CMFAS RES6A Quiz 05

The investor’s objective is to profit from a moderate upward movement in the stock’s price while simultaneously reducing the initial premium outlay and capping both potential maximum profit and maximum loss. A bull call spread is precisely designed for this purpose. It involves buying an in-the-money (ITM) call option and selling an out-of-the-money (OTM) call option on the same underlying security with the same expiration date. This construction results in a net debit (reduced cost compared to a standalone long call), a limited maximum profit (the difference between the strike prices minus the net debit), and a limited maximum loss (the net debit paid). This strategy aligns perfectly with a moderately bullish market view and the desire for defined risk and reward.

The question describes a structured product designed to provide a minimum return of principal at maturity, specifically noting that it does not involve options. The Constant Proportion Portfolio Insurance (CPPI) strategy is explicitly mentioned in the CMFAS Module 6A syllabus as a method for achieving a minimum return of principal without the use of options. In contrast, a minimum return of principal structured product can also employ a zero-coupon bond with a long-call strategy, but this method involves options. Products that do not have a minimum return of principal usually employ short options strategies. An inverse floating coupon structure relates to how coupon payments are determined, not to the principal protection mechanism itself.

The structured fund features an auto-redeemable clause that activates after 1.5 years of inception, and subsequently every 6 months until maturity. A key condition for this auto-redemption is met if the closing level of any of the underlying indices falls below 75% of its initial level on a specified early redemption observation date. In this scenario, the 2-year mark is an observation date (as it’s after 1.5 years and a multiple of 6 months). Since the EURO STOXX 50 Index is at 70% of its initial level, which is below the 75% threshold, the auto-redemption condition is triggered. When auto-redemption occurs, the product is redeemed at 100% of the principal value, ensuring capital preservation for the investor. The other options are incorrect because the condition for auto-redemption is based on ‘any’ index, not ‘all’ indices, and the product’s design ensures principal return upon early redemption, rather than a proportional loss or continuation without action.

Modified duration is a key measure of a bond’s interest rate risk, quantifying its price sensitivity to changes in interest rates. A higher modified duration indicates that a bond’s price will be more volatile in response to interest rate movements. The factors that increase a bond’s modified duration include a longer time to maturity, lower coupon rates, and a fall in bond yields. In the given scenario, Bond P has a significantly longer remaining term to maturity and a lower annual coupon payment compared to Bond Q. Both of these characteristics contribute to Bond P having a higher modified duration. Consequently, a bond with a higher modified duration is considered more susceptible to changes in interest rates, meaning its price will fluctuate more significantly when interest rates change.

The beta factor in the equity hedging formula specifically measures the portfolio’s systematic risk, which is its volatility or sensitivity relative to the overall market index. A higher beta indicates greater sensitivity to market movements, while a lower beta suggests less sensitivity. Therefore, when a portfolio manager aims to modify the market risk exposure, they are directly addressing the portfolio’s sensitivity to broad market fluctuations through the beta factor. The aggregate monetary worth of the portfolio’s holdings (portfolio value) determines the scale of the hedge but not the inherent market sensitivity. The intrinsic value of a single futures contract is used to convert the hedge ratio into a number of contracts. Specific non-market risks, which are unique to individual stocks, cannot be hedged using equity index futures, as these instruments are designed to hedge only systemic or market risks.

The Constant Proportion Portfolio Insurance (CPPI) strategy is designed to ensure that a minimum capital amount (the floor) is preserved. When the total portfolio value falls to the predetermined floor value, the core mechanism of CPPI dictates that the entire allocation to the risky asset must be liquidated. This capital is then re-allocated into the risk-free asset to protect the principal. Consequently, the investor no longer participates in any potential upside appreciation of the risky asset and is essentially guaranteed to receive their principal sum at maturity. The other options describe actions that contradict the fundamental capital preservation objective and dynamic allocation rules of a CPPI strategy, such as increasing risky asset exposure or lowering the floor value automatically.

According to the guidelines for Extended Settlement Contracts, 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, the Member and Trading Representative shall not accept orders for new trades for the customer. However, there is a specific exception: orders which would result in the customer’s Required Margins being reduced may be accepted. This means that while new positions or risk-increasing trades are generally prohibited, actions taken by the customer to decrease their overall margin requirement are permissible. The Member or Trading Representative also has the discretion to take actions, such as liquidating collateral or offsetting positions, to reduce their exposure, but this is a discretionary power to reduce exposure, not a mandatory immediate liquidation of all assets.

The trust deed is a crucial legal document that outlines the terms and conditions governing the relationship between investors, the fund manager, and the trustee. It explicitly describes the investment objectives of the fund, as well as the obligations and responsibilities of both the fund manager and the trustee. The trustee, being independent of the fund manager, acts as the custodian of the fund’s assets. Their primary responsibility is to ensure that the fund is managed strictly in accordance with the provisions of the trust deed. This role is fundamental in safeguarding investors’ interests and minimizing the risk of mismanagement by the fund manager. Therefore, if a fund manager proposes an investment strategy that deviates from the fund’s stated objectives, the trustee’s role is to ensure compliance with the existing trust deed, rather than evaluating profitability, mediating with unitholders for approval, or temporarily taking over management.

The question describes a scenario where an ETF aims to track an index, especially one with highly illiquid or difficult-to-access assets, without directly purchasing and holding all constituent securities. In such cases, synthetic replication is the most suitable methodology. Synthetic replication ETFs use derivative instruments, such as swaps or over-the-counter (OTC) transactions, to mirror the performance of the underlying index without physically owning the index’s components. This approach is particularly advantageous for indices that are challenging or costly to replicate physically due to illiquidity, high transaction costs, or regulatory restrictions. Full physical replication, representative sampling, and cash-based replication are all forms of direct replication, which involve the actual purchase and holding of the underlying securities, either all of them (full replication) or a subset (representative sampling). These methods would not align with the objective of avoiding direct acquisition of all constituent securities, especially for illiquid assets.

For a First-to-Default Credit Linked Note (CLN), the yield offered to note holders is directly influenced by the level of credit risk they are assuming. A higher potential yield is generally offered when the probability of a credit event (default) occurring is perceived to be higher. This probability increases under several conditions: 1. Increased number of reference entities: With more companies in the basket, there is a statistically higher chance that at least one of them will default, triggering the credit event. Therefore, a larger basket typically leads to a higher yield. 2. Lower average credit quality: Companies with lower credit ratings are inherently riskier and have a higher probability of default. To compensate investors for taking on this increased risk, the CLN must offer a higher yield. 3. Lower correlation among entities: If the reference entities are less correlated, their default risks are more independent. This means that the diversification benefit is reduced, and the overall risk of a first-to-default event is higher, as a default in one entity is less likely to be offset by the performance of others. Consequently, lower correlation typically demands a higher yield. Conversely, a smaller number of entities, higher credit quality, and higher correlation would generally lead to a lower yield because the perceived risk of a first-to-default event is reduced.

The phenomenon described, where the difference between the spot price and the futures price of a contract steadily decreases as the expiration date approaches, is known as convergence. As stated in the provided text, ‘But as the expiry date draws near, the net financing cost declines and forces the basis toward zero. The narrowing of the basis is called convergence.’ This process ensures that the futures price and spot price become the same at the expiry date, causing the basis to approach zero. The reduction in net financing costs over the remaining term is a key driver for this convergence.

This question assesses the understanding of structured product payoff calculations, specifically those involving accrual and knock-out barriers, as covered in CMFAS Module 6A. The product’s yield formula is given as 0.50% + [4.00% x n/N]. First, identify the given variables from the scenario: Principal Investment: SGD 1,000,000 Total Trading Days (N): 250 Days HSI fixed within the specified range (n): 150 Base Yield: 0.50% Conditional Yield Component: 4.00% The calculation proceeds as follows: 1. Calculate the conditional portion of the yield based on the number of days the HSI fixed within the range: (4.00% x n/N) = (4.00% x 150/250) = (4.00% x 0.6) = 2.40%. 2. Add the base yield to the conditional yield to determine the total annual yield for the product: 0.50% + 2.40% = 2.90%. 3. Calculate the accrual coupon amount by applying this total yield to the principal investment: SGD 1,000,000 x 2.90% = SGD 29,000. 4. Determine the total redemption proceeds for the investor at maturity by adding the principal back to the accrual coupon: SGD 1,000,000 (Principal) + SGD 29,000 (Accrual Coupon) = SGD 1,029,000. The other options represent common misinterpretations of the formula, such as neglecting the fixed 0.50% base yield, incorrectly assuming full accrual for all 250 days, or misapplying the pro-rata calculation to the base yield component.

Structured products can be designed to offer a minimum return of principal at maturity. One common method involves combining a zero-coupon bond with a long-call option strategy. However, the question specifically asks for a strategy that achieves this objective without involving options. The Constant Proportion Portfolio Insurance (CPPI) strategy is explicitly mentioned in the syllabus as a method for achieving a minimum return of principal without the involvement of options. Other options, such as using a short-call options strategy, would expose the principal to risk, while investing solely in high-yield bonds or basing pay-outs on worst-performing assets are related to the return component or performance metrics, not the core mechanism for principal protection without options.

A Stop Sell order is specifically designed for situations where a trader holds a long position and wishes to limit potential losses. It is placed below the current market price. When the market price falls to or below the specified stop price, the order is triggered and converted into a market order or a limit order, thereby exiting the position. In the given scenario, the trader wants to sell if the price falls from 3,200 to 3,150 to mitigate losses, which is the precise function of a Stop Sell order. Conversely, a Market-if-Touched (MIT) Sell order is typically placed above the current market price to initiate a sell once that higher price is touched, often for profit-taking or initiating a short position at a specific level, not for limiting losses on a long position when the price is declining. A Session State Order (SSO) triggers based on market transitions into new session states, not directly on a specific price level being touched during continuous trading for loss mitigation. A Limit Sell order placed at 3,150 points when the current price is 3,200 would be executed immediately at the best available price (at or above 3,200), as it instructs to sell at 3,150 or better, which does not achieve the objective of waiting for the price to fall to 3,150 to exit the position.

Auto-callable structured products are designed such that the issuer has the discretion to redeem the product early if certain conditions, often related to the underlying asset’s performance, are met. When an issuer exercises this call option, the investor receives their initial capital and any accrued returns as stipulated in the product’s terms. However, this early redemption means the investor’s holding period is shorter than the original maturity term, introducing ‘call risk’ because the investor has no control over the exact duration of their investment. Furthermore, the investor then faces ‘reinvestment risk,’ as they must find a new investment for the redeemed capital, potentially at less favourable rates. The other options are incorrect because: the early call does not guarantee a maximum return, as payouts can be capped and the product might have performed even better if held longer; the investor does not have the right to extend the investment, as they essentially sell their right to early redemption to the issuer in exchange for a potentially higher yield; and the investor’s capital is not locked in until the original maturity date, as an early call results in the redemption and return of capital to the investor.

A long strangle strategy involves simultaneously buying a slightly out-of-the-money (OTM) put and a slightly out-of-the-money call of the same underlying stock and expiration date. This strategy is employed when an options trader anticipates significant volatility in the underlying asset’s price but is uncertain about the direction of the movement. Compared to a long straddle, the long strangle has a lower initial premium cost because OTM options are generally cheaper than at-the-money (ATM) options. Consequently, while it offers unlimited profit potential from large price movements, it requires a more substantial price swing in either direction to reach the break-even points and become profitable. This aligns with the portfolio manager’s objective of minimizing initial capital expenditure while accepting the need for a larger price swing for profitability. A long straddle, while also a neutral volatility strategy, involves buying ATM options, which results in a higher initial cost and a narrower range for the underlying asset to move before reaching profitability. Bear put spreads are bearish strategies, profiting from a decline in price, and covered calls are typically bullish to neutral strategies that limit upside potential, neither of which addresses the goal of profiting from uncertain, significant volatility with minimized initial outlay.

Modified duration is a crucial metric for investors, as it quantifies a bond’s price sensitivity to changes in interest rates. A bond with a higher modified duration is considered more susceptible to interest rate fluctuations. The factors that influence modified duration are well-defined. An increase in the bond’s time to maturity directly leads to a higher modified duration because the bond’s cash flows are received further in the future, making their present value more sensitive to changes in the prevailing interest rates. Conversely, a fall in coupon rates or a fall in bond yields would also increase modified duration. Therefore, an extended period until the bond’s maturity date is a characteristic that would result in a higher modified duration. A higher annual coupon payment rate or an increase in the bond’s current yield to maturity would generally lead to a lower modified duration. More frequent distribution of coupon payments typically reduces a bond’s effective duration, as investors receive their cash flows sooner, thereby reducing the overall exposure to interest rate risk.

The question describes a common issue in commodity index tracking where fixed-period rolling of futures contracts can lead to suboptimal returns, especially in varying market conditions like backwardation and contango. It then asks for an approach to strategically manage rollovers to enhance performance by maximizing gains in backwardation and minimizing losses in contango. This directly aligns with the concept of a dynamic or ‘optimal yield’ rolling mechanism as described for formula funds with commodity indices. This mechanism actively adjusts the rolling strategy based on market structure to achieve better outcomes. The first option accurately describes this flexible, optimized approach. The second option, shifting to long-term contracts, might reduce rollover frequency but does not address the strategic optimization based on market structure. The third option, a strict, pre-determined rolling schedule, is precisely the problem the fund manager is trying to solve. The fourth option, diversifying the index, relates to the underlying assets’ composition rather than the futures rolling strategy.

To determine the number of futures contracts needed to hedge an equity portfolio’s market risk, the following formula is applied: Number of Contracts (N) = (Portfolio Value (VP) × Portfolio Beta (β)) / (Futures Price (F) × Contract Multiplier (T)). This formula effectively calculates the ‘modified portfolio value’ (VP × β) and divides it by the value of a single futures contract (F × T) to find the equivalent number of contracts. In this scenario: Portfolio Value (VP) = SGD 8,000,000 Portfolio Beta (β) = 1.25 Futures Price (F) = 2,800 Contract Multiplier (T) = SGD 50 First, calculate the value of one futures contract: F × T = 2,800 × SGD 50 = SGD 140,000. Next, apply the hedging formula: N = (SGD 8,000,000 × 1.25) / SGD 140,000 N = SGD 10,000,000 / SGD 140,000 N = 71.428… Since futures contracts must be traded in whole numbers, the number of contracts should be rounded to the nearest whole number. Therefore, Ms. Chen should sell 71 contracts to hedge the portfolio’s market risk.

A Credit Linked Note (CLN) exposes investors to the credit markets, often involving the sale of credit insurance (Credit Default Swaps or CDS). In a ‘first-to-default’ CLN structure, the note is linked to multiple underlying reference entities. If any one of these entities experiences a credit event, the embedded CDS is triggered. The cash or collateral held by the issuer, which represents the investor’s principal, is then used to compensate the CDS buyers. This means the CLN investor faces a potential loss of their principal, as it is utilized for the settlement of the credit event. The higher yield offered by CLNs reflects this increased credit risk. The other options describe scenarios that do not align with the typical mechanics of a first-to-default CLN, where a credit event on any referenced entity usually leads to the settlement of the embedded CDS and a potential loss of capital for the investor, rather than a mere suspension of coupons, partial repayment with continued linkage, or conversion to a standard bond.

Auto-callable structured products grant the issuer the discretion to redeem the product before its scheduled maturity. This feature, while potentially offering investors a higher yield, introduces two key risks for the investor: call risk and reinvestment risk. Call risk refers to the uncertainty of the investment’s holding period, as the investor has no control over when the issuer might call the product. If the product is called early, the investor then faces reinvestment risk, meaning they will need to find a new investment for their capital, potentially at a time when market conditions offer lower returns or less attractive opportunities. The redemption amount upon early call can be the original investment, higher, or lower, depending on the product’s specific terms, so capital preservation is not always guaranteed. Tracking error is typically associated with exchange-traded funds (ETFs), and while auto-callable products have downside risks, the question specifically asks about the implication of the issuer’s call right, which primarily relates to the holding period and reinvestment challenges.

An accumulator agreement obligates the investor to purchase a predefined number of shares at a specified strike price for the tenor of the agreement, as long as the share price remains below the knock-out barrier. If the underlying share price falls significantly below the strike price, the investor is still required to buy at the higher strike price, leading to substantial marked-to-market losses. For unfunded accumulators, a significant fall in share prices will trigger margin calls from the bank, requiring the investor to top up their margin. Failure to do so can lead to liquidation of the underlying shares or termination of the agreement by the bank, with the investor bearing all costs. The agreement does not automatically terminate due to low share prices, nor is the bank obligated to adjust the strike price downwards to protect the investor. Furthermore, the investor cannot unilaterally terminate the agreement without the bank’s consent, and doing so would incur substantial ‘break’ costs.

The scenario describes an institutional investor requiring an options contract with highly specific, non-standard terms (strike price, expiration date) to perfectly hedge a unique portfolio exposure. This level of customization is a defining characteristic of Over-The-Counter (OTC) traded options, as highlighted in the CMFAS Module 6A syllabus (Table 4.9 and 4.10). OTC contracts are tailor-made to suit the needs of the parties involved, unlike exchange-traded options which have standardized terms. Because OTC transactions do not trade on an exchange or through a formalised trading system and lack a clearing house, there are weaker performance guarantees. Consequently, the selection of a reputable or financially sound counterparty becomes crucial, and counterparty risk needs to be directly managed by the parties involved. The other options describe characteristics of exchange-traded options: standardized terms, settlement through a clearing house guaranteeing performance, and readily available daily mark-to-market prices due to standardization.

Forward contracts are private, over-the-counter (OTC) agreements negotiated directly between a buyer and a seller. This direct negotiation allows for significant customization of the contract’s terms, including the specific underlying asset (like an uncommon currency), the exact quantity, and a highly tailored delivery or settlement date. This flexibility is a key advantage of forwards when dealing with unique or non-standard hedging requirements that are not met by the standardized offerings of futures exchanges. In contrast, futures contracts are standardized in terms of quality, quantity, delivery time, and place, and are traded on regulated exchanges. The other options describe characteristics primarily associated with futures contracts: daily settlement and margin calls are part of the mark-to-market procedures for futures, managed by a clearing house to mitigate counterparty risk. Price discovery through an auction-like process on a regulated exchange is a feature of futures trading. Lastly, futures contracts are designed for high liquidity and transferability in a secondary market, whereas forward contracts are typically non-transferable and lack an active secondary market.

A portfolio manager holding a substantial long position in an equity market index and seeking to temporarily reduce exposure to systemic risk without selling the underlying assets would implement a short hedge. A short hedge involves selling futures contracts to offset potential losses in the underlying long position. By selling equity index futures, the manager creates a position that profits if the market declines, thereby offsetting losses in the long equity portfolio. This strategy is distinct from a long hedge, which involves buying futures to protect against a rise in price when one is short the underlying asset, or arbitrage, which exploits price discrepancies. Enhancing specific sector exposure is a different investment objective than reducing systemic risk.

The ‘Optimal Yield’ rolling methodology, as described for formula funds tracking commodity indices, is designed to enhance returns by actively managing the rolling of futures contracts. Instead of adhering to a fixed schedule, it dynamically selects the most opportune time to roll expiring contracts. In backwardation markets, where forward prices are lower than spot prices, it aims to maximize the profits generated from rolling over contracts. Conversely, in contango markets, where forward prices are higher than spot prices, it seeks to minimize the losses incurred during the rollover process. This adaptive approach distinguishes it from traditional fixed-period rolling mechanisms, which can be detrimental to returns. The other options describe different, incorrect, or unrelated strategies. Investing in physical commodities bypasses futures rolling entirely, which is not the function of this mechanism. Maintaining a static roll schedule is precisely what the Optimal Yield approach aims to avoid. Predicting future prices with guaranteed profit is an unrealistic claim and not the operational principle of this specific rolling methodology.

To construct a synthetic long put position, an investor needs to combine a short position in the underlying asset with a long call option. This combination replicates the payoff profile of directly holding a long put option. Buying the underlying asset and buying a put option would create a synthetic long call. Shorting the underlying asset and shorting a put option would result in a synthetic short call. Buying the underlying asset and shorting a call option would create a synthetic short put.

According to the specifications for futures contracts, specifically regarding the Daily Price Limit, if the price moves by 15% in either direction from the previous day’s settlement price, trading at or within a price limit of 15% is allowed for a 10-minute cooling-off period. Crucially, after this 10-minute period has elapsed, there shall be no price limits for the remainder of that trading day. This rule applies unless it is the last trading day of the expiring contract month, in which case there are no price limits at all. Therefore, once the initial cooling-off period concludes, the contract can trade freely without any upper or lower price restrictions for the rest of the day. The other options describe scenarios that are not consistent with these specific contract rules.

Tracking error is a measure of how closely an ETF’s performance mirrors its underlying index. One of the key factors influencing tracking error, as outlined in the CMFAS Module 6A syllabus, is the volatility of the benchmark itself. ETFs tracking highly volatile benchmarks, such as emerging markets, tend to exhibit higher tracking errors because it is more challenging for the fund to perfectly replicate the index’s movements amidst rapid price fluctuations, potential liquidity issues in the underlying assets, and the costs associated with frequent rebalancing. Counterparty risk is primarily a concern for synthetic replication ETFs or Exchange Traded Notes (ETNs), not typically a primary driver of higher tracking error in physically replicated funds due to benchmark volatility. A lower Total Expense Ratio (TER) would generally reduce, not increase, tracking error by minimizing ongoing costs. The daily calculation of Net Asset Value (NAV) is a standard valuation practice and does not inherently cause a higher tracking error due to market volatility.

The Central Depository (CDP) computes margin requirements, including Additional Margins, on a gross basis. This means that long and short positions belonging to different customers do not cancel each other out in the calculation of a Member’s overall margin requirement. Therefore, even if Customer A incurs a mark-to-market loss on a long position and Customer B generates a mark-to-market gain on a short position in the same underlying, the Member cannot net these positions for the purpose of CDP’s margin calculation. CDP will assess the Additional Margin for each customer’s account independently. A loss increases the Additional Margin requirement for that specific account, while a gain reduces it. The Member’s overall liability to CDP will be the sum of these individual, non-offsetting Additional Margin adjustments for both accounts. The principle of gross margining ensures that the Member maintains sufficient collateral for all open positions across different clients.