CMFAS RES6A Quiz 04

A ‘worst of’ Equity Linked Note (ELN) is a type of structured product linked to the performance of multiple underlying assets, such as shares or indices. The defining characteristic of a ‘worst of’ ELN is that its final return or payout is determined by the performance of the single underlying asset that performs the worst among the basket of assets. This ‘worst performance’ is typically measured by the largest percentage decline from its initial price to its final fixing price at maturity. Therefore, even if some underlying assets perform well, the investor’s return is negatively impacted by the one that performs the poorest. This structure exposes investors to a higher level of risk compared to a single-asset ELN, which is often compensated by a potentially higher yield or a lower strike level. The other options describe different, incorrect methods of determining the payout for a ‘worst of’ ELN, such as averaging performance (which would dilute the impact of the worst performer), focusing on the best performer (which describes a ‘best of’ structure), or a fixed payout based on any asset meeting a condition (which is not how a ‘worst of’ ELN’s variable payout is determined).

Rolling a futures position involves simultaneously closing an expiring contract and opening a new one for a future month to maintain continuous market exposure. To effectively achieve this, especially when aiming for an uninterrupted transition, the primary concern is often the certainty of execution for both legs of the trade. Market Orders provide this certainty by executing at the best available price immediately. While there might be some price slippage, it ensures that the old position is closed and the new position is established without leaving the investor unhedged or without the desired market exposure. Using two separate Market Orders concurrently is the most direct method to achieve this simultaneous execution on the SGX derivatives market. Limit Orders, while offering price control, carry the risk of non-execution if the specified prices are not met, which could disrupt the continuity of the market exposure. Stop Orders are conditional orders used for triggering trades based on specific price levels, typically for risk management or entering/exiting positions, rather than for the direct, simultaneous execution of a roll. Market-to-Limit (MTL) Orders introduce complexity with potential partial execution and conversion to a limit order, which might not be ideal for the clean and certain execution required for a seamless roll.

The scenario describes a trader simultaneously selling a September crude oil futures contract (which is the nearer delivery month) and buying a December crude oil futures contract (which is the further delivery month). Since both contracts are for the same underlying asset (crude oil), this constitutes an ‘intra-commodity’ spread. Because the contracts have different delivery months (September and December), it is an ‘inter-delivery’ spread. This specific combination of an intra-commodity, inter-delivery spread is known as a calendar spread. In the context of calendar spreads, selling the nearer delivery month contract and buying the further delivery month contract is a strategy typically employed when a trader anticipates that the yield curve will flatten or invert.

To determine the number of futures contracts required to hedge an equity portfolio, the formula for hedging equity risks is applied: N = (VP / (F T)) β. Here, VP represents the current value of the portfolio, F is the current futures quote, T is the value per tick or contract multiplier, and β is the beta of the portfolio. First, calculate the total value of one futures contract by multiplying the current futures quote (F) by the value per tick (T). In this scenario, 3,000 index points multiplied by $50 per index point equals $150,000 per contract. Next, divide the current value of the portfolio ($5,000,000) by the value of one futures contract ($150,000), which yields approximately 33.33. Finally, multiply this result by the portfolio’s beta (1.2). Therefore, 33.33 multiplied by 1.2 results in 40 contracts. This calculation provides the number of contracts needed to achieve the desired hedge.

Auto-callable structured products grant the issuer the discretion to redeem the product early. While this can result in a higher yield for investors, it introduces ‘call risk’ because the investor has no control over the exact holding period. A direct consequence of this early redemption is ‘reinvestment risk’. This means the investor receives their capital back sooner than anticipated and may then need to find new investment opportunities, which could be at less favorable interest rates or yields compared to the original product. The product’s terms dictate the redemption amount, which can be the initial capital, or higher or lower depending on performance, but it does not guarantee a fixed high yield for the original full tenor if called early. Furthermore, the text explicitly states that the negative effects of mark-to-market valuation are avoided once the call trigger is reached, as the product is redeemed. Therefore, incurring significant mark-to-market losses upon redemption is not a primary implication. Lastly, early redemption means the investor loses control over the holding period of that specific investment, leading to the challenge of reinvestment, rather than gaining complete control over subsequent investment timing and terms.

A Credit Linked Note (CLN) exposes the investor to the credit risk of a designated ‘reference entity’. When a credit default event occurs for this reference entity, the method of settlement outlined in the CLN’s terms dictates the investor’s outcome. For physical settlement, the issuer of the CLN (which is also the seller of the Credit Default Swap) will acquire the defaulted debt obligations of the reference entity. These obligations are then passed on to the CLN investor. This means the investor will hold the defaulted bonds, which are likely to trade at a significant discount to their original value, resulting in a loss of principal. This differs from cash settlement, where the investor would receive a cash amount equivalent to the loss, and from a scenario where no default occurs, in which case principal and coupons would be paid. CLNs are not designed to provide principal protection against the default of the reference entity.

The question tests the understanding and application of modified duration to calculate the change in a bond’s price due to a change in its yield to maturity. The formula for the percentage change in bond price (ΔP/P) is given by -D x ΔYTM, where D is the modified duration and ΔYTM is the change in yield to maturity. Given: – Current bond price (P) = $1,000 – Modified Duration (D) = 5 – Change in Yield to Maturity (ΔYTM) = -50 basis points (bps) First, convert the basis points to a decimal. 100 basis points equal 1%, so 50 basis points equal 0.50% or 0.0050 in decimal form. Since the yield decreases, ΔYTM is -0.0050. Now, apply the formula: ΔP/P = -D x ΔYTM ΔP/P = -5 x (-0.0050) ΔP/P = +0.025 This means the bond’s price will increase by 2.5%. Next, calculate the dollar change in price: Dollar Change = 2.5% of $1,000 = 0.025 x $1,000 = $25 Finally, calculate the new price of the bond: New Price = Current Price + Dollar Change New Price = $1,000 + $25 = $1,025 Therefore, the approximate new price of the bond would be $1,025. Other options represent common errors such as applying the incorrect sign for a decrease in yield, miscalculating the basis points conversion, or misinterpreting the modified duration value.

The structured fund’s auto-redeemable feature states that it becomes auto-redeemable after 1.5 years of inception, and every 6 months thereafter, if the closing level of any of the underlying indices falls below 75% of its initial level on a specified early redemption observation date. The fund commenced on 16 December 2014, making 16 June 2016 the first auto-redemption observation date (1.5 years later). On this date, the Nikkei 225 Stock Index closed at 72% of its initial level, which is below the 75% threshold. Since the condition for ‘any of the indices’ is met, the product will auto-redeem. Upon auto-redemption, the product is redeemed at 100% of the principal value. Therefore, the investor will receive their full principal investment back. The other options are incorrect because the auto-redemption condition only requires one index to fall below the threshold, the payout is fixed at 100% principal upon early redemption, and the first year’s fixed coupon would have already been paid at the end of the first year (16 December 2015).

To roll a short position forward, an investor must simultaneously close out their existing short position in the expiring contract and open a new short position in a further-dated contract. If the investor is short June contracts, they would buy back the June contracts to offset their current position. Concurrently, to maintain their short market exposure, they would sell an equivalent number of September contracts. This process effectively transfers their short position from the June expiry to the September expiry without a break in market exposure. Option 2 describes this exact sequence of actions. Option 1 describes rolling a long position. Options 3 and 4 do not represent a ‘roll’ but rather involve allowing the current contract to expire or closing the position without immediately re-establishing it in a future month, which would result in a temporary loss of market exposure or a different market action.

Knock-out products, such as Callable Bull/Bear Contracts (CBBCs), are defined by their unique mandatory call feature. This mechanism dictates that the product will automatically terminate early if the price of the underlying asset reaches a pre-determined barrier level at any point before its scheduled expiry. This early termination condition is a fundamental structural difference compared to standard European or American options, which typically only expire at maturity or are exercised at the holder’s discretion (for American options). While CBBCs do have a fixed lifespan, a pricing mechanism closely tied to the underlying, are often traded over-the-counter, and limit maximum loss to the initial investment, these characteristics are either shared with other derivatives or are secondary to the defining ‘knock-out’ feature.

To calculate the total expenses, we need to determine the commission, GST on commission, and financing interest for both the opening and closing of the CFD position. 1. Calculate Buy Transaction Costs: Value of Purchase = Quantity × Opening Price = 8,000 units × $2.50 = $20,000 Commission (Buy) = Value of Purchase × Commission Rate = $20,000 × 0.4% = $80.00 GST on Commission (Buy) = Commission (Buy) × GST Rate = $80.00 × 8% = $6.40 Total Transaction Cost (Buy) = Commission (Buy) + GST on Commission (Buy) = $80.00 + $6.40 = $86.40 2. Calculate Sell Transaction Costs: Value of Sale = Quantity × Closing Price = 8,000 units × $2.75 = $22,000 Commission (Sell) = Value of Sale × Commission Rate = $22,000 × 0.4% = $88.00 GST on Commission (Sell) = Commission (Sell) × GST Rate = $88.00 × 8% = $7.04 Total Transaction Cost (Sell) = Commission (Sell) + GST on Commission (Sell) = $88.00 + $7.04 = $95.04 3. Calculate Financing Interest: Financing Amount (based on initial value) = $20,000 Daily Interest Rate = Annual Financing Rate / 360 days = 6% / 360 = 0.0001666… Interest per day = Financing Amount × Daily Interest Rate = $20,000 × (6% / 360) = $3.3333… Total Financing Interest = Interest per day × Number of Days = $3.3333… × 20 days = $66.666… (rounded to $66.67) 4. Calculate Total Expenses: Total Expenses = Total Transaction Cost (Buy) + Total Transaction Cost (Sell) + Total Financing Interest Total Expenses = $86.40 + $95.04 + $66.67 = $248.11 Option 1 ($248.11) correctly includes all components: buy commission and GST, sell commission and GST, and financing interest calculated on a 360-day basis. Option 2 ($234.67) is incorrect because it excludes the Goods and Services Tax (GST) from the commission calculations. Option 3 ($181.44) is incorrect because it excludes the financing interest, which is a significant cost for holding CFD positions. Option 4 ($247.19) is incorrect because it calculates the financing interest using 365 days instead of the specified 360-day basis, leading to a slightly lower interest charge.

The Factsheet is a concise document specifically designed to highlight key information related to a fund. This includes details such as the launch date, investment manager information, key features of the product, asset allocation, performance figures, and the various applicable fees. Therefore, it is the most efficient and suitable document for an investor seeking a quick, consolidated overview of these essential characteristics. Semi-annual accounts and reports provide detailed financial statements and changes in net assets over reporting periods. Monthly performance reports focus on principal terms, investment policy, and detailed performance and risk analysis. While the full prospectus contains all comprehensive information, it is a much more extensive legal document and not intended for a ‘quick, consolidated overview’ as requested.

The question tests the understanding of the fundamental structural differences between a Discount Certificate and a Reverse Convertible, despite their potential for similar risk-return profiles, as explained by put-call parity. According to the CMFAS Module 6A syllabus, a Discount Certificate is constructed from a long zero-strike call option and a short call option. Its return is partly derived from the premium received from selling the call being greater than the cost of the zero-strike call, passed on as a discount at issuance. Conversely, a Reverse Convertible is typically composed of a bond (or note) and a short put option. While both products can achieve similar payoff profiles, their underlying derivative components are distinct. The other options either incorrectly describe the components, misrepresent the source of return, or make false claims about capital preservation or primary objectives.

The question describes a market condition where current spot prices for underlying commodities are consistently higher than their respective forward prices. This scenario is known as backwardation. In backwardation markets, the downward slope of the price curve typically creates profits when futures contracts are rolled over. The Optimal Yield methodology is designed to dynamically adjust its rolling strategy to maximize these rolling profits in such a market environment. Conversely, in contango markets, where forward prices are higher than spot prices, the methodology aims to minimize rolling losses.

A knock-out option is a type of barrier option that terminates or is extinguished if the price of the underlying asset touches or crosses a predetermined barrier level. In this scenario, the knock-out call option had a barrier at 3,100 points. When the index rose to 3,105 points, it crossed this barrier. At that moment, a ‘barrier event’ occurred, causing the option to be knocked out and cease to exist. The subsequent rise of the index to 3,250 points is irrelevant because the option had already terminated. The payoff upon termination depends entirely on the specific terms outlined in the option agreement, which could range from zero, a fraction of the initial premium, or a fixed mandatory payoff. Therefore, the option would not remain active, nor would it convert into a different type of option or guarantee a specific fixed payment based solely on the barrier and strike price difference.

The Zero Coupon Fixed Income Plus Option Strategy is designed with a capital preservation feature. This is primarily achieved through the zero-coupon fixed income instrument component. A zero-coupon bond is purchased at a discount and matures at its face value, providing a guaranteed return of the principal amount at maturity, provided there is no credit default by the issuer. The call option component, on the other hand, provides the potential for upside returns linked to the performance of an underlying asset, but it does not contribute to the principal preservation itself. The fees for this type of structured product are typically embedded within its structure, rather than being paid separately. Unlike traditional bonds, zero-coupon instruments do not make regular coupon payments.

The minimum value of a convertible bond, according to the traditional valuation approach, is determined by taking the greater of two values: its conversion value or its straight value. The conversion value represents what the bond would be worth if immediately converted into shares. It is calculated by multiplying the market price of the underlying share by the conversion ratio. The straight value is the value of an equivalent non-convertible bond. In this scenario, the market price of InnovateTech’s shares is SGD 2.80, and the conversion ratio is 35 shares per bond. Therefore, the conversion value is SGD 2.80 35 = SGD 98.00. The straight value of an equivalent non-convertible bond is given as SGD 92.00. Comparing these two, the greater value is SGD 98.00. Thus, the minimum value of the convertible bond is SGD 98.00.

Bull Knock-Out Certificates are structured products designed with a built-in termination feature, known as a Mandatory Call Event. For a Bull contract, this event is triggered when the underlying asset’s spot price falls to or below a predefined ‘Call Price’ before the contract’s maturity. Once this threshold is breached, the certificate is automatically terminated, and the holder receives a ‘residual value’. This residual value is typically calculated based on the difference between the settlement price (often the Call Price itself or a price determined at the time of the event) and the strike price, adjusted by the conversion ratio. This mechanism is designed to limit the issuer’s risk and means the certificate will cease to trade, preventing further losses for the issuer beyond a certain point, but also limiting the potential recovery for the holder if the underlying asset’s price subsequently rises.

The question describes an investor’s outlook for an underlying asset that is expected to exhibit limited price volatility within a narrow range. The investor also seeks a reduced premium and a mechanism for the option to terminate if a predefined boundary is breached. According to the provided text, ‘knock-out barrier options are ideal for small moves in a sideways market.’ Additionally, barrier options, including knock-out types, are generally ‘cheaper and require a lower premium compared to standard options’ because of the possibility of early termination. Therefore, a knock-out barrier option perfectly aligns with these requirements. A knock-in barrier option, conversely, is designed to become active only after a barrier is reached and is considered ideal for speculating large market moves, not small, sideways ones. Standard American-style options do not possess barrier features for early termination based on price levels, nor do they inherently offer a reduced premium due to such conditions. Reverse convertible options are a different type of structured product entirely, typically involving a bond and a short put option, and do not fit the description of a barrier option for this specific market view.

The put-call parity theorem establishes a fundamental relationship between the prices of European call and put options, provided they share the same underlying asset, strike price, and expiration date. A critical assumption for the standard formula (C + PV(X) = p + S) to hold is that the options must be European-style. This is because European options can only be exercised at their expiration date, which ensures that the terminal values of the two equivalent portfolios (a call option plus cash equal to the present value of the strike price, and a put option plus the underlying share) are identical. Consequently, their present values must also be equal. American options, however, grant the holder the right to exercise at any point up to and including the expiration date. This flexibility of early exercise means that the present values of the two portfolios may diverge, as the timing of cash flows is not fixed, thereby invalidating the strict equality presented by the put-call parity formula. The other options describe conditions that contradict the fundamental assumptions of put-call parity, such as requiring different underlying assets, significant dividends (the standard formula assumes zero dividends), or varying strike prices/expiration dates.

In the described scenario, the portfolio manager anticipates purchasing shares in the future but is concerned about a potential increase in the share price before the funds are available. This situation calls for a strategy to lock in the purchase price. A long hedge, achieved by buying Extended Settlement (ES) contracts, is specifically designed for this purpose. By purchasing ES contracts, the investor effectively locks in the ‘purchase’ price for the underlying shares, protecting against adverse price movements (i.e., a price rise) before the actual acquisition. The gain from the long ES position would offset the higher cost of buying the physical shares later, or the shares would be delivered at the ES contract price. Option 2 is incorrect because a short hedge involves selling ES contracts, typically used to protect against a price fall for existing holdings or anticipated sales, which is the opposite of the manager’s objective. Option 3 is incorrect because the manager’s stated goal is to ‘safeguard against this upward price movement,’ indicating a risk management or hedging objective, not pure speculation to amplify returns. While ES contracts can be used for speculation, the context here is risk mitigation. Option 4 is incorrect because, according to the syllabus, brokerage and clearing fees for ES contracts are payable whenever the investor enters into the trade, not deferred until the final settlement date.

An Up-and-Out Call option is designed for investors who anticipate a moderate increase in the underlying asset’s price. It offers a lower premium compared to a standard call option because it includes a ‘knock-out’ barrier. If the underlying asset’s price rises to or above this barrier, the option automatically terminates, meaning the investor foregoes any further potential gains beyond that point. This characteristic aligns with an investor’s desire for a lower premium while accepting the risk of early termination if the asset performs too strongly. A Down-and-Out Put is used for bearish views. Up-and-In and Down-and-In options are ‘knock-in’ options, meaning they only become active if the barrier is reached, which is contrary to the scenario where the option terminates upon reaching a barrier.

A Discount Certificate is a structured product designed to offer investors a discount at the time of investment while providing a capped upside potential and exposing them to the full decline of the underlying asset. According to the CMFAS Module 6A syllabus, its construction involves a long zero-strike call option and a short call option. The premium generated from selling the call option typically exceeds the cost of the zero-strike call, allowing the product to be issued at a discount to its face value. This specific combination of options, consistent with put-call parity principles, creates the desired risk-return profile. In contrast, a Reverse Convertible, while having a similar payoff profile of capped upside and full downside exposure, is typically composed of a bond (or note) and a short put option. Other option combinations would result in different risk-return profiles or would not align with the specific mechanism of a Discount Certificate being issued at a discount.

Constant Proportion Portfolio Insurance (CPPI) is a rule-based strategy designed to ensure capital preservation by dynamically adjusting the allocation between risky ‘performance assets’ and ‘safe assets’. When the value of performance assets declines, the fund’s ‘cushion’ (the amount that can be exposed to risk without jeopardizing principal preservation) shrinks. To maintain the required capital preservation level, the CPPI mechanism automatically reduces the exposure to the declining performance assets and increases the allocation to safe assets. This rebalancing protects the principal by moving assets away from risk when markets fall. Options that suggest increasing exposure to performance assets or taking on more risk contradict the capital preservation objective of CPPI during a downturn. The strategy is non-discretionary, meaning it follows a set formula, so a portfolio manager would not halt rebalancing based on discretion; rather, the rebalancing rules would be executed.

When an investor opens a CFD position, they deposit an initial margin. The value of the CFD position is marked-to-market daily, meaning any gains or losses are reflected in the investor’s account balance. If the account balance falls below a pre-determined ‘maintenance margin’ level, the CFD provider will issue a margin call. This requires the investor to deposit additional funds to restore the account balance to an acceptable level, typically back to the initial margin percentage of the current position value. Liquidation (forced closing of positions) only occurs if the investor fails to meet the margin call within the stipulated timeframe. In this scenario, the initial position value is $5.00 10,000 = $50,000. The initial margin paid is 15% of $50,000 = $7,500. When the share price drops to $4.60, the new position value is $4.60 10,000 = $46,000. The loss is $50,000 – $46,000 = $4,000. The account equity after the loss is $7,500 – $4,000 = $3,500. The maintenance margin requirement is 10% of the current position value ($46,000), which is $4,600. Since the account equity ($3,500) is below the maintenance margin ($4,600), a margin call is triggered. The investor would need to top up their account to bring the equity back to the initial margin level (15% of $46,000 = $6,900), meaning an additional deposit of $6,900 – $3,500 = $3,400 would be required.

The question addresses the inherent volatility differences between an Equal-Weighted Index (EWI) and a Market-Capitalization-Weighted Index (MWI). An EWI assigns the same weight to each stock in its portfolio, irrespective of its market capitalization. This means that smaller-capitalization stocks receive a proportionally larger weighting in an EWI compared to an MWI, where larger companies naturally dominate due to their higher market value. Smaller-capitalization stocks are generally known to be more volatile than larger, more established companies. Consequently, by having a greater tilt towards these smaller, more volatile stocks, an equal-weighted index typically exhibits higher overall volatility than a market-capitalization-weighted index that tracks the same universe of securities. While a market-capitalization-weighted index can be concentrated in a few large companies, these large-cap stocks often demonstrate lower individual volatility, contributing to a generally lower overall index volatility compared to an EWI.

The daily price limit mechanisms for Nikkei 225 Index Futures and MSCI Singapore Index Futures are structured differently. For Nikkei 225 Index Futures, a tiered system is applied. Initially, if the price fluctuates by 7% from the previous day’s settlement price, trading is permitted within this 7% limit for a 10-minute cooling-off period. Subsequently, an intermediate price limit of 10% is introduced, allowing trading within this range for another 10 minutes. Finally, a 15% price limit remains in effect for the rest of the trading day. Conversely, MSCI Singapore Index Futures operate with a single price limit. Should the price move by 15% in either direction from the previous day’s settlement price, trading is allowed at or within this 15% limit for a 10-minute period. After this initial cooling-off period, all price limits are removed for the remainder of the trading day. It is important to note that for both contracts, price limits are not applicable on their respective last trading days.

When the equity in a futures margin account falls below the maintenance margin level, a margin call is issued. The purpose of this call is not merely to bring the account back up to the maintenance margin, but to restore it to the initial margin level. This ensures that the investor has sufficient buffer against further adverse market movements. Therefore, if the maintenance margin is $6,000 and the account falls to $5,500, the investor is required to deposit funds to bring the balance back to the initial margin of $8,000. Failing to meet a margin call by the stipulated time can lead to the broker liquidating the position, but this is not the immediate or typical requirement upon the call itself.

Correlation risk, as described in CMFAS Module 6A, Chapter 9.4.10, refers to the likelihood of one event directly impacting another. A structured product is exposed to this risk when its underlying instruments are correlated. The syllabus specifically highlights that companies in the same industry, such as banking and financial services, or those with credit relationships, can exhibit high correlation because they share customers or are subject to similar economic conditions. If one company defaults, others in that highly correlated group are likely to be affected. Therefore, entities that are direct competitors within a specialized sector are highly correlated, as their performance is often tied to the same market dynamics, customer preferences, and regulatory environment. This increases the probability that a negative event affecting one will also impact the others, thereby elevating the structured product’s correlation risk. Options suggesting diverse markets, independent supply chains, or diversified uncorrelated ventures would, conversely, tend to reduce correlation risk by spreading exposure across different factors and mitigating the impact of a single event.

To determine the payout price at maturity, we first need to calculate the performance returns for both underlying indices from their initial date to the maturity date. The formula for index returns is (Index_Observe – Index_Initial) / Index_Initial 100%. For Nikkei 225 (Index 1): Initial value = 15,000 Maturity value = 18,000 R1 = (18,000 – 15,000) / 15,000 100% = (3,000 / 15,000) 100% = 0.20 100% = 20% For S&P 500 (Index 2): Initial value = 1,800 Maturity value = 2,070 R2 = (2,070 – 1,800) / 1,800 100% = (270 / 1,800) 100% = 0.15 100% = 15% Next, we compare the performance returns: R1 (20%) versus R2 (15%). Since R1 (20%) is greater than or equal to R2 (15%), the condition R1 >= R2 is met. According to the product terms for maturity payout, if R1 >= R2, the payout is 125.5%. The other options represent either the payout if R1 < R2 (100.0%) or payouts associated with early redemption events, which did not occur in this scenario.