CMFAS RES6A Quiz 21

UCITS regulations impose strict limits on counterparty risk exposure for funds, including synthetic ETFs that employ swaps for replication. Specifically, UCITS guidelines stipulate that an ETF is not permitted to invest more than 10% of its prevailing Net Asset Value (NAV) in derivative instruments, such as 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 prevailing NAV. This measure is crucial for managing and mitigating concentration risk associated with individual counterparties in swap-based investment strategies.

Extended Settlement (ES) contracts involve leverage, meaning a small percentage change in the underlying asset’s price can lead to a significantly larger percentage change in the investor’s initial capital. First, calculate the total contract value: 1,000 shares $12.00/share = $12,000. Next, determine the initial margin required: 10% of $12,000 = $1,200. Then, calculate the total loss incurred due to the price fall: The share price falls by 5%, which is 5% of $12.00 = $0.60 per share. For 1,000 shares, the total loss is 1,000 shares $0.60/share = $600. Finally, calculate the percentage loss on the initial margin: ($600 loss / $1,200 initial margin) 100% = 50%. This demonstrates the magnifying effect of leverage, where a 5% price movement in the underlying asset results in a 50% loss on the investor’s initial margin.

The investor’s requirements for a hedging instrument include near 100% hedge effectiveness, avoidance of strike price selection complexities, and immunity from time decay as a primary cost. Extended Settlement (ES) contracts are explicitly designed to meet these criteria. As detailed in the CMFAS Module 6A syllabus, ES contracts offer an immediate, near 100% hedge (delta = 1.0), do not require the selection of a strike price, and their cost is primarily the cash to maintain margin, which forms part of the settlement if held to maturity, rather than an initial premium subject to time decay. In contrast, put warrants, while offering downside protection, have hedging effectiveness that depends on the strike price and time to expiry (at-the-money delta = 0.5) and involve an initial premium subject to time decay. A call warrant would not be suitable for hedging a long position against price falls. A synthetic short position, though achieving a delta of 1.0, involves two separate transactions (long put and short call) and their associated costs, making it more complex than a direct ES contract for this specific need.

A structured note is fundamentally a debt instrument, often referred to as a debenture, whose return characteristics are linked to the performance of other underlying instruments. The principal component is essentially a debt instrument, meaning investors depend on the issuer for repayment, though this repayment is often not guaranteed. The return component, however, is typically derived from one or more embedded options or derivatives, which provide exposure to the chosen asset class. Note holders generally do not have a direct claim over these underlying instruments. Structured notes are governed by the Securities and Futures Act (SFA) and are subject to prospectus requirements, unless they are offered exclusively to Accredited Investors. Therefore, the most accurate description highlights its dual nature as a debt instrument with a derivative-driven return.

Legal risk for structured products highlights that investors typically own units of the structured product itself, not the underlying financial instruments directly. Therefore, in the event of an issuer’s default, ownership or legal rights to the underlying instruments do not automatically transfer to the investor. The investor’s claim is against the issuer of the structured product, usually as an unsecured creditor, rather than a direct claim on the underlying assets. The other options describe scenarios where investors would have direct or preferential rights to the underlying assets, which is generally not the case for structured product unit holders.

Structured warrants listed on SGX-ST typically employ the Asian style of expiry settlement. A key characteristic of this style, as outlined in the CMFAS Module 6A syllabus, is that the settlement price is determined by taking the arithmetic average of the official closing price of the underlying asset for the five market days immediately preceding the expiration date. This mechanism aims to reduce the impact of price volatility on a single day. Other options, such as using the closing price on the last trading day or the expiry date itself, or the highest price, do not align with the specified settlement procedures for structured warrants on SGX-ST.

When an Exchange Traded Fund (ETF) aims to track an index in a market with significant foreign ownership restrictions or operational difficulties for direct asset acquisition, synthetic replication is typically the most effective approach. This method involves using derivative instruments, such as total return swaps, to gain exposure to the index’s performance without directly holding the underlying securities. While this allows access to otherwise restricted markets, it introduces counterparty risk, as the ETF’s performance becomes dependent on the creditworthiness of the derivative issuer or swap counterparty. Full physical replication and representative sampling are forms of direct replication, which involve purchasing the actual underlying securities. These methods would be challenging or impossible to implement effectively in a market with stringent foreign ownership restrictions. A cash-based approach, while avoiding direct security purchases, is generally not suitable for tracking an equity index’s performance accurately.

To calculate the net profit for a Contracts for Differences (CFD) trade, one must first determine the gross profit or loss from the price movement of the underlying asset, and then deduct all associated expenses. 1. Calculate Initial Purchase Value: 8,000 shares $4.20 = $33,600 2. Calculate Buy Transaction Costs: Commission (Buy): $33,600 0.35% = $117.60 GST on Commission (Buy): $117.60 7% = $8.232 Total Buy Transaction Cost: $117.60 + $8.232 = $125.832 3. Calculate Final Sale Value: 8,000 shares $4.50 = $36,000 4. Calculate Sell Transaction Costs: Commission (Sell): $36,000 0.35% = $126.00 GST on Commission (Sell): $126.00 7% = $8.82 Total Sell Transaction Cost: $126.00 + $8.82 = $134.82 5. Calculate Financing Interest: The financing interest is based on the initial value of the position ($33,600). Daily financing rate: 5.5% / 360 days = 0.00015277… Daily interest: $33,600 (5.5% / 360) = $5.13333… Total financing interest for 7 days: $5.13333… 7 = $35.93333… 6. Calculate Total Expenses: Total Expenses = Total Buy Transaction Cost + Total Sell Transaction Cost + Total Financing Interest Total Expenses = $125.832 + $134.82 + $35.93333… = $296.58533… Rounded to two decimal places: $296.59 7. Calculate Gross Profit: Gross Profit = Final Sale Value – Initial Purchase Value Gross Profit = $36,000 – $33,600 = $2,400 8. Calculate Net Profit: Net Profit = Gross Profit – Total Expenses Net Profit = $2,400 – $296.58533… = $2,103.41466… Rounded to two decimal places, the net profit is $2,103.41.

Auto-callable structured products are designed such that the issuer has the discretion to redeem the product early if specific conditions, often related to the underlying asset’s performance, are met. This feature means that investors do not control the timing of the redemption. As a result, a primary risk for investors is the uncertainty surrounding the actual holding period of their investment, as the issuer’s decision dictates when the product might be called. This is commonly referred to as call risk. Additionally, an early redemption could lead to reinvestment risk, where the investor has to find a new investment for the returned capital, potentially at a less favourable rate. The investor does not retain the exclusive right to early redemption; instead, they effectively sell this right to the issuer in exchange for potentially higher yields. While early redemption is contingent on underlying asset performance reaching a threshold, it is still the issuer’s discretion to call, and this does not guarantee a minimum holding period. The redemption amount can also vary based on the product’s terms, and early calls introduce, rather than eliminate, reinvestment concerns.

To construct a synthetic short call position, an investor needs to combine a short position in the underlying asset with a short put option. This strategy effectively replicates the risk and reward characteristics of directly selling a call option. The other combinations listed result in different synthetic positions: a long underlying and long put creates a synthetic long call; a short underlying and long call creates a synthetic long put; and a long underlying and short call creates a synthetic short put.

The passage explicitly states, ‘There is a trade-off between the barrier level and the rebate payable to the investor if a knock-out event occurs. For a higher rebate, the knock-out strike level will be lower.’ This indicates an inverse relationship: to receive a higher rebate upon a knock-out, the barrier level (which is set as a percentage higher than the strike price) must be set at a lower point. A lower barrier level means the underlying asset price has to rise less to trigger the knock-out, making the event more probable. To compensate for this increased likelihood of early termination, the product is structured to offer a more attractive rebate. Conversely, a higher barrier level makes the knock-out event less likely, and therefore, the rebate offered would typically be lower.

When a portfolio manager seeks to hedge a diversified equity portfolio using index futures, the primary objective is to offset the portfolio’s systematic risk. The effectiveness of this hedge, particularly in determining the quantity of futures contracts, hinges on two critical factors. Firstly, the portfolio’s beta measures its sensitivity to overall market movements. A higher beta indicates greater sensitivity, requiring more futures contracts to achieve the desired hedge ratio. Secondly, the modified portfolio value represents the current market value of the portfolio being hedged, adjusted for any specific considerations. These two factors directly influence the calculation of the appropriate number of futures contracts needed to establish a hedge that effectively mitigates market risk. Other factors like interest rates, liquidity, historical volatility, time to expiry, dividend yields, or tick size, while relevant to futures trading or pricing in general, are not the primary determinants for calculating the number of contracts for a market-risk hedge as outlined in the syllabus.

The trust deed is a critical legal document for a structured fund. It outlines the terms and conditions governing the relationship between investors, the fund manager, and the trustee. A key aspect highlighted in the syllabus is the trustee’s independence from the fund manager. The trustee’s fundamental role is to act as the custodian of the fund’s assets, meaning they hold the assets on behalf of the investors. Furthermore, the trustee is responsible for ensuring that the fund manager adheres to the terms and conditions set out in the trust deed, thereby safeguarding investor interests and minimizing the risk of mismanagement. The other options describe roles typically performed by the fund manager, investment adviser, or fund administrator, not the primary, independent oversight and custodial function of the trustee.

Vertical spreads are defined by using options of the same underlying security and the same expiration month, but with different strike prices. This directly matches the scenario described in the question. Horizontal spreads (also known as calendar spreads) involve options with the same underlying security and strike prices but different expiration dates. Diagonal spreads combine elements of both vertical and horizontal spreads, featuring options with different strike prices and different expiration dates. A Condor spread is a variation of the butterfly spread, involving four options with four different strike prices, which does not fit the description of same expiration month and different strike prices as the primary defining characteristic.

Exchange Traded Notes (ETNs) are fundamentally different from Exchange Traded Funds (ETFs) in their structure. ETNs are debt securities issued by financial institutions, typically banks. This means that when an investor purchases an ETN, they are essentially acquiring a promise from the issuing bank to pay a return linked to the performance of an underlying index, minus any fees. As such, the investor is exposed to the credit risk, or counterparty risk, of the issuing bank. If the issuing bank were to face financial distress or default on its obligations, the investor could potentially lose their investment, regardless of how the underlying index performs. In contrast, a typical ETF is a fund that holds a portfolio of underlying assets, and its value is derived from these assets. While ETFs carry market risk and tracking risk, they generally do not expose investors to the direct credit risk of an issuer in the same manner as ETNs, as the fund’s assets are typically held separately from the fund manager’s balance sheet.

Reverse convertibles are structured products specifically designed to offer enhanced yields to investors. Their construction typically involves two main components: a long position in a zero-coupon bond and a short position in a put option. The zero-coupon bond provides a low-risk component, while the short put option introduces the higher-risk element and generates premium income. The combination of interest accretion from the bond and the premium from selling the put option contributes to the attractive yield. However, this product caps the investor’s upside return at a specific level, which is the sum of the bond’s interest and the put option premium. Crucially, the investor faces full downside exposure to the underlying asset if its price falls significantly, as dictated by the terms of the short put option. This results in an asymmetric return profile where positive returns are capped, but potential losses can extend to the full investment amount. Discount certificates, while having a similar payoff profile, are constructed differently, typically using a long zero-strike call option and a short call option. Products like equity-linked notes with capital protection or principal-protected notes are designed to safeguard the initial capital, which contradicts the full downside exposure characteristic of a reverse convertible.

The question describes a situation where the underlying asset of a structured warrant is denominated in a foreign currency, but the settlement is expected in Singapore Dollars. This specific characteristic, where the settlement and trading currency (home currency of the investor) differs from the underlying’s currency, is the defining feature of a Currency Translated Warrant. The provided text explicitly states this, giving an example of a warrant on the Hang Seng Index (HKD underlying) traded on SGX-ST with settlement in SGD. While the underlying could potentially be an index or a commodity, the critical element highlighted is the currency translation for settlement, making ‘Currency Translated Warrant’ the most accurate classification. Index Warrants are defined by their underlying being an index, and typically handle corporate actions internally. Basket Warrants have a pre-defined group of shares as their underlying. Yield Enhanced Securities focus on a specific payout structure designed to offer an attractive yield or discount, not primarily on currency translation.

The question addresses the risk of an ETF trading at a discount or premium to its Net Asset Value (NAV). The provided text explicitly states that price discrepancies, such as an ETF trading at a discount or premium, can arise for ETFs tracking specific markets or sectors that are subject to direct investment restrictions (e.g., China A-shares). Such restrictions hinder arbitrageurs from efficiently accessing the underlying assets to create or redeem ETF shares, which is the mechanism that typically keeps an ETF’s market price close to its NAV. Therefore, direct investment restrictions are a primary cause for a persistent discount. Regarding the other options: – Low trading volume on the local exchange (Option 2) does not inherently cause a persistent discount to NAV. The liquidity of an ETF is primarily measured by the liquidity of its underlying index constituents, not just its own trading volume on the exchange, as arbitrageurs can create/redeem shares in the primary market if the underlying is accessible. – High frequency of rebalancing (Option 3) would primarily contribute to tracking error, which is the disparity between the ETF’s performance and its underlying index, due to transaction costs and changes in index composition. It does not directly explain a persistent discount to NAV. – Engaging in extensive securities lending (Option 4) is a practice that can expose a physical replication ETF to counterparty risk if the borrower defaults. While it is a risk, it does not directly cause the ETF to trade at a persistent discount to its NAV; rather, it’s a risk of loss if the counterparty fails to honor commitments.

The question describes a situation where the 3-year Auto-Redeemable Structured Fund reaches its maturity date without an early redemption. According to the product terms for ‘Payout If Product Is Not Terminated Early’, if the performance of the Nikkei 225 index is greater than or equal to the performance of the S&P 500 index at the valuation time on the relevant early redemption observation date (or maturity date in this case), the payout is 125.5% of the initial investment. In the given scenario, Nikkei 225 performance (+20%) is indeed greater than S&P 500 performance (+15%). Therefore, the payout would be 125.5% of SGD 100,000, which equals SGD 125,500. The option of SGD 100,000 would apply if the S&P 500 performance had been greater than Nikkei 225 performance. The options of SGD 112,750 and SGD 104,250 relate to potential early redemption payouts based on the periodic yield, which is not applicable when the fund reaches maturity without an early call.

To determine the net profit or loss from a short CFD position, several components must be calculated: the initial sale value, the closing purchase value, transaction costs for both the opening and closing trades, and financing interest. 1. Calculate Initial Sale Value: 15,000 shares $2.50/share = $37,500.00 2. Calculate Commission on Sale: $37,500.00 0.35% = $131.25 3. Calculate GST on Sale Commission: $131.25 8% = $10.50 4. Calculate Total Transaction Cost (Sell): $131.25 + $10.50 = $141.75 5. Calculate Closing Purchase Value: 15,000 shares $2.35/share = $35,250.00 6. Calculate Commission on Purchase: $35,250.00 0.35% = $123.375 (rounded to $123.38) 7. Calculate GST on Purchase Commission: $123.38 8% = $9.8704 (rounded to $9.87) 8. Calculate Total Transaction Cost (Buy): $123.38 + $9.87 = $133.25 9. Calculate Financing Interest: Daily interest rate: 5.5% / 360 days = 0.00015277… Daily interest amount: $37,500.00 (5.5% / 360) = $5.72916… (rounded to $5.73 per day) Total financing interest for 7 days: $5.73 7 = $40.11 10. Calculate Total Expenses Incurred: $141.75 (Sell) + $133.25 (Buy) + $40.11 (Financing) = $315.11 11. Calculate Net Profit/Loss: Profit from price movement: $37,500.00 (Sale) – $35,250.00 (Purchase) = $2,250.00 Net Profit: $2,250.00 – $315.11 (Total Expenses) = $1,934.89 Since the share price dropped, a short position results in a profit from the price movement, which is then reduced by the total expenses.

A futures pack is a specialized futures order type designed for the simultaneous purchase or sale of a predefined number of futures contracts, specifically four consecutive delivery months, as a single transaction. This mechanism is introduced to create or liquidate positions along a particular segment of the yield curve while eliminating ‘legging risk’ – the risk of not being able to complete all legs of a spread or strategy due to partial fills. In contrast, a futures bundle covers a longer period, typically two or more years of consecutive quarterly delivery months. Placing individual orders for a series of futures contracts would not mitigate legging risk as effectively. A calendar spread option is an options strategy, not a futures order type for directly managing interest rate exposure across consecutive futures contracts in this manner.

A vertical spread is characterized by options of the same class (e.g., all calls or all puts), on the same underlying security, with the same expiration month, but with different strike prices. In the given scenario, the investor is buying a call at one strike price and selling another call at a different strike price, both for the same underlying and expiration month. This perfectly aligns with the definition of a vertical spread. A horizontal (or calendar) spread involves options with the same strike price but different expiration dates. A diagonal spread involves options with different strike prices and different expiration dates. A butterfly spread is a more complex strategy typically involving four options at three different strike prices.

Structured funds are fundamentally distinguished from traditional mutual funds by their use of derivatives to achieve synthetic returns linked to an underlying asset. This approach, as outlined in the syllabus, inherently introduces or increases certain risks. Specifically, the text states that structured funds ‘aim to replicate the underlying asset or to provide a synthetic return linked to the underlying asset of the fund by incorporating derivatives’ and that ‘Counterparty risk is more present in structured funds as compared to traditional mutual funds.’ Therefore, their reliance on derivatives and the associated higher counterparty risk is a defining characteristic. Other options describe different fund types or misrepresent the nature of structured funds. For instance, passive replication of a benchmark index through direct holdings is characteristic of trackers, not structured funds. Active management discretion without derivatives is typical of traditional mutual funds. Structured funds do not guarantee fixed returns and are exposed to various market risks, making the option about guaranteed fixed returns incorrect.

A diagonal spread is a type of option strategy constructed using options on the same underlying security but with both different strike prices and different expiration dates. This combination of varying strike prices and expiration dates is the defining characteristic that distinguishes it from other spread types. A vertical spread involves options with the same expiration date but different strike prices. A horizontal, or calendar, spread involves options with the same strike price but different expiration dates. A condor spread is a variation of a butterfly spread, typically involving four options with four different strike prices, but the primary defining feature of a diagonal spread is the simultaneous difference in both strike and expiration.

This question tests the understanding of a Dual Currency Investment (DCI) and its potential outcomes, particularly in a ‘worst-case scenario’ as described in the CMFAS Module 6A syllabus. In a DCI, if the alternate currency strengthens or remains above the strike price at maturity, the investor receives the principal plus interest in the base currency (best case). If the alternate currency weakens below the strike price, the investor receives a pre-determined amount of the alternate currency. This alternate currency then needs to be converted back to the base currency at the prevailing spot rate. The breakeven level is the exchange rate at which the converted alternate currency amount equals the initial principal. If the spot rate at maturity is below this breakeven level, the investor will receive less than their initial principal when converting the alternate currency back to the base currency, resulting in a loss of principal. In the given scenario, the maturity rate of EUR/SGD (1.4200) is below both the strike price (1.4500) and the breakeven level (1.4350). Therefore, the investor will receive the alternate currency (EUR), and upon converting it back to SGD at 1.4200, will incur a loss of the initial principal.

The question focuses on how a Callable Bull/Bear Contract (CBBC) addresses the risk of sudden, adverse price movements. The mandatory call feature is a defining characteristic of CBBCs. It dictates that if the underlying asset’s price reaches a pre-determined barrier level, the contract automatically terminates early. For a bull contract, if the underlying price falls to or below the call price, the contract is called, preventing further losses beyond that point. While this also means the investor cannot participate in any subsequent recovery, it serves as a built-in mechanism to limit downside exposure in the event of a sharp, adverse movement. Other options describe true characteristics of CBBCs but do not directly address the mechanism for managing sudden, adverse price movements in the context of loss limitation. The delta being close to 1 describes price tracking, fixed lifespan describes duration, and N-CBBC describes residual value, none of which directly explain how sudden adverse movements are managed by early termination.

Equity Linked Exchange Traded Funds (ETFs) are designed for trading on a stock exchange, which means investors can typically buy and sell units throughout the trading day at market prices. This characteristic provides a high degree of liquidity and a straightforward mechanism for exiting the investment. In contrast, Equity Linked Structured Notes and Structured Funds often have early redemption features that are conditional, depending on specific triggers or barrier options embedded within their complex structures. While an Equity Linked Investment-Linked Policy (ILP) allows for policy surrender, doing so prematurely often incurs significant surrender charges or penalties, making it a less ‘frictionless’ or ‘minimal cost’ option for a quick exit.

The Direct Market Access (DMA) model for Contracts for Differences (CFDs) is characterized by its pricing transparency. In this model, the CFD trade price is directly based on the underlying asset’s market price, which is observable by the investor. This means the investor gets direct access to the market where the underlying asset is traded, ensuring that the pricing is clear and not subject to the CFD provider’s discretion. In contrast, while a market-maker model aims for liquidity and efficient pricing, the bid-ask spread is at the discretion of the CFD provider and is not transparent to investors. Exchange-traded CFDs are mentioned as an exception to counterparty risk, but the provided text does not detail their pricing transparency in the same comparative manner as DMA and market-maker models. A ‘hybrid model’ is not presented as a primary distinct model in the context of pricing transparency in the given syllabus material.

To determine if a knock-out event has occurred, each index’s observed level must be compared to 75% of its initial level. A knock-out event is triggered if any index falls below this 75% threshold. Let’s calculate the percentage of the initial level for each index: Index P: (Observed Level 1900 / Initial Level 2500) 100% = 76%. This is not below 75%. Index Q: (Observed Level 88 / Initial Level 120) 100% = 73.33%. This is below 75%. Index R: (Observed Level 6100 / Initial Level 8000) 100% = 76.25%. This is not below 75%. Index S: (Observed Level 380 / Initial Level 500) 100% = 76%. This is not below 75%. Since Index Q’s observed level (73.33%) is below the 75% threshold, a knock-out event has occurred. The first option correctly identifies this. The second option is incorrect because Index P’s level, while close, is not below the 75% threshold. The third option is incorrect because Index Q did trigger the event. The fourth option introduces an incorrect criterion (collective average decline) not relevant to the defined knock-out condition.

A bear put spread is a strategy employed when an investor expects a moderate decrease in the price of an underlying asset. It involves buying a put option with a higher strike price and simultaneously selling a put option with a lower strike price, both for the same underlying asset and expiration date. The maximum potential profit for this strategy is calculated as the difference between the two strike prices minus the net debit paid to establish the position. In this scenario, the investor buys a put with a $60 strike for $7.00 and sells a put with a $50 strike for $2.00. The net debit is the premium paid minus the premium received, which is $7.00 – $2.00 = $5.00. The difference between the strike prices is $60 – $50 = $10.00. Therefore, the maximum profit is $10.00 (difference in strikes) – $5.00 (net debit) = $5.00. This maximum profit is realized if the underlying stock price closes at or below the lower strike price ($50) at expiration.