CMFAS RES6A Quiz 35

For a First-to-Default Credit Linked Note (CLN), the note holder is exposed to the risk of the first entity in the basket to default. The yield offered to the note holder is a compensation for assuming this credit risk. When the correlation of default events among the entities in the basket decreases, it implies that the default events of these entities are more independent of each other. This independence effectively increases the number of distinct ‘risk factors’ that could trigger a first default. Consequently, the overall probability of any one of the entities defaulting first within the basket increases. To compensate for this higher probability of a first default, note holders would demand a higher enhanced yield. Conversely, if the entities were perfectly correlated, the risk would be akin to a single entity defaulting, as they would all likely default together or not at all.

A Callable Bull/Bear Certificate (CBBC) has a predefined Call Price. If the price of the underlying asset breaches this Call Price, a Mandatory Call Event (MCE) is triggered. According to the principles governing CBBCs, once an MCE occurs, the CBBC is irrevocably terminated. This means that the investor’s position is closed out, and they will receive a residual value (which could be zero for N-category CBBCs or a small amount for R-category CBBCs). Crucially, even if the underlying asset’s price subsequently recovers significantly, the investor cannot benefit from this rebound because their CBBC position has already been terminated. The product’s design includes this knock-out feature to limit the issuer’s risk, but it also means the investor bears the risk of early termination and missing out on potential recoveries.

The question focuses on managing the risk associated with the rate at which an option’s delta changes in response to underlying asset price movements. This specific sensitivity is known as Gamma. According to risk management principles for options, Gamma risk is typically restricted through two primary methods: by setting limits on the absolute change in the option’s delta, or by applying risk tolerance amounts expressed as a maximum potential loss. Therefore, the strategy described in the first option directly addresses the control of Gamma. The second option describes a control strategy for Vega, which measures an option’s sensitivity to changes in market volatility. The third option relates to Rho, which measures the impact of interest rate changes on the option price. The fourth option refers to general risk limits for futures, such as open contracts or maximum loss limits, which are not specific to the rate of change of an option’s delta.

When an investor enters into a long Contract for Difference (CFD) position, they typically incur several types of costs. Firstly, a commission is charged by the dealer firm for both the opening and closing of the position, usually calculated as a percentage of the underlying asset’s total value. In Singapore, this commission is also subject to Goods and Services Tax (GST). Secondly, for holding a long position, the investor effectively borrows funds to finance the position, leading to daily financing or interest charges. These are computed based on the total value of the position and a prevailing interest rate benchmark for the number of days the position is open. Lastly, if the investor wishes to maintain their position beyond the CFD’s initial expiry date, they may incur contract rollover charges, the specifics of which depend on the CFD provider and the underlying asset. Therefore, initial commission, daily financing charges, GST on commission, and potential rollover fees are all relevant costs. Options suggesting stamp duty or capital gains tax are incorrect as CFDs do not involve physical share transfer (thus no stamp duty) and Singapore does not impose capital gains tax. Other options mention charges not typically associated with standard CFD transactions, such as fixed monthly management charges or mandatory annual subscriptions, or mischaracterize dividend adjustments as a direct cost incurred by the investor in the same manner as the other charges.

The investor’s primary concern is the ability to exit the investment quickly on any trading day without being contingent on specific market barriers or incurring substantial surrender charges. An Equity Linked Exchange Traded Fund (ETF) allows an investor to sell their position on any trading day, providing high liquidity and flexibility. In contrast, Equity Linked Structured Notes and Structured Funds typically allow early redemption only if barrier options are part of their structure, meaning redemption is contingent on the underlying asset price hitting a specified barrier level. An Equity Linked Investment-Linked Policy (ILP) can be surrendered, but early surrender often results in greater potential loss due to the nature of the insurance contract and associated charges, making it less ideal for an investor prioritizing minimal early exit penalties.

The Constant Proportion Portfolio Insurance (CPPI) strategy dynamically adjusts its allocation between a risky asset and a risk-free asset based on a ‘cushion’ (total portfolio value minus floor value) and a constant multiplier. In a prolonged range-bound market where the risky asset does not show significant appreciation, the cushion is likely to remain small or even shrink. As the cushion decreases, the allocation to the risky asset is reduced. If the risky asset then experiences a slight rebound, the cushion might increase, prompting the strategy to ‘buy’ more of the risky asset at a relatively higher price. Conversely, if the asset declines, the cushion shrinks, leading to ‘selling’ the risky asset at a lower price. This cycle of ‘buying high and selling low’ can erode the portfolio’s value. If the portfolio value continues to decline and approaches the floor value, the strategy will eventually be forced to allocate the entire fund to the risk-free asset to preserve the principal, thereby missing out on any potential future upside from the risky asset. This is a key risk of CPPI strategies in such market conditions.

The investor’s objectives are to establish a bearish position, achieve significant leverage, and minimize direct borrowing costs for short selling. Extended Settlement (ES) Contracts are specifically designed to allow investors to take short positions, offering substantial leverage (5x to 20x) and explicitly stating ‘No borrowing cost’ for such positions, as highlighted in the comparison table. This aligns perfectly with the investor’s desire to minimize borrowing costs. Contra trading allows for intra-day short selling, but it is typically for very short durations (less than 3 days) and does not offer the same kind of sustained leverage for a ‘short-term decline’ that might span several days or weeks. Margin financing is explicitly stated as not allowing short selling, making it unsuitable for establishing a bearish position. Direct short selling in the ready market, while allowing a bearish position, typically involves securities borrowing and lending (SBL) arrangements which incur borrowing costs, contrary to the investor’s aim to minimize such costs.

A Stop Sell order is specifically designed for situations where a trader holds a long position and wishes to protect profits or limit potential losses. This order is placed at a price level below the current market price. If the market price falls to or below this specified stop price, the order is triggered and converted into a market order (or a limit order, depending on the specific instruction) to sell the futures contract. This action helps to lock in gains or prevent further losses as the market declines. In contrast, a Market-if-Touched (MIT) Sell order is typically placed above the current market price and is used to initiate a short position if the market rallies to a certain level, not to protect a long position on a downturn. Stop Buy orders and MIT Buy orders are used for purchasing contracts, either to limit losses on a short position, enter a long position on a breakout, or enter a long position on a dip, respectively, and are therefore not relevant for selling to protect a long position.

Structured products are specifically designed to meet unique investor needs that cannot be fulfilled by standard financial instruments. As detailed in the syllabus, an investor seeking both market upside participation and principal preservation can achieve this through the careful construction of a structured product. This typically involves combining a principal component, often a fixed income instrument like a bond, which is designed to return the initial investment amount at maturity, with a return component, such as options or other derivatives, to provide exposure to the potential gains of an underlying asset. This combination allows for capital protection while still offering the opportunity to benefit from favorable market movements. The other options describe general features or uses of structured products but do not primarily address the specific dual objective of capital preservation combined with market upside participation.

The question pertains to the ‘Structure Risk’ associated with structured products, specifically when an investor shorts a pay-fixed interest rate put swaption. As detailed in the CMFAS Module 6A syllabus (Section 9.4.7), if a structured product involves shorting an interest rate put swaption, the investor (swaption seller) is liable to pay out a floating rate when the option is exercised. In this scenario, the losses to the swaption seller are explicitly stated as unlimited and dependent on how high the floating rate is when the option is exercised. Therefore, the primary financial risk is the potential for unlimited losses tied to rising floating interest rates. The other options describe different types of risks: a limited fixed-rate loss is characteristic of shorting a receive-fixed interest rate call swaption under normal conditions (also part of Structure Risk), early termination risk involves unwinding costs and discounted sales, and reinvestment risk relates to reinvesting proceeds at lower interest rates.

To determine if a knock-out event has occurred, we must calculate 75% of the initial level for each index and compare it to the observed level. The condition for a knock-out event is that any index level falls below 75% of its initial level. For Index X: Initial Level = 1200 75% of Initial Level = 1200 0.75 = 900 Observed Level = 910 Since 910 is not below 900, Index X does not trigger a knock-out event. For Index Y: Initial Level = 300 75% of Initial Level = 300 0.75 = 225 Observed Level = 220 Since 220 is below 225, Index Y triggers a knock-out event. For Index Z: Initial Level = 5000 75% of Initial Level = 5000 0.75 = 3750 Observed Level = 3760 Since 3760 is not below 3750, Index Z does not trigger a knock-out event. As the condition states that a knock-out event occurs if any index level falls below 75% of its initial level, and Index Y has met this condition, a knock-out event has indeed occurred.

Structured products inherently carry the credit risk of their issuer, which in this scenario is a Special Purpose Vehicle (SPV). Since the SPV is not guaranteed by its parent, investors cannot rely on the parent company for recourse in case of default. Additionally, when a structured product involves a swap agreement, such as an interest rate swap, the investor is exposed to the credit risk of the swap counterparty. Furthermore, if the product incorporates a Credit Default Swap (CDS), the credit quality of the underlying reference entities (in this case, the corporate bonds) linked to the CDS is a critical factor. A comprehensive assessment of credit and counterparty risks must therefore encompass all these elements: the SPV’s own credit standing, the creditworthiness of any swap counterparties, and the credit quality of the underlying assets or entities referenced by any embedded derivatives like CDS.

Callable Bull/Bear Contracts (CBBCs) are structured products that are issued by third parties, typically investment banks. A key characteristic is their independence from the underlying asset they track and the exchange on which that underlying asset is listed. This means that the issuer is a separate entity from the primary market of the underlying asset. The product’s performance is linked to the underlying, but its issuance and trading infrastructure are distinct. Therefore, stating that it is issued by a third-party financial institution and functions independently of the underlying asset and its listing exchange accurately describes its structure. Other options, such as direct issuance by the primary exchange, management by a regulatory authority, or creation by a consortium of institutional investors, do not align with the established characteristics of CBBCs as outlined in the CMFAS Module 6A syllabus.

When a Constant Proportion Portfolio Insurance (CPPI) structure’s total value falls to its pre-defined floor value, the primary objective of the strategy shifts to capital preservation. According to the principles of CPPI, at this critical point, the entire allocation that was previously in the risky asset is liquidated. The proceeds from this liquidation are then re-allocated into the risk-free asset. This action ensures that the investor’s principal sum is protected at maturity, as the portfolio is now fully invested in the risk-free component. A direct consequence of this full re-allocation is that the portfolio will no longer participate in any potential future price appreciation of the risky asset, as it no longer holds any exposure to it. The option stating that the entire allocation to the risky asset is liquidated and subsequently re-allocated into the risk-free asset, thereby foregoing any further potential upside from the risky asset, accurately describes this outcome. Other options, such as adjusting the multiplier to one, selling risk-free assets to buy more risky assets, or automatically recalibrating the floor to a lower percentage, do not align with the standard mechanics and protective measures of a CPPI strategy when its floor is breached.

The question addresses a key regulatory requirement for European-domiciled synthetic Exchange Traded Funds (ETFs) operating under UCITS regulations. These regulations are designed to ensure investor protection by limiting exposure to counterparty risk when funds use derivative instruments like swaps. Specifically, UCITS stipulates that an ETF cannot invest more than 10% of its prevailing Net Asset Value (NAV) in derivative instruments, including swaps, issued by a single counterparty. This limit also applies to the marked-to-market value of the swaps, which cannot exceed 10% of the fund’s NAV on a daily basis. This measure prevents over-reliance on a single entity and mitigates the impact of a potential counterparty default. Options suggesting higher limits, no limits, or alternative conditions for exposure are not in line with the UCITS framework.

When a Callable Bull/Bear Contract (CBBC) experiences a Mandatory Call Event (MCE), it signifies that the price of the underlying asset has reached the pre-determined call price. This event triggers the immediate early termination of the CBBC, and its trading ceases. The consequence for the holder regarding a cash payment depends on the specific type of CBBC. For an R-CBBC (Residual value CBBC), the holder may receive a small residual cash payment. However, for an N-CBBC (No residual value CBBC), the holder will not receive any cash payment once the MCE occurs and the CBBC is called. The other options are incorrect: CBBCs are cash-settled derivatives and do not involve physical delivery of the underlying asset. They are also not subject to margin calls in the same way as futures contracts, and an MCE leads to early termination, not an extension of maturity.

The concept of synthetic positions, as outlined in the CMFAS Module 6A syllabus under Put-Call Parity Theory, demonstrates how the risk and payoff profile of an underlying asset can be replicated using a combination of options. To create a synthetic long stock position, which simulates the financial outcome of directly owning the underlying share, an investor needs to acquire a long call option and simultaneously write (sell) a short put option. Both options must be on the same underlying asset, have the same strike price, and the same expiration date. This combination provides an unlimited profit potential as the underlying price increases and significant downside risk if the price falls, mirroring the characteristics of holding the actual stock. Other combinations like selling a call and buying a put would create a synthetic short stock. Buying both a call and a put (a long straddle) is a strategy to profit from high volatility, while selling both (a short straddle) profits from low volatility, neither of which replicates a simple long stock position.

The Capital Markets and Financial Advisory Services (CMFAS) Module 6A syllabus, specifically Chapter 7 on Structured Notes, outlines the requirements for a Product Highlights Sheet (PHS). The correct statement is that all text within the PHS must be presented in a font size of at least 10-points Times New Roman. Regarding length, the PHS should not be longer than 4 pages, but if it includes diagrams and a glossary, it should not exceed 8 pages, with the core information still limited to 4 pages. The PHS must not contain any information that is not also present in the Prospectus. Lastly, while technical terms should generally be avoided, they are not strictly prohibited; if unavoidable, issuers must attach a glossary to explain them.

Pairs trading using CFDs is a strategy designed to capitalize on the relative performance of two assets, rather than their absolute price movements. The core objective is to identify two assets (like companies in the same sector or correlated indices) whose prices have historically moved together but have recently diverged. The investor takes a long position in the perceived undervalued asset and a short position in the perceived overvalued asset, expecting their relative prices to revert to their historical norm. This approach aims to be ‘market-neutral,’ meaning the overall direction of the broader market should have minimal impact on the trade’s outcome, as the long and short positions are intended to offset general market risk. Therefore, the primary intention is to profit from the convergence of their relative prices, independent of the market’s overall trend. Predicting the overall market direction for profit is not the primary aim of a market-neutral strategy. While pairs trading aims to remove market risk, it does not eliminate all forms of investment risk, such as deal risk in merger arbitrage or the risk that anomalies persist. Maximizing leverage on a single asset is not the specific objective of a pairs trading strategy, which inherently involves two positions.

The question describes two distinct methods of collateralization for swap-based Exchange Traded Funds (ETFs). The first scenario, where the ETF manager uses sale proceeds to purchase and hold collateral, is characteristic of an unfunded swap-based ETF. In this structure, the ETF directly manages the collateral pool. The second scenario, where the ETF transfers sale proceeds to the swap counterparty, who then acquires and pledges the collateral to the ETF, describes a fully funded swap-based ETF. The fundamental difference between these two structures lies in which party is initially responsible for acquiring and holding the collateral that secures the swap agreement. Both structures aim to limit counterparty exposure to 10% of the ETF’s Net Asset Value and typically involve a third-party custodian. In both cases, the collateral is liquidated to repay investors in the event of a counterparty default.

The daily mark-to-market (MTM) process for Extended Settlement (ES) contracts is a crucial risk management tool implemented by the Central Depository (CDP). Its primary purpose is to revalue all open positions at the end of each trading day to reflect current market prices. This revaluation helps to limit the CDP’s exposure to potential losses arising from adverse price movements in the underlying assets. By preventing large losses from accumulating over time until the contract’s maturity, it ensures that members maintain sufficient funds to cover their obligations. Option 2 is incorrect because MTM aims to manage exposure and mitigate risk, not to eliminate all forms of settlement risk or require immediate full contract value settlement daily. Option 3 describes an arbitrage opportunity for investors when ES contracts trade at a discount, which is a separate characteristic of ES contracts and not the objective of the daily MTM process. Option 4 incorrectly links MTM to the determination of Initial Margins for new trades; Initial Margins are prescribed by SGX for new positions, while MTM revalues existing open positions.

The Constant Proportion Portfolio Insurance (CPPI) strategy aims to preserve capital while allowing participation in market upside. The amount that can be allocated to performance (risky) assets is determined by first calculating the ‘cushion’. The cushion is the difference between the current total asset value and the capital preservation target (also known as the floor). In this case, the cushion is SGD 1,200,000 (current total asset value) – SGD 1,000,000 (capital preservation target) = SGD 200,000. Next, the risky asset exposure is calculated by multiplying the cushion by the defined multiplier. So, SGD 200,000 (cushion) 3 (multiplier) = SGD 600,000. This is the maximum amount that can be allocated to performance assets.

For a structured product that involves selling an unhedged call option on an underlying asset, the seller (investor) takes on the obligation to deliver the underlying asset if its price rises above the strike price. Since the potential increase in the underlying asset’s price is theoretically unlimited, the potential loss for the option seller is also theoretically unlimited. This is a critical risk associated with short call positions. The premium received only partially offsets this potential loss, it does not cap it. The loss is not limited to the difference between the strike and current market price, nor is it necessarily the entire principal of the structured product, though it can be substantial.

Over-The-Counter (OTC) options are characterized by their flexibility and customizability, allowing parties to tailor contract terms such as strike prices, expiration dates, and notional sizes to meet specific requirements. This contrasts with exchange-traded options, which have standardized terms and are traded on regulated exchanges with the backing of a clearing house. While exchange-traded options offer liquidity and reduced counterparty risk due to standardization and clearing house guarantees, they do not provide the bespoke customization needed for unique corporate requirements. OTC options, despite having less regulatory oversight and higher counterparty risk, are ideal for situations demanding highly specific contract specifications.

A Credit Linked Note (CLN) is a structured product that exposes investors to credit markets, often involving the issuer selling credit insurance (like a Credit Default Swap or CDS) on a reference entity. The note itself is typically a fixed-income investment used as collateral. Therefore, an investor in a CLN faces two distinct credit risks: first, the credit risk of the entity that issued the note (or the entity holding the collateral for the CDS), and second, the credit risk of the ‘reference entity’ on which the embedded CDS is written. If either the note issuer defaults or the reference entity experiences a credit event, the investor’s principal or interest payments could be adversely affected. Other options mention general financial risks like interest rate risk, market risk, liquidity risk, operational risk, or reinvestment risk, which may be present in varying degrees, but they do not capture the fundamental dual credit risk exposure that is specific and primary to the structure of a Credit Linked Note.

The structured fund incorporates an auto-redeemable feature, which becomes active after 1.5 years from inception and subsequently every six months. A key condition for this early redemption is met if the closing level of any of the underlying indices falls below 75% of its initial level on a specified early redemption observation date. In the provided scenario, the Nikkei 225 Stock Index is observed at 70% of its initial level. Since 70% is below the 75% threshold, and the condition requires only one index to trigger it (‘any of the indices’), the product will be automatically redeemed. When auto-redemption occurs, the product terms specify that the investor receives 100% of the principal value. The performance of the other indices or the potential for formula-based coupon payments are superseded by the auto-redemption event.

The daily mark-to-market (MTM) process for Extended Settlement (ES) contracts, conducted by the Central Depository (CDP), serves a critical risk management function. Its primary objective is to limit the CDP’s exposure to potential losses arising from price fluctuations in the ES contracts. By revaluing all open positions daily, it prevents the accumulation of large, unmanageable losses that could otherwise occur if positions were only settled at maturity. This mechanism ensures that any gains or losses are recognized and settled on a daily basis, thereby maintaining financial stability within the clearing system. The first option accurately describes this core objective. The second option is incorrect because while initial margins are crucial for managing customer risk, they are distinct from the daily mark-to-market process’s primary objective for the CDP. Initial margins are collected upfront to cover potential future losses, whereas MTM is a daily revaluation of existing positions. The third option describes a potential market opportunity for investors, not the operational objective of the daily mark-to-market process itself. MTM is a risk management tool for the clearing house, not a mechanism to facilitate arbitrage. The fourth option is incorrect because the valuation price determined by SGX is for the ES contract itself, used for determining additional margins, not for establishing the official closing price of the underlying security. While the underlying’s price may be a factor in the ES contract’s valuation, the MTM process’s objective is not to set the underlying’s price.

Callable Bull/Bear Contracts (CBBCs) are a type of knock-out product characterized by a mandatory call feature. This means that if the price of the underlying asset reaches a pre-determined ‘call price’ or ‘barrier level’ at any point before the contract’s expiry, a Mandatory Call Event (MCE) is triggered. When an MCE occurs, the CBBC terminates early, and its trading ceases immediately. In contrast, traditional warrants do not possess such a mandatory early termination mechanism based on the underlying asset’s price hitting a specific level. Warrants typically have a fixed lifespan and are either exercised by the holder at or before expiry, or they expire worthless. The absence of an early termination feature in traditional warrants, as seen in CBBCs, is a key distinguishing characteristic.

The trader’s objective is to profit from substantial price movement (high volatility) while minimizing initial premium expenditure and accepting a wider breakeven range. A long strangle strategy involves simultaneously purchasing an out-of-the-money (OTM) call and an out-of-the-money (OTM) put with the same expiration date. OTM options are typically less expensive than at-the-money (ATM) options, thereby reducing the initial capital outlay compared to a long straddle. However, because the strike prices are further from the current market price, the underlying asset needs to experience a larger movement for the options to become profitable, leading to a wider breakeven range. A long straddle, while also a neutral strategy for high volatility, uses ATM options, which would result in a higher initial premium. Selling a straddle (short straddle) is a strategy that profits from low volatility, which contradicts the expectation of substantial price movement. A bullish call spread is a directional strategy, not a neutral one, and limits potential profit, which does not align with the scenario’s implied desire for significant gains from large movements.