CMFAS RES6A Quiz 33

Effective gearing is a crucial metric for warrants, calculated by multiplying the warrant’s delta by its gearing. Gearing indicates the leverage, showing how many more warrants can be bought compared to the underlying asset for the same capital outlay. Delta, on the other hand, measures the sensitivity of the warrant’s price to a change in the underlying asset’s price. Therefore, effective gearing combines these two aspects to represent the overall magnified sensitivity of the warrant’s price movement relative to the underlying asset’s price movement, taking into account the inherent leverage. This metric helps investors understand the potential for amplified returns or losses. The option describing the overall sensitivity of the warrant’s price to changes in the underlying asset’s price, accounting for its leverage, accurately captures the essence of effective gearing. Other options relate to different warrant characteristics: the direct multiple of underlying shares controlled by a warrant refers to the conversion ratio, the total cost relative to the underlying share price relates to the warrant’s premium, and the duration required for premium recovery through dividends refers to the premium payback period.

The portfolio manager’s objective is to achieve a direct, near-100% offset to potential price declines without needing to select a specific price point for future execution. Extended Settlement (ES) contracts are explicitly designed to offer an immediate, near 100% hedge (delta = 1.0) and do not require the selection of a strike price, making them highly suitable for this purpose as described in the CMFAS Module 6A syllabus. In contrast, put warrants, while offering downside protection, have a delta that depends on the strike price and time to expiry (e.g., at-the-money delta = 0.5), meaning they do not provide a near 100% hedge. They also necessitate the selection of a strike price. Call warrants are generally used for participating in upside movements, not for hedging an existing long position against declines. While a short position in a standard equity futures contract can also offer a high delta hedge, the specific advantages highlighted for ES contracts in the syllabus, particularly in comparison to warrants, directly address the manager’s stated requirements for a direct, near-100% hedge without strike price selection for physical shares.

The question describes a scenario where an early redemption event occurs on 15 September 2015. According to the product terms for ‘Early Redemption Observation Dates’, 15 September 2015 corresponds to the second observation date (1.5 years from the initial date). The condition for a mandatory call (knock-out event) is when the returns performance of Index 1 (R1) is greater than or equal to the returns performance of Index 2 (R2). In the given scenario, R1 (15%) is indeed greater than R2 (12%), thus triggering the early redemption. Referring to the ‘Payout Before Maturity’ table, for the second observation (1.5 years), the specified payout price is 112.75% of the initial investment. The other options represent payouts for different observation periods (108.50% for the first observation), maturity payouts (125.50% if R1 ≥ R2 at maturity), or the capital preservation payout at maturity (100.00% if R1 < R2 at maturity).

The scenario describes an Exchange Traded Fund (ETF) holding dividend income as uninvested cash for a period before distribution or reinvestment. This situation is a direct cause of tracking error, specifically referred to as ‘cash holdings’ or ‘cash drag’ in the CMFAS Module 6A syllabus (8.2.5.4e). When a portion of the fund’s assets is held as uninvested cash, it does not participate in the market movements of the underlying index. Consequently, the ETF’s performance may lag the index, leading to a deviation in returns. This ‘cash drag’ effect is a common reason for tracking error in dividend-paying equity ETFs. Option 2, widening the bid-ask spread, is typically related to the illiquidity of the underlying securities or issues with the creation and redemption process, not directly to the fund holding dividend cash. Option 3, increasing the Total Expense Ratio (TER), refers to the annual fees covering management, administration, and operational costs. While cash management has costs, holding dividend cash for a period does not inherently increase the TER as a percentage of assets in the manner suggested. Option 4, heightened rollover risk, is a specific type of tracking error associated with ETFs that invest in futures contracts and the need to roll them over as they expire. This is distinct from the issue of holding uninvested dividend cash.

The trust deed is a fundamental legal document for a collective investment scheme, establishing the framework for the fund’s operation and defining the roles and responsibilities of key parties. It specifically outlines the fund’s investment objectives, strategies, and any restrictions. The trustee, being independent of the fund manager, serves as the custodian of the fund’s assets. A primary and crucial duty of the trustee is to ensure that the fund manager adheres strictly to the terms and conditions stipulated in the trust deed. This oversight function is vital to protect investors’ interests by minimizing the risk of the fund being managed outside its agreed-upon parameters, including its investment mandate. The trustee does not typically provide investment advice, co-manage the fund, or automatically liquidate assets without due process; their role is focused on ensuring compliance with the governing legal document.

Contracts for Differences (CFDs) and equity futures contracts have distinct characteristics that are crucial for investors to understand. Regarding dividends, an investor holding a long position in a CFD is generally entitled to receive cash dividends declared by the underlying company. Conversely, holders of equity futures contracts are typically not entitled to these dividends. This is a key difference for an investor looking to benefit from dividend income while maintaining exposure to an equity. Additionally, CFDs offer flexibility in terms of holding period, allowing investors to maintain positions for as long as they wish, subject to the CFD provider’s policies, whereas futures contracts have fixed maturity dates requiring rollover if a longer exposure is desired. Financing costs are explicitly computed and added for CFDs, while they are implicit in the quoted price of futures. Furthermore, CFDs are mostly traded Over-The-Counter (OTC), carrying counterparty risk, while futures are typically traded on exchanges, mitigating counterparty risk.

A Bull Equity-Linked Note (ELN) is a structured product that combines a fixed-income instrument with an embedded short put option. The investor in an ELN essentially acts as the put writer. At the note’s maturity, there are two primary outcomes based on the underlying share price (ST) relative to the put option’s strike price (X). If ST is greater than or equal to X, the put option expires worthless, and the investor receives the full face value of the note in cash. However, if ST is less than X, the put option is in-the-money for the put buyer. As the put writer, the ELN investor is obligated to ‘buy’ the underlying shares at the strike price. In the context of an ELN, this means the investor receives a predetermined number of shares instead of cash. The number of shares is calculated by dividing the note’s face value by the strike price of the embedded put option. In this scenario, the face value is $10,000 and the strike price is $40, so the investor receives $10,000 / $40 = 250 shares of DEF Ltd. Since the market price of DEF Ltd shares at maturity ($35) is lower than the strike price ($40), the market value of the shares received (250 shares $35/share = $8,750) is less than the note’s face value, resulting in a potential loss for the investor.

A Bull Equity-Linked Note (ELN) is a structured product that combines a fixed-income instrument with an embedded short put option. The primary appeal for an investor to choose an ELN over a plain vanilla fixed-income note is the potential for an enhanced return or higher yield. This higher yield is compensation for the investor taking on the risk associated with the embedded put option. The significant risk for the investor is that if the underlying stock price falls below the strike price at the note’s maturity, the put option will be exercised. In this scenario, the investor will receive shares of the underlying company at a value equivalent to the note’s face value divided by the strike price. Since the market price of these shares would be lower than the strike price, the investor would effectively be forced to ‘buy’ the shares at a price higher than their prevailing market value, leading to a potential capital loss. The other options describe incorrect motivations or risks. ELNs do not guarantee capital preservation, nor do they offer direct stock ownership from inception. The investor benefits from the premium of the embedded put (via enhanced yield), rather than paying it. Furthermore, ELNs expose the investor to downside equity risk, rather than providing protection against a fall in the stock price.

The investor’s market outlook is a moderate downward movement, which indicates a moderately bearish view. Additionally, the investor prefers a strategy that generates an immediate cash inflow, meaning a credit strategy. A bear call spread is precisely designed for a moderately bearish market view and results in a net credit upon initiation. It is constructed by selling an in-the-money (ITM) call option and simultaneously buying an out-of-the-money (OTM) call option with the same underlying asset and expiration date. This structure allows the investor to profit if the underlying asset’s price declines or remains below the strike price of the sold call option. The maximum profit is the net credit received, achieved if both options expire worthless. A bull put spread, while also a credit spread, is suitable for a moderately bullish market view. A long put option is a debit strategy, requiring an initial cash outlay, even though it profits from a declining price. A bull call spread is a debit strategy and is used for a moderately bullish market outlook.

The provided text explicitly states that if the closing price is at or above the knock-out barrier on any day during the tenor of the accumulator, the accumulator will terminate immediately. This prevents the investor from purchasing further underlying shares at the strike price, thereby limiting their potential gain. Option 1 accurately reflects this consequence. Option 2 describes a feature of a ‘geared’ accumulator (e.g., 1X2) when the price falls below the strike, not a standard knock-out event. Option 3 is incorrect as the strike price is a fixed term, though it can be adjusted due to corporate actions, not automatically by hitting a knock-out barrier. Option 4 is not a feature of an accumulator; hitting a knock-out barrier terminates the agreement, it does not trigger a cash payout.

When the underlying stock price at the note’s maturity (ST) falls below the embedded put option’s strike price (X), the put option is exercised. In this scenario, the investor, through the structure of the Bull Equity-Linked Note (ELN), is effectively obligated to ‘buy’ the underlying shares at the strike price. The settlement typically involves the investor receiving a number of shares calculated by dividing the note’s face value by the strike price. In this case, with a face value of $10,000 and a strike price of $22.00, the investor would receive approximately 454.55 shares ($10,000 / $22.00). Since the market price of XYZ Corp shares at maturity ($20.00) is lower than the strike price ($22.00), the investor effectively acquires shares at a price higher than their current market value, leading to a loss. Receiving the full face value only occurs if the stock price is at or above the strike price. Receiving cash based on the current market value of shares or merely the initial issue price plus interest are not the standard settlement mechanisms when the embedded put option is exercised in an ELN.

For an issuer designing an equity-linked structured note, the objective is often to provide an attractive product to investors while managing the cost of its components. The text states that the ideal situation at the time of issuance is one where interest rates are high and asset price volatility is low. High interest rates are beneficial because they lower the present value of the zero-coupon bond component, thereby providing a larger ‘discount sum’ that can be used to purchase the embedded call option. Conversely, lower volatility in the underlying asset’s price makes the cost of equity options cheaper. Therefore, a combination of high interest rates and low underlying asset volatility allows the issuer to fund the call option more effectively and at a lower cost, potentially leading to a more appealing product for investors. Options suggesting low interest rates would mean a higher present value for the zero-coupon bond, leaving less capital for the option. Options suggesting high volatility would increase the cost of the embedded call option, making the product more expensive to structure.

Delta represents the sensitivity of an option’s price to a $1 change in the underlying asset’s price. For a call option, delta is positive, meaning that as the underlying asset’s price increases, the call option’s premium also increases. To calculate the approximate change in the option’s premium, you multiply the option’s delta by the change in the underlying asset’s price. In this scenario, the underlying share price increased by $2.00 ($52 – $50). With a delta of 0.65, the expected change in the call option’s premium is 0.65 $2.00 = $1.30. Since it is a call option and the underlying price increased, the premium would increase.

Structured products are designed to meet specific investor needs, often combining features like principal preservation with potential market upside. The principal component, typically a fixed income instrument such as a bond, is primarily allocated to ensure that the initial investment amount is returned to the investor at maturity. For example, a zero-coupon bond can be purchased such that its maturity value equals the initial investment. This component directly addresses the investor’s desire for capital preservation. The return component, on the other hand, is usually linked to derivatives like options, which provide exposure to the underlying asset’s performance and generate variable returns. While the principal component can sometimes be used as collateral or for credit risk management, its fundamental role in a product designed for principal preservation is to safeguard the initial capital.

A futures exchange primarily mitigates counterparty risk by operating as a central clearing house. In this capacity, it steps in as the central counterparty to every trade. This means that for every buyer, the clearing house is the seller, and for every seller, the clearing house is the buyer. This arrangement eliminates the need for individual market participants to assess the creditworthiness of their trading partners, as their counterparty risk is effectively transferred to the clearing house. The clearing house then manages this aggregated risk through mechanisms like margining and daily mark-to-market settlements, ensuring the integrity of the market.

A futures exchange, acting as a central counterparty (CCP), interposes itself between every buyer and seller. This means that for every trade, the CCP becomes the buyer to every seller and the seller to every buyer. This critical function centralises the credit risk, significantly reducing the burden on individual market participants. Instead of each participant having to assess the creditworthiness of potentially numerous other trading parties, they only need to manage their credit relationship with the clearing house. This minimises the individual need for credit assessments, setting of trading limits, and settling trades, thereby enhancing market efficiency and reducing systemic risk. The convergence of futures and spot prices typically occurs at the contract’s expiry, not necessarily well before. While some futures contracts involve physical delivery, many are cash-settled, and the CCP’s primary role is not to mandate physical settlement for all. Futures exchanges facilitate trading of standardised contracts, rather than direct negotiation bypassing such agreements.

Derivative-embedded synthetic replication ETFs, as per Singapore’s Code on Collective Investment Schemes (CIS) or UCITS, are subject to a maximum net counterparty exposure limit of 10% of the fund’s net asset value. This regulatory principle is designed to mitigate counterparty risk, ensuring that investors’ potential losses in the event of a derivative counterparty default are capped at this percentage. While collateral is typically deposited by the derivative issuer to cover the remaining exposure (e.g., 90%), the 10% net exposure represents the maximum direct risk borne by the fund and, consequently, its investors. Other options are incorrect because full elimination of counterparty risk is not achieved, unlimited exposure is not permitted, and the fund’s trustee does not provide a 100% financial guarantee against counterparty defaults; rather, they typically hold the collateral.

The scenario describes a situation where a major stock exchange activates a mechanism that temporarily halts all trading activity to prevent a complete collapse of market confidence during a rapid price plummet. According to the CMFAS Module 6A syllabus, ‘Circuit Breakers’ are systems in cash and derivative markets that trigger trading halts to mitigate market disruption risk. ‘Shock Absorbers’ slow down trading during significant volatility but do not halt it completely. ‘Limits’ (such as session or daily price limits) restrict price volatility without slowing or halting trading. ‘Counterparty Safeguards’ relate to counterparty risk, which is the risk that a party to a contract will not fulfill its obligations, and are not a direct measure for market-wide trading halts due to price plunges.

The question describes an ETF provider mirroring an index’s performance without acquiring the actual underlying securities, instead relying on contractual agreements with third parties. This method is known as synthetic replication. Synthetic replication ETFs utilize derivative and/or over-the-counter (OTC) transactions, such as swap agreements, to achieve their tracking objective. This allows them to replicate the index’s performance without physically holding the underlying assets. Options describing full replication, representative sampling, or physical/cash-based replication refer to direct replication methods, where the ETF directly invests in the index’s constituents, either entirely or through a subset.

The scenario describes an investor wanting to buy a futures contract when its price falls below the current market, which is the definition of a Market-if-Touched (MIT) buy order. An MIT order to buy is placed below the current market price, triggering when the price touches or falls to that level, and then converting into a market order. In contrast, a stop buy order is typically placed above the current market price. It is used to limit losses on a short position or to enter a long position if the price breaks above a certain level. Therefore, the fundamental difference lies in their placement relative to the current market price for initiating a buy position. Option 3 is incorrect because an MIT order converts to a market order, not a limit order, as stated in the provided text. Option 4 is incorrect as both MIT and Session State Orders (which can include Stop orders) are generally not visible to the market before triggering, and the primary distinction highlighted in the text between MIT and Stop orders is their price placement.

Forward contracts are private, cash-market agreements negotiated directly between a buyer and seller. This direct negotiation allows for the creation of highly customized contracts tailored to specific needs, such as hedging an exotic currency pair or a non-standard delivery period. This flexibility is a key advantage of forwards over futures, which are standardized contracts traded on regulated exchanges. The other options describe characteristics of futures contracts: mark-to-market procedures and the presence of a central clearing counterparty are features of futures that mitigate counterparty risk, while standardization is also a defining feature of futures that enables their exchange trading and liquidity.

The strong form cash hedge, also known as immunization, is a strategy used by financial institutions and fund managers to protect their portfolios from interest rate fluctuations over a known investment period. The core principle involves creating and maintaining a cash and futures portfolio that has the same interest rate sensitivity as a zero-coupon (or pure discount) bond with an initial maturity equal to the investment period. The interest rate sensitivity of the portfolio is continuously adjusted relative to this benchmark zero-coupon bond. If the cash portfolio’s sensitivity is less, futures are purchased; if it’s more, futures are sold. This aims to minimize the variance in the expected total return on the portfolio for the given investment period. The other options describe different hedging strategies or misrepresent aspects of futures hedging. Minimizing price variance for an indefinite period relates to a weak form cash hedge (inventory hedge). Acquiring futures for assets with uncertain cash receipt dates describes a weak form anticipated hedge. The concept of locking in a futures rate by holding to expiry is part of determining the target rate, but it substitutes price risk for basis risk if lifted before expiry, and does not eliminate all basis risk, nor does it guarantee locking in a specific spot rate.

A Mandatory Call Event (MCE) is a defining characteristic of Callable Bull/Bear Certificates (CBBCs). When the price of the underlying asset reaches or breaches the specified Call Price, the CBBC is immediately and irrevocably terminated. This means that once an MCE occurs, the investor’s position in the CBBC is closed out, and they cannot benefit from any subsequent rebound or recovery in the underlying asset’s price. The investor will receive a Residual Value, which can be zero for N-category CBBCs or a small amount for R-category CBBCs, but the instrument itself ceases to exist. It is not temporarily suspended, nor can it be held to maturity after an MCE, and there is no obligation for the issuer to return the initial capital.

The Interest Rate Parity Theory states that the forward premium or discount between two currencies should be equivalent to the difference in their domestic interest rates for securities of the same maturity, excluding minor transaction costs. When this relationship is violated, an opportunity for risk-free profit, known as covered interest arbitrage, emerges. An arbitrageur would capitalize on this by executing a series of simultaneous transactions: borrowing funds in the currency with the lower effective interest rate, immediately converting these funds into the higher-yielding currency, investing them for the duration, and concurrently entering into a forward contract to convert the principal and interest back to the original currency at a predetermined rate. This sequence of actions guarantees a profit irrespective of future spot exchange rate fluctuations, making it a risk-free endeavor. The collective actions of arbitrageurs engaging in such trades will increase demand for the undervalued currency and supply of the overvalued currency, ultimately pushing the spot and forward exchange rates back into alignment with the interest rate differential, thereby restoring market equilibrium. The other choices describe speculative activities, long-term investment strategies, or external lobbying efforts, none of which represent the direct, simultaneous, and risk-free exploitation of a parity violation by an arbitrageur.

The most efficient approach for a fund manager to swiftly rebalance a portfolio from equities to bonds, especially when dealing with illiquid underlying assets and aiming to minimize transaction costs and market disruption, is to utilize futures contracts. By selling equity index futures, the manager can effectively reduce the portfolio’s synthetic equity exposure, and by buying bond futures, they can simultaneously increase the synthetic bond exposure. This strategy allows for rapid adjustment of the portfolio’s asset allocation without the need to immediately liquidate illiquid cash market positions, which aligns with the benefits of futures such as lower brokerage costs, smaller cash outlay due to margining, shorter transaction times, and less market impact due to higher liquidity. Gradual liquidation of illiquid equities, while aiming to minimize market impact, is a slower process and may still incur significant costs. Engaging in OTC equity swaps or implementing a covered call strategy are alternative derivative strategies, but they are not typically the most direct or efficient methods for a broad, swift asset allocation shift between major asset classes like equities and bonds in the context described.

Extended Settlement (ES) Contracts are single stock futures listed on SGX-ST that offer several advantages for an investor with a bearish outlook over a medium-term horizon. They provide significant leverage, typically ranging from 5x to 20x, by requiring only a small margin collateral. Crucially, ES contracts allow investors to take short positions without the need for physical share borrowing, thereby avoiding immediate borrowing costs and the risk of a buy-in, unless the position is held to maturity and delivery fails. The contract tenure, often around 35 days, accommodates a three-week investment horizon. In contrast, Standard Contra Trading primarily facilitates very short-term positions (typically settled within T+3 days) and while it allows intra-day short selling, holding a position for three weeks would involve cash tie-up and is not designed for sustained leveraged shorting without borrowing costs in the same way as ES contracts. A Margin Account for Equities, as per the provided text, generally does not permit short selling. Direct Short Selling in the Ready Market involves the actual borrowing of shares, which incurs borrowing costs (e.g., through a Securities Borrowing and Lending arrangement) and carries the inherent risk of a buy-in if shares cannot be returned, which the investor explicitly wishes to avoid.

The residual value of a Bull contract when a mandatory call event is triggered is calculated using the formula: (Settlement Price – Strike Price) / Conversion Ratio. In this scenario, the settlement price is the spot price of the underlying asset at the time the mandatory call event is triggered, which is $20.50. The Strike Price is $20.00, and the Conversion Ratio is 5:1. Therefore, the residual value per contract is: ($20.50 – $20.00) / 5 = $0.50 / 5 = $0.10. An answer of $0.50 would be obtained if the conversion ratio was not applied to the difference between the settlement price and the strike price. An answer of $0.20 would result if the Call Price ($21.00) was mistakenly used as the settlement price in the calculation: ($21.00 – $20.00) / 5 = $0.20. An answer of $1.00 would be obtained if the difference between the Call Price and the Strike Price was taken, without applying the conversion ratio.

Delta measures the sensitivity of an option’s price to a $1 change in the price of its underlying asset. For a call option, as the underlying asset’s price increases, the call option’s premium also increases, resulting in a positive delta value, typically between 0 and 1. In the given scenario, a $1 increase in the underlying share price leads to a $0.65 increase in the call option’s premium, which directly indicates a delta of 0.65. Conversely, for a put option, as the underlying asset’s price increases, the put option’s premium decreases. This inverse relationship results in a negative delta value, typically between -1 and 0. If the put option’s premium decreases by $0.40 for every $1 increase in the underlying share price, its delta is -0.40. The other options incorrectly assign the delta signs or draw conclusions about the options’ moneyness that are not directly supported by the delta values alone.

The Credit Support Annex (CSA) is a critical legal document specifically designed for over-the-counter (OTC) derivative transactions. Its primary function is to establish the terms and conditions under which collateral is exchanged between counterparties. This mechanism is essential for mitigating the credit risk that arises from derivative positions, ensuring that potential losses due to a counterparty’s default are reduced. While other agreements like a Master Netting Agreement (MNA) are also used in derivatives, the CSA specifically addresses the collateral management aspect to control credit exposure. Futures Commission Merchant (FCM) agreements and Exchange Traded Derivatives (ETD) contracts relate to exchange-traded products and their associated intermediaries, which operate under different risk management frameworks compared to OTC transactions.

An Equity Linked Exchange Traded Fund (ETF) is generally designed to be highly liquid, trading on an exchange throughout the day, allowing investors to exit their position easily on any trading day. They are also known for their typically lower total expense ratios (TERs) and lower brokerage fees for transactions compared to other structured products. Structured Notes often have high upfront structuring and management fees built into the product price, and early redemption is typically conditional on barrier options. Structured Funds also carry various upfront, recurring, and back-end fees, and their early redemption is similarly conditional. Investment-Linked Policies (ILPs) involve insurance charges and investment charges, and early surrender can often result in significant losses, making them less suitable for investors prioritizing low-cost, liquid exit options.