CMFAS RES6A Quiz 46

A Credit Linked Note (CLN) with physical settlement means that in the event of a credit default by the reference entity, the CLN issuer (who sold credit insurance via a Credit Default Swap) will pay the CDS buyer the principal amount in cash and receive a debt obligation (e.g., a bond) of the defaulted reference entity. Consequently, the CLN investors will receive this defaulted bond. As the text states, it is unlikely for a defaulted bond to trade close to its par value, meaning the CLN holder is likely to suffer a substantial loss on their principal investment. The investor’s principal is not protected in this scenario, as CLNs expose investors to the credit risk of the reference entity. Receiving a cash payment representing the difference between par and market price is characteristic of cash settlement, not physical settlement. Conversion into equity shares is not a standard outcome for a CLN upon a credit default.

Delta measures the sensitivity of an option’s price to a change in the underlying asset’s price. For a call option, delta is positive, meaning that as the underlying share price increases, the option’s premium is expected to increase. The change in the option’s premium is calculated by multiplying the option’s delta by the change in the underlying share price. In this scenario, the delta is 0.65 and the underlying share price increases by $3.00. Therefore, the expected change in the option’s premium is 0.65 $3.00 = $1.95. Since it is a call option and the underlying price increased, the option premium is expected to increase.

The trader’s objective is to sell a long futures position for profit when the price rises to a specific high level, with the critical requirement of ‘ensuring immediate execution once a specific high price is reached’. A Market-if-Touched (MIT) Sell order is designed precisely for this purpose. As per the CMFAS Module 6A syllabus, an MIT order to sell is placed above the current market price and, once the trigger price is touched, it is submitted as a market order, thereby ensuring immediate execution at the prevailing market price. A Stop Sell order, conversely, is typically placed below the current market price to limit losses and, according to the provided text, converts to a limit order once triggered, which does not guarantee immediate execution. A Limit Sell order, while placed above the current market price for profit-taking, only guarantees execution at or above the specified price, meaning it might not be filled if the market touches the price and then moves away without sufficient liquidity. A Session State Order (SSO) triggers based on market transitions into a new session state, not on specific price levels for profit-taking, making it unsuitable for this scenario.

The scenario describes a portfolio manager simultaneously selling a near-term crude oil futures contract and buying a later-term crude oil futures contract, both for the same underlying asset (crude oil) but with different delivery months. This strategy is precisely the definition of a calendar spread, also known as a horizontal or time spread. A calendar spread involves establishing long and short positions on the same underlying asset but with different delivery months, often to profit from anticipated changes in the yield curve or time value. The manager’s action of selling the near contract and buying the far contract aligns with an expectation of a flattening yield curve. An inter-commodity spread would involve different commodities. An outright trade would be a single buy or sell position without an offsetting leg. A basis trade typically involves arbitrage between the spot and futures markets or two related securities.

UCITS regulations, which govern many European ETFs, stipulate specific limits on counterparty risk. For an ETF that uses derivative instruments, such as swaps, for replication, the amount that a single swap counterparty owes to the fund is restricted. This limit is set at a maximum of 10% of the fund’s prevailing Net Asset Value (NAV). This means that the marked-to-market value of swaps with any single counterparty cannot exceed 10% of the fund’s NAV on a daily basis. This regulation aims to mitigate counterparty risk within UCITS-compliant funds. While the limit can be voluntarily decreased, the regulatory maximum is 10%.

The scenario describes an investor explicitly seeking a product with 100% principal preservation, yet being advised to purchase a structured product where underlying bonds are used as collateral for a Credit Default Swap (CDS). This product structure exposes the investor to potential capital loss in a default event, directly contradicting their stated objective. This situation precisely exemplifies the ‘Risk of Mis-selling (Incongruence to Investment Strategy)’, which occurs when an investor misunderstands the investment strategy or risks of a product, leading to a mismatch with their investment objectives. While structured products can indeed carry legal risk (e.g., related to collateral priority), correlation risk (if the CDS basket components are highly correlated), or transactional risk (due to settlement timing differences), the primary issue in this specific case is the fundamental misalignment between the investor’s needs and the product’s suitability, which is the core aspect of mis-selling.

The scenario describes a market participant exploiting a temporary price discrepancy between a futures contract and its underlying asset to secure a profit without significant price risk by executing simultaneous buy and sell orders. This activity is known as arbitrage. Arbitrageurs capitalize on market inefficiencies where the same asset or equivalent assets trade at different prices in different markets, allowing for a risk-free profit. Hedging, on the other hand, is a strategy used to reduce or offset potential losses from adverse price movements. Speculation involves taking on market risk in anticipation of future price movements for potential profit. Market making involves providing liquidity to a market by continuously quoting both buy and sell prices, profiting from the bid-ask spread, which is distinct from exploiting a mispricing between related instruments.

Extended Settlement (ES) contracts are leveraged instruments, meaning a small initial capital outlay (initial margin) controls a much larger underlying asset value. When an investor takes a position, the profit or loss is calculated based on the full value of the underlying asset, not just the initial margin. If the initial margin requirement is 10% of the underlying value, and the underlying share price decreases by 5%, the loss on the total contract value is 5%. However, this 5% loss on the total contract value translates to a significantly larger percentage loss relative to the initial margin. For example, if the contract value is $10,000, the initial margin is $1,000 (10%). A 5% decrease in the underlying share price means a loss of $500 (5% of $10,000). This $500 loss represents 50% of the initial margin ($500 / $1,000). In contrast, directly owning the shares would result in a 5% loss on the total capital invested. Thus, leverage magnifies both potential gains and losses on the initial capital committed.

The scenario describes a situation where the difference between the futures price and the spot price of an underlying asset decreases as the futures contract approaches its expiry date. This phenomenon is precisely what is known as convergence in futures markets. As per the CMFAS Module 6A syllabus, the basis, which is the difference between the futures price and the spot price, tends to narrow and approach zero as the contract’s expiration date draws near. This narrowing of the basis is termed convergence, leading to the futures and spot prices becoming identical at expiry. The other options describe different market conditions or phenomena. ‘Basis widening’ is the opposite of what is described. ‘Market contango’ refers to a market condition where the futures price is higher than the spot price, typically due to positive cost of carry, but it does not describe the process of the basis narrowing. ‘Price divergence’ would imply the prices are moving further apart, which contradicts the observation.

The participation rate in an Equity-Linked Structured Note is determined by comparing the ‘discount sum’ derived from the zero-coupon bond component with the premium of the embedded call option. The discount sum represents the capital available to purchase the call option. It is calculated as the difference between the bond’s face value and its present value. In this scenario, the face value is $100 and the present value is $85, making the discount sum $100 – $85 = $15. The call option premium is given as $12. Since the discount sum ($15) is greater than the call option premium ($12), the product issuer can purchase more call option contracts than would be required for 100% participation. This results in a participation rate exceeding 100%. If the discount sum were equal to the call premium, the participation rate would be 100%. If the discount sum were less than the call premium, the participation rate would be below 100%. The bond’s yield to maturity is already factored into its present value, so it is not needed as a separate piece of information to determine the participation rate in this context.

The participation rate in an Equity-Linked Structured Note (ELSN) is fundamentally influenced by the discount sum generated from the zero-coupon bond component, relative to the cost of the equity call option. The discount sum is calculated as the difference between the bond’s face value and its present value. When the discount rate for a zero-coupon bond is higher, its present value (PV = Face Value / (1+r)^T) will be lower, assuming the face value and maturity period are constant. A lower present value, in turn, results in a larger discount sum (Face Value – Present Value). If the equity call option premium remains constant, a larger discount sum allows the issuer to acquire a greater number of call option contracts, or a higher proportion of the required options, for the investor. This directly translates to a higher potential participation rate for the investor in the upside performance of the underlying equity asset. Therefore, ELSN X, with its higher discount rate, would provide a larger discount sum, leading to a higher participation rate compared to ELSN Y.

Callable Bull/Bear Contracts (CBBCs) are structured products that incorporate a mandatory call feature, which is a key differentiator from standard warrants. This mechanism dictates that if the price of the underlying asset reaches a pre-determined call level at any point before the contract’s expiry, a ‘Mandatory Call Event’ (MCE) is triggered. When an MCE occurs, the CBBC terminates immediately, and trading ceases. For investors, this means the contract can expire prematurely, potentially resulting in a significant, or even total, loss of their initial investment, especially in the case of N-CBBCs (No residual value). While R-CBBCs (Residual value) may offer a small residual payment, the primary impact of the mandatory call is the risk of early termination and capital loss. The other options are incorrect because CBBCs do not guarantee minimum returns, their strike prices are fixed and not dynamically adjusted by the issuer, and they typically do not have margin requirements.

Exchange-Traded Notes (ETNs) are fundamentally different from Exchange-Traded Funds (ETFs) in their legal structure. ETNs are debt securities issued by financial institutions, meaning investors are exposed to the credit risk of the issuer. A key distinction highlighted in the syllabus is that ETNs are not subject to the diversification rules that apply to ETFs. This means an ETN can track a single asset or a highly concentrated portfolio without needing to meet specific diversification criteria. Option 2 is incorrect because ETNs are debt instruments, not open-ended investment companies, and ETFs are typically structured to allow for creation/redemption, making them behave like open-ended funds in terms of share supply. Option 3 is incorrect as ETFs offer both primary liquidity (creation/redemption) and secondary liquidity (exchange trading), which is a key differentiating factor for ETFs. ETNs, being debt, do not have the same creation/redemption mechanism as ETFs. Option 4 is incorrect; while some Exchange-Traded Commodities (ETCs), a type of ETN, can be physically backed, ETNs themselves are debt obligations and are not always physically backed. Furthermore, they carry issuer credit risk, which is a form of counterparty risk, and the statement about ETFs predominantly using synthetic replication is not universally true (e.g., many US ETFs use physical replication).

A Credit Linked Note (CLN) is a structured note that exposes the investor to the credit risk of a ‘reference entity’ (the distinct corporate entity in the question) in addition to the credit risk of the note issuer. The CLN essentially embeds a credit default swap (CDS) where the investor acts as the protection seller. If the reference entity experiences a defined credit event (such as default, bankruptcy, or restructuring), the CDS is triggered. This means the investor’s principal becomes exposed to the credit risk of the reference entity, and they may suffer a loss of principal, typically through cash settlement (receiving a reduced amount) or physical settlement (receiving defaulted bonds of the reference entity at a reduced value). The higher yield offered by CLNs is compensation for taking on this specific credit risk. The principal is not fully protected, nor does it automatically convert to equity. The investor is exposed to both the issuer’s credit risk and the reference entity’s credit risk.

A synthetic long stock position aims to replicate the risk-reward profile of directly owning the underlying share without actually purchasing it. This means the position should offer unlimited profit potential if the underlying asset’s price increases and unlimited loss potential if it decreases. According to the principles of put-call parity and synthetic structures, a synthetic long stock is constructed by combining a long call option and a short put option on the same underlying asset, with the same strike price and expiration date. The long call provides the upside potential, while the short put creates the downside exposure similar to holding the stock. Conversely, a synthetic short stock position would involve shorting a call and longing a put. Other combinations, such as longing both a call and a put, create a straddle or strangle, which profits from significant price movement in either direction, rather than replicating a directional stock position. Shorting both a call and a put creates a short straddle or strangle, which profits from low volatility.

The question describes a scenario where an ETF needs to track a highly illiquid index, making it challenging to acquire and hold all underlying securities directly. Synthetic replication is a methodology where an ETF uses derivative instruments, such as swap agreements, to replicate the performance of an underlying index without physically holding all its constituent assets. This approach is particularly efficient and practical for tracking indices composed of illiquid securities, as it bypasses the operational complexities and costs associated with direct physical acquisition and management. Full physical replication and representative sampling, while common direct replication methods, involve the actual purchase and holding of securities. For highly illiquid assets, these methods would face significant challenges in terms of availability, pricing, and transaction costs, making them less efficient or even impractical compared to synthetic replication.

The question describes a market view where the investor expects the nearby spread (wing) to strengthen relative to the distant spread (wing). According to CMFAS Module 6A, Section 3.3.2, this is precisely the condition under which an investor would buy a butterfly spread. The characteristic structure of a bought butterfly spread involves buying one of the nearest delivery months, selling two of the second nearest delivery months, and buying one of the furthest delivery months, represented by the ratio +1 : -2 : +1. This matches the first option. A condor spread (second option) has a different structure (+1 : -1 : -1 : +1) and is used for a different market view, typically when volatility is expected to decrease. A TED spread (third option) is a measure of credit risk, comparing US Treasury futures and Eurodollar futures, and is not a strategy for capitalizing on relative strength between futures wings. A bull spread (fourth option) is a directional strategy expecting a price rise, not a neutral spread strategy focused on the relationship between different wings.

When a Credit Linked Note (CLN) specifies physical settlement and its reference entity experiences a credit default, the CLN holder receives the defaulted debt obligation of that reference entity. This means the investor will own bonds or other debt instruments issued by the now-defaulted company. Such defaulted securities typically trade at a significant discount to their original face value, leading to a substantial loss for the investor. The CLN is not designed to provide principal protection against the default of the reference entity. Cash settlement, on the other hand, would involve the investor receiving a cash payment representing the difference between the par value and the market price of the defaulted debt, often determined through an auction process. The issuer’s role is to provide credit protection, not to guarantee the delivery of non-defaulted assets or full principal return in a default scenario.

The fundamental principle guiding SGX’s approach to corporate action adjustments for Extended Settlement (ES) contracts is to ensure that the economic value of the contract remains as closely as possible to its state before the corporate event. This objective is explicitly stated as making adjustments to reflect the impact of corporate events so that the contract value after the event will be, as far as practicable, equivalent to the value before the event. This prevents either party to the contract from being unfairly impacted by corporate actions such as special dividends, bonus issues, or share splits. Adjustments are typically made through modifying the contract multiplier or the settlement price. The other options describe actions that are either incorrect, not the primary objective, or relate to different aspects of ES contract management. ES contracts are not automatically closed out or converted into ready market contracts upon a corporate action announcement; instead, their terms are adjusted. While margin requirements can be revised by members or SGX, this is distinct from the core principle of adjusting the contract itself to maintain its economic equivalence.

This question assesses the understanding of index-linked notes that incorporate both principal preservation and a ‘greater of’ redemption mechanism. The note guarantees 100% principal preservation, ensuring the investor receives at least their initial principal. The additional return is determined by comparing two potential outcomes: a fixed minimum total return and the return from participation in the underlying index’s performance. In this scenario, the minimum total return is 20% of the principal, which amounts to SGD 200 (SGD 1,000 0.20). This would result in a total redemption of SGD 1,200 (SGD 1,000 principal + SGD 200 return). Alternatively, the 100% participation in the Average Index Performance of 15% would yield a return of SGD 150 (SGD 1,000 0.15), leading to a total redemption of SGD 1,150 (SGD 1,000 principal + SGD 150 return). Since the note is structured to pay the ‘greater of’ these two calculated amounts, the investor would receive SGD 1,200.

Gearing in warrants signifies the amplification of exposure to the underlying asset’s price movement relative to investing directly in the shares with the same capital. In this scenario, an investor with $1,000 could purchase 100 shares of ‘Tech Innovations Ltd.’ ($1,000 / $10 per share). If they opt for call warrants with a gearing ratio of 5x, it means that for the same $1,000 investment, they achieve an equivalent exposure to 5 times the number of underlying shares they could have bought directly. Therefore, 100 shares multiplied by the gearing ratio of 5 results in an equivalent exposure to 500 shares. This amplified exposure means that a small percentage change in the underlying share price can lead to a much larger percentage change in the warrant’s price, offering magnified potential returns but also magnified potential losses.

Merger arbitrage, a type of CFD pairs trading, involves taking a long position in the target company and a short position in the acquiring company, anticipating the successful completion of a merger. The primary risk in this strategy, known as ‘deal risk,’ is that the announced merger may fail. If the deal collapses, the target company’s share price is likely to fall significantly, leading to a loss on the long CFD position. Concurrently, the acquiring company’s share price might recover or even rise, as the market may view the failed acquisition as a positive development (e.g., avoiding overpayment or integration challenges), resulting in a loss on the short CFD position. Therefore, the investor faces the potential for losses on both legs of the trade. The other options describe general risks of CFDs or misinterpret the outcome of a failed merger. While margin calls (option 1) and illiquidity (option 4) are general risks of CFDs, they are not the specific primary risk associated with a failed merger arbitrage deal. Option 2 incorrectly assumes that leverage will always lead to offsetting gains, which is not the case when both legs move unfavorably due to deal failure.

The product’s initial date was 16 December 2014. The first callable date is 15 June 2016, which means the fund is call-protected for the initial 1.5 years. The observation date of 15 December 2017 falls after this call protection period, so the call barrier is operative. The Mandatory Call Event (knock-out trigger) occurs if the closing index level of ‘ANY 4’ of the underlying indices falls below 75% of their initial level. In the context of a product with exactly four underlying indices (Index1-4), ‘ANY 4’ implies that all four indices must meet this condition. On 15 December 2017, Index 1 is at 80% of its initial level, which is not below 75%. While Index 2 (70%), Index 3 (65%), and Index 4 (72%) are all below 75%, the condition for ‘ANY 4’ indices to be below 75% is not met because Index 1 remains above the threshold. Therefore, the knock-out event is not triggered, the fund does not terminate, and the variable quarterly coupons will continue to be paid as scheduled.

A long call butterfly spread is a neutral options strategy designed for situations where an investor anticipates minimal movement in the underlying asset’s price. This strategy aims to profit from the stock remaining within a narrow range around the middle strike price at expiration. It is characterized by both a limited maximum profit and a limited maximum loss, making it suitable for investors with a defined risk-reward profile and a view of low volatility. A long strangle, conversely, is a volatility strategy that profits from significant price movements in either direction. A short put spread is a bullish strategy, typically used when an investor expects the stock price to rise or remain above a certain level. A long call spread (or bull call spread) is also a bullish strategy, profiting from an increase in the underlying stock’s price.

Range Accrual Notes (RANs) are structured products where the interest payout is directly linked to whether a specified reference index remains within a predefined range during an observation period. The core mechanism for interest accrual in a RAN is that a coupon is earned only for the days the reference index (in this case, 3-month SORA) closes within the agreed-upon range. If the index closes outside this range on a particular day, no interest is accrued for that specific day. Therefore, the total interest received by the investor is determined by the cumulative number of days the reference index successfully stays within the stipulated range over the note’s term. The average value, start-to-end difference, or maximum deviation of the reference index are not the primary factors for calculating the interest payout in a standard RAN structure.

Reverse Convertibles are structured products designed to offer enhanced yields. Their construction involves a long position in a zero-coupon bond and a short position in a put option. The attractive yield for the investor comes from two primary sources: the interest accretion from the zero-coupon bond and the premium income received from selling the put option. The upside performance is capped, and the investor faces significant downside risk if the underlying asset’s price falls. Discount Certificates, while having a similar payoff profile to reverse convertibles (capped upside, significant downside), have a different construction. They typically consist of a long zero-strike call option and a short call option (at-the-money or out-of-the-money). The ‘discount’ aspect, which provides the enhanced return or lower entry cost, is primarily derived from the premium received from selling the call option. This premium effectively reduces the initial investment or enhances the potential return up to the cap.

The four main components that go into building a structured fund are the choice of the underlying asset, the choice of maturity, the degree of payout schedule, and the anticipated view on market scenarios. The ‘Anticipated View on Market Scenarios’ component is specifically where the fund’s strategy is aligned with a market outlook, such as bullish, bearish, or market-neutral. In this scenario, the investment manager’s anticipation of a sustained upward trend in global technology stocks directly translates into a bullish view, which is a core element of this component. While the market view will influence the selection of underlying assets (like technology stocks), the fund’s maturity, and the payout structure, these are distinct components. The question asks which component directly incorporates this specific market outlook, and that is the ‘Anticipated View on Market Scenarios’.

A Credit Linked Note (CLN) is a structured product that combines a fixed-income investment with an embedded credit default swap (CDS). This structure inherently exposes investors to two distinct credit-related risks. Firstly, there is the credit risk of the note issuer itself (or the Special Purpose Vehicle (SPV) holding collateral for the CDS). If the issuer defaults, the investor faces the risk of losing their principal and any accrued interest, regardless of the performance of the reference entity. Secondly, the investor is exposed to the credit risk of the ‘reference entity’ to which the embedded CDS is linked. Should this reference entity experience a credit event (such as default or bankruptcy), the terms of the CLN dictate that the investor’s return or principal repayment will be adversely affected, often resulting in a loss. The option that correctly identifies these two exposures highlights the fundamental credit risks inherent in a CLN structure. Other options might refer to market risks like interest rate or liquidity risk, which are not credit-specific, or misattribute risks from other structured products like Bond Linked Notes, or describe secondary credit risks that are typically subsumed under the issuer’s creditworthiness.

Index-linked notes with principal preservation guarantee the return of the initial principal amount at maturity. The return component is determined by comparing a minimum guaranteed return with the performance linked to the underlying index. In this scenario, the note offers a return equal to the greater of a 24% minimum total return at maturity or 100% participation in the index’s average performance. The index’s average performance is 20%. Comparing the two, 24% is greater than 20%. Therefore, the investor receives the 24% minimum total return on their principal investment. The 20% option is incorrect because the minimum return guarantee takes precedence when the index performance is lower. The 3% option is incorrect as it represents an annualised rate (24% / 8 years) and not the total return at maturity, which is what the question asks for. The 0% option is incorrect because the note explicitly includes a minimum total return and principal preservation.

SGX makes full corporate action adjustments to ES contracts when the Book Closure Date of the corporate event on the underlying security is before the settlement day. For corporate events that result in shareholders obtaining an increase or decrease in the number of shares, such as a bonus issue, the adjustment is typically made to the contract multiplier. This ensures that the contract value after the event remains, as far as practicable, equivalent to the value before the event. Adjusting the settlement price is generally for events that primarily affect the share’s value or price directly. Mandatory close-out and reissuance is not a standard adjustment method for such events. Bringing forward the Last Trading Day (LTD) is usually considered for corporate actions that do not fall into the specified categories, or as an alternative method determined by the Corporate Actions Adjustment Review Committee (CAARC) in specific circumstances, not as the primary adjustment for a standard bonus issue.