CMFAS RES6A Quiz 63

The Zero Coupon Fixed Income Plus Option Strategy, often referred to as a ‘Zero Plus’ option, is designed with a capital preservation feature. This is primarily achieved through the zero-coupon fixed income instrument component. This instrument is typically a zero-coupon note that is purchased at a discount and matures at par (100% of its face value) at the end of the product’s term. As long as the issuing bank does not default (i.e., no credit event), the investor is expected to receive 100% of their principal sum back from this fixed income component at maturity. The embedded call option provides the potential for upside returns, but the principal return is linked to the fixed income part. The intrinsic value of the call option is variable and depends on the underlying asset’s performance, not a guaranteed principal return. A separate capital guarantee from a third-party insurer is not the inherent mechanism of this specific strategy for capital preservation. Continuous rebalancing of the underlying asset is also not the primary method for ensuring principal return in this structure; the zero-coupon bond serves that purpose.

Extended Settlement (ES) contracts are particularly advantageous for investors who anticipate a market downturn and wish to profit from it efficiently. The ability to take a short position allows an investor to gain from falling prices, unlike traditional ready market shorting which can involve immediate borrowing costs and the risk of buying-in. Furthermore, ES contracts are marginable futures contracts, meaning only a small portion of the contract value is required as margin collateral. This provides significant leverage, maximizing capital efficiency by allowing exposure to a larger amount of securities with a relatively smaller capital outlay. Therefore, the combination of taking a short position and leveraging capital directly addresses the investor’s objective in the scenario. While other options like extended tenure, hedging, and arbitrage are benefits of ES contracts, they do not directly align as the most advantageous features for profiting from an anticipated price decline with efficient capital use.

Extended Settlement (ES) contracts offer a significant benefit for investors looking to take a short position, particularly in mitigating the immediate risks associated with traditional short selling in the ready market. When an investor shorts in the ready market, they typically borrow shares and sell them, facing the possibility of a ‘buy-in’ if they cannot return the borrowed shares. ES contracts, however, allow an investor to establish a short position to profit from a bearish outlook without the immediate need to borrow shares or the direct risk of a buy-in, unless the position is held to settlement and there is a failure to deliver. This feature makes ES contracts a more appealing option for investors concerned about the complexities and costs of traditional short selling. While ES contracts do offer leverage, it is typically within a defined range (e.g., 5x to 20x), not infinite leverage, which is a characteristic sometimes associated with contra trading for very short durations. The extended settlement period is indeed a benefit regarding financing costs, but it is not the primary advantage for an investor specifically concerned about avoiding buying-in risks when taking a short position. Furthermore, direct ownership of underlying shares upon expiration is relevant for long positions, not for short positions aimed at profiting from a decline in price.

The provided text on ‘Margining on Gross Basis’ (Section 13.7.3) explicitly states that 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. Therefore, for a Member firm holding positions for multiple distinct clients, the total number of open positions for margining by CDP is the sum of all long and short positions across those different customers. In this scenario, Global Investments would be margined for 700 long contracts + 400 short contracts = 1100 open positions. Options suggesting netting or only considering the larger position are incorrect because they contradict the principle of gross margining for a Member’s overall obligation to CDP concerning different customer accounts. While individual client margins might be calculated based on their net positions, the Member’s overall requirement from CDP is based on the gross sum of positions across different clients.

The investor’s requirement for a unique strike price and an unusual expiration date points to a need for a highly customised option contract. Over-the-counter (OTC) options are specifically designed to be tailor-made to suit the needs of the parties involved, allowing for customisation of terms like strike prices and expiration dates. In contrast, exchange-traded options have standardised terms and pre-defined specifications, making them unsuitable for such specific, non-standard requirements. A significant characteristic of OTC options is the absence of a clearing house, which means there are weaker performance guarantees, and counterparty risk becomes a crucial factor that needs to be carefully managed by the parties involved. Therefore, an OTC option is the most suitable choice, and managing counterparty risk is a primary consideration.

For an issuer designing an equity-linked structured note, the objective is often to provide capital protection while offering an attractive upside participation. The cost of the two main components – the zero-coupon bond (for capital protection) and the embedded call option (for upside participation) – is crucial. When market interest rates are elevated, the present value of the zero-coupon bond, which forms the capital protection component, is lower. This means a smaller portion of the investor’s initial capital is needed to secure the face value at maturity, leaving a larger ‘discount sum’ available. This larger sum can then be used to purchase the embedded call option. Concurrently, if the volatility of the underlying asset is subdued, the cost of purchasing the equity call option is cheaper. The combination of more funds available (due to higher interest rates) and cheaper options (due to lower volatility) allows the issuer to purchase a greater number of options, thereby enabling a higher participation rate for the investor in the underlying asset’s potential gains.

The question describes a derivatives trader concerned about the impact of unexpected shifts in market sentiment leading to significant changes in implied volatility. Vega is the option Greek that specifically measures the sensitivity of an option’s price to changes in the implied volatility of the underlying asset. A higher Vega indicates that the option’s price will be more affected by changes in volatility. As per the syllabus, Vega is measured by the change in value of an option (its premium) over a 1% change in market volatility. Therefore, monitoring Vega is crucial for managing this specific risk. Delta measures the sensitivity to changes in the underlying asset’s price. Gamma measures the rate of change of Delta. Theta measures the time decay of an option’s value. These other Greeks address different types of risk exposures.

Extended Settlement (ES) contracts are characterized by a high degree of leverage. This means that a relatively small initial margin allows an investor to control a much larger value of the underlying asset. As a result, any percentage movement in the underlying security’s price, whether favorable or unfavorable, is magnified when viewed as a percentage change relative to the investor’s initial capital outlay (the margin). Therefore, if the underlying security’s price moves adversely, the percentage loss on the investor’s initial investment will be a multiple of the percentage decline in the underlying security’s price. The provided text illustrates this with an example where a 5% price change in the underlying asset results in a 50% change on the investment, demonstrating a 10x leverage effect. Options suggesting the loss is equal to or a fraction of the underlying price change, or that losses are capped at the initial margin, misrepresent the nature of leverage and the associated risks, including the potential for margin calls and losses exceeding the initial margin.

A structured note is fundamentally a debt instrument, or debenture, whose return characteristics, such as coupon amount or market value, are linked to the performance of other underlying instruments. These underlying instruments can include equities, indices, interest rates, or credit derivatives. However, it is crucial to understand that the note holder typically does not have a direct claim over these underlying instruments; their claim is against the issuer of the structured note. The principal component of a structured note is often not guaranteed, and its repayment depends on the issuer’s creditworthiness or the performance of the underlying assets, unless it is specifically structured with capital protection. While structured notes are governed by the Securities and Futures Act (SFA) and are subject to prospectus requirements, these requirements can be exempted if the note is offered only to Accredited Investors, meaning they are not exclusively available to this group.

A Bull Callable Bull/Bear Contract (CBBC) experiences a Mandatory Call Event (MCE) when the spot price of the underlying asset touches or falls below its specified call price. In the given scenario, the spot price of $9.40 has fallen below the call price of $9.50, which triggers an MCE. Upon an MCE, the trading of the CBBC terminates immediately. For an R-Category CBBC, the call price is distinct from the strike price, and the holder is eligible to receive a residual cash payment. This differentiates it from an N-Category CBBC, where no residual value is paid. The CBBC is a derivative product and does not convert into the underlying asset.

Yield Enhanced Securities, also known as Discount Certificates, have a specific settlement mechanism. If the underlying asset’s closing price on the expiration date is at or above the exercise price (cap strike), 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 at expiration. In this scenario, the exercise price is $12.00, and TechInnovate Corp’s closing price on expiration is $11.80. Since $11.80 is below $12.00, the investor receives the closing price of the underlying asset, which is $11.80. The issue price ($11.50) and the initial reference spot price ($13.50) are not relevant for determining the cash settlement at expiration under these conditions.

A Credit Linked Note (CLN) exposes investors to two primary and distinct credit risks. As stated in the CMFAS Module 6A syllabus, these are the credit risk of the note issuer (or the Special Purpose Vehicle holding the collateral for the Credit Default Swap) and the credit risk of the ‘reference entity’ linked to the embedded Credit Default Swap. The investor is essentially taking on the credit risk of both the entity issuing the note and the entity whose credit event would trigger a payout on the embedded CDS. Other options introduce risks that are either not purely credit risks (e.g., market risk, liquidity risk, interest rate risk) or describe a specific aspect of one of the primary credit risks rather than the two distinct overarching exposures.

A Callable Bull/Bear Contract (CBBC) is a structured product that tracks the performance of an underlying asset. For a Bull CBBC, its value generally moves in the same direction as the underlying asset. The text specifies that the delta of a CBBC is close to 1, meaning its price changes tend to closely follow the underlying asset’s price changes. The conversion ratio indicates how many units of the CBBC are equivalent to one unit of the underlying asset. In this scenario, a conversion ratio of 10:1 means that 10 units of the CBBC correspond to 1 unit of the underlying asset. If the underlying asset’s price rises by $0.50, and the delta is close to 1, this $0.50 increase is effectively spread across the 10 units of the CBBC. Therefore, the approximate increase in the value of a single unit of the Bull CBBC would be $0.50 divided by the conversion ratio of 10, which equals $0.05. Since it’s a Bull CBBC and the underlying price increased, the CBBC’s value will also increase.

The portfolio manager’s objective is to implement a direct and highly effective hedge without significant upfront premium costs or sensitivity to strike price selection. Extended Settlement (ES) contracts are particularly suitable for this because they offer an immediate, near 100% hedge, characterized by a delta of 1.0. This means their price movement closely mirrors that of the underlying asset, providing a very direct hedge. Unlike warrants, ES contracts do not require the selection of a strike price, simplifying the hedging process and removing strike price sensitivity. Furthermore, the cost associated with ES contracts is primarily the cash to maintain margin, which forms part of the settlement if held to maturity, rather than an initial premium subject to time decay. Option 2 is incorrect as it describes a characteristic of warrants, not ES contracts. Option 3 is incorrect because ES contracts do not involve strike price selection; warrants do. Option 4 is incorrect because the provided text indicates that ES contracts are expected to have greater liquidity and tighter bid/offer spreads compared to warrants.

The financial cost component of a Callable Bull/Bear Contract (CBBC) is a crucial element of its pricing. According to the CMFAS Module 6A syllabus, this cost is incurred by the issuer for structuring the CBBC. It specifically includes the issuer’s cost of borrowing, any necessary adjustments for dividends (particularly if the underlying asset is equity-related), and the issuer’s own profit margin. A key characteristic of the financial cost is its behavior over time: it is higher for CBBCs with longer maturities and progressively declines as the CBBC moves closer to its expiration date. This cost is embedded in the CBBC’s price from the time of issuance, not just at maturity or exercise. Therefore, the statement that accurately describes it is that it comprises the issuer’s funding costs, dividend adjustments for equity-linked assets, and profit margin, and typically diminishes over the CBBC’s lifespan.

This question tests the understanding of a calendar spread strategy and its relationship to market expectations, specifically regarding the yield curve. A calendar spread, also known as a horizontal or time spread, involves simultaneously taking a long and a short position in futures contracts on the same underlying asset but with different delivery months. When a trader buys the nearer delivery month contract and sells the further delivery month contract, they are typically anticipating a steepening of the yield curve. A steepening yield curve implies that long-term interest rates are expected to rise more significantly or fall less than short-term interest rates, leading to a wider spread between them. Conversely, if a trader anticipates a flattening or inverting yield curve, they would typically sell the nearer contract and buy the further contract.

Arbitrage is fundamentally defined by the simultaneous buying and selling of the same or extremely similar asset in different markets to profit from a temporary price discrepancy. The key characteristic is that this profit is theoretically risk-free from market price fluctuations, as the positions are opened and closed almost simultaneously, eliminating exposure to future price movements. Option 2 describes speculation, which involves taking on market risk based on a forecast. Option 3 describes a long-term investment or a different type of strategy, not the immediate, risk-free nature of arbitrage. Option 4 mentions leverage, which can be used in arbitrage to amplify returns, but it is not the defining characteristic of arbitrage itself, and pure arbitrage aims to eliminate, not accept, higher potential losses from market risk.

Ratio spreads involve buying and selling option contracts in specified ratios, often resulting in a net short position. While they are considered market-neutral strategies for investors expecting little movement, a critical characteristic highlighted in the syllabus is the potentially unlimited risk on the downside. This occurs if the underlying asset moves significantly against the net short position, making the investor liable for losses beyond the initial premium received. The other options describe characteristics of different option strategies or misrepresent the risk profile of a net short ratio spread. For instance, a fixed maximum loss is typical of long butterfly or condor spreads, not a ratio spread with unlimited downside potential.

For a put option buyer, the option is exercised if the underlying asset price at expiration (ST) is below the exercise price (X). In this scenario, the exercise price is $75 and the stock price at expiration is $70. Since $70 is less than $75, the investor will exercise the option. The payoff from exercising the put option is calculated as X – ST, which is $75 – $70 = $5. The investor initially paid a premium of $6 for the option. To determine the net financial outcome, the premium paid must be subtracted from the payoff received. Therefore, the net outcome is $5 (payoff) – $6 (premium) = -$1. This represents a net loss of $1 for the investor. Option ‘A profit of $5’ would be the gross payoff, ignoring the premium paid. Option ‘A loss of $6’ would be the maximum loss, which occurs if the option expires worthless (i.e., if the stock price at expiration was at or above the exercise price). Option ‘A profit of $1’ would result from an incorrect calculation, such as subtracting the payoff from the premium.

Basis risk arises in a hedging situation when there are imperfections between the asset being hedged and the futures contract used. One of the primary causes of basis risk, as outlined in the CMFAS 6A syllabus, is when the underlying asset in the futures contract is not completely identical to the asset being hedged. In the given scenario, the potential difference in the exact grade of the raw material (hedged asset) compared to the standard grade specified in the futures contract (underlying asset) directly leads to basis risk. This means the spot price of the actual raw material purchased might not perfectly track the futures price, leading to an imperfect hedge. Credit risk relates to the possibility of a counterparty failing to meet its obligations. Liquidity risk refers to the difficulty of executing a transaction without significantly impacting the price due to insufficient market depth. Operational risk pertains to losses from internal process failures, people, or systems. None of these other risks are directly described by the asset mismatch in the scenario.

The question describes a scenario where an ETF uses synthetic replication to track an index with illiquid or restricted market components. Synthetic replication, whether derivative-embedded or swap-based, involves counterparty risk because the ETF relies on a third party to deliver the index performance. Under Singapore’s CMFAS Module 6A guidelines, specifically referencing the Code on CIS or UCITS, synthetic ETFs must comply with a maximum net counterparty exposure of 10% of the fund’s value. To achieve this, the derivative issuer or swap counterparty typically deposits collateral for the remaining 90% with a third-party custodian, which is owned by the ETF’s trustee. This mechanism limits potential losses for investors to a maximum of 10% of the fund’s value in case of a counterparty default. Therefore, ensuring the net counterparty exposure does not exceed 10% through collateralisation is a critical compliance measure. The other options are incorrect: holding 50% physical assets is not a requirement for synthetic replication; government guarantees for all derivatives are not a standard or required risk mitigation; and while credit ratings are important, relying solely on an AAA rating without the specific 10% exposure limit and collateralisation mechanism is not the primary regulatory compliance for counterparty risk in this context.

A Credit-Linked Note (CLN) is a structured product where the investor effectively sells credit protection, typically in the form of a Credit Default Swap (CDS), on a specific reference entity. Its payout is therefore contingent on whether a credit event (e.g., default, bankruptcy) occurs for that reference entity. Conversely, a Bond-Linked Note (BLN) involves the investor selling a put option on an underlying bond. The payout of a BLN is primarily determined by the market price of that bond, which can be influenced by various factors beyond just a credit event, such as interest rate changes, credit downgrades, or widening credit spreads. The investor in a BLN may end up owning the underlying bond even if no credit event has occurred, simply due to the bond’s price falling below the strike price of the embedded put option. Both products are yield enhancement tools, but their underlying risk exposures and payout triggers differ significantly.

A structured note is fundamentally a debt instrument, meaning the investor is lending money to the issuer. Its return characteristics, such as coupon payments or market value, are linked to the performance of various underlying instruments like equities, indices, or interest rates. However, it is crucial to understand that the note holder typically does not have a direct claim over these underlying instruments; they are merely a reference for the note’s performance. The principal component of a structured note, especially those without collateral, means that investors depend solely on the note issuer for repayment of principal. This principal repayment is often not guaranteed, exposing investors to the credit risk of the issuer. Therefore, the statement accurately describing a structured note highlights its nature as a debt instrument, the linkage to underlying assets without direct ownership, and the dependency on the issuer for principal repayment, which may not be guaranteed. Regarding the incorrect options: Not all structured notes provide a full capital guarantee at maturity; principal repayment is often not guaranteed, and the level of collateralization varies. Structured notes do not grant the investor direct voting rights or dividend entitlements from the underlying assets; they merely reference their performance. Lastly, structured notes are generally subject to prospectus requirements under the Securities and Futures Act (SFA) in Singapore, unless they are offered exclusively to Accredited Investors.

A synthetic long stock position is created by combining a long call option and a short put option on the same underlying asset, with identical strike prices and expiration dates. This strategy aims to replicate the profit and loss characteristics of directly owning the underlying stock, including unlimited upside potential and significant downside risk. The put-call parity principle demonstrates that such equivalent positions can be constructed. Conversely, selling a call and buying a put would create a synthetic short stock position. Purchasing both a call and a put (a long straddle or strangle) is a volatility strategy, betting on a large price movement in either direction, while selling both a call and a put (a short straddle or strangle) is a strategy betting on low volatility.

Under a Constant Proportion Portfolio Insurance (CPPI) strategy, the primary objective is to protect a certain percentage of the initial capital, known as the floor value. When the total value of the portfolio declines to the level of this pre-defined floor, the capital protection mechanism is activated. The standard operational response in such a situation is to liquidate all investments held in the risky asset component and re-allocate the entire portfolio into the risk-free asset. This action ensures that the principal amount at the floor level is preserved, effectively preventing further losses below that point. However, a consequence of this action is that the investor will no longer participate in any potential upside gains from the risky asset. The multiplier in a CPPI strategy is a fixed parameter derived from the crash size and is not automatically adjusted downwards when the floor is reached. Similarly, the floor value is either fixed or dynamically increased, not automatically lowered when the portfolio hits it. Injecting additional capital into the risky asset would contradict the core capital preservation objective of CPPI when the floor is triggered.

Structured warrants, as opposed to company warrants, are issued by third-party financial institutions, not the company whose shares are the underlying asset. For structured warrants listed on the SGX-ST, settlement is typically conducted via cash, rather than physical delivery of the underlying shares. Furthermore, structured warrants generally have a shorter maturity period, often less than one year, unlike company warrants which can have maturities of three to five years. Therefore, the characteristic that they are predominantly issued by financial institutions and are settled in cash on the SGX-ST accurately describes structured warrants.

The adjustment to the exercise price of a structured warrant due to dividends is calculated using a specific formula to account for the dilutive effect of the dividend. The formula for the new exercise price is: New Exercise Price = Old Exercise Price x Adjustment Factor. The Adjustment Factor is calculated as (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. In this scenario: Old Exercise Price = $10.00 P (Last cum-date closing price) = $12.00 SD (Special dividend per share) = $0.50 ND (Normal dividend per share) = $0.20 First, calculate the Adjustment Factor: Adjustment Factor = ($12.00 – $0.50 – $0.20) / ($12.00 – $0.20) Adjustment Factor = $11.30 / $11.80 Adjustment Factor ≈ 0.957627 Next, calculate the New Exercise Price: New Exercise Price = $10.00 x 0.957627 New Exercise Price ≈ $9.57627 Rounding to two decimal places, the adjusted exercise price is $9.58. An option of $9.75 might result from incorrectly excluding the normal dividend from the numerator’s subtraction (i.e., using (P-SD)/(P-ND)). An option of $10.00 would imply no adjustment was made, or a misinterpretation that dividends do not affect the exercise price. An option of $9.30 would result from simply subtracting the total dividend amount ($0.50 + $0.20 = $0.70) directly from the original exercise price ($10.00 – $0.70 = $9.30), which is an incorrect application of the adjustment methodology.

In an unfunded swap based ETF structure, the ETF itself takes an active role in managing the collateral. The ETF manager utilizes the capital raised from the sale of ETF units to acquire a pool of collateral assets. These assets are then placed with a third-party custodian and specifically pledged to the ETF. This arrangement ensures that the ETF directly holds and controls the collateral, which can be liquidated to repay investors in the event of a swap counterparty default. This contrasts with a fully funded swap structure where the ETF transfers its sale proceeds to the swap counterparty, and it is the counterparty who then purchases and pledges the collateral in favour of the ETF.

A Credit Linked Note (CLN) is designed such that its performance is tied to the creditworthiness of a ‘reference entity’. When a credit event, such as a default, occurs for this reference entity, the embedded Credit Default Swap (CDS) is triggered. In the case of physical settlement, the issuer of the CLN (who is also the seller of the CDS) will use the fixed income investment backing the CLN to acquire the defaulted debt obligation of the reference entity. Subsequently, the CLN investor will receive this defaulted debt obligation instead of their principal investment. Since the reference entity has defaulted, its debt obligations are highly unlikely to trade at their par value, leading to a substantial loss for the investor. The investor does not receive the full principal in cash, nor do they continue to receive coupons, as the note is typically redeemed early. Cash settlement, on the other hand, would involve the investor bearing a loss equivalent to the difference between the par value and the market price of the defaulted debt, settled in cash, which is a different mechanism.

When an investor’s CFD account balance drops below the maintenance margin, the CFD provider issues a margin call. This requires the investor to deposit additional funds to bring the account balance back to an acceptable level, typically the initial margin level. As per section 12.6.4 of the CMFAS Module 6A syllabus, if the investor fails to meet this margin call within the stipulated timeframe, the CFD provider will proceed with ‘liquidation.’ This involves the forced selling of the investor’s CFD holdings, either partially or entirely, to cover the deficit. The other options describe actions that are either incorrect consequences, secondary actions, or not the immediate and primary response to an unmet margin call.