CMFAS RES6A Quiz 16

This question pertains to the payoff structure of a Bull Equity-Linked Note (ELN) with an embedded short put option. An ELN is designed to offer an enhanced yield compared to a plain vanilla note, but it comes with equity risk. The key to understanding the outcome at maturity is comparing the underlying stock’s share price (ST) to the put option’s strike price (X). In this scenario, the ELN has a face value of $15,000 and an embedded put option with a strike price of $45.00. At maturity, the share price of Tech Innovations Inc. is $42.00. Since the share price ($42.00) is less than the strike price ($45.00), the embedded put option is in-the-money and will be exercised. When the put option is exercised, the noteholder (investor) does not receive the full face value in cash. Instead, they receive shares of the underlying stock. The number of shares received is calculated by dividing the note’s face value by the strike price of the embedded put option. Calculation: Number of shares = Face Value / Strike Price = $15,000 / $45.00 = 333.33 shares. Therefore, the investor would receive approximately 333 shares of Tech Innovations Inc. Let’s analyze the other options: – Receiving the full face value of $15,000 in cash would only occur if the share price at maturity was greater than or equal to the strike price ($45.00). – Receiving a cash payment reflecting the enhanced yield, irrespective of the share price, is incorrect. While ELNs offer enhanced yield, the specific payoff mechanism at maturity depends on the share price relative to the strike price. If the put is exercised, the payoff is in shares, and the investor may incur a loss if the market value of these shares is less than the initial investment. – Being required to pay the difference between the strike price and the market price is incorrect. The investor holding the ELN is effectively the ‘buyer’ of the structured product that has an embedded ‘short put’. The obligation to deliver shares (or the equivalent cash value) falls on the party who wrote the put (the issuer of the ELN), not the investor holding the ELN. The investor’s loss, if any, is realized through the lower market value of the shares received.

The question describes an investor shorting a pay-fixed interest rate swaption. According to CMFAS Module 6A, Section 9.4.7 (Structure Risk), if a structured product involves shorting an interest rate put swaption (which is synonymous with a pay-fixed swaption in this context), the investor (swaption seller) is liable to pay out a floating rate when the option is exercised. The text explicitly states that ‘The losses to the swaption seller are unlimited in this case and dependent on how high the floating rate is when the option is exercised.’ Therefore, the first option accurately describes this risk. The second option describes the loss profile for an investor who shorts a receive-fixed interest rate swaption, where the loss is generally limited to a pre-determined fixed rate, as per Figure 9.4.7(a). The third option refers to Reinvestment Risk (CMFAS Module 6A, Section 9.4.8), which is the risk that bond proceeds must be reinvested at lower interest rates than the initial yield-to-maturity, and is not directly related to the structure risk of a swaption. The fourth option describes Early Termination Risk (CMFAS Module 6A, Section 9.4.6), which involves potential discounts or unwinding costs if a structured product is withdrawn before maturity, and is not the primary characteristic of loss exposure for shorting a pay-fixed swaption.

The question describes a scenario where an investor expects the ‘nearby spread (wing) to strengthen (become more positive or less negative) relative to the distant spread (wing)’. This specific market view is the direct trigger for employing a Butterfly Spread strategy, as outlined in the CMFAS Module 6A syllabus. A Butterfly Spread is a neutral trading strategy that involves buying one of the nearest delivery months, selling two of the second nearest delivery months, and buying one of the furthest delivery months, with a ratio of +1:-2:+1. The Condor Spread, while also a four-legged strategy, has a different structure (+1:-1:-1:+1) and is used for a different market view, typically when volatility is expected to decrease. A Bull Spread is a simpler two-legged strategy designed to profit from a rise in the underlying asset’s price, not a strengthening of a specific spread relationship between three different delivery months. The TED Spread is an indicator of credit risk, representing the difference between US Treasuries futures and Eurodollar futures, and is not a trading strategy for capitalizing on inter-month price differences in the way described.

To establish an effective hedge for an equity portfolio using futures contracts, the portfolio manager must primarily consider two factors when determining the number of contracts. The portfolio’s beta measures its systematic risk relative to the overall market, indicating how much the portfolio’s value is expected to move for a given movement in the market. The modified portfolio value refers to the current market value of the portfolio, potentially adjusted for specific characteristics relevant to the futures contract being used. These two elements are critical in calculating the appropriate hedge ratio, which dictates the quantity of futures contracts needed to offset the portfolio’s market exposure. Other factors like historical volatility, interest rates, time to expiration, or market liquidity are important for overall strategy and contract selection but are not the primary determinants for the initial calculation of the number of contracts for a basic hedge.

Structured funds are distinct from traditional mutual funds primarily because they aim to replicate an underlying asset’s performance or provide a synthetic return by incorporating derivatives. This approach typically leads to a static or rule-based allocation strategy, rather than the active, discretionary management seen in traditional mutual funds. A significant consequence of using derivatives in structured funds is an increased exposure to various risks, including credit and counterparty risk, which are generally more prevalent compared to traditional mutual funds that typically invest directly in underlying assets without derivatives. The other options describe characteristics of traditional mutual funds (reliance on active discretion, direct investment, active allocation) or trackers (simple replication of a benchmark through passive management and minimizing credit risk, which is not true for structured funds).

UCITS regulations impose specific limits on counterparty exposure for funds, including synthetic ETFs that use swaps. The guidelines stipulate that a UCITS-compliant 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 swaps on a daily basis. Therefore, the maximum exposure to an individual counterparty through derivative instruments is 10% of the fund’s NAV. The other options present incorrect percentage limits or conditions that do not supersede this specific counterparty exposure rule under UCITS.

The scenario describes a market participant identifying a temporary price discrepancy between a futures contract and its underlying asset across different trading platforms, and then executing simultaneous trades to profit from this imbalance without taking on significant directional risk. This activity is the hallmark of an Arbitrageur. Arbitrageurs specifically seek to make riskless profits by exploiting disequilibrium or price differences between related markets or instruments. They do not take directional bets but rather capitalize on temporary inefficiencies. A Speculator, in contrast, takes a directional view on market prices, aiming to profit from future price movements and inherently taking on market risk. A Hedger uses futures to reduce or limit the risk associated with an existing position in the underlying asset, not to exploit price discrepancies for profit. A Market Maker provides liquidity to the market by continuously quoting bid and offer prices, profiting from the bid-ask spread, which is distinct from exploiting cross-market price inefficiencies.

When an investor writes a naked call option, they sell a call option without owning the underlying asset. If the price of the underlying asset rises significantly above the strike price, the option holder will exercise the option, requiring the writer to purchase the asset at the higher market price and sell it to the option holder at the lower strike price. This difference, which can theoretically be limitless as the stock price climbs, represents an unlimited loss for the option writer. The premium received initially only partially offsets this potential loss. The maximum profit for an option writer is the premium received, but their potential loss is unlimited. The obligation for a call writer is to sell the underlying shares if exercised, not to buy them at the strike price. While time value decay generally benefits option writers, it does not mitigate the primary risk of unlimited losses from adverse price movements in a naked call position.

The Constant Proportion Portfolio Insurance (CPPI) strategy involves dynamically adjusting asset allocation between a risky asset and a risk-free asset to ensure a minimum floor value is maintained. The allocation to the risky asset is determined by multiplying the ‘cushion’ by a predetermined ‘multiplier’. The cushion is the difference between the current total portfolio value and the floor value. In this scenario: 1. The initial principal sum is $100. 2. The floor value is adjusted to maintain 86% of the initial principal sum. Therefore, the floor value is 0.86 $100 = $86. 3. The current total portfolio value is $110. 4. The cushion is calculated as: Current Total Portfolio Value – Floor Value = $110 – $86 = $24. 5. The multiplier is given as 5. 6. The new allocation to the risky asset is: Cushion Multiplier = $24 5 = $120. Incorrect options arise from common misunderstandings, such as calculating the floor as a percentage of the current portfolio value instead of the initial principal, or using an incorrect base for the cushion calculation.

To determine the number of futures contracts required to fully hedge an equity portfolio against market risk, the formula for hedging equity risks is applied: N = (VP / (F x T)) x β. First, calculate the value of one futures contract: F x T = 3,000 points x S$50/point = S$150,000. Next, substitute the given values into the formula: N = (S$15,000,000 / S$150,000) x 1.2 N = 100 x 1.2 N = 120 contracts. Therefore, 120 futures contracts are needed to achieve a full hedge for the portfolio.

When the fixed rate for an Interest Rate Swap (IRS) in the market is higher than the implied fixed rate derived from a strip of futures contracts, an arbitrageur would sell the IRS to receive the higher fixed rate and simultaneously buy the futures strip to lock in a lower floating rate, thereby profiting from the discrepancy. However, the firm also has a speculative view that short-term interest rates will increase significantly in the latter half of the 1-year period. To capitalize on this expectation, the firm would want to sell the later-dated futures contracts, as their prices would fall if rates rise. Therefore, the most effective integrated strategy involves selling the market IRS (to exploit the arbitrage opportunity), buying the earlier-dated Eurodollar futures contracts (to cover the initial part of the strip against the IRS), and selling the later-dated Eurodollar futures contracts (to profit from the anticipated rise in rates in the second half). This combines the arbitrage profit with a speculative gain from the expected yield curve movement. Selling all four futures contracts (Option 2) would be a pure arbitrage strategy without incorporating the specific speculative view on later rates. Buying the IRS (Options 3 and 4) would be incorrect if the market IRS rate is higher than the futures strip, as it would mean paying the higher fixed rate.

A net short option position, such as selling a call or a put, inherently carries negative gamma. Negative gamma signifies that as the underlying asset’s price moves in an unfavourable direction, the option’s delta will change in a way that accelerates losses for the short position. For instance, if a short call position has negative gamma and the underlying price rises, the call’s delta (which is positive) will increase, meaning the position becomes even more exposed to further price increases. This effect is most pronounced for options that are at-the-money and nearing their expiration date, as gamma values are highest in these conditions, leading to the most rapid changes in delta. Therefore, a trader with a net short option position faces increased risk from significant underlying price movements, particularly with options exhibiting high gamma.

The provided syllabus material clearly outlines the typical construction of a Reverse Convertible and a Discount Certificate. A Reverse Convertible is generally composed of a bond (or note) and a short put option. A Discount Certificate, on the other hand, is constructed with a long zero-strike call option and a short call option. Despite these different compositions, both products can achieve similar risk-return profiles, specifically a capped upside and full downside exposure to the underlying asset. Therefore, Product X, described as a bond and a short put option, aligns with a Reverse Convertible, while Product Y, described as a long zero-strike call option and a short call option, aligns with a Discount Certificate. The statement that Product Y typically involves the investor paying a higher initial investment sum compared to Product X is incorrect; the syllabus states that a discount certificate is issued at a discount to face value, meaning the investment sum for it is less than for a similar reverse convertible.

The question tests the understanding of counterparty risk specific to different ETF replication strategies, as outlined in the CMFAS Module 6A syllabus, Section 8.2.11. For physically replicated ETFs that engage in securities lending, the counterparty risk arises from the potential default of the borrowers of the securities. If the borrower fails to return the securities or provide adequate collateral, the ETF could suffer losses. In contrast, for synthetically replicated ETFs, which typically use total return swaps to achieve their index exposure, the primary counterparty risk is associated with the swap dealers or derivative issuers. If these counterparties default, the ETF could lose the expected return or even a portion of its assets. Therefore, the source of counterparty risk is distinct for each replication method. The other options incorrectly attribute the source of counterparty risk, confuse it with market risk or liquidity risk, or misrepresent the presence of risk in synthetic ETFs.

Structured products are exposed to the credit risk of their issuer. When a Special Purpose Vehicle (SPV) issues a structured product, its legal separation from the parent entity means that if the parent does not explicitly guarantee the SPV’s obligations, investors will have no recourse to the parent in the event of the SPV’s default. This significantly increases the credit risk for the investor, as their recovery options are limited solely to the assets and solvency of the SPV itself. Option 2 describes market risk, not the specific credit risk related to the issuer’s solvency and parent guarantee. Option 3 is incorrect because an independent legal structure does not automatically confer a superior credit profile; in fact, without a parent guarantee, it can imply higher standalone credit risk for the SPV. Option 4 is also incorrect; while swap counterparty risk is a relevant credit risk in some structured products, the question specifically addresses the implication of the SPV lacking a parent guarantee on its own solvency, which directly impacts the investor’s recourse against the issuer.

The question focuses on the fundamental construction of a Discount Certificate, particularly its embedded derivative components, as compared to a Reverse Convertible, despite their similar risk-return profiles. According to the CMFAS Module 6A syllabus, a Discount Certificate is constructed by combining a long zero-strike call option with a short call option. The premium received from the sale of the calls is greater than the cost of the zero-strike option, allowing the product to be issued at a discount to face value. This composition is distinct from a Reverse Convertible, which is typically composed of a bond (or note) and a short put option. While both products cap upside potential and expose investors to full downside risk, their underlying derivative structures differ, as explained by put-call parity. Therefore, the option that correctly identifies the components of a Discount Certificate is the correct choice. The other options either describe a different product’s construction, incorrectly state the risk profile, or misrepresent the upside potential of such products.

The question describes a scenario where a portfolio manager wishes to exercise an option contract prior to its official expiration date to lock in profits from a favorable price movement. According to the CMFAS Module 6A syllabus, American-style options grant the holder the right to exercise at any time before expiration. In contrast, European-style options can only be exercised on the expiration date. Therefore, for the manager to exercise the option two weeks before expiry, it must be an American-style option. Asian-style and Bermudan-style options are types of exotic options with different payoff or exercise characteristics, not primarily defined by the ability to exercise at any point before expiry like American options.

This question tests the understanding of different classifications of spread trades in the futures market. A spread trade involves simultaneously taking a long and a short position in related futures contracts. The scenario describes a trade involving Natural Gas and Crude Oil. Since these are distinct commodities, the trade is an ‘Inter-commodity’ spread. Both contracts are traded on the CME, which is the same exchange, making it an ‘Intra-market’ spread. Finally, the contracts have different delivery months (March and June), which classifies it as an ‘Inter-delivery’ spread. Therefore, the most accurate characterization combines these three elements.

When an investor writes (sells) a call option, they receive a premium upfront from the buyer. The writer is obligated to sell the underlying asset at the exercise price if the option is exercised. The maximum gain for a call option writer occurs when the option expires worthless, meaning the underlying share price is at or below the exercise price. In this scenario, the option buyer will not exercise, and the writer gets to keep the entire premium received. Therefore, the maximum gain for the call writer is precisely the premium collected. In this case, the premium received is $6 per share. The maximum loss for a call writer, conversely, is theoretically unlimited, as the underlying share price can rise indefinitely above the exercise price, leading to increasing losses for the writer.

The Interest Rate Parity Theory establishes a relationship between the spot exchange rate, forward exchange rate, and the interest rates of two currencies. The formula provided is F = S x (1 + Rc(n/360)) / (1 + Rb(n/360)), where F is the forward rate, S is the spot rate, Rc is the interest rate of the counter currency (SGD in this case), Rb is the interest rate of the base currency (USD), and n is the number of days for the forward contract. Given: Spot rate (S) = 1.3500 SGD per USD Annualized interest rate for SGD (Rc) = 2.50% or 0.025 Annualized interest rate for USD (Rb) = 1.50% or 0.015 Number of days (n) = 90 First, calculate the daily interest factors for each currency: For SGD: (1 + 0.025 (90/360)) = (1 + 0.025 0.25) = (1 + 0.00625) = 1.00625 For USD: (1 + 0.015 (90/360)) = (1 + 0.015 0.25) = (1 + 0.00375) = 1.00375 Now, substitute these values into the formula: F = 1.3500 x (1.00625 / 1.00375) F = 1.3500 x 1.00249068 F = 1.3533624 Rounding to four decimal places, the implied forward rate is 1.3534 SGD per USD.

In a Constant Proportion Portfolio Insurance (CPPI) strategy, the allocation to the risky asset is determined by a multiplier times the cushion value (total portfolio value minus floor value). If the underlying risky asset experiences a prolonged period of range-bound trading, the portfolio value may stagnate or decline slightly. As the total portfolio value approaches the floor value, the cushion shrinks. A shrinking cushion, with a constant multiplier, leads to a reduced allocation to the risky asset. If the portfolio value drops to the floor, the entire fund is then allocated to the risk-free asset to protect the principal. This action, while protecting the principal, means the portfolio will miss out on any subsequent recovery or appreciation in the underlying risky asset. Therefore, the portfolio being fully allocated to the risk-free asset and foregoing future upside is a direct risk highlighted for CPPI in such market conditions. The multiplier in CPPI is constant, not variable, and the floor value generally approaches the principal sum as maturity nears, rather than significantly declining to create more cushion.

An Up-and-Out Call option is designed for investors who anticipate a moderate upward movement in the underlying asset’s price but believe it will not exceed a certain high barrier. This option provides a lower premium compared to a standard call option because of the embedded knock-out feature. If the asset’s price reaches or surpasses the specified ‘out’ barrier, the option terminates and becomes worthless. This aligns with the investor’s view of a modest rise without breaching a high threshold. A Down-and-In Put option, conversely, is for a bearish outlook and only becomes active if the price falls to a lower barrier. An Up-and-In Call option is for a bullish view where the investor expects the price to rise to a barrier to activate the option. A Double Knock-Out Put option is bearish and terminates if the price hits either an upper or lower barrier.

Mr. Tan’s objective is to profit from an anticipated decline in the share price of ‘TechInnovate Ltd.’ without directly short-selling. A put option grants the buyer the right, but not the obligation, to sell the underlying asset at a predetermined strike price. If the share price falls below the strike price, the put option buyer can exercise their right to sell at the higher strike price, thereby profiting from the decline. Buying a call option would be suitable for an investor expecting a price increase. Selling a call option obligates the seller to deliver shares if the price rises, and while the seller profits from the premium if the price falls, it’s not primarily about capitalizing on a decline with a ‘right.’ Selling a put option obligates the seller to buy shares if the price falls, leading to losses in a declining market.

A Market-if-Touched (MIT) order is specifically designed for scenarios where a trader wants to buy a contract below the current market price or sell a contract above the current market price. When the specified trigger price is touched, the MIT order is then submitted as a market order, ensuring execution. In the given situation, the trader holds a long position and aims to sell if the price rises to a certain level above the current market price to secure profits. An MIT sell order perfectly matches this requirement, as it is placed above the current market price and converts to a market order upon reaching that level. Conversely, a Sell Stop order is typically placed below the current market price to limit potential losses on a long position. A Sell Limit order is placed above the current market price to sell at that price or higher, but it does not convert into a market order upon touching a trigger; it simply waits to be filled at the limit price or better. A Session State Order (SSO) triggers based on market session transitions, not specific price levels for profit-taking.

To determine if a Knock-Out Event has occurred, we must check if the observed level of any individual index falls below 75% of its initial level. Let’s calculate the percentage of the initial level for each index: Index P: (Observed Level 890 / Initial Level 1200) = 0.74166… or 74.17%. This is not strictly less than 75%. Index Q: (Observed Level 190 / Initial Level 250) = 0.76 or 76%. This is not strictly less than 75%. Index R: (Observed Level 440 / Initial Level 600) = 0.73333… or 73.33%. This is strictly less than 75%. Index S: (Observed Level 130 / Initial Level 180) = 0.72222… or 72.22%. This is strictly less than 75%. Since Index R (and also Index S) has an observed level that is below 75% of its initial level, a Knock-Out Event has occurred. The condition for a Knock-Out Event is met if any index falls below the threshold, not necessarily all or an average. The fund’s weighted average return and hurdle rate are relevant for maturity payout calculations, not for determining a knock-out event.

The scenario describes a situation where an exchange aims to moderate the pace of trading and allow participants to reassess, specifically without halting trading completely. According to the CMFAS Module 6A syllabus, ‘Shock Absorbers’ are systems in the trading infrastructure that slow down trading when markets experience significant volatility but do not halt trading completely. This perfectly matches the description. A circuit breaker system, while also a market disruption mitigation measure, is designed to trigger trading halts, which is contrary to the scenario’s requirement of not stopping trading completely. Daily price limits are imposed to limit price volatility without necessarily slowing or halting trading activity. Counterparty default swaps are instruments used to manage counterparty risk, which is a different type of risk altogether, unrelated to mitigating market disruption through trading speed adjustments.

The question describes two types of equity index construction. Index Alpha’s characteristic, where its value is primarily influenced by the absolute price per share of its constituent companies, aligns with a price-weighted average index. In this type, the index is an arithmetic average of current prices, and the magnitude of a security’s price per share directly impacts the index more significantly. Index Beta’s characteristic, where each stock’s percentage price movement contributes uniformly to the index’s performance, irrespective of its market capitalization or individual share price, describes an equally-weighted average index. In an equally-weighted index, all stocks in the basket carry equal weight regardless of their prices and market value, and movements are based on the average of the percent price changes for the stocks in the index. Therefore, Index Alpha is a price-weighted average, and Index Beta is an equally-weighted average.

UCITS regulations impose specific limits on counterparty exposure for funds, including synthetic ETFs that use swaps. The rule states 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 marked-to-market value that a single swap counterparty can owe to the fund is limited to 10% of the fund’s NAV. In this scenario, with a fund NAV of €100 million, the maximum permissible marked-to-market value owed by a single counterparty would be 10% of €100 million, which equals €10 million. The other options represent incorrect percentages or misinterpretations of the UCITS counterparty risk limit.

Gamma measures the rate of change of an option’s delta, also known as the second-order price derivative. Managing gamma risk is crucial because a high gamma indicates that the option’s delta will change rapidly with small movements in the underlying asset’s price, leading to potentially large and sudden changes in the portfolio’s overall delta exposure. According to standard risk management practices for options, there are two primary methods to restrict gamma risk. The first method involves limiting the absolute change in delta, which directly controls how much the delta can fluctuate. The second method is to apply risk tolerance amounts expressed as a maximum loss, meaning that the institution sets a cap on the financial loss it is willing to incur due to gamma exposure. Other options describe methods for managing different types of risks: setting limits in USD or local currency is typically for delta, executing swap transactions can reduce rho risk, measuring potential loss through time decay relates to theta, and setting limits based on a 1% change in market volatility is for vega. Defining limits for individual counterparties and maturity concentration control are broader market and credit risk management techniques.

A standard stop-loss order, while a crucial risk management tool, does not guarantee execution at the exact specified price, especially in highly volatile market conditions. When the market experiences rapid price movements, gaps, or a lack of liquidity, the stop-loss order, once triggered, typically converts into a market order. This market order will then be filled at the best available price, which could be significantly worse than the stop price. This phenomenon is often referred to as ‘slippage’. The provided text explicitly states that ‘Even if a stop-loss price has been set, the CFD provider may not always execute the stop-loss order at the price. This can happen in volatile market conditions where there may be price jumps and there is no transaction taking place at the set order price.’ Option 1 is incorrect because standard stop-loss orders do not offer a price guarantee; this is a common misconception. Option 3 is incorrect as CFD providers are not generally obligated to absorb price differences for standard stop-loss orders; a ‘guaranteed stop-loss’ is a premium service that comes with an additional cost. Option 4 is incorrect because a stop-loss order, once triggered, aims for immediate execution at the prevailing market price, not to wait for the market to stabilize or convert into a limit order that guarantees a specific price or better.