CMFAS RES6A Quiz 20

Auto-callable structured products typically offer a higher potential yield to investors because investors effectively sell the right to early redemption to the issuer. This means the issuer has the discretion to call the product back early if certain conditions are met, such as the underlying asset reaching a predefined level. While this provides the issuer with flexibility, it exposes the investor to call risk, meaning the investment may be redeemed earlier than anticipated, and reinvestment risk, as the investor may have to reinvest the proceeds at a lower prevailing interest rate or in less attractive opportunities. The higher yield is essentially compensation for the investor taking on this call and reinvestment risk. The product does not guarantee full capital protection in all cases, nor does the investor have the exclusive right to early redemption. Furthermore, these products inherently involve embedded options, and their returns are not solely from direct participation in the underlying asset’s performance.

To hedge equity risk, the number of futures contracts (N) required is calculated using the formula: N = (Current Value of Portfolio (VP) / Value of each Futures Contract) Beta of Portfolio (β). In this scenario, the Current Value of Portfolio (VP) is SGD 15,000,000. The Beta of the stock portfolio (β) is 1.20. The Value of each STI Index futures contract is SGD 125,000. Plugging these values into the formula: N = (15,000,000 / 125,000) 1.20. First, calculate the ratio of the portfolio value to the contract value: 15,000,000 / 125,000 = 120. Then, multiply this result by the portfolio’s beta: 120 1.20 = 144. Therefore, Alex Chen needs to sell 144 futures contracts to hedge the portfolio’s market risk.

For the 3-month Singapore Dollar Interest Rate Futures contract, the provided specifications clearly state that its last trading day is ‘2 business days preceding the 3rd Wednesday of the expiring contract month’. Furthermore, the final settlement price for this specific contract is ‘Based on the Association of Banks in Singapore’s USD/SGD Swap Offered Rates determined at 11.00 am, Singapore time, on the last trading day’. The other options describe the last trading day and final settlement price mechanisms for different futures contracts detailed in the Appendix C, such as the Euroyen TIBOR Futures, Full-sized 10-year Japanese Government Bond Futures, or the unnamed interest rate futures contract mentioned first in the appendix.

When a structured note is issued through a Special Purpose Vehicle (SPV), the SPV is established as a separate legal entity from the financial institution that set it up. The notes are issued directly by the SPV, and the SPV uses the proceeds to acquire its own assets. A key characteristic of this structure is that the SPV’s assets and liabilities are not reflected on the balance sheet of the establishing financial institution, making it an ‘off-balance-sheet’ arrangement from the institution’s perspective. Consequently, in the event of a default, noteholders can only make a claim on the assets held by the SPV. They generally have no recourse to the financial institution that created the SPV. Therefore, the investor’s credit risk exposure is primarily to the creditworthiness of the SPV and its specific underlying assets, not directly to the establishing institution. Options suggesting full exposure to the establishing institution’s credit risk, consolidation of liabilities, or coverage by the Deposit Insurance Scheme are incorrect. Structured notes, whether directly issued or via an SPV, are not covered by the Deposit Insurance Scheme in Singapore, and there is no implicit or explicit guarantee from the establishing institution that provides recourse to its balance sheet for SPV-issued notes.

The Constant Proportion Portfolio Insurance (CPPI) strategy is designed to maintain a minimum portfolio value (the floor) by dynamically allocating between a risky asset and a risk-free asset. The allocation to the risky asset increases as the portfolio value rises above the floor and decreases as it approaches the floor. A critical risk of CPPI, as highlighted in the syllabus, occurs when there is a sharp and sudden decline in asset prices, especially after events like a major deleveraging. In such a scenario, the portfolio value can rapidly drop to or below its protected floor. When this happens, the strategy mandates that the entire fund be allocated to the risk-free asset to preserve the capital at the floor level. Once fully invested in the risk-free asset, the portfolio loses its ability to participate in any subsequent appreciation of the underlying risky asset, even if the market recovers. This outcome directly corresponds to a sharp market downturn causing the portfolio to hit its floor. Other market conditions, such as a steady increase or extreme euphoria, would typically lead to a higher allocation to risky assets. A range-bound market might lead to ‘buying high and selling low’ but doesn’t necessarily force a full allocation to risk-free assets unless the floor is breached.

For a Mandatory Call Event (knock-out trigger) to occur, all specified conditions must be simultaneously met. Based on the product terms, these conditions are: 1. The event must occur after the initial 1.5-year call protection period. The initial date was 16 December 2014, so the call protection ended on 16 June 2016. The observation date of 15 December 2017 is after this period, so this condition is met. 2. The event must occur on an Early Redemption Observation Date. 15 December 2017 is listed as one of the Early Redemption Observation Dates, so this condition is met. 3. The closing index level of ‘ANY 4’ of the underlying indices (Index1-4) on the Early Redemption Observation Date must be < 75% of the initial level. Since there are exactly four underlying indices, 'ANY 4' implies that all four indices must fall below the 75% threshold. In the given scenario, Index A (70%) and Index C (72%) are below 75%. However, Index B (80%) and Index D (78%) are not below 75%. Therefore, the condition that all four indices must be below 75% is not met. Since not all conditions for the Mandatory Call Event are satisfied, the event is not triggered. Option 2 is incorrect because while the observation date is past the call protection, the critical condition regarding the number of indices falling below the threshold is not met. Option 3 is incorrect because the condition specifies 'ANY 4' (meaning all four in this context), not just a majority. Option 4 is incorrect because 15 December is indeed an Early Redemption Observation Date, as explicitly stated in the product terms.

UCITS regulations, which govern many European ETFs, impose specific limits on counterparty risk. For derivative instruments such as swaps, a UCITS-compliant ETF is restricted from having more than 10% of its prevailing Net Asset Value (NAV) exposed to a single counterparty. This limit applies to the amount the swap counterparty owes to the fund and is monitored on a daily mark-to-market basis. This measure is crucial for managing and mitigating potential risks associated with the default of a counterparty in synthetic replication strategies.

The question pertains to the final settlement price methodology for the 5-year Singapore Government Bond futures contract. According to the specifications, the final yield for all bonds in the selected basket is derived by weighting the yield of a benchmark bond within that basket. The remaining weighting is then equally distributed over the yields of the other bonds in the basket. Therefore, the method involving weighting a designated benchmark bond’s yield is the correct approach for deriving the final yield from the basket. Other options describe either incorrect methods or steps involved in calculating individual bond yields before the final weighting process, rather than the overall derivation of the final yield from the entire basket.

Principal preservation in a structured product means that a portion of the investment is typically allocated to fixed income securities with the aim of returning the initial capital at maturity. However, this does not constitute a guarantee, as the underlying fixed income securities are subject to default risk, which can impact the value of the entire structured product. This feature generally results in a lower product cost compared to a principal guarantee, which involves additional collateral or investment insurance and is priced into the product, making it more expensive. Structured products with preservation features can still be considered high risk. Early termination of such products can lead to losses on the initial investment, and liquidity is generally low, requiring investors to be prepared to hold the product until maturity to maximize its full value.

A long strangle strategy involves simultaneously buying a slightly out-of-the-money (OTM) put and a slightly out-of-the-money (OTM) call of the same underlying stock and expiration date. This strategy is ideal when an options trader anticipates significant volatility in the underlying asset but is unsure of the direction of the price movement. Compared to a long straddle, which uses at-the-money (ATM) options, a long strangle typically has a lower initial premium cost because OTM options are generally cheaper than ATM options. This aligns with the objective of minimizing initial capital outlay while still positioning to profit from substantial price swings. Both bull call spreads and bear put spreads are directional strategies, meaning they are used when an investor has a specific view on whether the market will move up or down, making them unsuitable for a neutral outlook that expects volatility without a clear directional bias.

The correct statement highlights a key difference between Contracts for Differences (CFDs) and equity futures contracts regarding dividend entitlements. CFD investors are typically entitled to receive dividend payments from the underlying shares, with adjustments made to their account. In contrast, holders of equity futures contracts are generally not entitled to such dividend payments. This is a crucial distinction for investors whose strategy involves benefiting from dividends. The other options describe characteristics that are either incorrect or reversed when comparing CFDs and equity futures. Equity futures have fixed maturity dates, while CFDs can be extended or rolled over. CFDs are mostly traded Over-The-Counter (OTC), leading to counterparty risk, whereas equity futures are traded on exchanges, mitigating this risk. Lastly, CFDs have explicitly computed financing costs, while for equity futures, these costs are implicit and embedded in the quoted price.

UCITS regulations, which govern many European-domiciled ETFs, stipulate a strict counterparty risk limit. 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 limit applies to the marked-to-market value of the swap on a daily basis. If the exposure to a single counterparty approaches or reaches this 10% threshold due to market fluctuations, the ETF manager has a regulatory obligation to take action to reduce this exposure. This could involve reducing the size of the swap, entering into offsetting transactions, or diversifying the swap exposure across multiple counterparties to ensure continuous compliance. The other options describe actions that are either not mandated by the regulations in this specific scenario, are incorrect interpretations of the rules, or represent an extreme outcome not directly implied as the immediate necessary action.

When a mandatory call event is triggered for a Bull contract, the contract is terminated, and the holder receives a residual value. This residual value is calculated based on the difference between the settlement price (the spot price at which the knock-out event occurred) and the strike price, divided by the conversion ratio. In this scenario, the spot price fell to $27.00, which is below the Call Price of $28.00, triggering the mandatory call. The settlement price for the residual value calculation is $27.00. The strike price is $25.00, and the conversion ratio is 5:1. Therefore, the residual value per contract is calculated as ($27.00 – $25.00) / 5 = $2.00 / 5 = $0.40. The financial cost and time to maturity are not relevant for calculating the residual value upon a mandatory call event.

The scenario describes a situation where a software glitch, an internal system failure within the fund management company’s proprietary trading system, leads to the misexecution of client orders. This directly falls under the definition of operational risk, which includes risks arising from inadequate or failed internal processes, people, and systems. Issuer risk relates to the financial stability and ability of a product issuer to meet its obligations. Concentration risk pertains to the lack of diversification in an investment portfolio. Basis risk is specific to futures contracts, referring to the difference between the futures price and the cash price of an underlying asset.

The question describes a situation requiring a highly specific and non-standardized hedge for a unique business need. In such cases, forward contracts are the most suitable derivative instrument. Forwards are private agreements negotiated directly between two parties, allowing for complete customization of terms such as the underlying asset, quantity, quality, delivery location, and settlement date. This flexibility is crucial when market-standardized contracts (like futures) do not precisely match the required specifications. While futures offer advantages like exchange-traded liquidity, price discovery, and reduced counterparty risk through a clearing house and mark-to-market procedures, their standardized nature makes them unsuitable for bespoke hedging requirements. Therefore, the capacity for direct negotiation and tailored terms is the most critical characteristic for addressing a unique, non-standardized exposure.

The scenario describes an ETF needing to track an index that includes assets with foreign investment limitations and low liquidity, leading the fund manager to use derivative instruments. This approach is characteristic of synthetic replication (either derivative embedded or swap-based). A fundamental aspect of synthetic replication, as outlined in the CMFAS Module 6A syllabus, is the reliance on the creditworthiness of the counterparty(ies) providing the derivatives. Singapore’s regulatory framework for such funds (e.g., Code on CIS or UCITS) addresses this by imposing a maximum of 10% net counterparty exposure. This requires the counterparty to collateralise the ETF, typically for the remaining 90%, with the collateral held by a third-party custodian and owned by the ETF’s trustee. Therefore, a critical consideration for investors is the management of counterparty credit risk and ensuring adherence to these regulatory exposure limits. The other options describe aspects of direct replication methods or misinterpret the primary risks associated with synthetic replication in the given context.

A bull call spread is a vertical spread created by simultaneously purchasing a call option with a lower strike price (often in-the-money) and selling a call option with a higher strike price (often out-of-the-money), both on the same underlying security and with the same expiration date. This strategy is designed for investors who anticipate a moderate increase in the price of the underlying asset. Its key features include a limited maximum profit and, crucially, a limited maximum loss, which is equal to the net debit paid to establish the position. The sale of the higher strike call helps to offset the cost of buying the lower strike call, thereby reducing the initial premium outlay compared to simply buying a single long call option. A long strangle, on the other hand, is suitable for anticipating large price movements in either direction, not specifically a moderate bullish move, and typically involves a higher initial outlay. A naked long call provides unlimited upside potential but also carries a higher initial cost and a maximum loss equal to the full premium paid, without the benefit of a reduced outlay or capped loss provided by a spread. A bear put spread is a strategy employed when an investor expects the price of the underlying asset to decline, which is contrary to the moderately bullish outlook described in the scenario.

A structured note is fundamentally a debt instrument or debenture whose return characteristics, including coupon payments or market value, are linked to the performance of underlying instruments. It typically combines a principal component, which is a debt instrument, with a return component, often in the form of one or more embedded derivatives or options. This derivative component provides exposure to the chosen asset class, such as commodities in this scenario. Crucially, the note holder does not typically have a direct claim or ownership over the underlying instruments. Furthermore, principal repayment is often not guaranteed and can be exposed to the performance of the underlying assets, distinguishing it from traditional bonds with guaranteed principal. Therefore, the option stating it is a debt instrument combined with derivatives, where principal repayment can be exposed to underlying performance, accurately captures its fundamental nature. Options suggesting direct ownership, solely fixed returns, or guaranteed capital preservation are incorrect as they misrepresent the core characteristics of structured notes.

Structured funds are distinct from traditional mutual funds in their operational model. Traditional mutual funds typically rely on the fund manager’s active expertise and discretionary decisions regarding asset allocation to achieve their investment objectives. In contrast, structured funds are designed to replicate the performance of an underlying asset or provide a synthetic return linked to it. This is often achieved by incorporating derivatives and employing static or rule-based allocation decisions, rather than active management. While some structured funds may offer capital preservation, this is a specific feature of certain products, not a universal primary goal, and they are not restricted to investing only in physical assets; synthetic replication using derivatives is a common method.

A Contract for Differences (CFD) is a derivative product that allows an investor to speculate on the price movements of an underlying asset, such as a company’s shares, without actually owning the asset. A key feature of equity CFDs is that investors holding a long position are entitled to receive cash dividends on the underlying stock, and participate in other corporate actions like share splits, similar to direct shareholders. However, a crucial distinction is that CFD investors do not hold direct ownership of the underlying shares and, consequently, are not entitled to any voting rights. This perfectly aligns with the investor’s objective of benefiting from price appreciation and dividends while avoiding direct ownership obligations and voting privileges. Purchasing shares of an Exchange Traded Fund (ETF) would involve owning units of a fund, not direct shares of the specific company, and the ETF itself would hold the voting rights. Directly acquiring the company’s ordinary shares would grant direct ownership, obligations, and voting rights, which the investor explicitly wishes to bypass. A long position in an American-style call option provides exposure to price appreciation but typically does not entitle the holder to dividend distributions unless exercised, which would then lead to direct ownership and voting rights, contrary to the investor’s stated goal.

Extended Settlement (ES) contracts are particularly appealing to speculative investors because they offer significant leverage. This means an investor can control a large notional value of the underlying shares by putting up only a small initial margin. While this leverage can amplify potential gains from favorable price movements, it equally magnifies losses when the market moves against the investor. A relatively small percentage decline in the underlying asset’s price can lead to a substantially larger percentage loss on the investor’s initial margin. The extended settlement period is a feature, but the primary risk amplified by it is not necessarily ‘unforeseen market-wide systemic risks’ as directly as leverage amplifies losses. Physical delivery is a settlement mechanism, not the primary appeal for a speculator, and its associated risks are different. A fixed contract price is part of the contract’s nature, but the risk described in that option is not the most direct or magnified consequence of the feature that enables small capital outlay for speculative gains.

To construct a synthetic short put position, an investor needs to combine a long position in the underlying asset with a short call option on that same asset, with the same expiration date and strike price. This combination replicates the payoff profile of a short put, where the investor profits if the underlying asset’s price remains above the strike price at expiration, and faces potential losses if the price falls significantly. Option 2 describes a synthetic long put. Option 3 describes a synthetic short call. Option 4 describes a synthetic long call.

When a portfolio manager uses futures contracts for asset allocation and rebalancing, a significant advantage is the efficiency and cost-effectiveness compared to trading the underlying cash market instruments. Futures transactions typically incur lower brokerage costs. Furthermore, the high liquidity of futures markets means that large transactions have less impact on market prices, leading to less market disruption. This allows for smoother and more economical adjustments to the portfolio’s asset mix without significantly moving the market against the fund manager. Other options are incorrect because futures do not eliminate all market volatility, nor do they guarantee higher yields on cash components. While futures offer flexibility in managing overall market exposure, they do not enhance the ability to select individual securities within a broad index for precise exposure; rather, they provide broad index exposure.

The question asks to identify the index construction method that ensures the index’s movement primarily reflects the average percentage price change of its constituent stocks, rather than being influenced by absolute price or market capitalization. An equally-weighted average index assigns equal importance to the percentage price change of every stock within the index, regardless of its price or market value. This directly aligns with the objective described. A price-weighted average index, on the other hand, is an arithmetic average of current prices, meaning stocks with higher absolute prices have a greater impact on the index. A market-value-weighted (or capitalization-weighted) average index reflects the total market capitalization of its components, giving larger companies more influence. A dividend-adjusted index is not a primary method of weighting for price change contribution, but rather an adjustment for total returns.

The Eurodollar futures contract specifications differentiate between the minimum price fluctuation for the spot month and other contract months. For contract months that are not the nearest (spot) month, the minimum price fluctuation is 0.0050 point. Given that one point for a Eurodollar futures contract is USD 2,500 (calculated as 0.01% of USD 1,000,000 for three months, or 1 basis point = USD 25), a 0.0050 point fluctuation translates to 0.0050 USD 2,500 = USD 12.50. The question refers to a contract six months from expiry, which falls under ‘other contract months’. Therefore, the smallest monetary value change for a single contract in this scenario is USD 12.50.

The TED spread is a key indicator of credit risk in the financial markets. It is calculated as the difference between the interest rate on 3-month U.S. Treasury bill futures and the 3-month Eurodollar futures interest rate, both for contracts with the same expiration month. U.S. Treasury bills are considered to be virtually risk-free, while the Eurodollar rate reflects the credit risk of commercial banks. When the TED spread increases, it indicates that the market is demanding a higher premium for lending to banks (reflected in Eurodollar rates) compared to lending to the U.S. government (reflected in Treasury bill rates). This widening spread signals an increase in the perceived credit risk or a deterioration of liquidity in the interbank lending market, suggesting that financial institutions are considered riskier borrowers.

Structure risk, as defined in the CMFAS Module 6A syllabus, specifically refers to the inherent complexity and non-standardised nature of structured products. These products are created by combining two or more underlying financial instruments in various ways, meaning their benefits and liabilities are entirely dependent on their unique construction. Investors must thoroughly understand this specific structure to appreciate the potential downside losses, as there is no fixed or standard form. Other options describe different, albeit related, risks associated with structured products: counterparty risk relates to the default of an issuer or swap counterparty, early termination risk concerns losses from premature liquidation, and liquidity risk pertains to the difficulty of trading the product in a secondary market.

The convergence of futures prices and spot prices at the expiry date of the futures contract is a fundamental principle in futures markets. This phenomenon occurs because if the futures price and the spot price did not converge at expiry, an immediate and risk-free arbitrage opportunity would exist. For example, an arbitrageur could simultaneously buy the cheaper asset (either the physical commodity in the spot market or the futures contract) and sell the more expensive one, guaranteeing a profit. The actions of such arbitrageurs would quickly eliminate any price discrepancy, thereby forcing the futures price to converge with the spot price. This concept is highlighted in the syllabus, which states that ‘On the date of the expiry of the futures contract, the futures price and spot price converge.’ The other options present misinterpretations or less fundamental reasons. The expectancy model focuses on the futures price as an indicator of the expected future spot price, but it doesn’t directly explain the convergence at expiry driven by arbitrage. The cost-of-carry model explains the relationship between spot and futures prices before expiry but does not prevent convergence; furthermore, the futures price does not consistently exceed the spot price. While exchanges have rules, the underlying economic force for convergence is the elimination of arbitrage, not merely a regulatory decree without economic basis.

The zero-plus option strategy is designed to offer capital preservation while allowing participation in market upside. This is achieved by allocating a significant portion of the initial capital to fixed-income instruments, such as zero-coupon bonds, which are projected to grow to the full initial capital amount by maturity. The remaining portion of the capital is then used to purchase call options on a target index or asset. The fund’s participation share in the index’s gains is determined by the ratio of the capital available for investment in options to the cost (price) of those call options. In this specific scenario, 15% of the initial capital is dedicated to purchasing call options, and the price of these call options is 30% of their notional value. Therefore, the participation share is calculated by dividing the capital allocated to options (15%) by the call option price (30%), resulting in a 50% participation share. This implies that the fund would capture 50% of any gains made by the underlying index, relative to the option’s notional value.

The question pertains to ‘Structure Risk’ as outlined in CMFAS Module 6A, Section 9.4.7. When an investor shorts an interest rate put swaption, they are essentially selling protection against an increase in interest rates. If market floating interest rates rise significantly, the swaption buyer (who holds the pay-fixed swaption) would exercise the option. In this situation, the investor (swaption seller) becomes liable to pay out the floating rate. The syllabus explicitly states that for shorting an interest rate put swaption, the losses to the swaption seller are unlimited and directly dependent on how high the floating rate is when the option is exercised. Therefore, a significant rise in floating rates would lead to an uncapped potential loss for the investor. The other options describe different scenarios or risks: a limited loss is typically associated with shorting an interest rate call swaption under normal market conditions, unwinding costs relate to early termination risk, and reduced yield from reinvestment at lower rates refers to reinvestment risk.