CMFAS RES6A Quiz 27

When a corporate treasurer expects interest rates to decline, the yield on a future deposit will be lower. To lock in the current higher yield, the treasurer needs a strategy that generates a profit if rates indeed fall. Eurodollar futures prices move inversely to implied interest rates. Therefore, if interest rates are expected to fall, Eurodollar futures prices are expected to rise. By buying Eurodollar futures contracts, the treasurer can profit from this expected price increase. This profit from the futures position will then offset the lower interest earned on the actual deposit when the funds become available, effectively locking in a yield closer to the current rate. Selling Eurodollar futures would be appropriate if one expects rates to rise (to hedge borrowing costs or if expecting a deposit yield to increase), as falling futures prices would generate a profit.

Exchange-Traded Notes (ETNs) are fundamentally debt instruments issued by financial institutions. Their performance is linked to an underlying market benchmark or strategy, but they do not directly hold the underlying assets. Consequently, investors in ETNs are exposed to the credit risk of the issuer. Conversely, Exchange-Traded Funds (ETFs) are investment funds that hold a proportional stake in the actual financial products or assets they track. When an investor purchases an ETF, they are investing in a fund that owns multiple assets, offering direct exposure and diversification. This distinction in structure – debt instrument versus investment fund holding assets – is a primary difference between ETNs and ETFs. Other options incorrectly describe their maturity dates, regulatory requirements for trustees, or general tax treatment.

The question focuses on identifying the appropriate risk management control for managing an options portfolio’s exposure to market volatility. Vega is the option Greek that measures the sensitivity of an option’s price to changes in the volatility of the underlying asset. As per the CMFAS Module 6A syllabus, limits for Vega are typically set in terms of the maximum loss that would be tolerated given specific movements in volatility. Therefore, establishing a maximum allowable loss for the option’s premium, contingent on a defined percentage shift in market volatility, directly addresses Vega risk. The other options relate to different option Greeks: Theta measures potential loss due to time decay, Delta measures sensitivity to the underlying asset’s price, and Rho measures sensitivity to interest rate changes. Each of these requires different risk management approaches.

The basis in futures trading is defined as the difference between the spot price of an underlying asset and the price of its corresponding futures contract. A fundamental characteristic of basis is its tendency to diminish and converge to zero as the futures contract approaches its expiration date. This convergence occurs because, at expiry, the futures contract effectively becomes a spot transaction, and thus their prices must align. The second option describes the cost of carry, which includes financial and economic costs, and is a component in determining the fair futures price, not the definition of basis itself. The third option relates to the expectancy model of futures pricing, which suggests the futures price is the expected future spot price. The fourth option describes the interest rate parity theory, which explains the relationship between forward/futures exchange rates and interest rate differentials between two currencies, a concept distinct from the general definition and behavior of basis.

This question assesses understanding of synthetic replication methods for Exchange Traded Funds (ETFs), specifically derivative-embedded structures, and the associated regulatory requirements for counterparty risk management under the Singapore syllabus (e.g., Code on CIS or UCITS). For derivative-embedded ETFs, the regulatory framework mandates a maximum net counterparty exposure of 10% of the fund’s value. To achieve this, the derivative issuer typically provides collateral for the remaining portion (e.g., 90%) to a third-party custodian, with the collateral owned by the ETF’s trustee. This mechanism is crucial for mitigating counterparty default risk, ensuring that investors’ potential loss from a counterparty default is limited to a maximum of 10% of the fund’s value. The other options describe incorrect or non-existent regulatory requirements for this type of ETF.

Knock-out products are structured products that terminate when the price of the underlying asset reaches a predetermined level, known as the barrier. For a knock-out option, if the underlying asset’s price touches or crosses this barrier during the option’s life, a ‘barrier event’ occurs, and the option is extinguished or ‘knocked out.’ This means the option immediately ceases to be valid and expires, regardless of its intrinsic value at that point. The terms of the option agreement would then dictate any final payoff, which could be zero, a fraction of the premium, or a fixed amount. It does not transform into a standard option, nor does it cause the strike price to reset or grant new exercise rights at the barrier price.

The question describes a fund structure that aims to replicate an underlying asset or provide a synthetic return linked to it, often incorporating derivatives. This approach allows for rule-based allocation, enabling the fund to take long, short, or market-neutral positions and potentially manage capital preservation. These characteristics are defining features of structured funds. Traditional mutual funds typically rely on active management and direct investment into underlying assets without using derivatives. Tracker funds are passively managed and solely aim to replicate the performance of their benchmark, usually through direct investment, rather than employing complex synthetic strategies for varied market views. A SICAV (Société D’investissement à Capital Variable) refers to a legal structure for an investment company, not a specific investment strategy involving derivatives for synthetic returns or varied market views.

The question tests the understanding of the critical distinction between ‘principal preservation’ and ‘principal guarantee’ in structured products, a key concept in CMFAS Module 6A. Principal preservation typically involves investing a portion of the product’s capital in fixed income securities (like zero-coupon bonds) with the expectation that they will mature at or above the initial principal amount. However, this is not a guarantee, as the underlying fixed income security can default, leading to a loss of principal. In contrast, a principal guarantee feature means the investor’s initial investment is explicitly guaranteed, often by specific collateral, acting as a form of investment insurance. This guarantee provides a higher level of security for the principal compared to mere preservation, and consequently, products with a guarantee feature usually cost more due to this added layer of protection. The other options contain inaccuracies regarding cost, early withdrawal implications, or the level of protection offered by each feature.

Structured products designed to offer a minimum return of principal at maturity typically employ specific strategies to achieve this capital preservation. Two common methods mentioned in the syllabus are the use of a zero-coupon bond combined with a long-call option, and the Constant Proportion Portfolio Insurance (CPPI) strategy. These approaches are specifically engineered to protect the investor’s initial capital. In contrast, structured products that do not offer a minimum return of principal at maturity often utilize short options strategies. Therefore, incorporating short options strategies into a product’s pay-out mechanism would fundamentally contradict the objective of providing a minimum return of principal. Basing the pay-out on the performance of an underlying asset or a basket of assets (like the best-performing asset) describes how the return component is calculated, but it is not a strategy for principal protection itself, nor does it inherently contradict it if combined with a principal-protecting mechanism.

To hedge a future deposit against a forecasted decline in interest rates, the treasurer aims to lock in the current higher yield. Eurodollar futures prices move inversely to interest rates; if interest rates fall, Eurodollar futures prices rise. Therefore, to profit from falling interest rates and offset the lower yield on the actual deposit, the treasurer should take a long position in Eurodollar futures, meaning they should buy Eurodollar futures contracts. This strategy ensures that any loss in deposit interest due to falling rates is compensated by a gain from the futures position, effectively locking in a yield close to the current market rate. Selling Eurodollar futures would be appropriate if hedging against rising interest rates for a future borrowing.

The investor’s objectives are to generate additional income from existing shares and obtain a limited buffer against minor downward price movements, while anticipating moderate price fluctuations or a slight upward trend. Selling call options against existing shares, also known as a covered call strategy, perfectly aligns with these goals. By selling calls, the investor receives a premium, which provides immediate income and acts as a buffer against a small decline in the stock price. The strategy is suitable for a stable to moderately bullish outlook, as the upside potential is capped at the strike price of the sold call plus the premium received. Purchasing put options (Option 2), while providing downside protection, involves paying a premium, which reduces returns rather than generating additional income from the existing shares. Selling call options without owning the underlying shares (Option 3) is an uncovered or naked call strategy, which carries unlimited risk if the stock price rises significantly, making it unsuitable for an investor seeking a ‘limited buffer’ or moderate risk. Purchasing call options (Option 4) is a purely bullish strategy used to profit from a significant price increase and also involves paying a premium, thus not generating income from existing shares or providing downside protection.

Equity Linked Notes (ELNs) are structured notes that incorporate an issuer’s note and a short put option linked to a reference financial asset. One of the key terms of an ELN is its mode of settlement. When the underlying asset for an ELN is a broad market equity index, physical delivery of the index itself is not feasible. Therefore, ELNs linked to an index are always settled in cash. For ELNs linked to individual stocks, settlement can be structured as either cash or physical, depending on the terms defined at issuance. The settlement method is a pre-defined term and not typically at the discretion of the issuer or contingent on the index’s performance relative to the strike price at maturity.

The daily mark-to-market (MTM) process for Extended Settlement (ES) contracts is a crucial risk management mechanism. Its primary objective, as stated in the provided materials, is to limit the Central Depository’s (CDP) exposure to price changes and prevent the accumulation of significant losses until the maturity of the ES contracts. This ensures that potential losses are recognized and covered daily, rather than allowing them to build up over time. While Initial Margins (IM) are required from customers for new trades and ES contracts can present arbitrage opportunities when trading at a discount, these are distinct concepts from the core purpose of daily MTM. Similarly, the valuation price is an input to the MTM process, but the MTM’s overarching goal is risk mitigation for the clearing house.

Contracts for Differences (CFDs) and equity futures contracts exhibit key differences in how they handle dividend adjustments and financing costs. For CFDs, investors who hold a long position are generally entitled to receive dividend adjustments, which are typically credited to their trading account. Furthermore, CFDs are associated with an explicitly computed financing cost, which is added for the duration the position is held. Conversely, equity futures contracts typically do not entitle the holder to receive dividends from the underlying asset. Instead, the financing cost for equity futures is not explicitly charged but is implicitly embedded within the quoted price of the futures contract itself, reflecting the cost of carrying the underlying asset until the contract’s maturity.

The question tests the understanding of a knock-out event condition as defined in the provided scenario. A knock-out event is triggered if any index level falls below 75% of its initial level. To determine if a knock-out event has occurred, we must calculate 75% of the initial level for each index and compare it to its observed level. For Index P: 75% of 2500 = 1875. The observed level is 1900, which is greater than 1875. So, Index P does not trigger a knock-out. For Index Q: 75% of 800 = 600. The observed level is 610, which is greater than 600. So, Index Q does not trigger a knock-out. For Index R: 75% of 120 = 90. The observed level is 85, which is less than 90. Therefore, Index R triggers a knock-out event. For Index S: 75% of 3000 = 2250. The observed level is 2350, which is greater than 2250. So, Index S does not trigger a knock-out. Since Index R’s observed level (85) fell below 75% of its initial level (90), a knock-out event has indeed occurred. The condition for a knock-out is met if any single index breaches the threshold, regardless of the performance of other indices or an overall average.

The investor’s objectives are a moderate upward movement in share price, reduced initial cost, and capped maximum profit and loss. A Bull Call Spread is specifically designed for a moderately bullish market view. It is constructed by simultaneously purchasing an in-the-money (ITM) call option and selling a higher-striking out-of-the-money (OTM) call option on the same underlying security with the same expiration date. This strategy reduces the net cost of entering the bullish position (as the premium received from selling the OTM call offsets part of the premium paid for the ITM call) and limits both the potential profit and potential loss. The maximum profit is the difference between the strike prices minus the net debit paid, and the maximum loss is limited to the net debit paid. The option of purchasing an ITM call at $70 (below the current price of $75) and selling an OTM call at $80 (above the current price of $75) perfectly matches this description and the investor’s objectives. A strangle (purchasing an OTM call and an OTM put) is used for high volatility, not a moderate directional view. A bear call spread (selling a lower strike call and buying a higher strike call) is for a bearish outlook. A simple long call option, while bullish, typically has a higher initial cost and offers unlimited upside potential, which goes against the objective of capping maximum profit.

The SGX rules for Extended Settlement (ES) contracts outline specific allowable trading activities based on the timing of customer margin receipt indications. According to the guidelines, if a Member or Trading Representative receives an indication from a customer that margins are forthcoming after the T+2 period, or that no funds are forthcoming, the permitted trading activities are restricted. In such cases, only risk-reducing activities are allowed. Risk-increasing and risk-neutral activities are explicitly prohibited. The same restriction applies once the period extends beyond T+2. Since the customer in the scenario indicates that margins will be received on T+3, this falls under the condition where margins are forthcoming after T+2, thus limiting permissible actions to only risk-reducing trades.

Effective gearing is a crucial metric for investors in warrants, as it combines the leverage provided by gearing with the price sensitivity indicated by delta. Gearing shows how many more warrants can be bought with a certain amount of capital compared to buying the underlying share, essentially highlighting the leverage. Delta, on the other hand, measures the rate at which the warrant’s price changes with respect to changes in the price of the underlying asset, reflecting its direct price responsiveness. The product of these two, effective gearing (Delta x Gearing), provides a comprehensive measure of the warrant’s overall sensitivity to the underlying share’s price movements, allowing investors to understand the amplified impact of price changes. The ratio of the warrant’s price change to the underlying share’s price change describes delta. The number of warrants purchasable for the same capital as one underlying share describes gearing. A measure reflecting the market’s consensus estimate of the underlying asset’s future price volatility describes implied volatility, which is a different concept used in warrant valuation.

The Constant Proportion Portfolio Insurance (CPPI) strategy is designed to protect a portion of the investor’s capital by ensuring the portfolio value does not fall below a predetermined floor. When the total value of the CPPI structure declines to the set floor value, the strategy mandates an immediate and critical action. At this point, the entire allocation that was previously invested in the risky asset is liquidated. The proceeds from this liquidation are then re-allocated into a risk-free asset. This action effectively locks in the capital at the floor level, preventing any further losses from the risky asset. As a consequence, investors will no longer participate in any potential future appreciation of the risky asset, as their investment is now entirely in the risk-free component, ensuring they receive at least their principal sum (or the floor value) at maturity. The other options describe actions that are not consistent with the immediate response of a standard CPPI strategy when the floor is reached. Adjusting the multiplier might occur under different circumstances, but not as the primary response to hitting the floor. Injecting additional capital or lowering the floor would contradict the fundamental capital protection objective of the CPPI strategy.

Interest rate options are unique because their underlying asset is an interest rate itself, not a bond or other security. They are also cash-settled, meaning that upon exercise, there is no physical delivery of an underlying security. Instead, the difference between the exercise rate and the prevailing market rate is settled in cash. In this scenario, the investor bought a call option, which gives the right to ‘make’ or receive a known interest rate payment. A call option is in-the-money and would be exercised if the prevailing interest rate is higher than the exercise rate. Since the prevailing rate (1.8%) is higher than the exercise rate (1.5%), the option is in-the-money, and the investor would exercise it to receive a cash settlement based on this difference. The investor’s risk is limited to the premium paid. The other options are incorrect because interest rate options do not involve the purchase of debt instruments or physical delivery of securities, and the option would not expire worthless if it is in-the-money.

This question tests the understanding of how accrual and knock-out barriers affect the coupon calculation for a structured product. The yield formula is 0.75% + [3.50% x n/N]. The key is to correctly identify ‘n’, the number of days the index accrues. In this scenario, the index fixes within the accrual range for 150 days before trading above the knock-out barrier, which stops further coupon accumulation. Therefore, ‘n’ is 150 days, and ‘N’ is 300 total trading days. First, calculate the accrual coupon rate: Rate = 0.75% + [3.50% x (150 / 300)] Rate = 0.75% + [3.50% x 0.5] Rate = 0.75% + 1.75% Rate = 2.50% Next, calculate the accrual coupon amount based on the principal investment of SGD 500,000: Coupon Amount = SGD 500,000 x 2.50% Coupon Amount = SGD 12,500 Finally, the total redemption proceeds at maturity include the principal repayment plus the accrued coupon: Total Redemption Proceeds = Principal + Coupon Amount Total Redemption Proceeds = SGD 500,000 + SGD 12,500 Total Redemption Proceeds = SGD 512,500

The question assesses the understanding of Extended Settlement (ES) contracts as a hedging tool compared to warrants, as outlined in the CMFAS Module 6A syllabus. ES contracts are noted for providing an immediate, near 100% hedge (delta = 1.0) because they are designed to track the underlying asset closely and are physically settled. In contrast, the effectiveness of a warrant as a hedge depends significantly on factors such as its strike price and the remaining time to expiry, often having a delta closer to 0.5 when at-the-money. Therefore, for a portfolio manager seeking immediate and almost complete protection against a sharp price decline, the near 100% hedge offered by ES contracts is a distinct advantage. Other options are incorrect because: ES contracts do not require the selection of a strike price, unlike warrants; ES contracts are generally expected to have greater liquidity and tighter bid/offer spreads than warrants; and the cost of ES contracts is primarily the cash to maintain margin, which forms part of settlement, whereas warrants involve an initial premium subject to time decay.

When a Callable Bull/Bear Certificate (CBBC) experiences a Mandatory Call Event (MCE), it means the price of the underlying asset has crossed and closed beyond the specified Call Price. For an R-category investor, this event leads to the immediate and irrevocable termination of the CBBC. The investor will receive a residual value, which may be small or even zero, depending on the specific terms and the underlying asset’s price at the time of the MCE. A crucial aspect is that once the CBBC is called, the investor cannot benefit from any subsequent recovery or rebound in the underlying asset’s price, as the contract has ceased to exist. Therefore, the first option accurately describes the immediate consequence of an MCE for an R-category investor. The other options are incorrect because an MCE is not subject to investor choice or grace periods, nor does it involve renegotiation of terms or the ability to hold until maturity after the event.

Arbitrage opportunities between Interest Rate Swaps (IRS) and Eurodollar futures strips arise when there is a discrepancy between the fixed rate of an IRS and the implied forward rates derived from a series of futures contracts. If the fixed rate of the IRS is trading significantly above the implied rate from the futures strip, it means the IRS is relatively ‘expensive’ to receive the fixed rate, or ‘cheap’ to pay the fixed rate. To profit from this, an arbitrageur would want to receive the higher fixed rate offered by the IRS and simultaneously hedge or lock in the lower implied rate from the futures market. Therefore, the arbitrageur would sell the Interest Rate Swap (meaning they receive the fixed rate and pay the floating rate) and buy the corresponding strip of Eurodollar futures contracts. Buying the futures contracts would allow them to benefit if the futures prices rise (or yields fall) to align with the higher IRS fixed rate, or to simply lock in the lower implied rate to offset the floating payments of the IRS. The other options involve incorrect directional trades for either the IRS, the futures, or both, or represent an incomplete arbitrage strategy.

Indirect Investment Policy Funds, often referred to as Swap-based Funds, are characterized by their indirect approach to gaining exposure to an underlying asset. As described in the syllabus, these funds do not invest directly or fully in the underlying asset. Instead, they typically allocate their net proceeds into one or more derivative transactions. These derivatives are structured to provide a return linked to the performance of the underlying asset. The fund may also invest in a hedging asset and then use derivative instruments to exchange the performance of this hedging asset for a performance linked to the desired underlying asset. This mechanism allows the fund to synthetically track the underlying asset’s performance without direct ownership. Therefore, investing in derivative transactions to replicate the underlying asset’s performance is the primary method.

For Contracts for Differences (CFDs), investors do not physically own the underlying asset. Instead, they gain economic exposure to the price movements and corporate actions of the underlying asset. When an investor holds a short CFD position, they are essentially betting on the price of the underlying asset to fall. In the context of dividends, a short position means the investor is economically obligated to pay the dividend, similar to how a borrower of shares would be responsible for passing on dividends to the lender. Therefore, when a cash dividend is announced, the investor’s CFD account will be debited by an amount equivalent to the dividend per share, multiplied by the number of CFD units held. Conversely, an investor holding a long CFD position would receive a credit for the dividend amount. Options suggesting a credit or no impact are incorrect as they misrepresent the economic exposure of a short position. Receiving a direct payment from the company is also incorrect because CFDs are cash-settled derivatives, and the investor does not hold the actual shares.

For Contracts for Differences (CFDs), corporate actions like cash dividends are handled by adjusting the investor’s account. If an investor holds a long CFD position, meaning they are speculating on a price increase, they will receive a credit equivalent to the dividend amount that would have been paid on the underlying shares. Conversely, if an investor holds a short CFD position, speculating on a price decrease, their account would be debited the dividend amount. This mechanism ensures that the CFD mirrors the economic outcome of holding the actual underlying asset without the investor owning the shares directly. The timing of this adjustment (e.g., ex-date, payment date) can vary by CFD provider and the underlying asset’s country, but the principle of crediting long positions and debiting short positions remains consistent.

The structured product outlines specific early redemption observation dates and their corresponding payout prices. The observation dates occur every six months, starting from 15 March 2015. The date 15 September 2016 corresponds to the 2.5-year observation point (1.0 year on 15 Mar 2015, 1.5 years on 15 Sep 2015, 2.0 years on 15 Mar 2016, 2.5 years on 15 Sep 2016). The product terms state that an early redemption event is triggered if the Returns Performance of Index 1 (Nikkei 225) is greater than or equal to the Returns Performance of Index 2 (S&P 500) on an observation date. In this scenario, the Nikkei 225 performance (+15.0%) is indeed greater than the S&P 500 performance (+12.0%). Therefore, an early redemption occurs on 15 September 2016. The payout price specified for the 2.5-year observation is 121.25% of the initial investment.

For the first objective, limiting potential losses if the price falls, a Stop Sell order is the appropriate choice. A Stop Sell order is placed below the current market price and is triggered when the market price falls to or below the specified stop price, converting it into a market or limit order to sell. For the second objective, exiting a long position if the price unexpectedly rallies to a higher point, a Market-if-Touched (MIT) Sell order is suitable. An MIT Sell order is placed above the current market price and is triggered when the market price rises to or above the specified trigger price, converting it into a market order to sell. This distinction is crucial: Stop Sell orders are for selling below the current market to cut losses, while MIT Sell orders are for selling above the current market, often to take profits or initiate a reversal strategy.

A zero-cost collar is an option strategy designed to protect an existing long stock position from downside risk while generating income, without incurring a net premium cost. This is achieved by simultaneously purchasing a protective put option and selling an out-of-the-money covered call option. The strike prices are typically adjusted such that the premium received from selling the call equals the premium paid for buying the put, resulting in a zero net cash outlay. This strategy provides a floor for the stock price (from the put) and generates income (from the call), but it also caps the potential upside profit of the stock beyond the call’s strike price. The other options do not fully meet all the specified objectives: buying only a protective put incurs a cost and does not generate income; selling a covered call generates income and offers limited downside protection but caps upside and does not explicitly aim for zero net cost protection against significant falls; and entering into a forward contract is a different hedging instrument altogether, not an option strategy, and doesn’t align with the income generation aspect of selling an option.