CMFAS RES6A Quiz 22

A bull put spread is a credit spread, meaning the investor receives a net premium upfront when initiating the trade. This strategy is employed when the trader has a moderately bullish outlook on the underlying asset. The maximum profit achievable from a bull put spread is equal to the net credit received when the position is opened. In this scenario, the trader sells a put option for $6.00 (receiving credit) and buys another put option for $2.50 (paying debit). The net credit received is $6.00 – $2.50 = $3.50. This $3.50 represents the maximum profit if the underlying stock price closes above the higher strike price ($75) at expiration, causing both options to expire worthless. The maximum loss for a bull put spread is calculated as the difference between the strike prices minus the net credit received, which would be ($75 – $65) – $3.50 = $10 – $3.50 = $6.50.

A bear put spread is implemented by buying a higher striking in-the-money put option and selling a lower striking out-of-the-money put option of the same underlying security with the same expiration date. This strategy results in a net debit (cash outlay) upon entry. The maximum potential profit for a bear put spread is achieved when the underlying asset’s price falls below the strike price of the sold (lower strike) put option at expiration. The calculation for maximum profit is the difference between the two strike prices minus the net debit paid to establish the position. In this scenario: – Higher Strike Price (Long Put) = $70 – Lower Strike Price (Short Put) = $60 – Premium Paid for Long Put = $8.00 – Premium Received for Short Put = $3.00 First, calculate the net debit (cash outlay): Net Debit = Premium Paid – Premium Received = $8.00 – $3.00 = $5.00 Next, calculate the maximum potential profit: Maximum Profit = (Higher Strike Price – Lower Strike Price) – Net Debit Maximum Profit = ($70 – $60) – $5.00 Maximum Profit = $10.00 – $5.00 = $5.00 Therefore, the maximum potential profit for this bear put spread strategy is $5.00.

The scenario describes a common challenge in portfolio management: the need to quickly adjust asset allocation when some underlying assets are illiquid. The text explicitly states that using futures to allocate assets can be more effective and less costly because of several factors. These include cheaper brokerage costs, a smaller cash outlay due to margining, shorter transaction times, less impact on the market due to higher liquidity, and being less disruptive to the overall portfolio management process. Therefore, futures provide a mechanism to rapidly adjust market exposure and achieve the desired asset allocation without the immediate need to liquidate illiquid cash market positions, which could otherwise incur significant costs or market disruption. The other options are incorrect because futures contracts do require margin payments, they do not guarantee exact prices or eliminate all price volatility, and while futures can be used to delay loss realization in certain accounting systems, this is not their primary benefit for rapid asset allocation shifts, nor does it apply to indefinite deferral of capital gains or losses generally.

The question pertains to the management and evaluation of a futures-based hedging strategy, as outlined in the CMFAS Module 6A syllabus, specifically under ‘Managing the Hedge’. During the lifespan of a hedge, the text indicates that ‘changes in volatilities and yield spread relationships, for instance, may necessitate changing the hedge ratio’. This highlights the dynamic market factors that require monitoring for potential adjustments to maintain hedge effectiveness. After a hedge is concluded and lifted, its effectiveness is evaluated. The primary factors identified as ‘main sources of error’ are ‘due to the projected value of the basis at the lift date and the parameters estimated for cross hedges’. Therefore, the option that correctly identifies both these aspects aligns with the syllabus material. Other options mention factors that are either too broad, relate more to initial structuring, or are general market risks rather than the specific monitoring and error sources discussed in the context of hedge management and evaluation.

Bond-Linked Notes (BLNs) and Credit-Linked Notes (CLNs) are both structured products designed for yield enhancement, but they differ fundamentally in their underlying mechanisms and payout triggers. A BLN embeds a short put option on a bond, meaning the investor effectively sells a put option and may be obligated to buy the bond at the strike price if its market price falls. The payout of a BLN is therefore dependent on the price movement of the underlying bond, which can be influenced by various factors beyond just a credit event, such as interest rate changes, credit downgrades, or widening spreads. Conversely, a CLN involves the investor selling credit protection, typically through a Credit Default Swap (CDS) on a specific reference entity. The payout of a CLN is contingent upon the occurrence of a defined credit event (e.g., default, bankruptcy) of that reference entity. In a BLN, the investor might end up owning the bond even if no credit event occurs, simply due to the bond’s price falling below the strike price of the embedded put option. This distinction in the underlying instrument (put option on a bond vs. CDS on a reference entity) and the primary payout trigger (bond price vs. credit event) is crucial for understanding the risk and return profiles of these structured products.

Structured products designed to offer a minimum return of principal at maturity typically employ specific combinations of financial instruments. One common method, as outlined in the syllabus, involves using a zero-coupon bond to secure the principal amount, which matures at the product’s expiry to return the initial capital. To provide potential upside participation in the underlying asset’s performance, this is often combined with a long-call option strategy. This setup ensures the investor’s principal is protected while allowing for market-linked returns. Option 2 is incorrect because short options strategies are generally used in structured products that do not offer principal protection, as they expose the investor to potential losses beyond the premium received. High-yield corporate debt is typically part of the return component, not the principal protection mechanism itself. Option 3 describes a Constant Proportion Portfolio Insurance (CPPI) framework, which is indeed a strategy for principal protection. However, the syllabus explicitly states that in a CPPI strategy, ‘no options are involved.’ Therefore, an option that suggests CPPI ‘involving various equity derivatives’ contradicts the provided material. Option 4 mentions a credit default swap (CDS) and a step-up coupon mechanism. A CDS is a feature used to manage credit risk, and a step-up coupon relates to the product’s income stream, neither of which serves as the primary mechanism for guaranteeing the return of principal at maturity.

The question requires the application of the formula for adjusting the exercise price of warrants due to dividends. The adjustment factor is calculated as (P – SD – ND) / (P – ND), where P is the last cum-date closing price of the underlying share, SD is the Special Dividend per Share, and ND is the Normal Dividend per Share. Given P = $5.00, SD = $0.15, and ND = $0.05, the calculation is (5.00 – 0.15 – 0.05) / (5.00 – 0.05) = 4.80 / 4.95. This results in approximately 0.9697. Incorrect options arise from misapplying the formula, such as omitting a dividend from the numerator or denominator, or incorrectly swapping the numerator and denominator.

For a put option buyer, the intrinsic value is calculated as the exercise price minus the underlying asset price, but only if this difference is positive. If the underlying asset price is at or above the exercise price, the intrinsic value of the put option is zero, as it would not be profitable to exercise. In this scenario, the underlying asset price ($80) is higher than the exercise price ($75), meaning the option is out-of-the-money, and its intrinsic value is $0. The maximum loss for a put option buyer is limited to the premium paid for the option, regardless of how high the underlying asset price rises. Therefore, the investor’s maximum loss is the $6 premium paid.

A futures hedge ratio is primarily designed to mitigate specific risks, often related to price movements of an underlying asset. The effectiveness of this hedge can be significantly impacted by changes in market dynamics. A material alteration in the underlying asset’s price volatility directly affects the risk profile of the asset and, consequently, the required hedge ratio to maintain the desired level of risk reduction. The provided syllabus material explicitly states that ‘changes in volatilities and yield spread relationships may necessitate changing the hedge ratio.’ A prolonged period of market stability would generally indicate that the existing hedge is performing as expected or that the need for aggressive hedging has diminished, rather than requiring an adjustment to the ratio itself. Corporate actions like stock splits primarily affect the number of shares represented by a contract or the contract specifications, but not necessarily the fundamental hedge ratio based on market risk conditions like volatility. A slight increase in bid-ask spread relates to transaction costs and market liquidity, which are important operational considerations but do not directly drive the need to adjust the core hedge ratio for risk exposure.

The ‘zero plus option strategy’ is designed to provide investors with 100% capital preservation at maturity while allowing participation in the upside potential of an underlying asset or index. This is achieved by dividing the initial investment into two main components. A significant portion of the capital (e.g., 80%) is invested in fixed income assets, typically zero-coupon bonds, which are structured to grow to the full initial capital amount by the maturity date. The remaining portion of the capital (e.g., 20%) is then used to purchase call options on the target market index. These call options provide exposure to the index’s appreciation, allowing the fund to participate in any gains without risking the principal amount, which is secured by the fixed income component. The participation share depends on the cost of the call options relative to the capital allocated for them. Other strategies, such as Total Return Swaps, primarily aim to replicate index performance synthetically and do not inherently guarantee capital preservation in the same manner. Direct investment with dynamic allocation or simply purchasing put options represent different approaches to managing risk and return, not the specific ‘zero plus option strategy’ for capital guarantee and upside participation.

Structured warrants listed on SGX-ST employ an ‘Asian style’ expiry settlement. This means that the final day on which the warrant can be traded in the market is distinct from its actual expiry date. Typically, the last trading day occurs before the expiry date, allowing for a period where the warrant is no longer traded but its final settlement value is determined based on the underlying asset’s price at the official expiry. The other options describe scenarios that contradict this specific characteristic of ‘Asian style’ expiry settlement for structured warrants on SGX-ST.

The Zero plus option strategy is explicitly described as appealing to conservative investors who prioritize principal preservation and hold a moderate bullish view on the underlying asset. This strategy allows for participation in upside movements, but with the understanding that if the underlying asset performs exceptionally well, the return will underperform the asset itself. The investor also receives their principal back at maturity in the worst-case scenario, subject to the issuer’s creditworthiness, and must be prepared to hold the investment for the entire tenor due to illiquidity. This perfectly matches the investor’s profile of prioritizing capital protection, having a moderate bullish outlook, seeking upside participation with the mentioned caveat, and being prepared for illiquidity. A Short option strategy, including Dual Currency Investments (DCI), carries substantial downside risk and a negatively skewed risk-reward ratio, making it unsuitable for an investor prioritizing capital protection. While a Constant Proportion Portfolio Insurance (CPPI) strategy also offers principal preservation and participation, the question’s specific mention of a ‘moderate bullish outlook’ and the characteristic of ‘underperformance relative to the asset itself if exceedingly well’ are direct suitability points for the Zero plus option strategy as detailed in the provided text.

Structured warrants listed on SGX-ST are predominantly settled in cash upon expiration, especially if they are in-the-money. The warrant holder does not typically receive physical delivery of the underlying shares. Instead, the cash settlement amount is calculated based on the difference between the market price of the underlying asset and the exercise price, adjusted by the conversion ratio. This mechanism simplifies the settlement process for both the issuer and the holder, aligning with the nature of structured products designed for trading rather than physical delivery. Physical settlement, where the underlying shares are exchanged, is less common for structured warrants on SGX-ST.

The trust deed is a crucial legal document in the operation of a structured fund. Its fundamental purpose is to establish the terms and conditions governing the relationship between investors, the fund manager, and the trustee. It explicitly describes the fund’s investment objectives and clearly delineates the obligations and responsibilities of both the fund manager and the trustee. A key aspect highlighted is the independence of the trustee, who acts as the custodian of the fund’s assets, ensuring that the fund is managed in strict accordance with the trust deed to mitigate the risk of mismanagement by the fund manager. Option 2 describes the Product Highlights Sheet, which is a summary document. Option 3 refers to information typically found in the offering document under ‘Performance of the scheme’. Option 4 relates to details about ‘Subscription of units’ and ‘What Type of Investors Invest in Structured Funds’, also found in the offering document.

A covered call strategy involves buying the underlying stock and simultaneously selling a call option on that stock. The maximum profit for a covered call strategy is realized when the underlying stock price rises to or above the strike price of the call option. In this scenario, the profit is calculated as the strike price minus the initial stock purchase price, plus the premium received from selling the call option. Given: Stock purchase price (S0) = $45.00 Call option strike price (X) = $48.00 Premium received (c0) = $2.50 Maximum Profit = X – S0 + c0 Maximum Profit = $48.00 – $45.00 + $2.50 Maximum Profit = $3.00 + $2.50 = $5.50 This profit is capped at the strike price because if the stock price goes above the strike price, the call option will be exercised, and the investor will be obliged to sell the stock at the strike price, thereby limiting the upside gain.

The scenario describes a structured product’s inherent lack of a fixed or standardized form due to the extensive customization and numerous possible combinations of underlying financial instruments. It highlights the critical need for investors to thoroughly comprehend the specific design and its implications for potential gains and losses. This directly corresponds to the definition of Structure risk. Structure risk arises because the benefits and liabilities of a structured product are highly dependent on how each product is constructed, making it crucial for investors to appreciate the potential downside loss by understanding its unique structure. Correlation risk relates to the likelihood of an event impacting another, liquidity risk concerns the marketability of the product, and early termination risk pertains to losses from premature withdrawal, none of which are the primary focus of the given scenario.

The trust deed is a fundamental legal document for structured funds. It explicitly outlines the investment objectives of the fund and the obligations and responsibilities of both the fund manager and the trustee. The trustee, being independent of the fund manager, plays a crucial role as the custodian of the fund’s assets. Their primary responsibility is to ensure that the fund is managed strictly in accordance with the terms set out in the trust deed, thereby acting as a safeguard against potential mismanagement or deviation from the agreed investment strategy by the fund manager. This mechanism is designed to protect investors’ interests by ensuring the fund operates within its defined parameters.

The principal component of a structured product is specifically designed to address the objective of capital preservation. As outlined in the CMFAS Module 6A syllabus, this component typically involves investing in a fixed income instrument, such as a zero-coupon bond. The purpose of this investment is to ensure that at maturity, the initial capital invested is returned to the investor, thereby protecting it from market losses. The return component, on the other hand, is responsible for generating potential market upside through exposure to underlying assets, often via options. While the principal component can sometimes be used as collateral or for credit risk guarantees, its primary function in a product designed for capital preservation is to safeguard the initial investment.

Pairs trading is a strategy designed to be ‘market-neutral,’ meaning it aims to profit from the relative performance of two assets rather than the overall market direction. This is achieved by taking a long position in one asset and a short position in another, typically correlated, asset. The core premise is that if their prices diverge from historical norms, they will eventually converge back. However, a significant risk is that these perceived anomalies or deviations between the underlying assets may persist for extended periods, or even widen further, without the expected convergence. In such a scenario, the losses from one or both legs of the trade could overwhelm any potential gains, leading to substantial overall financial losses for the investor, despite the initial market-neutral intent. Other risks like margin calls due to leverage or illiquidity of underlying assets are general risks associated with CFDs, while double commissions are a cost, not a risk that fundamentally undermines the strategy’s market-neutral objective in the same way the failure of convergence does.

The correct option accurately distinguishes the early redemption characteristics and consequences for the three product types. For an Equity Linked Structured Note, early redemption is typically not a simple investor-initiated action but is often contingent on specific market events or structural features, such as the underlying asset price hitting a predefined barrier level. If an investor wishes to exit before maturity without such a trigger, they would likely have to sell in a secondary market, potentially at a significant discount. For an Equity Linked Investment-Linked Policy (ILP), while the policy can be surrendered at any time, the terms of the ILP often stipulate that early surrender, especially in the initial years, leads to a substantial loss of the capital invested. This is due to the allocation of initial premiums towards insurance charges and high upfront fees, meaning a smaller portion is invested in the early years. In contrast, Equity Linked Exchange Traded Funds (ETFs) are generally highly liquid and can be bought or sold on a stock exchange on any trading day, similar to regular shares, with standard brokerage fees. Therefore, stating that ETFs are illiquid or that structured notes offer daily exchange liquidity (as in option 2) is incorrect. Similarly, the assertion that early ILP surrender incurs minimal charges (as in option 3) or that all three products have uniform early exit mechanisms and costs (as in option 4) is inaccurate.

Structured warrants listed on SGX-ST operate under an ‘Asian style’ expiry settlement. This means that the last day on which the warrant can be traded is distinct from its actual expiry date. This characteristic is important for investors to understand for managing their positions. Furthermore, structured warrants on SGX-ST are cash-settled, not physically settled, meaning the holder receives a cash payment based on the intrinsic value at expiry rather than the underlying asset itself. Issuers of structured warrants are also required to appoint designated market-makers (DMMs) to ensure liquidity in the market.

Callable Bull/Bear Contracts (CBBCs) are structured products designed to track the performance of an underlying asset. A key characteristic is that their price changes tend to closely follow the price changes of the underlying asset, indicated by a delta close to 1. The conversion ratio specifies how many units of the CBBC correspond to one unit of the underlying asset. If the conversion ratio is N:1, it means N units of the CBBC control 1 unit of the underlying. Consequently, for a single unit of the CBBC, its price movement will be the change in the underlying asset divided by the conversion ratio. In this scenario, a Bull CBBC is held, meaning the investor takes a bullish position. If the underlying index increases by 10 points and the conversion ratio is 5:1, the value of one unit of the Bull CBBC would increase by approximately 10 points / 5 = 2 points. The other options represent common misunderstandings, such as ignoring the conversion ratio, reversing the direction of the price movement for a Bull CBBC, or incorrectly assuming independence from the underlying asset.

UCITS regulations, which govern many ETFs in Europe and are a key part of understanding global ETF structures, stipulate specific limits on counterparty exposure for swap-based (synthetic) ETFs. These regulations are designed to mitigate the risks associated with derivative instruments. Specifically, an ETF is not permitted to invest more than 10% of its prevailing Net Asset Value (NAV) in derivative instruments, including swaps, issued by a single counterparty. This means the maximum amount that a single swap counterparty can owe to the fund is capped at 10% of the fund’s NAV. This limit helps to diversify counterparty risk and protect the fund’s assets.

Arbitrage involves exploiting temporary price discrepancies between different markets for the same or similar assets to generate risk-free profit. When an equity index futures contract is trading at a premium (i.e., it is overvalued) compared to the aggregate value of its underlying constituent stocks in the cash market, an arbitrageur would simultaneously sell the overvalued futures contract and buy the undervalued underlying basket of stocks. This action locks in the profit from the price difference. As the market corrects and the futures price converges with the cash price, the arbitrageur closes both positions, realizing the profit. The second option describes the strategy for when the futures contract is undervalued relative to the cash market. The third option describes a passive approach that misses the arbitrage opportunity. The fourth option describes an options strategy, which is distinct from a direct cash-and-futures arbitrage.

A long butterfly spread, whether constructed with calls or puts, is a neutral options strategy. This means the investor anticipates that the underlying asset’s price will experience minimal movement and remain relatively stable until expiration. The strategy is designed to profit from this lack of significant price fluctuation. A key characteristic of this strategy is that both the potential profit and the maximum loss are limited. The maximum profit is achieved when the underlying price settles exactly at the middle strike price (the strike of the two short options) at expiration. The maximum loss is limited to the initial net debit paid to establish the position. Therefore, a market outlook expecting minimal price movement, coupled with limited profit and limited risk, accurately describes this strategy. Other options suggesting bullish, bearish, or high volatility outlooks, or implying unlimited profit or risk, are incorrect for a long butterfly spread.

The premium of a warrant represents the portion of its market price that exceeds its intrinsic value. To determine the premium, one must first calculate the intrinsic value. For a call warrant, the intrinsic value is the difference between the underlying asset’s market price and the warrant’s exercise price, provided this difference is positive. If the difference is zero or negative, the intrinsic value is zero. In this scenario, the underlying asset is at $10.00 and the exercise price is $9.00, so the intrinsic value is $10.00 – $9.00 = $1.00. Once the intrinsic value is known, the premium is calculated by subtracting the intrinsic value from the warrant’s market price. Given the warrant is quoted at $1.50, the premium is $1.50 (warrant price) – $1.00 (intrinsic value) = $0.50. This $0.50 largely represents the time value of the warrant.

For Over-The-Counter (OTC) options, counterparty credit risk is a significant concern because there is no central clearing house guaranteeing the trades. To mitigate this risk, financial institutions typically sign a Credit Support Annex (CSA). The CSA is a legal document that forms part of the ISDA Master Agreement and defines the terms and conditions for the exchange of collateral between the two parties. This collateral serves to reduce the exposure to potential losses if one counterparty defaults on its obligations. A Master Netting Agreement allows for the offsetting of mutual obligations to reduce overall exposure but does not specifically detail collateral exchange terms in the same way a CSA does for credit risk mitigation. An Exchange-Traded Derivatives (ETD) contract refers to instruments traded on an exchange, where the clearing house acts as the counterparty, thus having a different risk management structure. A Futures Commission Merchant (FCM) mandate relates to the relationship with a broker for futures trading, not directly to bilateral OTC option credit risk mitigation.

The question tests the candidate’s understanding of the specific final settlement price determination for the 3-month Singapore Dollar Interest Rate Futures contract, as outlined in the CMFAS Module 6A syllabus. According to the contract specifications provided, the final settlement price for this particular futures contract is based on the Association of Banks in Singapore’s USD/SGD Swap Offered Rates. This rate is specifically determined at 11:00 am, Singapore time, on the last trading day of the contract. The other options describe settlement mechanisms for different futures contracts mentioned in the syllabus, such as Eurodollar Futures (British Bankers’ Association rates), Euroyen TIBOR Futures (TFX’s final settlement price), or Full-sized 10-year Japanese Government Bond Futures (TSE’s 10-year JGB futures contract opening price), and are therefore incorrect for the 3-month Singapore Dollar Interest Rate Futures.

The basis represents the difference between the spot price of an asset and the futures price of a contract on that asset. In a hedging situation where the asset being hedged is identical to the underlying asset of the futures contract, a fundamental principle of futures markets is that the futures price and the spot price will converge at the contract’s expiry. This convergence means that the difference between them, the basis, will reduce to zero. This ensures that the hedge provides effective price protection up to the expiry date. If the basis did not converge to zero, it would present an arbitrage opportunity. Options suggesting the basis remains constant, widens, or becomes negative at expiry for perfectly matched assets contradict this fundamental principle of futures pricing and hedging effectiveness.

Effective gearing is a crucial metric for warrants, indicating the actual leverage an investor gains, considering the warrant’s sensitivity to the underlying asset’s price movements. It is calculated by multiplying the warrant’s delta by its gearing. First, calculate the gearing: Gearing = Underlying Share Price / Warrant Price. In this scenario, Gearing = $12.00 / $1.50 = 8.0. Next, calculate the effective gearing: Effective Gearing = Delta x Gearing. Given a delta of 0.75, Effective Gearing = 0.75 x 8.0 = 6.0. This means that for every 1% change in the underlying share price, the warrant’s price is expected to change by 6.0% (assuming the delta remains constant).