CMFAS RES6A Quiz 13

Gamma measures the sensitivity of an option’s delta to changes in the underlying asset price. A higher gamma indicates that the option’s delta will change more rapidly for a given movement in the underlying price. This has significant implications for risk management, especially for strategies like delta hedging. If an option has a high gamma, its delta will fluctuate more dramatically, requiring more frequent adjustments to the hedge (re-hedging). This increased need for re-hedging can lead to higher transaction costs and, more importantly, exposes the portfolio to greater risk if market prices move unfavourably between hedging adjustments, potentially leading to larger losses. Therefore, an option with higher gamma, while offering greater potential gains for option buyers, also carries higher risk for option sellers or those managing a delta-hedged portfolio, as it implies a greater potential for rapid value changes.

The hedge ratio for long-term interest rate risk, particularly when using bond futures, is determined by comparing the Price Value of a Basis Point (PVBP) of the security to be hedged against the PVBP of the most deliverable bond, adjusted by its conversion factor. The formula used is: Hedge ratio = PVBP of hedge security / (PVBP of most deliverable bond × Conversion factor for most deliverable bond). In this scenario, the PVBP of the bond portfolio to be hedged is 0.8500. The PVBP of the cheapest-to-deliver (CTD) bond is 0.0750, and its conversion factor is 0.92. Plugging these values into the formula: Hedge ratio = 0.8500 / (0.0750 × 0.92). First, calculate the denominator: 0.0750 × 0.92 = 0.0690. Then, calculate the hedge ratio: 0.8500 / 0.0690 = 12.31884… Rounding to two decimal places, the hedge ratio is 12.32. This ratio indicates the number of futures contracts needed per unit of the hedged bond’s PVBP, adjusted for the CTD bond’s characteristics.

The ‘cushion’ in a Constant Proportion Portfolio Insurance (CPPI) strategy is defined as the portion of the fund’s assets that can be exposed to risk without compromising the capital preservation feature. In the given scenario, the fund’s current value is SGD 120 million, and the capital preservation level is SGD 100 million. Therefore, the cushion is the difference between these two values, which is SGD 20 million (SGD 120 million – SGD 100 million). This SGD 20 million is the amount that the fund manager can strategically allocate to higher-risk, performance-seeking assets in an attempt to generate higher returns, while ensuring that the core capital preservation target of SGD 100 million remains protected. The other options describe either the total fund value, the capital preservation level itself, or a different concept like drawdown, none of which accurately represent the ‘cushion’ within a CPPI framework.

The structured product’s terms specify distinct payout conditions depending on whether an early redemption event occurs or if the product reaches its full maturity. In this scenario, no early redemption has taken place, meaning the product proceeds to maturity. At maturity, if the returns performance of Index 1 (Nikkei 225) is less than that of Index 2 (S&P 500), the product terms dictate that the payout will be the ‘Redemption Value’. The Redemption Value is explicitly defined as 100% of the initial investment. Therefore, the investor receives their full initial capital back. The 125.5% payout is only applicable if Index 1’s performance is greater than or equal to Index 2’s performance at maturity. Early redemption payouts are irrelevant as the product was not called early. The concept of a variable payout based on the absolute difference between index performances is not part of the product’s defined terms.

The scenario describes a situation where the underlying asset’s market is suspended, leading to illiquidity. Because the CFD provider cannot trade in the underlying market to hedge or offset the investor’s position, they are unable to process closing orders for the CFD. This inability to close an open position at a fair price or at all, due to insufficient trading activity in the underlying market, is the definition of liquidity risk. While the CFD provider is declining to act, the root cause is the market’s lack of liquidity, not the provider’s financial distress or general unwillingness to honor contracts, which would characterize counterparty risk. Currency risk relates to exchange rate fluctuations affecting foreign-denominated assets, and financing cost risk pertains to interest charges on leveraged positions; neither is the primary issue preventing the investor from closing their position in this specific context.

Constant Proportion Portfolio Insurance (CPPI) is a specific trading strategy designed to ensure a fixed minimum return at a future date. It achieves this by continuously re-balancing the investment portfolio between performance assets (which are typically more volatile) and safe assets (which are more stable). This re-balancing is strictly rule-based and non-discretionary, following a set formula or mathematical algorithm. The core mechanism involves adjusting the exposure to performance assets so that the overall portfolio can absorb a defined decrease in value without falling below the level required for principal preservation. This allows investors to participate in market upside while maintaining a level of capital protection. The other options describe broader or different investment approaches: Dynamic Asset Allocation is a general term for actively adjusting portfolio weights; Strategic Asset Management focuses on long-term asset mix; and Tactical Asset Rebalancing involves short-term, often discretionary, adjustments to exploit market opportunities, which is not the primary mechanism for guaranteed capital preservation as described.

A calendar spread, also known as a horizontal or time spread, involves simultaneously entering a long and a short position on the same underlying asset but with different delivery months. The strategy is employed based on a trader’s view of the yield curve. When a trader anticipates the yield curve to steepen, meaning long-term rates are expected to rise more significantly than short-term rates, the typical strategy is to buy the nearer delivery month contract and sell the further delivery month contract. This position benefits if the spread between the near and far contracts widens in favor of the near contract. Conversely, if a trader expects the yield curve to flatten or invert, they would sell the nearer delivery month contract and buy the further delivery month contract. The other options do not represent a standard calendar spread strategy for capitalizing on a steepening yield curve.

The daily mark-to-market (MTM) process for Extended Settlement (ES) contracts is a critical risk management mechanism. At the close of each trading day, the Central Depository (CDP) revalues all open ES contract positions based on their respective valuation prices. The primary objective of this daily revaluation is to limit the CDP’s exposure to potential losses arising from price fluctuations in the underlying securities. By preventing significant losses from accumulating until the contract’s maturity, MTM helps maintain the financial stability and integrity of the clearing system. Members are consequently required to ensure they have sufficient funds or credit facilities to cover any MTM losses.

The investor has a moderately bullish outlook, indicating they would typically buy a call option to profit from a price increase. Their objective is to reduce premium cost and have the option terminate if the price declines significantly below a threshold. A ‘Down-and-Out’ option is designed to terminate (knock-out) if the underlying asset’s price falls to or below a specified barrier level. Therefore, a Down-and-Out Call option perfectly matches this strategy: it allows the investor to benefit from an upward movement while terminating the contract and limiting potential losses (and premium cost) if the price moves unfavorably downwards past the barrier. An Up-and-Out Call would terminate if the price rises too much, which contradicts the bullish view. A Down-and-In Call would only become active if the price falls to the barrier, which is the opposite of the desired termination. An Up-and-In Put is for a bearish view and activates on an upward movement, which is entirely inconsistent with the investor’s objectives.

Structured funds in Singapore are regulated under the Code on Collective Investment Schemes (CIS) within the Securities & Futures Act (SFA). A fundamental requirement for managing such funds is that the asset management company must hold a Capital Markets Services (CMS) license. Furthermore, a significant operational distinction for structured funds, compared to structured notes and deposits, is the mandatory provision of regular Net Asset Values (NAVs) to investors. This ensures transparency and allows investors to track the fund’s performance and value consistently. The other options describe characteristics that are either incorrect for structured funds or apply to different types of financial products or regulatory frameworks. Structured funds typically have separate fees, unlike the embedded fees often found in structured notes and deposits. They are governed by the SFA, not the Banking Act, and fund managers have a fiduciary duty to act in the best interests of investors, not solely to maximize short-term gains without such an obligation.

Extended Settlement (ES) contracts offer a distinct advantage for investors seeking to profit from anticipated price declines in underlying securities. Unlike traditional short selling in the ready market, which can involve borrowing costs and the risk of a ‘buy-in’ if shares cannot be delivered, ES contracts allow investors to take a short position with reduced immediate transactional complexities. The process of buying-in is typically avoided unless the position is held until settlement and there is a failure to deliver the underlying shares. This makes ES contracts a more efficient and less cumbersome avenue for gaining bearish exposure. The other options are incorrect: ES contracts offer significant leverage but not unlimited leverage, and initial margin is always required. They do not guarantee profits, as their value is subject to market fluctuations. Furthermore, ES contracts typically have a relatively short maturity period, often around 35 days, making them unsuitable for long-term investment strategies spanning several years.

The intrinsic value of a put option is determined by the difference between its exercise price and the underlying asset’s market price, but only when the exercise price is higher than the market price. If the market price of the underlying asset is equal to or greater than the exercise price, the intrinsic value of the put option is considered zero. In the given scenario, the exercise price is $75 and the underlying stock’s current market price is $72. Since the exercise price ($75) is greater than the market price ($72), the put option is in-the-money. The intrinsic value is calculated as the exercise price minus the underlying asset price, which is $75 – $72 = $3. The option premium paid ($6) represents the total cost of the option, encompassing both its intrinsic and time value, and is not the intrinsic value itself.

The TED spread is calculated as the difference between the interest rate on 3-month Eurodollar futures contracts and 3-month US Treasury bill futures contracts with the same expiration month. Eurodollar futures rates reflect the credit risk of corporate borrowers, while US Treasury bills are considered risk-free. When there is a significant increase in perceived default risk among corporate borrowers, the interest rates on Eurodollar futures contracts would tend to rise to compensate for this higher risk. Simultaneously, a flight to quality towards highly secure sovereign debt instruments (like US Treasury bills) would likely cause their yields to fall or remain low, as demand increases. Consequently, the spread between the higher Eurodollar rate and the lower Treasury bill rate would widen, indicating an increase in overall credit risk in the market. Therefore, a widening of the TED spread reflects increased credit risk.

The maximum gain for a covered call strategy is achieved when the underlying stock price rises to or above the strike price of the call option. In this scenario, the investor benefits from the appreciation of the stock up to the strike price, and also retains the premium collected from selling the call option. The calculation for the maximum per-share gain is the difference between the strike price and the initial stock purchase price, plus the premium received. Here, the initial stock price is $25.00, the strike price is $27.00, and the premium received is $1.50. Therefore, the maximum gain is ($27.00 – $25.00) + $1.50 = $2.00 + $1.50 = $3.50. This represents the highest profit an investor can make from this specific covered call position.

The investor has constructed a diagonal spread. A diagonal spread is characterized by using options on the same underlying security but with different strike prices and different expiration dates. In the given scenario, the investor is dealing with options on the same Company X, but one call option has a strike price of $50 and expires in June, while the other has a strike price of $55 and expires in September. This combination of differing strike prices and differing expiration dates precisely fits the definition of a diagonal spread. A vertical spread would involve options with the same expiration date but different strike prices. A horizontal (or calendar) spread would involve options with the same strike price but different expiration dates. A condor spread involves four options with four different strike prices, which is not the case here.

The Constant Proportion Portfolio Insurance (CPPI) strategy relies on several key assumptions about the underlying asset to maintain its protective floor and allow for participation in market upside. One crucial assumption is that the asset will experience ‘limited drawdown as measured by percentage decline from peak to trough’. When the underlying asset undergoes frequent, sharp declines, as described in the scenario, this directly violates the assumption of limited drawdown. Such significant drops can cause the CPPI portfolio’s value to fall to its predetermined floor, which then triggers a mandatory reallocation of the entire fund into risk-free assets. Once this occurs, the portfolio loses its ability to participate in any subsequent appreciation of the underlying asset. While sharp declines also imply higher volatility (challenging the ‘low volatility’ assumption) and a lack of consistent appreciation (challenging the ‘asset appreciates in value over time’ assumption), the most direct and immediate cause for the portfolio hitting its floor due to the magnitude of the price drop is the failure to meet the ‘limited drawdown’ characteristic. The option regarding the asset maintaining a high correlation with risk-free assets is not one of the fundamental assumptions for a CPPI strategy’s effectiveness.

For non-cash corporate actions such as scrip dividends, bonus issues, and rights issues, the CMFAS Module 6A syllabus states that CFD investors may or may not be entitled to such entitlements. Crucially, the CFD provider may require investors to close all open positions before the ex-date of the corporate action. This is distinct from cash dividends, where long CFD positions are typically entitled, or share splits, where the quantity and price are adjusted. Therefore, the most accurate outcome for a bonus issue is that the provider might require the investor to close their position.

Extended Settlement (ES) contracts are highly leveraged instruments. While this leverage can magnify gains, it also significantly amplifies losses. When the market price of the underlying share moves unfavorably against a long position, the value of the investor’s position decreases. If the equity in the investor’s account falls below the maintenance margin level, the broker will issue a margin call. This requires the investor to deposit additional funds to restore the margin to the required level. Failure to meet a margin call within the specified time can lead to the broker liquidating the position. A critical risk of ES contracts is that losses are not limited to the initial margin deposited; due to the leverage, losses can exceed the initial margin, and the investor remains liable for any resulting shortfall.

The question asks to identify which futures contract, for a 0.1 index point movement, represents the highest monetary value change based on the provided specifications. Let’s examine the minimum price fluctuation for each contract: Nikkei 225 Index Futures: A 0.1 index point fluctuation corresponds to USD 10. MSCI Singapore Index Futures: A 0.1 index point fluctuation corresponds to SGD 20. Straits Times Index Futures: A 0.1 index point fluctuation corresponds to SGD 10. To compare these, we need to consider the currencies. SGD 20 is greater than SGD 10. When comparing USD 10 to SGD 20, even with typical exchange rates (e.g., 1 USD being approximately 1.3 to 1.4 SGD), USD 10 would be around SGD 13 to SGD 14. Therefore, SGD 20 for the MSCI Singapore Index Futures represents the largest monetary value change for a 0.1 index point movement among the options provided. This demonstrates an understanding of the specific financial implications of contract specifications.

The Capital Markets and Financial Advisory Services (CMFAS) Module 6A syllabus, specifically Chapter 7 on Structured Notes, outlines detailed requirements for the Product Highlights Sheet (PHS). According to section 7.10.1, point 7, if there is a risk that an investor may lose all of their principal investment, this must be emphasised with bold or italicised formatting in the PHS. This ensures critical risks are clearly communicated to investors. The other options are incorrect based on the syllabus. The PHS must not contain any information that is not in the Prospectus (section 7.10.1). While the PHS is a complement to the Prospectus, it is provided for every structured note issue, and institutional or accredited investors are exempted from receiving it, meaning it is not primarily designed for them (section 7.10). Lastly, the PHS length should not be longer than 4 pages, and if it includes diagrams and a glossary, it should not exceed 8 pages, not 10 pages (section 7.10.1, point i).

The question describes the concept of a warrant’s premium without explicitly using the term. The premium of a warrant is defined as the difference between its market price and its intrinsic value. This premium is largely attributed to the time value of the warrant, which reflects the potential for the underlying asset’s price to move favorably before the warrant’s expiry. As time passes, this time value erodes. The other options, such as breakeven price adjustment, dilutive effects of corporate actions, or market-making spread, are related to warrants but do not primarily represent the difference between the warrant’s market price and its intrinsic value.

Extended Settlement (ES) contracts offer distinct advantages for investors seeking to establish short positions for durations longer than a single trading day. Unlike margin financing, which typically does not allow for short selling, ES contracts are specifically designed to enable investors to take short positions that can be held for the entire tenure of the contract. This capability also differentiates them from contra trading, where short selling is generally limited to intra-day transactions. A notable benefit of using ES contracts for short positions is the absence of direct borrowing costs, which can be a factor in other financing methods. The risk of a buying-in event, commonly associated with shorting in the ready market, is also significantly reduced with ES contracts, occurring only if the position is held to settlement and there is a failure to deliver.

The Interest Rate Parity (IRP) Theory states that the forward premium or discount between two currencies should be equal to the difference in their domestic interest rates for securities of the same maturity, adjusted for transaction costs. The formula for the forward rate (F) is given by: F = S x (1 + Rc(n/360)) / (1 + Rb(n/360)), where S is the spot rate, Rc is the counter currency interest rate, Rb is the base currency interest rate, and n is the number of days. In this scenario: Spot rate (S) = 1.3500 SGD/USD (USD is the base currency, SGD is the counter currency) Singapore Dollar interest rate (Rc) = 2.0% p.a. = 0.02 US Dollar interest rate (Rb) = 3.0% p.a. = 0.03 Period (n) = 90 days First, calculate the theoretical 90-day forward rate (F_IRP) implied by Interest Rate Parity: F_IRP = 1.3500 x (1 + 0.02 (90/360)) / (1 + 0.03 (90/360)) F_IRP = 1.3500 x (1 + 0.005) / (1 + 0.0075) F_IRP = 1.3500 x 1.005 / 1.0075 F_IRP = 1.3500 x 0.9975186335 F_IRP ≈ 1.34665 SGD/USD Now, compare the theoretical forward rate with the actual market forward rate: Actual 90-day forward rate (F_actual) = 1.3550 SGD/USD Theoretical 90-day forward rate (F_IRP) ≈ 1.3467 SGD/USD Since F_actual (1.3550) > F_IRP (1.3467), the US Dollar is overvalued in the forward market relative to what interest rate parity suggests. An arbitrageur would exploit this by selling the overvalued forward currency (USD) and creating a synthetic position to buy the undervalued implied forward currency (USD). The arbitrage strategy involves: 1. Borrowing the lower interest rate currency: Borrow Singapore Dollars (at 2.0%). 2. Converting to the higher interest rate currency at the spot rate: Convert the borrowed SGD into USD at the spot rate of 1.3500 SGD/USD. 3. Investing the higher interest rate currency: Invest the US Dollars for 90 days (at 3.0%). This will yield a certain amount of USD at the end of the period. 4. Simultaneously selling the future amount of US Dollars forward: Enter into a forward contract to sell the US Dollars (principal + interest) that will be received in 90 days, at the actual market forward rate of 1.3550 SGD/USD. This locks in the conversion back to SGD. At maturity, the invested US Dollars mature, are converted back to Singapore Dollars via the forward contract, and the proceeds are used to repay the Singapore Dollar loan. The difference will be a risk-free profit.

For a Bear knock-out contract, a mandatory call event is typically triggered when the underlying asset’s spot price rises to or above the Call Price. In this scenario, the current spot price of $26.50 has risen above the Call Price of $26.00, thus triggering a mandatory call. Based on the calculation method demonstrated in the provided examples for a Bear contract’s residual value upon a mandatory call event, the formula used is: Residual Value = (Current Spot Price – Call Price) / Conversion Ratio Given: Strike Price = $28.00 Call Price = $26.00 Conversion Ratio = 5:1 Current Spot Price = $26.50 Residual Value = ($26.50 – $26.00) / 5 Residual Value = $0.50 / 5 Residual Value = $0.10 The initial spot price and financial cost are not relevant for calculating the residual value upon a mandatory call event.

The investor’s objective is to benefit from moderate upward movement, which aligns with a rising underlying asset. The desire for full capital preservation if an upper limit is breached, along with a capped maximum return, directly describes the characteristics of a Barrier Capital Preservation Certificate (often referred to as ‘Shark’s Fin’). This product specifically contains an up-and-out barrier knock-out call. If the underlying price hits the barrier, the investor receives the agreed capital amount, ensuring capital preservation. The upside is capped, matching the investor’s comfort level. A Barrier Capital Preservation Certificate (Straddle) is designed for situations with no firm view on direction and expects the underlying to remain within a range, which contradicts the desire to benefit from upward movement. A Knock-Out Put option is suitable for a falling underlying, not a rising one. A Barrier Reverse Convertible involves being short a knock-out put option, meaning the principal can be affected by a knock-out event, which differs from the guaranteed capital amount upon an upward knock-out in the described scenario.

Company warrants are issued by the underlying company itself, often as a ‘sweetener’ for other issues like bond or rights issues. A key characteristic is that upon exercise, the company issues new shares, which can lead to a dilution of the company’s earnings per share. Structured warrants, however, are issued by third-party financial institutions and are typically settled in cash, particularly those listed on the SGX-ST. This means the holder receives a cash payment based on the warrant’s intrinsic value at expiry, rather than physical shares, and there is no direct impact on the underlying company’s share capital. The other statements are incorrect: company warrants are generally long-dated (3-5 years) while structured warrants usually expire in less than 1 year; warrants are paid in full upfront and are not subject to margin calls; and company warrants are typically American-style, allowing exercise any time until expiry, while structured warrants can have various exercise styles.

Put-call parity establishes a theoretical relationship between the prices of European call and put options with the same underlying asset, strike price, and expiration date. This relationship holds because, for European options, their values at expiration are identical for specific portfolios. However, American options grant the holder the right to exercise at any time up to and including the expiration date. This early exercise feature introduces an additional layer of complexity and value that can cause the present values of the two portfolios (call + present value of strike vs. put + underlying share) to diverge before expiration, thus breaking the fundamental equivalence required for the put-call parity formula to hold consistently.

When an investor’s futures account experiences losses that cause the equity to fall below the maintenance margin level, a margin call is issued. The purpose of this call is not merely to restore the account to the maintenance margin, but to bring it back up to the original initial margin requirement. This ensures that the investor maintains sufficient collateral to cover potential future losses and uphold the integrity of the leveraged position. Failure to meet this additional margin call by the stipulated time typically results in the forced liquidation of the investor’s open positions by the broker or exchange.

Arbitrage is a strategy designed to profit from temporary price discrepancies between two or more markets for the same or equivalent assets, without taking on significant risk. When the spot price of an underlying asset is lower than its corresponding futures contract price for the nearest expiry, after accounting for all relevant carrying costs (like financing and storage, if applicable), it indicates that the futures contract is relatively overpriced compared to the spot market. To exploit this inefficiency, an arbitrageur would simultaneously buy the cheaper asset (the underlying equity index in the spot market) and sell the more expensive asset (the futures contract). This action locks in a risk-free profit, as the prices are expected to converge by the futures contract’s expiry. The opposite strategy, selling the spot and buying futures, would be employed if the spot price were higher than the futures price. Options that involve buying or selling both the spot and futures contracts without exploiting a price discrepancy are typically speculative strategies, not arbitrage, as they expose the investor to market risk.

This question assesses the understanding of how accrual and knock-out barriers function in a structured product’s yield calculation. The annualized yield formula is 0.75% + [4.25% x n/N], where ‘n’ is the number of trading days the index fixes within the specified range, and ‘N’ is the total trading days for the investment period. The key is to correctly identify ‘n’. In this scenario, the STI fixed within the range for the first 120 trading days. On the 121st day, it fixed above the knock-out barrier, which means the accrual of the additional yield component stops at 120 days. Therefore, ‘n’ should be 120. The total trading days for the 9-month period, ‘N’, is 180. First, calculate the annualized accrual coupon rate: Rate = 0.75% + [4.25% x (120 / 180)] Rate = 0.75% + [4.25% x (2/3)] Rate = 0.75% + 2.8333…% Rate = 3.5833…% Next, calculate the actual coupon earned over the 9-month investment period. Since the rate is annualized, it must be pro-rated for 9 months: Coupon = Principal x Annualized Rate x (Investment Period in Months / 12) Coupon = SGD 750,000 x 0.0358333… x (9 / 12) Coupon = SGD 750,000 x 0.0358333… x 0.75 Coupon = SGD 20,156.25 Finally, the total redemption proceeds are the principal plus the earned coupon: Total Redemption = SGD 750,000 + SGD 20,156.25 Total Redemption = SGD 770,156.25 Incorrect options arise from misinterpreting the knock-out condition (e.g., assuming accrual continues for all 180 days), failing to pro-rate the annualized yield for the investment period, or incorrectly identifying ‘n’ (e.g., using the days the index was above the knock-out barrier).