CMFAS RES6A Quiz 43

The portfolio manager’s primary concern is a potential increase in the share price of ‘Global Dynamics Corp.’ before their funds are available, which would raise the cost of their intended acquisition. To mitigate this risk, the manager needs to lock in a purchase price for the shares. Purchasing Extended Settlement (ES) contracts for ‘Global Dynamics Corp.’ achieves this by establishing a forward purchase price. When the ES contract expires, the manager can take physical delivery of the shares at the price agreed upon when the ES contract was bought, effectively hedging against any adverse price appreciation in the interim. This strategy is known as a long hedge. Initiating a sale of ES contracts (Option 2) would be a short hedge, typically used to protect against a decline in the price of shares already owned or an anticipated sale. This would expose the manager to further losses if the share price were to increase, which is the opposite of the desired outcome. Executing a short-term options strategy (Option 3), while a financial instrument, does not directly provide the same mechanism for locking in a future purchase price and taking physical delivery as an ES contract does in this context. Postponing any commitment (Option 4) would leave the manager fully exposed to the risk of a price increase, failing to mitigate the identified concern.

For Contracts for Differences (CFDs), the treatment of certain corporate actions like non-cash dividends, bonus issues, and rights issues differs significantly from direct share ownership. The syllabus explicitly states that CFD investors may not be entitled to such corporate actions. Consequently, the CFD provider may require investors to close all open positions related to the underlying equity before the ex-date. This is to manage the complexities and potential lack of entitlement to these non-cash distributions in a derivative product. Other corporate actions, such as share splits or reverse splits, typically involve adjustments to the quantity and price of the CFD to reflect the market equivalent transaction, but this is not the standard handling for bonus issues where entitlement is uncertain. CFD investors do not hold the actual underlying shares, so receiving physical shares is not applicable. Similarly, automatically crediting a cash equivalent is not the typical response for a non-cash bonus issue.

Forward contracts are privately negotiated agreements between two parties, often tailored to specific needs. Unlike futures contracts, which are standardized and traded on exchanges with a central clearing party acting as the counterparty, forward contracts expose each party directly to the credit risk of the other party. This is known as counterparty risk, meaning there is a risk of loss if the other party defaults on its obligations. The other options describe characteristics typically associated with futures contracts: daily settlement and guarantee by a central clearing party, transparent price discovery through an auction mechanism on an exchange, and enhanced liquidity due to an active secondary market.

A Range Accrual Note (RAN) is a structured product designed to pay interest when a specified reference index remains within a predefined range. As outlined in the CMFAS Module 6A syllabus, if the reference index trades outside this agreed range, the investor typically receives less or no interest for the days the index is out of range. A key feature of RANs is often principal preservation, meaning the initial capital invested is returned at maturity, assuming no credit event of the issuer. The question specifically excludes the triggering of an explicit knock-out barrier to focus on the fundamental consequence of the index simply moving outside the accrual range. Therefore, the investor would not earn interest for the days the index is outside the range, but their principal would remain protected.

Knock-out options are a type of barrier option designed to terminate when the underlying asset’s price reaches a specific predetermined level, known as the barrier. In this scenario, the knock-out call option has a barrier at $55. When the underlying stock price rises to $56, it crosses this barrier. For a knock-out option, hitting or crossing the barrier triggers its immediate termination. This means the option ceases to exist, and its validity ends. The payoff upon termination can vary based on the specific terms of the option agreement; it could be zero, a fraction of the initial premium, or a fixed mandatory payoff. It does not convert into a standard option, nor does its strike price adjust, nor does it grant a new exercise right at the barrier price.

The question asks about characteristics of a structured product that does not guarantee the return of initial capital. According to the CMFAS 6A syllabus, a maturity pay-out which does not have a minimum return of principal usually employs short options strategies. Furthermore, products that have a conversion feature, either to another currency or type of asset, are explicitly stated as not being principal protected. Therefore, a product without guaranteed principal return would likely feature short options strategies and potentially a conversion feature. The other options describe mechanisms typically associated with principal-protected structured products. Relying on a zero-coupon bond combined with a long-call strategy or employing a Constant Proportion Portfolio Insurance (CPPI) strategy are methods used to achieve a minimum return of principal. While the return component can include high-yield bonds, this relates to the potential returns, not the preservation of the initial principal.

For a First-to-Default Credit Linked Note (CLN), the yield demanded by note holders is influenced by several factors, including the correlation among the underlying reference entities in the basket. When the correlation between these entities decreases, it implies that their default events are less likely to occur simultaneously. This effectively increases the number of independent risk factors that the note holder is exposed to. As the note holder is providing credit protection against the first default in the basket, a lower correlation means a higher overall probability of any single entity defaulting first, thereby increasing the risk for the note holder. To compensate for this elevated risk, investors will demand a higher yield.

Hedging strategies are implemented to reduce exposure to adverse price movements. While they effectively contain potential losses or protect existing profits, a fundamental characteristic of hedging is that it also caps potential gains if the market moves favorably for the hedged position. This is because the hedge locks in a price or range, preventing the full realization of profits from beneficial price shifts. Hedging does not eliminate all price risks; instead, it transforms price risk into basis risk, which is the risk that the price of the underlying asset and the hedging instrument will not move in perfect correlation. Therefore, while hedging provides protection, it comes at the cost of limiting upside potential.

When a customer fails to meet a margin call by the close of T+2, the Member and Trading Representative are generally prohibited from accepting orders for new trades. However, there is a specific exception: orders that would result in the customer’s Required Margins being reduced may still be accepted. A ‘risk reducing trade’ is defined as the closure of a position in an ES contract which reduces a customer’s Maintenance Margins requirements, such as the liquidation of a naked open position. This directly aligns with the exception. An order to liquidate an existing naked open position would reduce the required margins, making it an acceptable trade. Conversely, establishing any new position, even if it’s considered ‘risk neutral’ (meaning it doesn’t impact Maintenance Margins requirements), is still a ‘new trade’ and would not be allowed unless it explicitly reduces required margins, which a risk-neutral trade does not. A ‘risk increasing trade,’ such as closing one leg of a spread position that increases Maintenance Margins, would certainly not be permitted.

For a put option, it is considered ‘in-the-money’ (ITM) when the strike price is greater than the current market price of the underlying asset. In this scenario, the strike price is $50.00, and the market price is $48.50. Since the strike price ($50.00) is higher than the market price ($48.50), the put option is in-the-money. The intrinsic value of a put option is calculated as the difference between the option’s strike price and the current market price of the underlying asset, but only if this difference is positive. If the difference is negative or zero, the intrinsic value is zero. In this case, the intrinsic value is $50.00 (Strike Price) – $48.50 (Current Market Price) = $1.50. Therefore, the option is in-the-money with an intrinsic value of $1.50.

The ‘zero plus option’ strategy is designed to offer both capital preservation and participation in equity market gains. The capital preservation component is fundamentally achieved by investing a substantial portion of the initial capital into a fixed income instrument, most commonly a zero-coupon bond. This bond is specifically chosen and structured so that its value will grow to equal 100% of the initial capital by the maturity date of the product. The remaining portion of the initial capital is then used to purchase call options on the desired equity index, providing the potential for upside participation. Therefore, the zero-coupon bond is the primary mechanism ensuring the return of the principal.

For a First-to-Default Credit Linked Note (CLN), the yield to the note holders is influenced by several factors, including the correlation among the underlying reference entities. When the underlying entities exhibit a low degree of correlation with each other, it implies a greater number of independent risk factors within the basket. This increases the overall probability of at least one default occurring within the basket, as the default events are less likely to happen simultaneously. Consequently, investors assume a higher collective risk, and to compensate for this elevated risk, they require a higher potential yield. Conversely, a high degree of correlation means the entities are more likely to default together, effectively reducing the diversification benefit and making the basket’s risk profile closer to that of a single entity, thus typically leading to a lower yield. A smaller number of highly creditworthy entities would also generally lead to a lower default probability and thus a lower yield, as the risk of default is lower. Strong positive correlation is a form of high correlation, which would not lead to an enhanced yield.

Structured products are typically designed with specific risk/reward profiles tailored for investors willing to hold them until maturity. This customization often results in a limited or non-existent active secondary market, making it challenging for investors to sell their positions prematurely. Attempting to liquidate such products before maturity can lead to significant losses, as there may not be readily available buyers or the price offered could be at a substantial discount. While factors like issuer credit rating changes or shifts in interest rates can impact the product’s value, the fundamental impediment to a quick and fair-priced early exit for structured products is their inherent illiquidity due to the lack of a robust secondary trading environment. The investor’s initial investment amount does not directly influence the product’s market liquidity.

Reinvestment risk refers to the possibility that an investor will be forced to reinvest income from a bond (coupon payments and/or principal) at a lower interest rate than the bond’s original yield-to-maturity. This risk is most significant for bonds that generate a substantial amount of cash flow over their lifetime, which then needs to be reinvested. Therefore, bonds with large coupon payments, a higher frequency of coupon payments, and longer maturities are most susceptible to reinvestment risk. Zero-coupon bonds, by definition, do not pay coupons and thus have no reinvestment risk. Callable bonds generally have high reinvestment risk because the issuer can call them when interest rates fall, forcing the investor to reinvest the principal at lower prevailing rates. However, the question asks for the combination of characteristics that heighten the risk, and large, frequent coupons over a long maturity directly contribute to a greater volume of cash flows needing reinvestment. Bonds trading at a discount or with infrequent payments would generally have lower reinvestment risk compared to those with large, frequent coupons.

Callable Bull/Bear Contracts (CBBCs) are designed to track the performance of an underlying asset. The provided syllabus material explicitly states that ‘Price changes of a CBBC tend to closely follow the prices changes of the underlying asset as the delta of the CBBC is close to 1 (∆ ≅ 1).’ For a Bull CBBC with a 1:1 conversion ratio, if the underlying asset increases in value, the CBBC will increase by approximately the same amount. Therefore, a 1.5% rise in the underlying index would lead to an approximate 1.5% increase in the Bull CBBC’s value. The second option describes the behavior of a Bear CBBC, which would move inversely to the underlying. The third option is incorrect as CBBCs are not primarily designed for capital protection; they offer leveraged exposure. The fourth option describes a fixed coupon payment, which is a characteristic of other structured products like Barrier Reverse Convertibles, but not the typical price movement mechanism for a CBBC in response to underlying asset changes.

A Discount Certificate is a structured product whose construction involves a long zero-strike call option and a short call option. The premium received from the sale of the calls is greater than the cost incurred from the purchase of the zero-strike option, allowing the product to be issued at a discount to face value. This contrasts with a Reverse Convertible, which is typically composed of a bond (or note) and a short put option. While both instruments can achieve similar risk-return profiles, particularly with capped upside and full downside exposure, their underlying derivative components differ as explained by put-call parity. An Equity-Linked Structured Note, on the other hand, is generally constructed with a low-risk component (like a zero-coupon bond for capital preservation) and a high-risk component (like a call option for potential returns).

Structured products are typically designed for investors who intend to hold them until maturity due to their customized nature. This often results in a limited secondary market, making it challenging for investors to sell them before their maturity date. Consequently, an investor who liquidates a structured product prematurely may incur a significant loss of their principal sum. While issuers or their affiliates often provide a secondary market, they are generally not legally obliged to do so, and the liquidity provided can vary. The early liquidation price is also influenced by prevailing market conditions, the performance of underlying instruments, and the marked-to-market values of any embedded derivatives, not just the initial purchase price or remaining time to maturity.

The question focuses on the distinct daily price limit mechanisms for Nikkei 225 Index Futures and MSCI Singapore Index Futures, as outlined in the CMFAS Module 6A syllabus. For Nikkei 225 Index Futures, the daily price limit system is multi-tiered: initially, if the price moves by 7% from the previous day’s settlement price, trading is allowed within this 7% limit for 10 minutes. Subsequently, an intermediate price limit of 10% applies. If this 10% limit is reached, there is another 10-minute cooling-off period, after which a final price limit of 15% applies for the rest of the trading day. In contrast, for MSCI Singapore Index Futures, the mechanism is simpler: if the price moves by 15% from the previous day’s settlement price, trading is allowed within this 15% limit for 10 minutes. After this single cooling-off period, there are no further price limits for the remainder of the trading day. Therefore, the key difference lies in the progressive, tiered limits of the Nikkei 225 contract versus the single limit followed by unlimited movement for the MSCI Singapore contract. The other options contain inaccuracies regarding the initial limits, subsequent limits, or misrepresent commonalities as distinctions.

A call option buyer acquires the right, but not the obligation, to purchase the underlying asset at a predetermined strike price within a specified period. Conversely, a put option seller assumes an obligation to take delivery of the underlying asset at the strike price if the put option buyer chooses to exercise their right to sell. Therefore, the call option buyer has a right to buy, and the put option seller has an obligation to buy (take delivery). The other options incorrectly assign rights or obligations, confusing the roles of option buyers and sellers for both call and put contracts.

When an investor shorts a pay-fixed interest rate put swaption, they are acting as the swaption seller. In this position, the investor is liable to pay out a floating rate when the option is exercised by the swaption buyer. The buyer will typically exercise this swaption when market interest rates are higher than the strike rate, as this allows them to pay a fixed rate and receive a higher floating rate. Consequently, if market interest rates experience a substantial upward trend, the floating rate that the investor (as the swaption seller) is obligated to pay will also increase. The provided text explicitly states that for a pay-fixed swaption where the investor is the seller, the losses are unlimited and dependent on how high the floating rate is when the option is exercised. Therefore, the most significant risk is the potential for unlimited losses due to escalating floating rate payments. The other options describe different types of risks or incorrect liability profiles for this specific structured product.

Arbitrageurs seek to profit from temporary price discrepancies between a financial instrument and its underlying asset, or between different markets. In this scenario, the futures contract is trading at a premium to its theoretical fair value, meaning it is relatively overpriced compared to the underlying index. To execute a risk-free arbitrage, an investor would sell the overpriced futures contract and simultaneously buy the relatively cheaper underlying asset (in this case, the constituent stocks of the index). This strategy locks in a profit, as the arbitrageur is effectively selling high and buying low, with the expectation that the prices will converge by the futures’ expiration. Buying the futures and short-selling the underlying would be appropriate if the futures were trading at a discount. Purchasing both or selling both are speculative strategies, not arbitrage, as they involve taking a directional view on the market and are exposed to market risk. Waiting for a price decline before buying the underlying introduces market risk and is not a risk-free arbitrage.

When an investor holds a short Extended Settlement (ES) position and fails to deliver the required shares by the due date (the third market day following the expiration date), the Central Depository Pte Ltd (CDP) is mandated to initiate a buying-in process. This process commences on the day immediately following the due date, which is effectively the last trading day plus four. The shares are acquired from the market at a price that is set at two minimum bids above the highest of three reference points: the previous day’s closing price, the current last done price, or the current bid. This mechanism ensures that the delivery obligation is met, albeit at a potentially higher cost to the defaulting investor. Other options describe incorrect procedures or actors for this specific scenario under SGX rules.

The investor’s priorities are products with generally lower ongoing costs and direct market liquidity for early exit without specific barrier conditions. Equity Linked Exchange Traded Funds (ETFs) are characterized by their low Total Expense Ratios (TERs), indicating generally lower management and administrative fees. Additionally, ETFs are traded on stock exchanges, allowing investors to sell their positions on any trading day, thus providing direct market liquidity. This contrasts with Equity Linked Structured Notes and Equity Linked Structured Funds, where early redemption is often contingent on barrier options being part of the structure, and structured notes typically have high product costs due to their complexity. Equity Linked Investment-Linked Policies (ILPs) involve multiple layers of fees, including insurance and investment charges, and early surrender often results in a greater potential loss, making them less aligned with the investor’s stated preferences for low ongoing costs and flexible early exit.

The 5-year Singapore Government Bond Futures contract, as specified in the CMFAS Module 6A syllabus, explicitly states that it has ‘Daily Price Limit: None’. This means there are no upper or lower bounds on how much the price of the futures contract can move in a single trading day. This contrasts with some other futures contracts which may have predefined price limits or circuit breakers to manage volatility. Understanding this characteristic is crucial for participants trading this specific instrument, as it implies unrestricted price discovery within trading hours.

The design of a structured fund involves several key components, each serving a distinct purpose. The ‘Anticipated View on Market Scenarios’ component directly addresses and incorporates the fund manager’s or investor’s outlook on future market conditions, such as bullish, bearish, or market-neutral perspectives. This view then influences the selection of underlying assets and the design of the payout structure to align with the desired market exposure. While the selection of underlying assets is crucial for implementing the market view, and the payout structure defines how returns are distributed, these are mechanisms for executing the market view, not the component that defines the view itself. The fund’s maturity period relates to the investment horizon, not the directional market outlook.

An Exchange Traded Fund (ETF) is specifically designed as an open-ended investment fund that aims to replicate the performance of a published market index. It is listed and traded on a stock exchange, allowing investors to buy or sell units to gain exposure to all the constituents of the underlying index, thereby diversifying their portfolio without having to purchase individual assets. A traditional Unit Trust, while a collective investment scheme, is typically actively managed and priced at its Net Asset Value (NAV) at the end of the day, rather than continuously traded on an exchange for index replication. A bespoke Structured Note is a debt instrument with a specific payoff profile linked to an underlying asset or index, but its primary function is not broad market index replication and diversification through exchange trading in the same manner as an ETF. A Closed-End Fund has a fixed number of shares and trades on an exchange, but its market price can deviate significantly from its NAV, and it is not inherently defined by its objective to replicate a specific market index.

A standard stop-loss order is designed to convert into a market order (or a stop-limit order) once a specified trigger price is reached. However, in highly volatile market conditions or when there is a significant price gap (slippage), the market price can move past the stop-loss level without any trades occurring at that exact price. In such instances, the triggered stop-loss order will be executed at the first available price in the market, which may be considerably worse than the intended stop-loss price. This risk is explicitly mentioned in the CMFAS Module 6A syllabus, highlighting that CFD providers may not always execute standard stop-loss orders at the set price during volatile conditions. A ‘guaranteed stop-loss’ service, which typically incurs an additional premium, would ensure execution at the exact specified price, but this is not the characteristic of a standard stop-loss order.

CDP computes margin requirements on a gross basis. This means that long and short positions held for different customers do not cancel each other out when calculating a Member’s overall margin requirement. Therefore, the Member is margined for the sum of all open positions across different clients, regardless of whether they are long or short in the same underlying security. In the given scenario, the firm holds 150 long positions for Client A and 120 short positions for Client B. On a gross basis, CDP would calculate the margin requirement for the total of 150 + 120 = 270 open positions. Options suggesting netting or only considering the larger side are incorrect as they contradict the gross margining principle for different customers. Spread margining applies when an investor holds both a long and a short position in ES contracts of different contract months of the same underlying security, but this is for a single investor’s positions, not across different clients for the Member’s overall requirement.

A diagonal spread is defined by its use of options on the same underlying security that have both different strike prices and different expiration dates. This structure makes it a combination of characteristics found in both vertical spreads (which have different strike prices but the same expiration) and horizontal or calendar spreads (which have the same strike price but different expiration dates). A vertical spread would involve options with the same expiration date but varying strike prices. A horizontal (calendar) spread would involve options with the same strike price but different expiration dates. A ratio spread, while also involving multiple options, is characterized by buying and selling options in specific quantities or ratios, and its primary definition does not hinge on the combination of different strike prices and expiration dates in the same manner as a diagonal spread.

The basis in a futures contract is defined as the difference between the futures price and the spot price of the underlying asset. As a futures contract approaches its expiration date, the futures price and the spot price are expected to converge. This convergence occurs because, at expiry, the futures contract is settled at the prevailing cash market price, effectively making the futures price equal to the spot price. Therefore, the difference between them, the basis, narrows and ultimately becomes zero at the moment of expiration. This phenomenon is explicitly referred to as ‘convergence’ in the syllabus material. The other options describe incorrect behaviors for the basis as a contract nears maturity.