CMFAS RES6A Quiz 65

The scenario describes a need for an option contract with highly specific, non-standard terms, including an unusual maturity date and a precise strike price not typically available on public exchanges. Over-The-Counter (OTC) options are specifically designed for such situations, as their terms can be fully customised to suit the exact needs of the parties involved. However, a critical consideration for OTC options is the absence of a clearing house, which means performance guarantees are weaker, and counterparty risk must be carefully managed by selecting a reputable and financially sound counterparty. Exchange-traded options, while offering benefits like regulation, standardisation, and clearing house guarantees, lack the flexibility for such bespoke customisation. A futures contract is a different financial instrument altogether, primarily used for hedging but not an option, and also typically standardised. A European-style exchange-traded option still falls under the category of exchange-traded options and would not offer the required level of customisation for strike price and maturity date.

UCITS regulations, which govern many European-domiciled funds including ETFs, impose specific limits on counterparty exposure for funds that use derivative instruments like swaps for replication. The regulations stipulate that a UCITS-compliant 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 limit is designed to mitigate counterparty risk, which is the risk that the swap counterparty may default on its obligations. The marked-to-market value of these swaps must also not exceed 10% of the fund’s NAV on a daily basis. While this limit can be voluntarily decreased by the fund, 10% represents the maximum permissible exposure under UCITS guidelines.

Section 13.7.10, ‘Reporting of Under-Margined Accounts,’ specifies the conditions under which a Member must immediately notify the MAS and SGX. This obligation arises when any customer’s account (excluding the licensee’s own proprietary account) is under-margined by an amount that exceeds the Member’s aggregate resources. For a CMS licence holder who is not an SGX-ST member, the trigger is when the customer’s account is under-margined by an amount exceeding its adjusted net capital. Therefore, the critical threshold for immediate notification to the regulators is when the under-margined amount surpasses the Member’s aggregate resources. Other options describe general margin management practices or incorrect thresholds for this specific regulatory reporting requirement.

The premium of a call warrant is calculated using the formula: Premium = (Conversion Ratio x Warrant Price) + Strike Price – Underlying Share Price. In this scenario, the conversion ratio (n) is 2, the warrant price (WP) is $1.20, the strike price (X) is $9.50, and the underlying share price (S) is $10.00. Plugging these values into the formula: Premium = (2 x $1.20) + $9.50 – $10.00. This simplifies to $2.40 + $9.50 – $10.00, which equals $11.90 – $10.00, resulting in a premium of $1.90.

The question describes the specific content and purpose of a fund’s factsheet. A factsheet is a concise document designed to highlight key information related to the fund, such as its launch date, investment manager information, key features of the product, asset allocation, performance figures, and various applicable fees. This makes it the most suitable document for an investor seeking a quick, essential overview of the fund’s characteristics. The other options describe different types of reports with distinct focuses: financial statements (semi-annual accounts) provide detailed financial positions and changes; the investment manager report focuses on underlying asset performance, volatility, and outlook; and the monthly performance report details various return periods and risk analysis metrics.

For Contracts for Differences (CFDs), corporate actions like cash dividends are typically passed through to the CFD holder. If an investor holds a long CFD position, they will receive a credit equivalent to the dividend. Conversely, if an investor holds a short CFD position, they are effectively borrowing the underlying asset and are therefore obligated to pay the dividend to the counterparty. This results in the dividend amount being debited from their account. The CFD provider adjusts the investor’s account to reflect the economic impact of the dividend, ensuring that the CFD mirrors the financial outcome of holding the underlying asset, whether long or short.

Before an investor decides to implement a hedge, a comprehensive evaluation of various factors is undertaken to identify and measure the risks involved. While assessing the probability and probable size of price changes, calculating transaction costs, and understanding basis risk are all crucial steps in this process, the ultimate decision to proceed with hedging hinges on a direct comparison. The syllabus explicitly states that the ‘Cost of Hedging v Risk Value’ is the final comparison that leads to the decision to hedge or not. The risk value represents the potential loss associated with not hedging, while hedging costs encompass all expenses related to the futures contract. If the potential risk of not hedging significantly outweighs the cost of hedging, the decision to hedge becomes financially prudent. The other options represent important considerations or earlier steps in the evaluation process, but they do not constitute the primary comparative analysis that drives the final decision to implement the hedge.

The scenario describes a firm exploiting a temporary price difference between related markets or an asset and its futures contract, without taking on directional market risk. This activity is characteristic of an arbitrageur, whose primary goal is to achieve riskless profits from market inefficiencies or disequilibrium. Arbitrageurs rely on quick execution to capitalize on these fleeting opportunities. Speculators, in contrast, take directional bets on market prices, aiming to profit from anticipated price movements. Hedgers use futures to reduce or limit existing risks associated with adverse price changes in an underlying asset they hold. While proprietary trading firms may engage in arbitrage, ‘arbitrageur’ describes the specific role and strategy being performed in this context, rather than the type of firm itself.

The question requires the application of the dividend adjustment formula for warrants. The formula for the Adjustment Factor is (P – SD – ND) / (P – ND), where P is the last cum-date closing price of the underlying, SD is the Special Dividend per Share, and ND is the Normal Dividend per Share. The New Exercise Price is then calculated by multiplying the Old Exercise Price by this Adjustment Factor. Given: Old Exercise Price = $25.00 Last cum-date closing price (P) = $30.00 Normal Dividend (ND) = $0.50 Special Dividend (SD) = $1.00 First, calculate the Adjustment Factor: Adjustment Factor = (30.00 – 1.00 – 0.50) / (30.00 – 0.50) Adjustment Factor = (28.50) / (29.50) Adjustment Factor ≈ 0.96610169 Next, calculate the New Exercise Price: New Exercise Price = Old Exercise Price × Adjustment Factor New Exercise Price = $25.00 × 0.96610169 New Exercise Price ≈ $24.15254225 Rounding to two decimal places, the adjusted exercise price is $24.15.

The question describes a market condition where forward prices are consistently higher than spot prices. This scenario is known as a contango market. According to the principles of an ‘Optimal Yield’ rolling mechanism in structured funds that track commodity indices, the strategy is designed to adapt to market dynamics. In a contango market, rolling over expiring futures contracts typically leads to losses due to the upward slope of the price curve. Therefore, the primary objective of the Optimal Yield methodology in such a market is to minimize these rolling losses. It does not aim to maximize profits in contango, as that is the goal in a backwardation market. The mechanism also explicitly moves away from fixed rolling periods to achieve its dynamic objectives, and while exposure adjustments might occur in a fund, the ‘Optimal Yield’ specifically addresses the rolling process of futures contracts.

The Factsheet is specifically designed as a concise document that highlights key information related to a fund, such as its launch date, investment manager information, key features of the product, asset allocation, performance figures, and applicable fees. This makes it the most appropriate document for an initial, high-level overview. The Semi-annual Accounts and Reports to Unitholders provide detailed financial statements, including statements of net assets and changes in net assets, which are more comprehensive than a quick overview. The Monthly Performance Report focuses on detailed performance metrics, risk analysis, and principal terms, which goes beyond a fundamental characteristic summary. The Investment Manager Report details the performance of underlying assets and provides the fund manager’s outlook, which is also more specific than a general overview of the fund’s basic features.

The product terms specify that a Mandatory Call Event (knock-out) is triggered if the closing level of ‘ANY 4’ of the underlying indices falls below 75% of their initial level. Given there are exactly four underlying indices, ‘ANY 4’ implies that all four indices must meet this condition. In the provided scenario, the initial level for each index was 1,200 points. Therefore, 75% of the initial level is calculated as 0.75 1,200 = 900 points. To trigger the Mandatory Call Event, all four indices must close below 900 points. Let’s evaluate each index’s closing level against this barrier: Index A closed at 880 points (below 900). Index B closed at 910 points (not below 900). Index C closed at 895 points (below 900). Index D closed at 905 points (not below 900). Since Index B and Index D did not close below 900 points, the condition that ‘all four’ indices must be below 75% of their initial level is not met. Consequently, the Mandatory Call Event is not triggered. The scenario also explicitly states that the product has passed its initial call protection period, making that reason for non-triggering incorrect. The trigger condition is based on individual index levels against a barrier, not an average performance.

The question describes a mechanism designed to temporarily suspend trading activities across specific financial instruments to provide market participants with a pause and prevent further disorderly declines. This function is precisely what ‘Circuit Breakers’ are designed to do. As outlined in the CMFAS Module 6A syllabus, circuit breakers are systems in cash and derivative markets that trigger trading halts. ‘Shock Absorbers’ are distinct in that they slow down trading when markets experience significant volatility but do not halt trading completely. ‘Session Price Limits’ are measures imposed to limit price volatility without slowing or halting trading activity. ‘Dynamic Margin Adjustments’ refer to changes in the collateral required for trading, which is a risk management tool used by exchanges and clearing houses, but it is not a direct mechanism for suspending or slowing market activity in response to a disruption event in the same way as the other options.

Index-Linked Notes (ILNs) with principal preservation are structured products designed to return the investor’s initial capital at maturity, regardless of the underlying index’s performance. In addition to this principal preservation, the note offers a variable return component. This return is typically calculated as the greater of a predefined minimum total return (often expressed as an annual percentage or a total percentage over the tenor) and a specified participation rate in the underlying index’s performance (e.g., its average performance over the note’s term). This structure allows investors to participate in potential market upside while protecting their initial investment from market downturns. The other options describe features not characteristic of a principal-protected Index-Linked Note: fixed interest payments with fluctuating principal, an obligation to purchase underlying assets, or returns solely based on issuer creditworthiness without index linkage.

Effective gearing is a measure of a warrant’s sensitivity to changes in the underlying asset’s price, combining the effects of both gearing and delta. It is calculated by multiplying the warrant’s delta by its gearing. In this scenario, the effective gearing is 0.6 (delta) multiplied by 8 (gearing), which equals 4.8. This means that for every 1% change in the underlying stock price, the warrant’s price is expected to change by 4.8%. Therefore, if the underlying stock price increases by 1%, the warrant’s price would approximately increase by 4.8%.

The MAS Guidelines on Product Highlights Sheets (PHS) are designed to enhance investor understanding of capital markets products. The fundamental objective of a PHS is to present a concise, balanced, and easily digestible summary of a product’s key features, benefits, risks, and fees. This enables investors to grasp the essential aspects of a product quickly and make informed decisions, without having to immediately delve into a lengthy and complex offer document. It acts as a supplementary document, not a replacement for the full prospectus, and is mandated to highlight risks alongside potential benefits, rather than solely focusing on marketing or guaranteeing returns.

The cost-of-carry model posits that the fair futures price should equal the spot price plus the net cost of carrying the asset until the futures contract’s expiry. When the observed futures price deviates significantly from this fair value, arbitrage opportunities arise. If the futures price is trading at a substantial premium (i.e., it is higher than the spot price plus the cost of carry), arbitrageurs would engage in a strategy known as ‘cost-and-carry arbitrage’. This involves simultaneously selling the overpriced futures contract and buying the underlying asset in the spot market. They would then hold the asset until the futures contract expires, at which point the spot and futures prices converge. This allows them to lock in a risk-free profit from the initial mispricing. Buying an undervalued futures contract and selling the asset short would be the strategy if the futures price were trading at a discount (Reverse Cost-and-Carry Arbitrage). Increasing long positions or withdrawing from the market are not typical arbitrage responses to such a clear mispricing.

The scenario explicitly details an investor’s difficulty in closing a Contract for Differences (CFD) position because the underlying market for an international equity has become extremely illiquid due to unforeseen geopolitical events. The CFD provider’s inability to execute the trade at a fair price, or at all, directly stems from this lack of liquidity in the underlying asset market. This situation perfectly illustrates liquidity risk, which is the exposure an investor faces when there are not enough trades being made in the market for an underlying asset, making it difficult or impossible to trade CFDs on that asset at a desired price. Counterparty risk, on the other hand, refers to the risk that the CFD provider itself may be unable or unwilling to meet its contractual obligations due to its own financial difficulties. Currency risk relates to the impact of fluctuating foreign exchange rates on the investment’s value. Financing cost risk involves the impact of interest rate movements on the daily charges for holding a leveraged CFD position. Therefore, the primary risk described is liquidity risk.

In an unfunded swap-based Exchange Traded Fund (ETF), the ETF itself plays a direct role in managing the collateral. The proceeds generated from the sale of the ETF’s units are used by the ETF manager to purchase a pool of collateral. This collateral is then held with a third-party custodian. The returns from this collateral are subsequently exchanged with a swap counterparty for the performance of the target index. This arrangement is designed to limit the ETF’s exposure to the swap counterparty, with the collateral pool typically rebalanced daily to maintain its value at a minimum of 90% of the ETF’s Net Asset Value (NAV). In contrast, a fully funded swap-based ETF involves the ETF transferring its sale proceeds to the swap counterparty, who then purchases and pledges the collateral to the ETF.

The question describes two types of derivative instruments. One offers protection against counterparty default through a clearing house, which is characteristic of futures contracts. The other is a direct, private agreement, which describes a forward contract. Forward contracts are negotiated directly between a buyer and a seller on mutually agreed terms, making them non-standardised. Because they are private agreements and traded over-the-counter (OTC) without a central clearing house, investors are exposed to counterparty risk, meaning the risk that the other party to the contract will default on their obligations. Futures, on the other hand, are standardised, traded on regulated exchanges, and cleared through a clearing house, which eliminates counterparty risk for market participants. Therefore, the primary distinguishing characteristic of the direct, private agreement (forward contract) is its non-standardised nature and the presence of counterparty risk. Options describing trading on a regulated exchange, daily mark-to-market procedures, or an active secondary market are characteristics of futures contracts, not forward contracts.

For a Bull Knock-Out contract, when a mandatory call event is triggered, the payoff to the investor is determined by the residual value. The residual value is calculated as the difference between the settlement price (which is the spot price at which the mandatory call event occurred) and the strike price, with this difference then divided by the conversion ratio. In the given scenario, the underlying asset’s spot price falls to $27.50, which triggers the mandatory call event. This $27.50 becomes the settlement price. The strike price is $25.00, and the conversion ratio is 5:1. Therefore, the calculation for the residual value is ($27.50 – $25.00) / 5. This simplifies to $2.50 / 5, resulting in a residual value of $0.50 per contract. Incorrect options might arise from common errors such as neglecting the conversion ratio, mistakenly using the call price as the settlement price, or using an initial spot price instead of the actual settlement price at the time of the mandatory call event.

The CMFAS Module 6A guidelines stipulate specific documentation requirements for structured notes based on the type of investor. When structured notes are offered to retail investors, the selling financial institution is obligated to provide both a Prospectus and a Product Highlights Sheet (PHS). However, a key exemption exists: if the notes are offered to institutional or accredited investors, the note issuer is exempted from providing either the Prospectus or the Product Highlights Sheet. Therefore, in a situation where a product is marketed to both retail and accredited investors, the PHS must be provided to the retail segment, while the accredited investors are not subject to this mandatory disclosure.

Before a portfolio manager decides to implement a hedging strategy, a comprehensive evaluation of various factors is undertaken. While all listed factors like transaction costs, probability of price changes, and basis risk are important, the ultimate decision to proceed with a hedge hinges on a critical comparison. This comparison involves weighing the potential financial impact or ‘risk value’ that would be incurred if no hedge were put in place, against the total ‘cost of hedging’. The cost of hedging includes elements such as brokerage fees, financing costs for margins, and any other associated expenses. If the risk value of remaining unhedged is significantly higher than the cost of implementing the hedge, the decision to hedge becomes financially justifiable. This ensures that the protective benefits outweigh the expenses incurred.

Structured products designed to provide a minimum return of principal at maturity can achieve this through different mechanisms. One common approach involves combining a zero-coupon bond with a long-call option. However, another distinct strategy that also aims for principal protection, but notably does not involve options, is the Constant Proportion Portfolio Insurance (CPPI) strategy. This method dynamically adjusts the allocation between a risky asset and a risk-free asset to maintain a minimum capital floor. Short options strategies, conversely, are typically employed in structured products that do not offer a minimum return of principal, as they generate premium income but expose the investor to potential losses beyond the initial capital. Integrating credit default swaps (CDS) is a feature used to manage credit risk of the underlying entities, not primarily to guarantee the investor’s principal return without options.

The provided text explicitly states that while the payoff profiles of a Reverse Convertible and a Discount Certificate can be the same, their compositions are different. It then highlights the application of the put-call parity theory [c + PV(X) = p + S] and shows that a Reverse Convertible is composed of a Bond (Note) + Short Put, while a Discount Certificate is composed of a Long Call (Zero strike) + Short Call. Put-call parity is a fundamental concept in options pricing that demonstrates how different combinations of options and a risk-free asset (like a bond) can be equivalent in terms of their payoff profiles at expiration. Therefore, the similar risk-return profiles of these two distinct structured products are explained by the put-call parity, which shows the equivalence between the bond + short put structure and the long zero-strike call + short call structure. The other options describe features or risks that are either incorrect, not universally applicable to both products, or do not explain the fundamental structural equivalence that leads to similar payoff profiles.

Equity Linked Structured Notes are complex financial instruments that often incorporate derivatives, leading to higher product costs. Their fees, including sales, structuring, and management charges, are typically embedded within the product’s initial price, making them primarily upfront and built-in. In contrast, Equity Linked Exchange Traded Funds (ETFs) are generally designed for cost-efficiency, aiming to track an underlying asset or index. They are characterized by a low total expense ratio (TER), which predominantly consists of recurring management and administration fees, alongside minor upfront and back-end brokerage fees. The other options inaccurately describe these fee structures; for instance, Structured Notes do not primarily incur recurring fees or have negligible costs, and ETFs are not defined by substantial upfront commissions or significant back-end redemption charges as their main fee component.

When an investor holds a short Extended Settlement (ES) contract position and fails to deliver the required underlying shares by the specified due date (which is the 3rd market day following the expiration date), the Central Depository Pte Ltd (CDP) is mandated to intervene. The CDP initiates a ‘buying-in’ process to procure the necessary shares from the market to fulfill the investor’s delivery obligation. This buying-in process commences on the day immediately following the due date for delivery. The starting price for this buying-in is set at a premium, specifically at 2 minimum bids above the closing price of the previous day, the current last done price, or the current bid, whichever of these is the highest. This mechanism ensures that the delivery obligation is met, but it exposes the defaulting investor to potentially significant losses due to the higher acquisition cost. The other options describe incorrect timings for the buying-in process, alternative settlement methods that are not the primary action for failed physical delivery, or unrelated market interventions.

The TED spread is defined as the difference between the price of 3-month US Treasuries futures contracts and 3-month Eurodollar futures contracts with the same expiration month. It serves as a key indicator of credit risk. US T-bills are considered risk-free, while Eurodollar futures rates reflect the credit ratings of corporate borrowers. When the TED spread increases, it signifies that the perceived default risk in the market is rising, leading investors to favor safer assets like US Treasuries over corporate debt. Conversely, a shrinking TED spread indicates a decrease in perceived default risk. Therefore, a consistent increase in the TED spread points to a heightened perception of credit risk among corporate entities.

The basis in a futures contract is defined as the difference between the spot price of the underlying asset and the futures price. As a futures contract approaches its expiry date, the futures price and the spot price of the underlying asset are expected to converge. This convergence occurs because, at the exact moment of expiration, the futures contract is settled at the prevailing cash (spot) market price. Therefore, the difference between these two prices, known as the basis, must narrow and ultimately become zero at the time of settlement. This phenomenon is a fundamental characteristic of futures markets, ensuring that the contract accurately reflects the value of the physical asset at maturity. The other options describe behaviors that contradict this principle of convergence.

The question tests the understanding of how different structured product compositions can achieve similar risk-return profiles, specifically focusing on Reverse Convertibles and Discount Certificates as detailed in the CMFAS Module 6A syllabus. The provided text explicitly states that while the payoff profiles of these two products can be the same, their compositions are different, and this equivalence is highlighted through the application of the put-call parity theory [c + PV(X) = p + S]. Put-call parity is a fundamental principle in options pricing that establishes a relationship between the price of a European call option, a European put option, the underlying asset, and a zero-coupon bond. It demonstrates that certain combinations of these instruments can be synthetically equivalent, leading to identical payoff structures. Therefore, the ability to construct a Reverse Convertible (Bond + Short Put) and a Discount Certificate (Long Zero-Strike Call + Short Call) to yield a similar investment payoff is a direct application of put-call parity. The other options describe features or objectives of various structured products but do not explain the fundamental reason for the equivalence in payoff between two distinct compositions.