CMFAS RES6A Quiz 09

The question tests the understanding of daily price limit mechanisms for different futures contracts as specified in the CMFAS Module 6A syllabus, Appendix C. For Nikkei 225 Index Futures, the daily price limit system is tiered: first, trading is allowed within a 7% limit for 10 minutes from the previous day’s settlement price. If volatility continues, an intermediate price limit of 10% applies for another 10-minute cooling-off period. Finally, a 15% price limit applies for the remainder of the trading day. In contrast, for MSCI Singapore Index Futures (and Straits Times Index Futures), the daily price limit mechanism is simpler: whenever the price moves by 15% in either direction from the previous day’s settlement price, trading at or within this 15% limit is allowed for 10 minutes. After this cooling-off period, there are no further price limits for the remainder of the trading day. Both contracts specify no price limits on their last trading day. Therefore, the key difference lies in the multi-tiered approach of the Nikkei 225 Index Futures versus the single-tier, then no-limit approach of the MSCI Singapore Index Futures.

An accumulator is an equity-linked structured product where an investor commits to purchasing a predetermined quantity of a reference stock at regular intervals at a fixed strike price. This strike price is typically set at a discount to the market price at the agreement’s inception. A critical risk associated with accumulators is the ‘price risk’. If the market price of the underlying shares declines significantly below the agreed strike price, the investor is still contractually bound to acquire the shares at the higher, fixed strike price. This situation results in the investor purchasing shares at a value greater than their current market worth, leading to immediate unrealised losses on the accumulated shares. The product inherently lacks capital preservation features, and the investor’s potential upside is limited by a knock-out barrier, which would terminate the agreement if the share price rises above a certain level.

The investor’s objective is to profit from a moderate upward trend in the underlying asset while keeping the upfront premium low. They are also willing to accept the risk that their option position will terminate if the asset price rises significantly beyond a certain point. An Up-and-Out Call option perfectly matches these requirements. It is a call option, suitable for a bullish outlook. The ‘Up-and-Out’ feature means the option terminates (knocks out) if the underlying asset’s price moves up to or beyond a specified barrier. This early termination possibility reduces the option’s premium compared to a standard option, satisfying the desire for lower upfront cost. The investor’s willingness to have the option terminate if the price rises substantially aligns with the knock-out characteristic of this option type. Other options are not suitable: a Down-and-In Put option is for a bearish view; an Up-and-In Call option becomes active, rather than terminating, if the price rises to a barrier; and a Down-and-Out Call option terminates if the price falls, not rises excessively.

The Trust Deed is the foundational legal document for a collective investment scheme, such as a structured fund. It meticulously outlines the terms and conditions governing the relationship between the investors, the fund manager, and the independent trustee. Crucially, it defines the fund’s investment objectives, the permissible scope of investment activities, and the specific obligations and responsibilities of both the fund manager and the trustee. The trustee’s role, as stipulated in the Trust Deed, includes acting as the custodian of the fund’s assets and ensuring that the fund manager operates strictly in accordance with the Trust Deed, thereby safeguarding against mismanagement or deviations from the stated investment objectives. While the Product Highlights Sheet provides a summary of key features and risks, and an Offering Circular (or prospectus) provides detailed information to potential investors, neither serves as the primary legal instrument that governs the operational framework and the roles of the parties in the same way the Trust Deed does. A Manager’s Internal Compliance Manual would guide the manager’s internal processes but is not the overarching legal document defining the fund’s structure and the trustee’s oversight.

The scenario describes a portfolio manager seeking to protect a long stock position from moderate downside risk, generate income, and achieve a cash-neutral hedging strategy in a relatively stable market. A zero-cost collar, also known as a costless collar, perfectly aligns with these objectives. It involves simultaneously buying an out-of-the-money protective put and selling an out-of-the-money covered call. The strike prices are typically adjusted such that the premium received from selling the call option offsets the premium paid for buying the put option, resulting in a net zero cash outlay. This strategy provides downside protection up to the put’s strike price and generates income, while the sale of the call caps the upside potential beyond its strike price. This is ideal for a stable or range-bound market outlook where an investor wants to limit risk without incurring significant hedging costs. Purchasing only a protective put option would provide downside protection but would incur an upfront premium cost, failing the ‘minimal upfront cash outlay’ objective. Selling only a covered call option would generate income and cap upside, but it offers limited downside protection against a sharp market fall and doesn’t inherently aim for a cash-neutral position in the same way a collar does. Executing a long straddle involves buying both a call and a put with the same strike and expiry, which is a strategy for anticipating significant volatility and large price movements in either direction, incurring substantial upfront costs, and is therefore unsuitable for a stable market outlook or a cash-neutral goal.

The observed behavior, where the futures price and the spot price for the underlying commodity are gradually moving closer as the contract approaches its expiry date, is a direct illustration of the principle of convergence. This principle, as outlined in the CMFAS Module 6A syllabus, states that on the date of expiry of a futures contract, the futures price and the spot price of the underlying asset will converge and become equal. Consequently, the basis, which is defined as the spot price minus the futures price, will approach zero as the expiry date nears. This convergence ensures that any price discrepancies between the cash market and the futures market are eliminated at the point of contract expiration. The second option is incorrect because extreme backwardation implies a significant positive basis (where the spot price is much higher than the futures price), which would represent a large difference, not a narrowing one. While prices converge from either a contango or backwardation state, the description refers to the act of convergence itself, not a specific market state like extreme backwardation. The third option is incorrect. An increasing cost of carry would typically lead to a wider positive spread between the futures price and the spot price (futures price increasing relative to spot), assuming a contango market. This would cause the prices to diverge, not converge, as the cost of holding the asset increases. The fourth option is incorrect. Arbitrageurs exploit price discrepancies to profit from mispricings. As the futures and spot prices move closer, the discrepancies are narrowing, not widening. This means that arbitrage opportunities would be diminishing, not becoming more prevalent, as the market approaches equilibrium at expiry.

An accumulator is a structured note where an investor agrees to purchase a reference stock at a predetermined strike price over a period. In a ‘1X2 gear’ scheme, the investor’s obligation changes based on the stock’s price relative to the strike price and knock-out barrier. If the daily closing price of the underlying shares falls below the strike price, the investor is obligated to purchase double (2X) the predefined quantity of the reference stock at the fixed strike price. This is a key feature that increases the investor’s exposure when the market moves unfavorably. The agreement would only terminate if the daily closing price reaches or exceeds the knock-out barrier. The investor does not have the option to purchase at the lower market price, nor is the obligation waived; the strike price is fixed at the outset.

A Range Accrual Note (RAN) specifies an accrual barrier and a knock-out barrier. Interest is typically accrued daily as long as the reference index remains within this defined range. However, a critical feature of many RANs, as described in the syllabus, is the knock-out event. A knock-out event occurs if the reference index trades at or above the knock-out barrier (or sometimes at or below an accrual barrier, depending on the specific terms). Once a knock-out event is triggered, the accrual of coupons ceases permanently for the remainder of the investment tenure. Any interest accrued up to the point of the knock-out event will be paid out, but no further interest will accumulate, even if the index subsequently returns within the original range. Therefore, in the given scenario, when the index briefly touched 3,250 (above the 3,200 knock-out barrier) in the 9th month, a knock-out event was triggered, stopping all future coupon accrual. The investor would only receive interest for the first 8 months during which the index remained within the specified range and no knock-out occurred.

The Interest Rate Parity (IRP) theory states that the forward exchange rate should reflect the interest rate differential between two currencies. If the market’s 90-day forward rate for USD/JPY is trading below the rate implied by IRP, it means that forward USD is ‘undervalued’ or ‘cheaper’ in the market compared to its theoretical value. An arbitrageur would exploit this by borrowing the counter currency (JPY), converting it to the base currency (USD) at the spot rate, and investing the USD at the prevailing USD interest rate. Simultaneously, to lock in a risk-free profit, the arbitrageur would buy USD forward (which is equivalent to selling JPY forward) at the currently undervalued market forward rate. At the end of 90 days, the invested USD would mature and be used to fulfill the forward contract, converting back to JPY to repay the initial JPY loan, thereby generating a risk-free profit from the pricing discrepancy.

A Designated Market-Maker (DMM) appointed by a warrant issuer on SGX-ST plays a crucial role in maintaining an orderly and liquid market for structured warrants. Their primary responsibility is to provide continuous, competitive bid and offer prices for the structured warrants during trading hours. This commitment ensures that investors can readily buy and sell warrants, thereby facilitating trading and enhancing overall market liquidity. The maximum spread between their bid and offer quotes, along with the minimum lot size, is typically specified in the listing documents. Other functions, such as managing the exercise process, setting initial issue terms, or acting as a custodian for underlying securities, are distinct roles performed by other entities like the warrant agent, the issuer, or a custodian, respectively.

When a futures trader’s margin account balance falls below the maintenance margin level due to adverse market movements, an ‘additional margin call’ is issued. The immediate requirement for the trader is to deposit additional funds to bring the account balance back up to the initial margin level. This is crucial for maintaining the open position and preventing forced liquidation. Option 2 describes a potential consequence if the margin call is not met, rather than the immediate requirement. Options 3 and 4 are incorrect as they misrepresent the urgency and nature of margin requirements in futures trading.

The provided text explains that in contango markets, forward prices are higher than spot prices, which typically leads to losses when futures contracts are rolled over. The ‘Optimal Yield’ methodology, as described, is specifically designed to minimize these rolling losses by choosing opportune times to roll contracts, rather than adhering to fixed roll periods. Option 2 describes the strategy for backwardation markets, where the aim is to maximize rolling profits due to lower forward prices. Options 3 and 4 propose actions that do not align with the described ‘Optimal Yield’ rolling mechanism for managing contango, which focuses on the timing and execution of contract rollovers to mitigate losses.

Hedging is a strategy employed to mitigate financial risk, not to eliminate it entirely. When a company uses futures contracts to hedge against price fluctuations in a raw material, its primary objective is to convert the inherent price risk into basis risk. Price risk refers to the uncertainty of future prices, while basis risk is the risk that the price of the underlying asset and the price of the futures contract will not move in perfect correlation. By converting price risk to basis risk, the company aims to confine its final cost within a more predictable and determinable range, thereby reducing the impact of adverse price movements. However, this strategy typically also caps potential profits if prices move favorably, and it does not remove all market or specific risks, nor does it guarantee a profit.

An unfunded swap-based ETF operates by the ETF manager utilizing the proceeds generated from the sale of its units to acquire a portfolio of assets. This acquired collateral is then pledged directly to the ETF itself, held with a third-party custodian. The returns from this collateral are subsequently exchanged with a swap counterparty for the performance of the underlying index. This structure ensures that the ETF directly holds the collateral to mitigate counterparty risk. In contrast, a fully funded swap-based ETF involves the ETF transferring its sale proceeds to the swap counterparty, who then purchases the collateral and pledges it in favour of the ETF, typically with a third-party custodian. The other options describe mechanisms not aligned with the unfunded swap structure or are generally incorrect for ETF collateralization.

An Equity-Linked Structured Note (ELSN) is designed with two main components to achieve its dual objectives. The primary objective of capital preservation is typically met by incorporating a zero-coupon bond. This bond is purchased at a discount and accretes to its face value at maturity, aiming to return the initial principal. The secondary objective of generating a positive return from equity market upside is achieved through a long position in an equity call option. If the underlying equity asset performs well, the call option gains value, providing the investor with potential profits. The other options describe different financial instruments or investment strategies that do not align with the standard construction and objectives of an Equity-Linked Structured Note as outlined in the CMFAS Module 6A syllabus.

The scenario describes a manufacturing firm requiring a highly tailored agreement for a specialized raw material not actively traded on organized exchanges, with a unique delivery schedule. This points directly to the characteristics of a forward contract, which is a private agreement negotiated directly between a buyer and a seller on mutually agreed terms, making it ideal for customized business and investment solutions not available in standardized futures markets. The firm’s concern about the potential for the other party to fail on their obligations highlights the primary risk associated with forward contracts: counterparty risk. Unlike futures contracts, which are standardized and traded on regulated exchanges with the exchange acting as a counterparty, forward contracts are over-the-counter (OTC) instruments and are directly exposed to the risk of default by the other party. Futures contracts would not be suitable due to their standardization, while options contracts provide a right, not an obligation, and swap agreements typically involve exchanges of cash flows rather than physical delivery of a single, non-standardized commodity in this context.

The Zero Plus Option strategy involves a zero-coupon fixed income instrument and a call option on an underlying financial instrument. The ‘Participation Rate’ is a key term in this strategy. It specifically quantifies the extent to which the structured product’s return will increase for every 1% positive performance of the underlying financial instrument above its strike price. Therefore, it directly determines the investor’s share in the upside potential. The principal preservation aspect is generally provided by the zero-coupon bond component, ensuring the investor gets back at least 100% of the principal sum, barring credit events, but this is distinct from the participation rate. The ‘Strike Price’ is the level at which the underlying asset’s performance begins to contribute to the product’s return. While some structured products may have caps on returns, the participation rate itself defines the rate of participation, not an absolute limit.

Arbitrage between futures and Interest Rate Swaps (IRS) aims to profit from temporary price discrepancies between the two instruments. When the market price of an IRS differs from the implied rate derived from a strip of futures contracts, an arbitrage opportunity arises. The core principle of arbitrage is to simultaneously buy the instrument that is relatively undervalued and sell the instrument that is relatively overvalued. This strategy locks in a risk-free profit by exploiting the mispricing, assuming transaction costs are negligible. The arbitrageur does not take a directional view on market movements but rather capitalizes on the current pricing inefficiency. Taking a long position in both, liquidating positions, or engaging in unhedged speculation are not characteristic actions of a pure arbitrage strategy in this context.

This question tests the understanding of Index-Linked Notes (ILNs) with principal preservation and a ‘greater of’ return structure, as outlined in the CMFAS Module 6A syllabus, Chapter 7.7.2. The note explicitly states ‘100% principal preservation at maturity’, which means the investor will always receive their original principal back. The return on principal is determined by the ‘greater of’ two conditions: a 20% minimum total return at maturity or 90% participation in the average annual performance of the index. This implies that the investor’s total return will be at least 20% (on top of the principal) if the index performance results in a lower return. However, if 90% of the index’s average performance yields a return greater than 20%, the investor will receive that higher amount. Therefore, the investor is guaranteed their principal and a minimum total return of 20%, with the potential for a higher return if the index performs exceptionally well. The second option is incorrect because if the index’s average performance is 15%, 90% participation would yield 13.5%. Since the note guarantees the ‘greater of’ 20% or 13.5%, the investor would receive the 20% minimum total return. The third option is incorrect because the 20% is a minimum total return, not a cap. The investor can achieve a higher return if the index performs strongly. The fourth option is incorrect due to the explicit ‘100% principal preservation’ feature, which protects the investor from principal loss.

A Credit Linked Note (CLN) is a structured product where the investor takes on the credit risk of a ‘reference entity’. In the event of a credit default by this reference entity, the settlement mechanism of the CLN becomes crucial. If the CLN specifies physical settlement, the issuing bank, which acts as the seller of the Credit Default Swap (CDS) embedded in the CLN, will use the collateral to exchange for the defaulted debt obligation of the reference entity. Consequently, the CLN investor will receive this defaulted bond. Such a bond is highly unlikely to trade at its par value in the market, meaning the investor will likely suffer a substantial loss on their principal investment. The CLN is not designed for principal preservation in a default scenario, which makes the option suggesting full principal return incorrect. The option describing the issuer paying the difference between par and market value refers to cash settlement, not physical settlement. Lastly, the conversion into equity shares is not a characteristic of a CLN; this mechanism is typically associated with other types of structured products or convertible instruments.

Synthetic replication ETFs, such as ETF B in this scenario, achieve their exposure to an underlying index by entering into total return swaps with a counterparty, typically an investment bank. In these swap arrangements, the ETF receives the performance of the index from the counterparty in exchange for a fee, and often collateral. This structure inherently introduces counterparty risk, which is the risk that the swap dealer or derivative issuer may default on its obligations, leading to potential losses for the ETF. Physical replication ETFs, like ETF A, directly hold the underlying assets or a representative sample of them, and therefore do not have this specific counterparty risk from swap dealers. While both types of ETFs are exposed to market risk, tracking error, liquidity risk, and foreign exchange risk (especially for emerging markets), counterparty risk from swap agreements is a distinguishing feature and a primary concern for synthetic replication ETFs. The benchmark’s volatility contributes to the tracking error for both ETFs, and liquidity risk is a general characteristic of exchange-traded products. Foreign exchange risk is tied to the underlying assets’ currency exposure, not the replication method itself.

The question describes a physically replicated ETF tracking a highly volatile, illiquid emerging market equity index that consistently shows substantial tracking error. The most direct and primary contributor to this, as per the CMFAS Module 6A syllabus (Section 8.2.5, point 1 on Bid-Ask Spreads), is the illiquidity of the underlying securities. When underlying index securities are thinly traded, their bid-ask spreads widen. This can impede the efficient creation and redemption process of ETF units, causing the ETF to trade at a premium or discount to its Net Asset Value (NAV), and consequently, increasing its tracking error. Option 1 is incorrect because a lower Total Expense Ratio (TER) would generally lead to a smaller tracking difference, as TER represents costs deducted from the fund’s performance. Option 3 is incorrect because while the Net Asset Value (NAV) is calculated only once daily and can differ from the intraday traded price, the frequency of NAV calculation itself is not a primary cause of tracking error. The deviation of the traded price from NAV (premium/discount) can be a symptom of issues like inefficient creation/redemption due to underlying illiquidity, which then contributes to tracking error. Option 4 describes holding short-term government bonds for liquidity. This falls under ‘cash holdings’ or ‘portfolio holdings’ differences (Section 8.2.5, point 4e), which can indeed contribute to tracking error (known as ‘cash drag’). However, in the specific context of an ‘illiquid emerging market equity index,’ the fundamental issues with the liquidity of the underlying market itself, leading to wider bid-ask spreads, are typically a more significant and primary driver of the observed substantial tracking error, as explicitly detailed in the provided text.

The question describes an investor’s ‘expected upward trend’ in a specific market, which directly reflects their ‘outlook’ or ‘view’ on market scenarios. This aligns with the ‘Anticipated View on Market Scenarios’ component of a structured fund, where investors express bullish, bearish, or market-neutral views. While the ‘global renewable energy stocks’ represent the underlying asset, and the ‘three-year horizon’ relates to the maturity, the outlook on these elements is what defines the market scenario component. The payout mechanism, on the other hand, determines how returns are distributed (e.g., fixed coupons or participative returns) and is a consequence of the chosen market view and underlying asset, rather than being the view itself.

Futures contracts are subject to daily mark-to-market settlement. This process involves adjusting each trading account to reflect the day’s profits or losses based on the settlement price set by the exchange. After this adjustment, the account’s margin is checked against the minimum performance bond requirements. If the investor has sustained losses that cause their account balance to fall below this required margin, they will receive a margin call from their Licensed Representative. The margin call requires the investor to either deposit additional funds into their account or reduce their open positions to meet the minimum requirements. Automatic liquidation or suspension of trading privileges are typically consequences of failing to meet a margin call, not the immediate first step after a loss. Daily price limits regulate price fluctuations during trading but do not prevent the recording of losses up to the settlement price or the subsequent margin call if the account’s margin becomes insufficient.

The Constant Proportion Portfolio Insurance (CPPI) strategy is designed to protect a portion of the investor’s principal by ensuring that the portfolio value does not fall below a predetermined ‘floor.’ A critical mechanism within CPPI dictates that if the total portfolio value declines to this floor, the entire allocation to the risky asset must be liquidated. The proceeds from this liquidation are then re-allocated to a risk-free asset (such as cash or highly liquid bonds). This action effectively ‘locks in’ the principal at the floor level, preventing further losses from the risky component. While this protects capital, it also means the investor will no longer participate in any potential upside appreciation of the risky asset if it were to recover.

The question pertains to the concept of Gamma in options trading, specifically its implications for dynamic delta hedging. Gamma measures the rate at which an option’s delta changes in response to movements in the underlying asset’s price. When options have a high gamma, their delta changes very rapidly for even small movements in the underlying asset. For a trader maintaining a delta-neutral portfolio with short option positions, a sudden, significant price movement in the underlying asset, coupled with high gamma, means that the portfolio’s delta neutrality will be quickly broken. To re-establish the hedge and maintain delta neutrality, the trader will need to make more frequent and potentially larger adjustments to their position in the underlying asset. This dynamic re-hedging can be costly and challenging, especially if the market moves unfavorably against the short option positions, leading to an increased risk of significant losses. Therefore, high gamma signifies greater risk for short option positions due to the rapid and unpredictable changes in delta.

A knock-out event, also known as a Mandatory Call Event (MCE), is triggered if any of the underlying indices fall below a specified percentage (in this case, 75%) of their initial level on an observation date. To determine if a knock-out event has occurred, we must calculate the 75% threshold for each index and compare it to its observed level. For Index P: Initial Level = 2000. 75% threshold = 2000 0.75 = 1500. Observed Level = 1490. Since 1490 is less than 1500, Index P has fallen below its 75% threshold. For Index Q: Initial Level = 500. 75% threshold = 500 0.75 = 375. Observed Level = 380. Since 380 is greater than 375, Index Q has not fallen below its 75% threshold. For Index R: Initial Level = 100. 75% threshold = 100 0.75 = 75. Observed Level = 76. Since 76 is greater than 75, Index R has not fallen below its 75% threshold. For Index S: Initial Level = 3000. 75% threshold = 3000 0.75 = 2250. Observed Level = 2200. Since 2200 is less than 2250, Index S has fallen below its 75% threshold. Since both Index P and Index S have fallen below their respective 75% initial level thresholds, 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. Therefore, the statement that a knock-out event has occurred because Index P and Index S both fell below their respective 75% initial level thresholds is correct.

The Auto-Redeemable Structured Fund XYZ specifies that if the auto-redemption condition is met at the 1.5-year mark, the product is redeemed at a pre-determined price of 112.75% of the initial investment. This means the investor receives their principal plus a gain of 12.75%. Once redeemed, the investment terminates, and the investor no longer participates in any potential future performance of the underlying indices, even if they were to perform exceptionally well. The second option is incorrect because the investor receives a return above the principal (112.75%), not just the principal. The third option is incorrect as auto-redemption means the product is terminated and paid out, not converted into direct holdings of the underlying indices. The fourth option is incorrect because auto-redemption prevents the fund from reaching its full 3-year maturity, thus the maximum payout of 125.5% at maturity cannot be achieved.

The S&P 500 Equal Weight Index (EWI) is constructed by giving each stock in the index the same weight, regardless of its market capitalization. This approach inherently leads to a greater allocation to smaller-capitalization stocks compared to a market-weighted index (MWI), where larger companies naturally command a greater proportion of the index. Smaller-cap stocks are generally known to be more volatile than larger, more established companies. Therefore, the EWI’s tilt towards these smaller, more volatile constituents results in it typically exhibiting higher overall volatility than the MWI. A fund manager aiming to minimize inherent volatility would need to consider this characteristic, understanding that the EWI’s construction leads to a higher risk profile in terms of price fluctuations.

The question describes a scenario where the 3-year Auto-Redeemable Structured Fund is called early. According to the product terms, a Mandatory Call Event occurs if the Returns Performance of Index 1 (Nikkei 225) is greater than or equal to the Returns Performance of Index 2 (S&P 500). In the given scenario, Nikkei 225’s performance (+10%) is indeed greater than S&P 500’s performance (+8%), thus triggering an early redemption. The fund is call protected for the initial 1-year period, and the first early redemption observation date is 15 March 2015, which is exactly 1 year after the Initial Date (16 March 2014). Therefore, the ‘No. of Observations’ for calculating the payout is 1. The payout amount to the investor is the Terminal Value, which is calculated as ‘Redemption Value x Payout Price’. The Redemption Value is stated as 100% of the initial investment. The Payout Price is defined as ‘Periodic Yield x No. of Observations’. However, in the context of structured products and to ensure capital preservation as per the investment objective, the ‘Payout Price’ in the formula ‘Terminal Value = Redemption Value x Payout Price’ typically represents the total percentage multiplier including the principal. Therefore, the total payout percentage is 100% (for principal) plus the accumulated periodic yield. Given: – Initial Investment = SGD 100,000 – Redemption Value = 100% of initial investment = SGD 100,000 – Periodic Yield = 4.25% – No. of Observations = 1 (for the first early redemption date) Total Payout Percentage = 100% + (Periodic Yield x No. of Observations) Total Payout Percentage = 100% + (4.25% x 1) = 100% + 4.25% = 104.25% Total amount received by the investor = Initial Investment x Total Payout Percentage Total amount received = SGD 100,000 x 1.0425 = SGD 104,250. Option 1 correctly reflects this calculation.