CMFAS RES6A Quiz 24

The Constant Proportion Portfolio Insurance (CPPI) strategy dynamically adjusts its allocation between a risky asset and a risk-free asset based on the ‘cushion’ (total portfolio value minus floor value) and a fixed multiplier. The strategy dictates that as the risky asset appreciates, the cushion grows, leading to a higher allocation to the risky asset. Conversely, if the risky asset declines, the cushion shrinks, leading to a reduction in the risky asset allocation. In a prolonged range-bound market, where the underlying asset’s value fluctuates without a clear upward trend, this mechanism can result in the portfolio manager repeatedly buying the risky asset when its value is relatively high (as the cushion temporarily increases) and selling it when its value is relatively low (as the cushion temporarily decreases). This ‘buy high, sell low’ phenomenon is detrimental to returns. If this trend continues, the portfolio value may eventually drop to the floor value. At this point, to protect the principal, the entire fund is allocated to the risk-free asset, effectively locking in any losses and preventing participation in any subsequent appreciation of the underlying asset should it eventually break out of the range. This is a significant risk highlighted for CPPI products in such market conditions. The other options describe scenarios that are either not characteristic of CPPI’s primary risks in a range-bound market or misrepresent how CPPI mechanics operate. For instance, the multiplier is fixed in CPPI, and the allocation does adjust based on the cushion. The floor value changes predictably based on time and yield, not erratically. While fees are a general concern, the specific risk for a range-bound market is the ‘buy high, sell low’ effect and the potential for full allocation to the risk-free asset.

To determine the number of futures contracts needed to hedge an equity portfolio, the formula used is N = (VP / Value_per_contract) β, where N is the number of contracts, VP is the current value of the portfolio, Value_per_contract is the value of one futures contract, and β is the beta of the portfolio. In this scenario, the portfolio value (VP) is SGD 8,400,000, the value of each equity index futures contract is SGD 200, and the portfolio beta (β) is 1.25. Plugging these values into the formula: N = (SGD 8,400,000 / SGD 200) 1.25. First, calculate the ratio of portfolio value to contract value: 8,400,000 / 200 = 42,000. Then, multiply this by the beta: 42,000 1.25 = 52,500. Therefore, Sarah needs to short 52,500 futures contracts to hedge her portfolio.

The Product Highlights Sheet (PHS), as mandated by the Monetary Authority of Singapore (MAS), serves a critical role in investor protection, particularly for retail investors. Its fundamental objective is to provide a clear, concise, and easily digestible summary of a financial product’s essential characteristics, including its key features, potential benefits, associated risks, and all material terms and fees. This enables investors to quickly understand the core aspects of a product without having to immediately delve into lengthy and complex legal documents. The PHS is designed to facilitate informed decision-making by presenting a balanced view, highlighting both the potential rewards and the inherent risks. It is not intended to be a comprehensive legal contract, a purely promotional tool, or a replacement for the full offer document or prospectus, but rather a supplementary document that distills critical information.

A bear put spread is a bearish strategy implemented by buying a higher strike put option and simultaneously selling a lower strike put option, both for the same underlying asset and expiration date. This strategy results in a net debit (cash outlay) because the premium paid for the higher strike (in-the-money) put is typically greater than the premium received for the lower strike (out-of-the-money) put. The maximum profit for a bear put spread occurs when the underlying asset’s price falls below the strike price of the short put option at expiration. In this situation, both put options expire in-the-money. The profit is calculated as the difference between the strike prices minus the initial net debit paid to establish the position. In the given scenario: – Investor buys a put with strike $125 for $8. – Investor sells a put with strike $115 for $3. – The net debit (initial cost) is $8 – $3 = $5. If Stellar Corp.’s share price closes at $110 at expiration: – The long $125 put option is in-the-money. Its intrinsic value is $125 – $110 = $15. – The short $115 put option is also in-the-money. Its intrinsic value is $115 – $110 = $5. The net gain from the options at expiration is the intrinsic value of the long put minus the intrinsic value of the short put: $15 – $5 = $10. To find the overall net financial outcome, we subtract the initial net debit from the net gain at expiration: $10 (gain from options) – $5 (initial debit) = $5. Therefore, the investor realizes a net profit of $5 per share. This outcome represents the maximum possible profit for this bear put spread strategy, which occurs when the underlying price is at or below the lower strike price.

An Equity Linked Note (ELN) is a structured product that offers investors a return linked to the performance of an underlying asset, typically a single stock or an index. When the underlying asset’s price falls below the strike price at maturity, the settlement method significantly impacts the investor’s outcome and future exposure. For an ELN with cash settlement, the investor receives a cash amount equivalent to the value of the underlying shares at the prevailing market price on the maturity date. This effectively closes the investment, and the investor no longer has direct exposure to the underlying asset’s subsequent price movements. In contrast, an ELN with physical settlement obligates the investor to receive the actual underlying shares. By taking ownership of these shares, the investor retains direct exposure to the company’s future performance. This means the investor can choose to hold the shares, hoping for a price recovery, or sell them immediately at the prevailing market price, which would yield a similar cash amount to a cash-settled ELN at that moment. The key difference lies in the ongoing market exposure and the strategic options available to the investor post-maturity.

When an investor wishes to maintain their market exposure in a futures contract beyond its current expiration date, they employ a strategy known as ‘rolling’ their position. This involves simultaneously closing out the expiring contract and opening a new, equivalent position in a contract with a later expiration month. For example, if an investor is long a December contract and wants to maintain that long exposure into March, they would sell their December contract and buy a March contract. This action allows them to avoid the obligations of delivery or cash settlement associated with the expiring contract while continuing to participate in the market. Simply allowing the contract to expire would result in cash settlement (for cash-settled instruments like index futures) or physical delivery (for commodities), effectively ending the market exposure. Liquidating the position with a market order also ends the exposure without immediately re-establishing it for a future period. Physical delivery is generally not applicable for cash-settled index futures.

Structured warrants listed on SGX-ST utilise an Asian style of expiry settlement. This means that the settlement price is not determined by a single closing price on the expiry date or last trading day. Instead, it is calculated as the arithmetic average of the official closing prices of the underlying asset for the five market days immediately preceding the expiration date. This averaging mechanism is designed to mitigate the impact of price volatility on the final settlement value. Other methods, such as using only the last trading day’s price or the highest price, do not align with the specified settlement procedures for these warrants.

A Constant Proportion Portfolio Insurance (CPPI) strategy dynamically allocates assets between a risky asset and a risk-free asset to ensure a minimum portfolio value (floor) while participating in potential upside. The allocation to the risky asset is determined by a multiplier (M) applied to the ‘cushion,’ which is the difference between the current portfolio value and the floor. In this scenario: Initial Portfolio Value = $100 million Floor = $85 million Multiplier (M) = 4 1. Before the decline: Cushion = Current Portfolio Value – Floor = $100 million – $85 million = $15 million Target Risky Asset Allocation = Multiplier x Cushion = 4 x $15 million = $60 million 2. After the decline: New Portfolio Value = $90 million New Cushion = New Portfolio Value – Floor = $90 million – $85 million = $5 million New Target Risky Asset Allocation = Multiplier x New Cushion = 4 x $5 million = $20 million Since the target allocation to risky assets has decreased from $60 million to $20 million, the CPPI manager must reduce the exposure to risky assets. This is achieved by selling a portion of the risky assets and reallocating the proceeds to the risk-free asset. This action helps to protect the portfolio’s floor by reducing exposure to volatile assets as the cushion shrinks. Option 1 correctly describes this necessary reallocation. Option 2 is incorrect as CPPI reduces risky asset exposure when the cushion shrinks. Option 3 is incorrect because CPPI is a dynamic strategy requiring adjustments. Option 4 is incorrect as it would increase risk, contrary to the floor protection objective of CPPI.

The question addresses the inherent characteristics of an Equal Weight Index (EWI) versus a Market Weight Index (MWI), specifically concerning volatility. An EWI assigns the same weight to each stock in the index, which means it inherently gives a larger proportional weighting to smaller market capitalization stocks compared to an MWI, where larger companies naturally command a greater share. Smaller-cap stocks are generally more susceptible to price fluctuations and tend to be more volatile than their larger, more established counterparts. Therefore, an EWI, by its design, will have a greater exposure to these more volatile smaller companies, leading to higher overall volatility for the index itself. This is a key consideration for a fund manager evaluating risk and potential price movements.

The core distinction between an unfunded swap-based ETF and a fully funded swap-based ETF lies in the initial management and ownership of the collateral purchased with the ETF’s unit sale proceeds. In an unfunded swap-based ETF, the ETF itself directly uses the proceeds from the sale of its units to purchase a pool of collateral, which it then holds with a third-party custodian. The returns from this collateral are exchanged with the swap counterparty for the performance of the underlying index. Conversely, in a fully funded swap-based ETF, the ETF transfers its unit sale proceeds to the swap counterparty. It is the swap counterparty that then uses these proceeds to purchase a pool of collateral, which is subsequently placed with a third-party custodian and pledged in favour of the ETF. Both structures aim to limit the ETF’s overall exposure to the swap counterparty to 10% of the ETF’s Net Asset Value (NAV). The daily rebalancing requirement for unfunded swap-based ETFs ensures the collateral pool’s value is at least 90% of the ETF’s NAV.

A HSI Daily Range Accrual Note (RAN) specifies conditions under which coupon accrual occurs. A knock-out event is triggered if the HSI trades at or above a knock-out barrier or at or below an accrual barrier. When such an event occurs, the accumulation of new coupons immediately stops. However, the terms of a RAN typically ensure that any coupons that have already been accrued up to the point of the knock-out event will still be paid out according to the note’s periodic interest payment schedule. Crucially, for a principal-protected RAN, the investor’s initial principal amount remains preserved and is expected to be returned at maturity, along with any accrued coupons. The other options describe scenarios that are not characteristic of a principal-protected HSI Daily Range Accrual Note under a knock-out event, such as immediate principal impairment, a reset of the interest rate, or complete forfeiture of all accrued coupons.

The question assesses the understanding of distinct daily price limit mechanisms for different futures contracts, a key aspect of risk management and market stability protocols in the CMFAS Module 6A syllabus. For Nikkei 225 Index Futures, the daily price limit system is structured in multiple tiers. 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% is enforced for the remainder of the trading day. In contrast, MSCI Singapore Index Futures follow a different protocol. When the price moves by 15% from the previous day’s settlement price, trading is allowed within this 15% limit for a 10-minute cooling-off period. After this initial cooling-off period, there are no further price limits for the rest of the trading day. Therefore, the primary divergence lies in Nikkei 225 having a progressive, tiered limit system (7% -> 10% -> 15%) with multiple cooling-off stages, while MSCI Singapore employs a single 15% limit followed by the complete removal of limits for the day.

Callable Bull/Bear Contracts (CBBCs) are distinct from standard warrants primarily due to their mandatory call mechanism. This feature dictates that a CBBC will terminate early if the price of its underlying asset reaches a pre-determined knock-out level. For a bull contract, this occurs if the underlying asset falls to or below the call price, while for a bear contract, it occurs if the underlying asset rises to or above the call price. This early termination mechanism is absent in standard warrants, which typically have a fixed maturity date without such a trigger. Furthermore, in the pricing of CBBCs, implied volatility is generally considered to be insignificant because their price movements closely track those of the underlying asset, with a delta usually close to 1. Conversely, implied volatility is a crucial factor in the pricing of standard warrants, influencing their time value. Therefore, the statement that CBBCs have a mandatory call mechanism leading to early termination and that implied volatility is generally insignificant to their pricing accurately distinguishes them from standard warrants.

Auto-callable structured products grant the issuer the discretion to redeem the product prior to its stated maturity. This feature means investors effectively cede their right to early redemption to the issuer, often in exchange for a potentially higher yield. Consequently, investors face ‘call risk’ because they have no control over the exact holding period of their investment. If the product is called early, investors may also encounter ‘reinvestment risk,’ as they would need to find a new investment for their redeemed capital, possibly at less favorable rates. The product’s returns are not solely from the underlying asset’s performance but also from premiums received for writing options, and payouts can be capped or uncapped. While some auto-callable products may offer downside protection, it is not a universal guarantee of 100% capital protection for all such instruments.

The Product Highlights Sheet (PHS) is a crucial regulatory document mandated by the Monetary Authority of Singapore (MAS) for investment products offered to retail investors. Its fundamental objective is to provide a concise, clear, and easy-to-understand summary of the product’s key features, benefits, risks, and fees and charges. This enables retail investors to quickly grasp the essential aspects of the product and make an informed investment decision. It is designed to be a standalone document that complements, rather than replaces, the full prospectus or offering document, which contains more detailed legal and financial information. The PHS is not primarily a marketing tool, nor is it intended to be the sole legal binding document or an exhaustive detailing of every possible market scenario.

The question describes a scenario where a financial institution aims to raise capital through structured notes while simultaneously protecting its main balance sheet from direct liability in case of default. This objective is best achieved through a Special Purpose Vehicle (SPV) issuance. An SPV is a separate legal entity established for the specific transaction. The notes are issued by the SPV, and its assets and liabilities are not reflected on the bank’s main balance sheet, making it an ‘off-balance sheet’ arrangement from the bank’s perspective. In the event of a default, noteholders can only claim against the SPV’s assets and have no recourse to the bank that set up the SPV, thereby insulating the bank’s core operations. In contrast, direct issuance by the bank or issuing structured deposits or debentures directly by the bank would result in the debt being a direct obligation on the bank’s balance sheet, exposing it to direct recourse.

A Range Accrual Note (RAN) pays interest only for the days when its reference index closes within a pre-defined range. The coupon is typically accrued on a daily basis. If the reference index closes outside the specified range on any particular day, no interest is earned for that day. Therefore, to determine the interest payout for a given observation period, the annual coupon rate is applied only to the aggregate number of days the reference index remained within the range, scaled by the total days in a year (e.g., 365 or 360, depending on the calculation basis). The other options describe incorrect methods of calculating interest for a RAN, such as assuming a zero payout if the index ever leaves the range, prorating a full coupon based on the ratio of in-range days, or paying a full coupon based on a simple majority of in-range days.

A knock-out event, also known as a Mandatory Call Event (MCE), is triggered if any of the underlying index levels falls below a predefined percentage of its initial level on an observation date. In this scenario, the condition for a knock-out event is that any index level must be less than 75% of its initial level. To determine if a knock-out event has occurred, we calculate 75% of the initial level for each index and compare it with 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 590, which is less than 600. Therefore, Index Q triggers a knock-out event. For Index R: 75% of 1200 = 900. The observed level is 920, which is greater than 900. So, Index R does not trigger a knock-out. Since the condition states ‘any index level’ falling below the threshold, the fact that Index Q’s level (590) is below its 75% threshold (600) means a knock-out event has indeed occurred. The other options either misinterpret the ‘any index’ condition, make incorrect calculations, or confuse the knock-out condition with overall fund performance.

An Inverse Floater Note is specifically designed to pay coupons that are inversely linked to a floating interest rate index. This means that as the reference interest rate index rises, the coupon payments to the investor will decrease. Conversely, if the index falls, the coupon payments would increase. The initial coupon is often higher than a bank deposit rate, but this advantage diminishes or reverses if rates climb. The formula provided, Coupon = [X% ― Leverage x Floating Rate Index], clearly demonstrates this inverse relationship. Therefore, a sustained upward trend in the reference index will lead to a reduction in the coupon payments. The other options describe characteristics of different types of notes or misinterpret the inverse relationship. For example, a standard floating rate note would see coupon payments increase with rising rates, and the principal value of an inverse floater note is not necessarily affected by the index movement, but the coupon is. While a floor can be structured into the coupon, a cap on reduction is not the primary mechanism described for rising rates.

To construct a synthetic short put, an investor combines a long position in the underlying asset with a short call option. This strategy effectively replicates the payoff profile of directly selling a put option. A short put position profits when the underlying asset’s price remains above the strike price and incurs losses if the price falls significantly below the strike price. Similarly, holding the underlying asset and simultaneously selling a call option creates a position that gains from the underlying’s price appreciation up to the call’s strike price (offset by the premium received) and loses if the underlying’s price falls, while also limiting upside potential beyond the strike price due to the short call. The other options describe different synthetic positions: a short position in the underlying asset combined with a long call option creates a synthetic long put; a long position in the underlying asset combined with a long put option creates a synthetic long call; and a short position in the underlying asset combined with a short put option creates a synthetic short call.

The question describes a scenario where a company’s influence on an index is primarily driven by its share price magnitude, rather than its overall market value. This characteristic is specific to a price-weighted average index. In such an index, the index value is an arithmetic average of the current prices of the constituent stocks. Consequently, a stock with a higher per-share price will have a greater impact on the index’s movement, regardless of its market capitalization. This can lead to a situation where a smaller company with a high share price influences the index more than a larger company with a lower share price, which is often considered not to be a true reflection of the overall market. In contrast, a market-value-weighted average index (also known as capitalization-weighted) assigns weights based on the total market capitalization of each company, meaning larger companies by market value have a greater influence. An equally-weighted average index gives each stock the same weight, irrespective of its price or market capitalization, with movements based on the average of the percent price changes for the stocks.

The structured product specifies that a Mandatory Call Event (knock-out event) is triggered if the closing index level of ANY 4 of the underlying indices (Index1-4) on an Early Redemption Observation Date is less than 75% of its initial level. The product is also call-protected for an initial 1.5-year period, meaning the earliest a call event can occur is on the First Callable Date (15 June 2016). The scenario takes place on 15 December 2017, which is after the call protection period and is a valid Early Redemption Observation Date. In the given scenario: – Index 1: 70% (below 75%) – Index 2: 76% (not below 75%) – Index 3: 72% (below 75%) – Index 4: 73% (below 75%) Only three out of the four underlying indices closed below 75% of their initial level. For a Mandatory Call Event to be triggered under the condition ‘ANY 4 of the underlying indices (Index1-4)’ when there are exactly four such indices, all four indices must close below 75% of their initial level. Since Index 2 did not meet this condition, the Mandatory Call Event is not triggered. Consequently, the fund will not terminate early, and the variable quarterly coupons will continue to be paid as per the product terms, provided no knock-out event occurs on subsequent observation dates.

Contracts for Differences (CFDs) are derivative products that allow investors to speculate on the price movements of underlying assets without actually owning them. Despite not holding the physical asset, CFD positions are adjusted to reflect the economic impact of corporate actions, such as cash dividends. For an investor holding a ‘long’ CFD position, which means they are speculating on a price increase, they are treated as if they own the underlying shares. Therefore, when a cash dividend is declared, their CFD account is credited with an amount equivalent to the dividend. Conversely, an investor holding a ‘short’ CFD position, speculating on a price decrease, is treated as if they have borrowed and sold the underlying shares. In this scenario, if a dividend is declared, their CFD account is debited with the dividend amount, reflecting the obligation to pay the dividend to the lender of the shares, similar to physical short-selling. This ensures that the profit and loss of a CFD position accurately mirrors the economic outcome of holding or shorting the actual underlying asset.

A Knock-Out Event, also known as a Mandatory Call Event (MCE), occurs if any index level falls below 75% of its initial level on an observation date. To determine if an event has occurred, we calculate the percentage of the initial level for each index at the observation date: For Index Alpha: (760 / 1000) = 0.76 or 76%. This is not below 75%. For Index Beta: (370 / 500) = 0.74 or 74%. This is below 75%. For Index Gamma: (1900 / 2000) = 0.95 or 95%. This is not below 75%. Since Index Beta’s observation level (74%) is below the 75% threshold, a Knock-Out Event has occurred.

Structured warrants are subject to adjustments for certain corporate actions of the underlying security, such as dividends. This is done to ensure fair treatment for warrant holders and to prevent the dilution of the warrant’s value. As per the provided CMFAS Module 6A material, when a company declares a special dividend, the exercise price of an existing structured warrant is adjusted. The adjustment factor for the exercise price is calculated as (P – SD – ND) / (P – ND), where P is the last cum-date closing price, SD is the special dividend, and ND is the normal dividend. When a special dividend (SD) is paid, the numerator (P – SD – ND) becomes smaller than the denominator (P – ND), resulting in an adjustment factor less than 1. Consequently, the new exercise price will be lower than the old exercise price. This reduction in the exercise price compensates the warrant holder for the expected decrease in the underlying share’s value when it trades ex-dividend, thereby maintaining the economic value of the warrant. Therefore, the exercise price is lowered to account for this dilutive effect.

Early termination risk specifically refers to the possibility that if a structured product is withdrawn or liquidated before its scheduled maturity, the underlying assets may need to be sold at a discount. This discounted sale directly leads to an adverse impact on the overall value of the structured product for the investor. While other risks like liquidity risk (difficulty in finding a buyer) or structure risk (complexity of the product) might be present, the scenario explicitly describes the consequence of the underlying assets being sold at a discount due to early exit, which is the core definition of early termination risk. Reinvestment risk relates to the inability to reinvest proceeds at a favorable rate, volatility risk concerns price fluctuations of embedded options, and transactional risk involves timing differences in contract settlement, none of which directly describe the scenario presented.

Equity index futures and individual stocks have distinct characteristics, especially when considering short selling. For equity index futures, the underlying is a cash index, and there are no dividends paid on the future contract itself. Consequently, a short seller of an equity index future does not incur an obligation to pay dividends to the long position holder, nor do they need to borrow the underlying index components. In contrast, when short selling individual stocks, the short seller typically borrows shares from a lender and is obligated to pay any dividends declared by the company to the share owner (the long party). Additionally, short selling individual stocks is often subject to an uptick rule, which does not apply to equity index futures. Therefore, the absence of dividend obligations and the requirement to borrow shares are key operational differences for short selling equity index futures compared to individual stocks.

This question tests the understanding of ‘worst of’ Equity Linked Notes (ELNs) and their settlement mechanisms. In a ‘worst of’ ELN, the performance of the note is determined by the single worst-performing underlying asset among a basket of assets. The question specifies that Beta Inc had the worst performance (-12%) compared to its initial price, and crucially, its final price (SGD 28.00) was below its strike price (SGD 30.00). Since the ELN has a physical settlement clause, the investor will receive shares of the worst-performing underlying asset, which is Beta Inc. The number of shares would be calculated based on the nominal investment and Beta Inc’s strike price. The positive performance of other shares or the second-worst performance of Gamma Ltd does not alter the outcome for a ‘worst of’ ELN. A cash settlement would only occur if explicitly specified in the terms, but here physical settlement is stated.

The scenario describes a financial entity identifying and profiting from a temporary price discrepancy between an underlying asset in the cash market and its related futures contract, without taking a directional view on market movement. This activity, which involves exploiting market inefficiencies to secure riskless or near-riskless profits, is the defining characteristic of an arbitrageur. Arbitrageurs typically rely on sophisticated systems to identify and act on these fleeting opportunities, thereby contributing to market efficiency. A speculator, in contrast, takes directional bets on market prices. A hedger uses futures to mitigate risk from an existing or anticipated exposure to an underlying asset. While an arbitrageur might work for a proprietary trading firm, the specific role and activity described in the scenario is that of an arbitrageur.

Pairs trading is designed to be market-neutral, meaning the overall direction of the market should not significantly impact the outcome, as long and short positions are intended to offset market risk. However, a key risk, as highlighted in the CMFAS Module 6A syllabus, is that the perceived deviation in underlying share prices from historical norms may persist for extended periods without converging. This means the expected ‘mean reversion’ does not occur, leading to losses if the divergence widens or remains unfavorable. The strategy relies on the relative performance and eventual convergence of the paired assets. If this convergence does not happen, or if the market moves against the investor in a way that overwhelms the profitable leg, significant losses can occur despite the market-neutral intent. Other options describe general CFD risks (like margin calls) or costs (commissions) or misinterpret the nature of market neutrality in pairs trading.