CMFAS RES6A Quiz 12

Under the UCITS regulations, specifically for synthetic ETFs that use swap agreements, there is a stipulated limit on counterparty risk exposure. The regulations state that an ETF is not allowed 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, based on the marked-to-market value of the swap, cannot exceed 10% of the fund’s NAV on a daily basis. Therefore, for a fund with a NAV of S$100 million, the maximum permissible marked-to-market value a single swap counterparty can owe is 10% of S$100 million, which equals S$10 million.

For a put option, it is considered ‘in-the-money’ (ITM) when the strike price is greater than the current market price of the underlying asset. The intrinsic value of a put option is calculated as the difference between the strike price and the current market price, but only if it is in-the-money; otherwise, the intrinsic value is zero. In the given scenario, the put option has a strike price of $50. Initially, the underlying asset is at $48, meaning the option is in-the-money ($50 > $48). If the underlying asset’s price then drops further to $45 just before expiration, the put option remains in-the-money because $50 is still greater than $45. Furthermore, as the underlying price decreases below the strike price, the intrinsic value of a put option increases. The intrinsic value would change from ($50 – $48) = $2 to ($50 – $45) = $5. Therefore, the option is in-the-money, and its intrinsic value has increased.

A Mandatory Call Event (MCE) for a Bear Contract is triggered when the spot price of the underlying asset touches or exceeds the specified call price at any time before the expiry date. In this scenario, the underlying share price touched the call price, thus triggering an MCE. For a Category N-CBBC (No residual value), the call price is equal to its strike price, and crucially, the CBBC holder will not receive any cash payment once the MCE occurs and the CBBC is called. The contract expires early, and trading terminates immediately. The option stating that the CBBC expires early, trading terminates, and the investor receives no cash payment accurately reflects these characteristics. The option suggesting a residual cash payment would be applicable to a Category R-CBBC, not an N-CBBC. The options implying the contract continues to trade or that the strike price is adjusted are incorrect, as an MCE leads to immediate early expiry and the contract terms like strike price are fixed.

The question describes a scenario where an investor seeks capital preservation in a structured product without involving options. The provided text explicitly states that a structured product aiming for a minimum return of principal without options typically employs a Constant Proportion Portfolio Insurance (CPPI) strategy. Option 1 correctly identifies this strategy. Option 2, combining a zero-coupon bond with a long-call option, is a common method for principal protection but inherently involves options, making it unsuitable for the ‘without options’ condition. Option 3, implementing a short put option strategy, is generally used in structured products that do not offer a minimum return of principal, as it exposes the investor to potential losses. Option 4, allocating the entire principal component into highly rated corporate debt, while a conservative investment, does not describe a structured product strategy for guaranteeing a minimum return of principal without options in the same way CPPI does within the context of structured products.

The S&P 500 Equal Weight Index (EWI) is constructed by assigning an equal weight to each constituent stock, regardless of its market capitalization. This contrasts with the S&P 500 Market Weight Index (MWI), where stocks are weighted by their market capitalization, leading to a higher concentration in a few very large companies. Therefore, the EWI inherently has lower stock concentration as it underweights large-cap stocks and overweights a greater number of smaller-cap stocks. Consequently, because smaller-cap stocks are generally more volatile than larger companies, the EWI tends to exhibit higher overall volatility compared to the MWI. The EWI is also rebalanced quarterly to maintain equal weighting, unlike the MWI which is periodically adjusted but not rebalanced in the same manner.

When the market price of an Interest Rate Swap (IRS) is significantly higher than the rate implied by a strip of futures contracts, it indicates a temporary mispricing. The IRS is considered ‘overpriced’ relative to the futures market. To execute an arbitrage strategy, one would sell the overpriced instrument and simultaneously buy the underpriced components. In this scenario, selling the 1-year IRS means receiving the higher fixed rate payments. Concurrently, buying the strip of four Eurodollar futures contracts effectively locks in a lower implied fixed rate for the same period. This combination allows the arbitrageur to profit from the difference between the higher fixed rate received from the IRS and the lower fixed rate effectively paid through the futures strip. The other options represent either the opposite, loss-making strategy, or speculative positions rather than a pure arbitrage designed to capitalize on a current market discrepancy.

Basis risk arises when the asset being hedged is not perfectly identical to the underlying asset of the futures contract, or when there is uncertainty about the exact timing of the cash transaction relative to the futures contract’s expiration. In the given scenario, the imperfect alignment between the characteristics of the physical asset and the standardized futures contract terms directly describes the conditions that lead to basis risk. This risk represents the potential for the spot price of the asset to be hedged and the futures price of the contract used not to move in perfect tandem, thus making the hedge imperfect. Operational risk relates to failures in internal processes, people, and systems. Settlement risk pertains to the failure of one party to deliver on its obligations. Systemic risk refers to the risk of collapse of an entire financial system. While these are all types of financial risks, the specific issue described in the question, stemming from the mismatch between the hedged item and the hedging instrument, is precisely what constitutes basis risk.

The question tests the candidate’s understanding of the specific contract specifications for different futures products, particularly their minimum price fluctuations. The 3-month Singapore Dollar Interest Rate Futures contract has a minimum price fluctuation of 0.005 point, which translates to SGD 12.50. In contrast, the Full-sized 10-year Japanese Government Bond Futures contract has a minimum price fluctuation of JPY 0.01 per JPY 100 notional value, which equates to JPY 10,000. It is crucial to differentiate between the point values and their corresponding monetary equivalents for each specific contract as outlined in the CMFAS Module 6A syllabus.

For a Bull Callable Bull/Bear Contract (CBBC), a Mandatory Call Event (MCE) is triggered when the underlying asset’s spot price falls to or below the specified call price. In this scenario, the spot price declines and touches the call price of $52, thus triggering an MCE. When an MCE occurs, the CBBC expires early, and its trading terminates immediately. For an R-Category CBBC, the call price is different from the strike price, and the holder may receive a small cash payment, known as a ‘Residual Value’, when the CBBC is called. Therefore, the CBBC will expire early, trading will cease, and the holder has the possibility of receiving a residual value. The other options are incorrect because the MCE is indeed triggered for a Bull contract when the price falls to the call price, an R-Category CBBC may have a residual value (unlike an N-Category), and the strike price is not adjusted upon an MCE; instead, the contract terminates.

When the equity in an investor’s margin account falls below the maintenance margin level due to adverse market movements, the exchange or broker issues an additional margin call. The investor is then required to deposit additional funds to bring the account balance back up to the initial margin level, as stated in the syllabus material. This ensures that the investor maintains sufficient collateral for their open positions. Liquidating the position might be a choice the investor makes to limit further losses, but it is not the immediate required action in response to a margin call. Automatic liquidation of other assets typically only occurs if the margin call is not met within the stipulated time. Deferring action is not permissible once a margin call is issued, as the investor is required to meet the call promptly.

According to CMFAS Module 6A, structured warrants are subject to adjustments arising from corporate actions of the underlying security, such as dividends. When a special dividend is declared, the exercise price of the structured warrant is adjusted to account for the diluting effect on the underlying stock’s theoretical value. The adjustment factor for the exercise price is calculated as (P – SD – ND) / (P – ND), where P is the last cum-date closing price, SD is the special dividend per share, and ND is the normal dividend per share. Since the special dividend (SD) is subtracted in the numerator, the adjustment factor will be less than 1 (assuming SD > 0). Multiplying the old exercise price by an adjustment factor less than 1 results in a reduced new exercise price. This adjustment aims to compensate warrant holders for the value lost from the underlying asset due to the dividend payout.

The fundamental difference between principal preservation and principal guarantee in structured products relates to the certainty and mechanism of capital protection. Principal preservation typically involves investing a portion of the product’s capital into underlying fixed income securities, such as zero-coupon bonds, with the expectation that these will mature and return the initial principal. However, this return is not absolute; the underlying fixed income securities themselves carry credit risk and could default, meaning the full principal is not guaranteed. On the other hand, a principal guarantee feature provides a more robust form of protection where the investor’s initial investment is explicitly secured, often by specific collateral. This guarantee functions as a form of investment insurance, and its cost is incorporated into the structured product, making products with a principal guarantee generally more expensive than those offering only principal preservation for an equivalent principal amount. It is crucial for investors to understand that even with principal preservation, there is a risk of losing the initial investment, especially if the underlying fixed income securities default or if the product is terminated early.

When a portfolio manager is developing an effective hedge program, a critical step is to determine the ‘hedgeability’ of the target security and select an appropriate ‘hedge vehicle’. The syllabus material (3.4.2 Developing an Effective Hedge Program, point 3 & 4, and 3.4.3 Determining the Hedge Instrument) explicitly states that it is essential to find a hedge instrument that is highly correlated with the target security. This correlation ensures that the price movements of the hedging instrument effectively offset the price movements of the underlying asset, thereby achieving the objective of reducing price risk. While factors like trading volume (liquidity), volatility (risk of the hedge instrument itself), and margin requirements (transaction costs) are important considerations in the overall hedging decision and program management, the degree of price correlation is the primary characteristic that determines the effectiveness of the chosen instrument in mitigating the specific risk exposure of the underlying portfolio.

A structured note is fundamentally a debt instrument that integrates one or more derivatives. This combination means its return characteristics, such as coupon payments and/or principal repayment, are directly linked to the performance of underlying instruments like equities, indices, or interest rates. Crucially, investors in structured notes typically do not hold a direct claim over these underlying assets; instead, their principal repayment often depends on the creditworthiness of the note issuer, and it is not always guaranteed. Unlike conventional bonds, structured notes do not necessarily offer fixed coupons or guaranteed principal. They are also distinct from direct equity investments, as they are debt instruments, not ownership claims on underlying assets.

The coupon payment for an Inverse Floater Note is determined by the formula: Coupon = Max [X% ― Leverage x Floating Rate Index, Min Coupon]. In this specific case, the fixed component (X%) is 5.0%, the leverage factor is 2, the Floating Rate Index is 2.0%, and the minimum coupon floor is 0.5%. First, calculate the leveraged impact of the floating rate: 2 (leverage) multiplied by 2.0% (Floating Rate Index) equals 4.0%. Next, subtract this leveraged amount from the fixed component: 5.0% minus 4.0% results in 1.0%. Finally, compare this calculated coupon rate (1.0%) with the guaranteed minimum coupon (0.5%). Since 1.0% is greater than 0.5%, the investor receives the calculated rate of 1.0%.

A calendar spread, also known as a horizontal or time spread, involves simultaneously taking a long and a short position on futures contracts for the same underlying asset but with different delivery months. The strategy is driven by expectations regarding the shape of the yield curve. If a trader anticipates the yield curve to flatten or invert, the appropriate strategy is to sell the nearer delivery month contract and buy the further delivery month contract. This position profits if the spread between the near and far contracts narrows or inverts as expected. Conversely, buying the nearer contract and selling the further contract is the strategy for an anticipated steepening of the yield curve. Options describing trades on different underlying assets or outright positions do not represent a calendar spread.

American style options grant the holder the right to exercise the option at any time up to and including the expiration date. This flexibility for the holder translates into a significant risk for the option writer, as they have no control over when the option might be exercised. This means the writer cannot predict the exact timing or magnitude of their obligation, making risk management more challenging. In contrast, European options can only be exercised at expiration, offering more predictability for the writer regarding the timing of their obligation. Option 2 is incorrect because for a naked call option writer, unlimited losses occur if the underlying asset price rises significantly, not falls. If the price falls, the call option would likely expire worthless, benefiting the writer. Option 3 describes a general characteristic of options (time decay) but not a unique risk stemming from the exercise provisions of American options for the writer. Option 4 describes a characteristic of European options, which can only be exercised at expiration, not American options.

The question describes a strategy that is neutral, combines bull and bear spreads, and uses four futures contracts with distinct, equally distributed delivery months to achieve a wider profit range than a butterfly spread. This precisely defines a condor spread. A butterfly spread also combines bull and bear spreads and is neutral, but it typically involves four legs where the middle month is sold twice, meaning there is a common middle expiration date, unlike the condor spread’s four distinct expiration dates. A calendar spread involves simultaneously entering a long and short position on the same underlying asset but with different delivery months, typically two contracts. The TED spread is an indicator of credit risk, calculated as the difference between 3-month U.S. Treasury futures and 3-month Eurodollar futures, and is not a trading strategy for profiting from limited price movement in this manner.

Structured products, especially those with underlying exotic options or credit default swaps, are often designed for investors willing to hold them to maturity. The text explicitly states that there is typically a limited secondary market for these customized products, making it difficult for investors to sell them before maturity. If an investor needs to liquidate such an investment prematurely, they face significant liquidity risk. This risk can manifest as a substantial loss of the principal sum, as the product may have to be sold at a significant discount due to the lack of ready buyers or active trading in its components. While an issuer might provide a secondary market, they are generally not legally obliged to do so, and the price would depend on prevailing market conditions, not a guaranteed return. Liquidity risk is a distinct concern from credit events, which relate to the default of a reference entity.

When an investor shorts a pay-fixed interest rate swaption, they are essentially selling protection against an increase in interest rates. If the swaption buyer exercises the option, the investor (swaption seller) becomes liable to pay out a floating rate while receiving a fixed rate. As described in the CMFAS Module 6A syllabus (Figure 9.4.7(b) – Pay-Fixed Interest Rate Swaption), the losses to the swaption seller in this scenario are unlimited and directly dependent on how high the floating rate is when the option is exercised. This contrasts with a receive-fixed interest rate swaption (Figure 9.4.7(a)), where losses are typically limited to a pre-determined fixed rate. The other options describe different types of risks or incorrect limitations of loss for this specific structured product component.

The scenario describes an investor’s need for a derivative contract that can accommodate a specific, non-standardized commodity and a unique delivery period, along with a preference for a direct, private agreement. Forward contracts are uniquely suited for such customized requirements because they are negotiated directly between a buyer and a seller on mutually agreed terms, making them non-standardized. A crucial feature of forward contracts is that they are traded Over-The-Counter (OTC) and inherently expose the parties to counterparty risk, as there is no central clearing house to guarantee performance. Conversely, futures contracts are standardized, traded on regulated exchanges, and the exchange itself acts as the counterparty, effectively eliminating counterparty risk. However, futures contracts lack the flexibility for customization that the investor in this scenario requires.

A standard stop-loss order, when triggered, becomes a market order. In volatile market conditions, especially when there are price gaps, there may not be any trades at the exact stop price. If the market ‘gaps’ past the stop price, the order will be executed at the next available price. In this scenario, since the price gapped down from $5.10 directly to $4.80, bypassing $5.00, the stop-loss order would be filled at $4.80, leading to a larger loss than the investor initially anticipated. This phenomenon is known as slippage. Guaranteed stop-loss orders, which ensure execution at the specified price regardless of market gaps, are typically a premium service offered by some CFD providers and are not the default for standard stop-loss orders. The order would not remain in a queue like a limit order, nor would it be automatically cancelled; it would attempt to execute at the best available price once triggered.

The question describes the need to control the ‘sensitivity of an option’s delta to changes in the underlying asset’s price’. This specific sensitivity is defined as Gamma. Gamma measures the rate of change of an option’s delta with respect to a change in the underlying asset’s price. According to the CMFAS 6A syllabus, methods to restrict Gamma include limiting the absolute change in delta or applying risk tolerance amounts expressed as a maximum loss. Therefore, the first option accurately describes the strategies for managing Gamma risk. The second option describes the management of Vega, which relates to changes in market volatility. The third option pertains to Rho, which measures the impact of interest rate changes. The fourth option refers to Theta, which quantifies the potential loss due to time decay.

According to the CMFAS Module 6A syllabus, specifically section 13.7.8 ‘Acceptance of Orders during Margin Calls’, if a customer fails to obtain the necessary margins by the close of the market on T+2 (two market days from the date the margin call was triggered), the Member and Trading Representative shall not accept orders for new trades for the customer. However, there is a crucial exception: orders which would result in the customer’s Required Margins being reduced may be accepted. This refers to what is defined as a ‘risk reducing trade’, which is the closure of a position in an ES contract that reduces a customer’s Maintenance Margins requirements (e.g., liquidation of a naked open position). Therefore, an order that reduces the customer’s existing Required Margins is permissible. Orders to establish new positions, whether risk-neutral or risk-increasing, are generally not allowed if the margin call has not been met by the deadline. An order to close one component of an existing spread position that leads to an increase in Maintenance Margins is explicitly defined as a ‘risk increasing trade’ and would not be accepted.

The premium percentage for a call warrant is calculated using the formula: Premium (%) = [(nWP + X – S) / S] x 100. In this scenario, the underlying share price (S) is $12.50, the exercise price (X) is $12.00, the warrant price (WP) is $0.40, and the conversion ratio (n) is 3. First, calculate the effective cost of the warrants: nWP = 3 $0.40 = $1.20. Next, determine the total cost if the warrant were exercised: $1.20 (warrant cost per share) + $12.00 (exercise price) = $13.20. The premium in absolute terms is the difference between this total cost and the current underlying share price: $13.20 – $12.50 = $0.70. Finally, convert this absolute premium into a percentage by dividing it by the current underlying share price and multiplying by 100: ($0.70 / $12.50) 100 = 5.60%.

Range Accrual Notes (RANs) are structured notes where the interest payout is conditional on a reference index remaining within a specified range. A key feature of many RANs, as highlighted in the CMFAS Module 6A syllabus, is principal preservation. This means that even if the reference index performs poorly or consistently falls outside the agreed range, the investor is typically guaranteed to receive their full principal sum back at maturity, subject to the creditworthiness of the issuer. However, if the reference index consistently closes outside the predefined range, the terms of the note usually stipulate that the interest accrued for those days, or the entire period, will be zero. Therefore, in such a scenario, the investor would receive their full principal but no interest.

A knock-out event, also referred to as a Mandatory Call Event (MCE), occurs if any underlying index level falls below 75% of its initial level on an observation date. To determine if a knock-out event has occurred, we must calculate 75% of the initial level for each index and compare it with its observed level. For Index Alpha: Initial Level = 1200. The 75% threshold is 0.75 1200 = 900. The observed level is 880. Since 880 is less than 900, Index Alpha has fallen below 75% of its initial level, triggering a knock-out event. For Index Beta: Initial Level = 800. The 75% threshold is 0.75 800 = 600. The observed level is 610. Since 610 is greater than 600, Index Beta has not triggered a knock-out event. For Index Gamma: Initial Level = 2500. The 75% threshold is 0.75 2500 = 1875. The observed level is 1900. Since 1900 is greater than 1875, Index Gamma has not triggered a knock-out event. For Index Delta: Initial Level = 150. The 75% threshold is 0.75 150 = 112.5. The observed level is 165. Since 165 is greater than 112.5, Index Delta has not triggered a knock-out event. Since Index Alpha’s observed level (880) is below its 75% threshold (900), a knock-out event is triggered by Index Alpha.

To determine the adjusted exercise price of a call warrant following dividend declarations, the adjustment factor for dividends must first be calculated. The formula for the adjustment factor is (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. The new exercise price is then found by multiplying the old exercise price by this adjustment factor. Given: P (last cum-date closing price) = $5.00 SD (Special Dividend per Share) = $0.20 ND (Normal Dividend per Share) = $0.10 Old Exercise Price = $5.50 First, calculate the Adjustment Factor: Numerator = P – SD – ND = $5.00 – $0.20 – $0.10 = $4.70 Denominator = P – ND = $5.00 – $0.10 = $4.90 Adjustment Factor = $4.70 / $4.90 ≈ 0.95918367 Next, calculate the New Exercise Price: New Exercise Price = Old Exercise Price × Adjustment Factor New Exercise Price = $5.50 × 0.95918367 ≈ $5.2755 Rounding to two decimal places, the adjusted exercise price is $5.28.

The question describes an investor’s objective to profit from an anticipated price decline in a stock while specifically avoiding the complexities and potential costs associated with traditional short selling in the ready market, such as the risk of a forced buy-in. Extended Settlement (ES) contracts offer a direct advantage in this regard because they allow investors to take a short position without the immediate requirement to borrow shares. This significantly reduces the likelihood of a buy-in process, which typically occurs in traditional short selling if shares cannot be delivered. While ES contracts also offer capital efficiency, an extended settlement period, and arbitraging opportunities, these benefits do not directly address the specific concern of mitigating traditional short selling complexities and buy-in risk as effectively as the ability to establish a short position without immediate share borrowing.

The question describes a structured note where the return or settlement is determined by the worst-performing asset in a basket of underlying equities. This specific characteristic is the defining feature of a ‘worst of’ Equity Linked Note (ELN). An ELN generally employs an issuer’s note and a short put, linked to a stock index or a particular stock. A ‘worst of’ ELN is a variation linked to more than one underlying share or index, and its return depends on the performance of the poorest performing underlying in the basket. The other options are incorrect because they describe different types of structured notes: A Multi-callable Range Accrual Note (RAN) focuses on an underlying index staying within a specified range and includes an issuer’s call option. A Bond Linked Note (BLN) embeds a short-put on a bond, with its payout dependent on the bond’s price and potential credit events. A Credit Linked Note (CLN) has exposure to credit markets, where the issuer offers credit insurance (like a Credit Default Swap), and its risks are tied to the creditworthiness of the note issuer and a reference entity, not the performance of a basket of equities.