. The first option accurately captures this shared principle. The other options are incorrect because they do not align with the specific timing mechanisms detailed for these contracts in the provided information. For instance, the last trading day is not necessarily one business day before the final settlement price is published for both, nor is it the first business day of the expiring month or the last business day of the preceding month.

The question describes the characteristics of three specific option Greeks: the second-order sensitivity to the underlying asset’s price movement refers to Gamma (the rate of change of Delta); the responsiveness to changes in market volatility refers to Vega; and the erosion of option value over time refers to Theta (time decay). The CMFAS Module 6A syllabus material explicitly states that Gamma, Vega, and Theta are sometimes controlled together by setting a maximum loss for all three combined. This approach allows the positive effects of Theta (which typically increases an option’s value as time passes for options held by the writer, or decreases for the holder) to be offset against the negative effects of Gamma (which can lead to significant losses if the underlying moves sharply). Delta measures the first-order sensitivity to the underlying asset’s price, and Rho measures the impact of interest rate changes, and these are typically managed with separate limits or strategies.

Under the UCITS regulations, which govern European-domiciled funds, there are specific limits on counterparty risk exposure for synthetic Exchange Traded Funds (ETFs) that use swaps for replication. The regulations stipulate that an ETF is not permitted to invest more than 10% of its prevailing Net Asset Value (NAV) in derivative instruments, including swaps, issued by a single counterparty. This means the maximum amount that a single swap counterparty can owe to the fund is capped at 10% of the fund’s NAV. This limit is designed to mitigate counterparty risk within the fund structure.

The question pertains to the concept of synthetic positions derived from the put-call parity theory, specifically how to replicate a long stock position using options. A synthetic long stock position is created by combining a long call option with a short put option, both having the same underlying asset, strike price, and expiration date. This combination replicates the unlimited profit potential and downside risk profile of directly owning the underlying share. Option 1 (Acquiring a long call option and simultaneously selling a put option) correctly describes the construction of a synthetic long stock. A long call provides upside participation, while a short put obligates the seller to buy the underlying if the price falls below the strike, effectively mimicking the downside exposure of holding the stock. Option 2 (Selling a call option and simultaneously acquiring a put option) would create a synthetic short stock position, which has an inverse risk-reward profile compared to a long stock. Option 3 (Acquiring both a call option and a put option) describes a long strangle or straddle, depending on the strike prices. This strategy profits from significant price movement in either direction, but does not replicate a linear long stock position. Option 4 (Selling both a call option and a put option) describes a short strangle or straddle, which profits from the underlying asset remaining within a certain price range and does not replicate a long stock position.

A Credit Linked Note (CLN) is a structured product where the investor takes on the credit risk of a ‘reference entity’. In the event of a credit default by this reference entity, the settlement mechanism of the underlying Credit Default Swap (CDS) determines the investor’s outcome. If the CLN is structured for physical settlement, the issuing bank, which sold the credit protection, will pay the CDS buyer the principal amount in cash and receive a debt obligation (e.g., a bond) of the now-defaulted reference entity. Consequently, the CLN investors will receive this defaulted bond. Such a bond, from a defaulted entity, is highly likely to trade at a substantial discount to its original face value, leading to a loss for the investor. This is a key risk of CLNs. Receiving the full principal amount or a cash payment based on the difference between par and market value would correspond to different scenarios or settlement types (the latter being cash settlement). Conversion into a senior secured bond of the issuer is not a standard outcome for a CLN upon reference entity default.

Synthetic replication ETFs utilize derivatives, typically total return swaps, with a counterparty to achieve their investment objective. This introduces counterparty risk, which is the risk that the swap counterparty may default on its obligations. In contrast, physical replication ETFs directly hold the underlying securities, thus generally having lower direct counterparty risk, though some exposure can exist through activities like securities lending. Regarding tracking error, synthetic ETFs often achieve a lower tracking error because the swap is designed to deliver the exact performance of the underlying index, minimizing the impact of transaction costs, rebalancing, and cash holdings that can affect physically replicated portfolios. Physical replication ETFs, despite holding the actual assets, can experience higher tracking error due to factors such as transaction costs, portfolio rebalancing, dividend reinvestment timing, and cash drag.

When the market price of an Interest Rate Swap (IRS) offers a fixed rate that is notably higher than the aggregate implied fixed rate derived from a strip of Eurodollar futures contracts, it indicates that the IRS fixed rate is relatively overvalued compared to the futures strip. To execute a pure arbitrage strategy, one must simultaneously sell the overvalued instrument and buy the undervalued instrument. In this scenario, the arbitrageur would ‘sell’ the expensive fixed rate of the IRS by becoming a fixed-rate receiver (and paying the floating rate). Concurrently, they would ‘buy’ the cheaper implied fixed rate by purchasing the corresponding Eurodollar futures contracts. This locks in a risk-free profit from the discrepancy. The other options either describe the incorrect actions for this specific market condition, represent speculative positions rather than pure arbitrage, or involve incomplete strategies that do not fully exploit the price divergence.

The question describes a scenario where an ETF provider needs to track a broad market index with a large number of illiquid securities, while also focusing on cost efficiency. Full physical replication, which involves acquiring every security in the index, would be impractical and costly in such a situation due to the sheer volume and illiquidity of the underlying assets. Synthetic replication methods, such as derivative-embedded or swap-based approaches, avoid direct ownership of the underlying securities but introduce other considerations like counterparty risk and specific derivative costs. Representative sampling is a direct replication methodology specifically designed for such scenarios. It involves selecting a carefully chosen subset of the index’s constituents that collectively mimic the overall risk and return characteristics of the full index. This approach allows the ETF to achieve its tracking objective while managing operational costs and overcoming the challenges associated with illiquid or numerous underlying securities.

The minimum value of a convertible bond is determined by taking the greater of its conversion value or its straight value. The conversion value represents what the bond would be worth if immediately converted into shares, calculated as the market price of the underlying share multiplied by the conversion ratio. In this scenario, the conversion value is SGD 10 (market price of share) multiplied by 80 (conversion ratio), which equals SGD 800. The straight value is the value of an equivalent non-convertible bond, which is given as SGD 900. Comparing these two values, SGD 900 is greater than SGD 800. Therefore, the minimum value of the convertible bond is SGD 900. The other options represent either only the conversion value or incorrect calculations that do not follow the established valuation approach for convertible bonds.

For an investor who writes (sells) a call option, their maximum potential gain is limited to the premium they receive from the buyer. This occurs when the underlying share price at expiration is at or below the exercise price, rendering the option out-of-the-money or at-the-money. In such a scenario, the option buyer will not exercise, and the writer retains the full premium as profit. The maximum loss for a call writer, however, is theoretically unlimited, as the underlying share price can rise indefinitely. Conversely, for a call option buyer, the maximum loss is limited to the premium paid, while the maximum gain is theoretically unlimited.

The product terms explicitly state that if no early redemption occurs and, at maturity, the performance of Index 1 (Nikkei 225) is less than the performance of Index 2 (S&P 500), the payout will be the ‘Redemption Value’. The Redemption Value is defined as 100% of the initial investment. This aligns with the product’s ‘capital preservation’ feature, which offers protection against market downside by returning 100% of the initial investment capital if the underlying index underperforms at maturity. The payout of 125.5% is only applicable if Index 1’s performance is equal to or greater than Index 2’s performance at maturity. The early redemption payout percentages are irrelevant as no early redemption was triggered. A variable percentage based on the difference between index performances is not a feature described for this product’s maturity payout under these conditions.

Foreign Exchange (FX) warrants are leveraged instruments that allow investors to speculate on currency movements. When an investor anticipates a significant appreciation of the Euro against the US Dollar, it signifies a bullish view on the Euro and a bearish view on the US Dollar. For the EUR/USD currency pair, the Euro is the base currency. To profit from an anticipated increase in the value of the base currency, an investor would typically purchase call warrants on that specific currency pair. Therefore, buying EUR/USD call warrants is the appropriate action to capitalize on the expected appreciation of the Euro against the US Dollar. Purchasing EUR/USD put warrants would be suitable if the investor expected the Euro to depreciate. Options involving the USD/EUR pair are incorrect as the question explicitly specifies using FX warrants on the EUR/USD currency pair.

Expected dividends affect option prices primarily because they lead to a reduction in the underlying share price when the stock goes ex-dividend. For call options, a decrease in the underlying share price is unfavorable, causing their value to decline. Conversely, for put options, a decrease in the underlying share price is favorable, leading to an increase in their value. Therefore, a significant increase in expected dividends would generally lead to a decrease in call option prices and an increase in put option prices, assuming all other factors remain constant. The other options describe incorrect relationships or misinterpret the impact of dividends on both option types.

Before deciding to implement a hedging strategy, a crucial step involves evaluating whether the benefits of hedging outweigh its costs. This means comparing the potential financial loss from an adverse market movement (risk value associated with not hedging) against the total expenses incurred to put the hedge in place (cost of hedging). If the cost of hedging significantly exceeds the risk value, the decision might be against hedging, as it would not be economically rational. The other options represent considerations that are either part of developing the hedge program after the decision to hedge has been made (like identifying the most correlated hedge vehicle or setting the acceptable residual risk level), or a more granular detail within the cost analysis rather than the overarching decision point (like the percentage of principal value constituted by transaction costs).

For a put option, it is considered ‘in-the-money’ (ITM) when the strike price is higher than the current market price of the underlying asset. Its intrinsic value is calculated as the difference between the strike price and the market price (Strike Price – Market Price), provided this difference is positive. If the market price is equal to or higher than the strike price, the put option is ‘out-of-the-money’ (OTM) or ‘at-the-money’ (ATM), and its intrinsic value is zero. In the initial situation, the put option has a strike price of $50 and the underlying asset is trading at $45. Since the strike price ($50) is greater than the market price ($45), the option is in-the-money. Its intrinsic value is $50 – $45 = $5. When the market price of the underlying asset increases to $52, the strike price ($50) is now less than the market price ($52). This means the put option is now out-of-the-money. Consequently, its intrinsic value becomes zero, as there would be no profit from immediate exercise. Therefore, the option transitions from being in-the-money to out-of-the-money, and its intrinsic value diminishes from $5 to $0.

For a cash-settled put warrant, the settlement amount is calculated using the formula: (Exercise Price – Share Price) / Conversion Ratio. In this scenario, the Exercise Price (X) is $16.00, the Share Price (S) is $15.50, and the Conversion Ratio (n) is 4. Therefore, the cash settlement per warrant is ($16.00 – $15.50) / 4 = $0.50 / 4 = $0.125. The warrant is in-the-money because the exercise price is higher than the share price. Other options represent common errors such as forgetting to apply the conversion ratio, incorrectly assuming the warrant is out-of-the-money, or using an incorrect formula.

The trading name of a structured warrant provides key information about its features. In the given example, ‘GHI JKL ePW251115’, the ‘e’ prefix signifies that the warrant is European-style. The ‘PW’ notation indicates that it is a Put Warrant. Therefore, the ‘ePW’ component collectively describes the warrant as a European-style put warrant. An American-style warrant would have no prefix for its exercise style, and ‘CW’ would denote a call warrant.

Over-the-Counter (OTC) options are specifically designed for situations requiring highly customised terms, such as unique strike prices or unconventional expiration dates, because their contracts are tailor-made between the parties involved. Unlike exchange-traded options, OTC options do not trade on an organised exchange and lack a central clearing house to guarantee performance. This absence of a clearing house means that counterparty risk is a significant factor that must be actively managed, making the selection of a reputable and financially stable counterparty critical. Exchange-traded options, while offering benefits like standardised terms and clearing house guarantees, do not provide the flexibility needed for highly specific, non-standard exposures.

A Barrier Capital Preservation Certificate (Straddle) is designed with both an upper and a lower knock-out barrier. The core characteristic is that if the underlying asset’s price breaches either of these barriers at any point during the product’s lifetime, a knock-out event occurs. Upon such an event, the product immediately ceases to participate in the underlying’s performance, and the investor receives the agreed capital amount, effectively concluding the product’s term. This mechanism ensures capital preservation in the event of significant price movements outside the expected range, but it also limits potential profits and the product’s lifespan. The product does not continue with reduced leverage, offer unlimited profit potential, or convert into a standard bond upon a knock-out event.

A Stop Sell order is specifically designed to limit potential losses or protect profits on a long position. It is placed at a price level below the current market price. When the market price falls to or below the specified Stop Price, the order is triggered and converts into a market order or a limit order to sell. In this scenario, the trader holds a long position and wants to sell if the price drops to 29,800 points, which is below the current market price of 30,000 points. Therefore, a Stop Sell order with a Stop Price of 29,800 points is the correct choice. A Market-if-Touched (MIT) Sell order, on the other hand, is placed above the current market price and triggers when the price rises to that level. A Session State Order (SSO) triggers based on transitions into new session states, not specific price levels. A Limit Sell order at 29,800 points would execute immediately if the current market price is 30,000 points, as it would be filled at 30,000 or higher, which does not meet the objective of exiting only if the price falls to 29,800.

When a company expects to receive foreign currency in the future, it faces the risk that the foreign currency might depreciate against its local currency, thereby reducing the value of the expected receipt. To effectively hedge this foreign exchange risk using futures contracts, the company needs to lock in a future selling price for the foreign currency. This objective is achieved by establishing a short position, meaning selling, in futures contracts for that specific currency pair. By selling EUR/SGD futures, Global Connect Pte Ltd commits to exchanging Euros for Singapore Dollars at a predetermined exchange rate on a future date, regardless of the spot rate at that time. This action effectively hedges against a potential decline in the Euro’s value relative to the Singapore Dollar.

The fund’s trustee is legally mandated to hold ownership of all assets within the Collective Investment Scheme (CIS) and ensure these assets are kept separate from the fund management company. A primary responsibility of the trustee, acting in a fiduciary capacity, is to safeguard the interests of the unit holders by ensuring the fund manager adheres strictly to the investment objectives and restrictions stipulated in the trust deed and prospectus. While the fund manager is responsible for the day-to-day management and performance of the fund’s assets, and the administrative agent handles operational processes like transaction settlement, neither holds the legal ownership of the assets nor the ultimate oversight role of ensuring the fund manager’s compliance with the trust deed. The fund’s auditor conducts periodic reviews of processes but does not have the ongoing legal ownership or direct oversight responsibility of the trustee.

The product’s terms specify that a Knock-Out Event (Mandatory Call Event) occurs if any index level falls below 75% of its Initial Level. To determine if a Knock-Out Event has occurred, we calculate 75% of the Initial Level for each index and compare it to the Observed Level: For Index P: 75% of 2500 = 1875. The Observed Level is 1850. Since 1850 is less than 1875, Index P has triggered a Knock-Out Event. For Index Q: 75% of 1200 = 900. The Observed Level is 910. Since 910 is not less than 900, Index Q has not triggered a Knock-Out Event. For Index R: 75% of 800 = 600. The Observed Level is 605. Since 605 is not less than 600, Index R has not triggered a Knock-Out Event. For Index S: 75% of 3000 = 2250. The Observed Level is 2200. Since 2200 is less than 2250, Index S has triggered a Knock-Out Event. Since at least one index (in this case, Index P and Index S) has fallen below 75% of its Initial Level, a Knock-Out Event has occurred, leading to a Mandatory Call Event and potential early redemption.

A Market-if-Touched (MIT) order is designed to convert into a market order once a specified trigger price is touched. For a sell order, an MIT is placed above the current market price. This means if the market price rises to or above the set trigger price, the MIT order is activated and becomes a market order to sell, allowing the trader to secure profits at a higher price. In contrast, a Stop Sell order is typically placed below the current market price and is used to limit losses if the price falls. A Limit Sell order specifies a minimum price at which to sell, but it is a standing order that executes at or above the limit price, rather than converting to a market order upon touching a specific higher price to ensure execution. A Session State Order is triggered by a change in the market’s session state, not by a specific price movement.