CMFAS RES6A Quiz 15

The high degree of leverage inherent in Extended Settlement (ES) contracts means that a small percentage change in the price of the underlying security can result in a significantly larger percentage change in the investor’s initial margin. In this scenario, the initial margin requirement is 10%. This implies a leverage factor of 1 divided by the margin percentage (1 / 0.10 = 10 times). Therefore, an 8% decline in the underlying security’s value would lead to an approximate loss of 8% multiplied by the leverage factor (8% 10 = 80%) on the investor’s initial margin. This demonstrates how leverage magnifies both potential gains and losses relative to the initial capital committed.

The Capital Protected Portfolio Insurance (CPPI) strategy’s asset allocation mechanism is designed to protect principal by adjusting exposure to risky assets based on the ‘cushion’ (total portfolio value minus floor value). When the market declines, the cushion shrinks, leading to a reduction in the allocation to risky assets (selling low). Conversely, when the market rallies, the cushion grows, prompting an increase in risky asset allocation (buying high). In a range-bound market, this dynamic can force the portfolio to repeatedly sell low and buy high, leading to suboptimal returns or even a situation where the entire fund is eventually allocated to the risk-free asset, foregoing future appreciation. This is a significant risk highlighted in the syllabus material. The other options describe characteristics that are either incorrect according to the provided text (e.g., floor value changes, CPPI has low liquidity) or misrepresent the CPPI mechanism (e.g., the multiplier is constant in CPPI, but the allocation to risky assets is dynamic based on the cushion).

A covered call strategy involves an investor holding the underlying stock and simultaneously selling a call option against those shares. This approach is highly suitable for an investor who already owns the stock, anticipates that its price will remain relatively stable or experience only a modest decline, and aims to generate additional income from their existing holdings through the premium collected from selling the call. While this strategy limits the potential for significant upside gains, it provides immediate cash flow and offers a degree of protection against minor price drops. Purchasing an uncovered put option would result in a premium expense, thus failing to generate income, and is typically adopted by investors with a strong bearish outlook, seeking to profit from a substantial price decrease. Writing an uncovered (naked) call option also generates premium income, but it exposes the investor to the risk of unlimited losses if the underlying stock price experiences a sharp increase. This level of risk is generally not aligned with an investor’s goal of achieving moderate stability and income from an existing portfolio, as the position is not hedged. A protective put strategy entails buying a put option while simultaneously holding the underlying stock. Its main objective is to provide downside protection, acting as a form of portfolio insurance by establishing a floor for potential losses. However, this strategy requires the payment of a premium, which reduces overall returns and does not contribute to income generation, making it unsuitable for the stated objective of generating additional income.

When evaluating the effectiveness of a hedge, particularly a currency hedge, it is crucial to assess how well the hedge achieved its objective of mitigating risk. A key element in this assessment is the behavior of the ‘basis,’ which is the difference between the spot price of the underlying asset (in this case, the currency) and the futures price. The success of a hedge often relies on the assumption that the basis will behave in a predictable manner or as projected at the time the hedge was initiated. Unanticipated changes in the basis, known as basis risk, can lead to hedging errors and reduce the overall effectiveness of the strategy. Therefore, comparing the actual basis movement to the anticipated basis movement at both the inception and the lifting of the hedge provides critical insight into how well the hedge performed in offsetting the underlying exposure. Other factors like transaction volume, macroeconomic indicators, or market liquidity are relevant to market analysis or trade execution but are not the primary measure of the hedge’s intrinsic effectiveness in risk mitigation.

The observed phenomenon, where the difference between the spot price and the futures price consistently diminishes as the contract approaches its expiration date, is known as convergence. As a futures contract nears maturity, the time to carry the underlying asset decreases, leading to a reduction in the net financing costs. This reduction forces the basis (the difference between spot and futures prices) towards zero, eventually becoming identical at the expiry date. Therefore, the inherent tendency of futures and spot prices to converge is the primary principle at play. While relative liquidity, market expectations, and cost of carry all influence the basis, the consistent narrowing specifically as expiry approaches is a direct manifestation of convergence.

An accumulator is a structured note that allows an investor to purchase a predetermined quantity of a reference stock at regular intervals, typically at a discounted strike price. A key feature of most accumulators is the knock-out barrier. If the daily closing price of the underlying shares reaches or exceeds this barrier, the derivative agreement is immediately terminated. This mechanism limits the investor’s potential upside gains. Upon termination, the investor is obligated to pay for and take delivery of any shares accumulated up to that point at the agreed strike price. The agreement does not continue, nor is there a penalty for the knock-out event, as it is a predefined feature of the product’s structure.

The Interest Rate Parity (IRP) theory suggests that the forward exchange rate should reflect the interest rate differential between two currencies to prevent arbitrage. The theoretical forward rate (F) can be calculated using the formula: F = S (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. Given: Spot rate (S) = 1.3500 USD/SGD US interest rate (Rc) = 2.0% = 0.020 (USD is the counter currency) Singapore interest rate (Rb) = 0.5% = 0.005 (SGD is the base currency) Number of days (n) = 90 Calculate the theoretical 90-day forward rate: F_theoretical = 1.3500 (1 + 0.020 (90/360)) / (1 + 0.005 (90/360)) F_theoretical = 1.3500 (1 + 0.020 0.25) / (1 + 0.005 0.25) F_theoretical = 1.3500 (1 + 0.005) / (1 + 0.00125) F_theoretical = 1.3500 1.005 / 1.00125 F_theoretical = 1.3500 1.00374531 F_theoretical = 1.355056 The market futures contract is trading at 1.3600 USD/SGD. Comparing the market rate with the theoretical rate: Market Futures Rate (1.3600) > Theoretical Forward Rate (1.355056) Since the market futures contract is overpriced (meaning future USD is too expensive relative to future SGD based on interest rate differentials), arbitrageurs would engage in a strategy to profit from this mispricing. The strategy involves selling the overpriced market futures contract and simultaneously creating a synthetic long forward position at the cheaper theoretical rate. 1. Sell USD/SGD futures: This means selling USD forward and buying SGD forward at the overpriced market rate of 1.3600. 2. Create a synthetic long USD forward position: To do this, arbitrageurs would: Borrow the base currency (SGD) at its lower interest rate (0.5%). Convert the borrowed SGD to the counter currency (USD) at the spot rate (1.3500). Invest the USD at its higher interest rate (2.0%). At maturity, the invested USD will grow and can be used to fulfill the ‘buy USD’ part of the synthetic position, while the arbitrageur profits from the difference between the higher rate at which they sold USD forward (via futures) and the lower effective rate at which they bought USD forward (synthetically). This combination of actions allows arbitrageurs to lock in a risk-free profit, pushing the market futures rate back towards the theoretical rate.

When an investor initiates a futures position, they deposit an initial margin. The maintenance margin is the minimum amount that must be maintained in the account. A margin call is triggered when the account equity falls below the maintenance margin level. In this scenario, the initial margin is $16,000 and the maintenance margin is $12,000. This means the investor can sustain a loss of up to $16,000 – $12,000 = $4,000 before a margin call is issued. Since the investor has a short position, they incur a loss when the underlying index rises. The contract multiplier is $100 per index point. Therefore, a loss of $4,000 corresponds to an index movement of $4,000 / $100 = 40 points. As it’s a short position and the market moves against the investor (causing a loss), the index must rise by 40 points. Starting from an index level of 2,000, a rise of 40 points would bring the index to 2,000 + 40 = 2,040. At this level, the account equity would fall to the maintenance margin, triggering a margin call.

American-style options grant the holder the right to exercise at any time up to and including the expiration date. In contrast, European-style options can only be exercised on the expiration date itself. Therefore, for an investor to be able to exercise an option immediately before its expiration date, it must be an American-style option. While an option having a high intrinsic value or positive time value indicates it is profitable or has remaining life, these factors do not determine the ability to exercise early. The style of the option is the defining characteristic for early exercise.

The trading name of a structured warrant provides key information about its features. According to the CMFAS Module 6A syllabus, the ‘e’ prefix in a structured warrant’s trading name, such as ‘XYZ Bank ePW270320’, specifically indicates that the warrant has a European exercise style. A European-style warrant can only be exercised on its expiration date, unlike an American-style warrant which has no ‘e’ prefix and can typically be exercised any time up to and including the expiration date. The ‘e’ does not refer to the issuer’s geographical location, the underlying asset’s listing exchange, or any early redemption features.

This question assesses the understanding of the fundamental obligations of option sellers, a core concept in the CMFAS Module 6A syllabus. A call option seller is obligated to deliver the underlying asset at the contracted strike price if the buyer exercises the option. This means they must sell the asset at that specific price. Conversely, a put option seller is obligated to take delivery of the underlying asset at the contracted strike price if the buyer exercises the option. This means they must buy the asset at that specific price. The strike price is the fixed price for the transaction upon exercise, and the seller’s role is one of obligation, not a right to initiate a transaction.

To determine the premium payback period, several steps are required. First, calculate the market conversion price by dividing the market price of the convertible bond (SGD 105) by the conversion ratio (20 shares), which gives SGD 5.25 per share. Next, find the market conversion premium per share by subtracting the current share price (SGD 5.00) from the market conversion price (SGD 5.25), resulting in a premium of SGD 0.25 per share. Then, calculate the annual coupon payment from the bond: 4% of the SGD 100 par value is SGD 4.00. The income from holding an equivalent number of shares would be the conversion ratio (20) multiplied by the annual dividend per share (SGD 0.10), which is SGD 2.00. The income differential per bond is the coupon payment minus the dividend income from equivalent shares (SGD 4.00 – SGD 2.00 = SGD 2.00). To get the income differential per share, divide this by the conversion ratio (SGD 2.00 / 20 = SGD 0.10). Finally, the premium payback period is calculated by dividing the market conversion premium per share (SGD 0.25) by the income differential per share (SGD 0.10), which equals 2.5 years.

The scenario describes a situation where the CFD provider itself is facing financial difficulties, potentially rendering it unable to meet its contractual obligations to the investor. This directly aligns with the definition of counterparty risk, which is the exposure one faces when the entity (counterparty) in a transaction is unable or unwilling to fulfill its commitments. In CFD trading, the CFD provider acts as the counterparty. Liquidity risk pertains to the inability to trade CFDs on an underlying asset due to insufficient market activity, not the provider’s solvency. Currency risk arises from fluctuations in foreign exchange rates for foreign-denominated instruments, which is not the core issue presented. Financing cost risk relates to changes in interest rates affecting the cost of holding a leveraged CFD position, also not the primary concern in this scenario.

The question describes a scenario where a company uses futures contracts to hedge against price fluctuations of a raw material. The core concern highlighted is the ‘potential divergence between the spot price of the raw material and the futures price of the contract when the hedge is eventually closed out.’ This divergence is known as the basis. Basis risk in hedging refers to the risk that the basis (the difference between the spot price of the asset being hedged and the futures price of the contract used) changes unexpectedly over the hedging period. If the basis changes unpredictably, the hedge will not perfectly offset the price risk, leading to an imperfect outcome. Therefore, the risk that the relationship between the spot price and the futures price changes unpredictably directly addresses this concern. Other options describe different types of risks or related concepts but do not precisely capture the essence of basis risk in a hedging context.

Auto-callable structured products grant the issuer the discretion to redeem the product early. From the investor’s perspective, this introduces ‘call risk,’ as they have no control over when the product might be called, leading to uncertainty regarding the exact holding period of their investment. Furthermore, if the product is redeemed early, the investor faces ‘reinvestment risk,’ meaning they may struggle to find a new investment opportunity with comparable returns, especially in a declining interest rate environment. The other options are incorrect: the investor sells their right to early redemption to the issuer, not acquires it; the redemption amount is not always guaranteed to be the initial capital plus a fixed return, as it depends on the product’s terms and performance; and early redemption does not primarily eliminate counterparty risk by converting to a direct asset holding.

For Yield Enhanced Securities, also known as Discount Certificates, the settlement mechanism is defined by the underlying asset’s price at expiration relative to the exercise price. If the underlying asset’s closing price on the expiration or valuation date is at or above the exercise price, the holder receives a cash settlement equal to the exercise price. Conversely, if the closing price is below the exercise price, the holder receives a cash settlement equal to the value of the underlying on the expiration date. In the given scenario, the underlying asset’s closing price of $5.20 is above the exercise price (cap strike) of $5.00. Therefore, the investor will receive a cash settlement equivalent to the exercise price, which is $5.00.

The correct option accurately reflects the guidelines for the Product Highlights Sheet (PHS) for structured notes in Singapore. According to the CMFAS Module 6A syllabus, specifically section 7.10.1, the PHS has specific length requirements: ‘Length should not be longer than 4 pages. If it includes diagrams and the glossary, it should not exceed 8 pages, where the information which is not contained in diagrams or a glossary is on no more than 4 pages.’ This means the core informational content, excluding supplementary elements like diagrams or a glossary, must be concise and fit within four pages. The other options contain inaccuracies: the PHS is a summary and should not necessarily reproduce all details from the full Prospectus, though it must not contain information not in the Prospectus. The required font size is at least 10-points Times New Roman, not 12-points Arial. Lastly, the exemption from providing a PHS applies when structured notes are offered to institutional or accredited investors, not simply when another document like an Information Memorandum is provided.

When an Exchange Traded Fund (ETF) trades on the secondary market at a premium to its Net Asset Value (NAV), an arbitrage opportunity arises. An arbitrageur would exploit this by purchasing the underlying basket of securities that the ETF tracks. These securities are then delivered to the ETF’s management company in exchange for newly created ETF shares in the primary market. Subsequently, the arbitrageur sells these newly acquired ETF shares on the secondary market at the prevailing premium price. This action increases the supply of ETF shares in the market, which in turn puts downward pressure on the ETF’s market price, moving it closer to its NAV. This mechanism is a key feature of ETFs, ensuring that their market price generally tracks their underlying NAV.

The scenario describes a common challenge in portfolio management: adjusting asset allocation when some underlying assets are illiquid. The provided text explicitly states that futures can be used for asset allocation, especially when stocks are illiquid, allowing a fund manager to buy bond futures now and later sell them when the illiquid stocks are liquidated. By selling equity index futures, the manager can synthetically reduce the portfolio’s equity exposure, and by simultaneously buying bond futures, the manager can synthetically increase bond exposure. This achieves the desired asset allocation shift without the need to immediately dispose of the illiquid equities, thus avoiding potential losses from forced sales or market disruption. The other options either propose less direct methods, contradict the benefits of futures for this purpose, or suggest using different instruments (options) when the question specifically asks about futures in this context.

When a treasurer anticipates receiving funds for a future deposit and expects interest rates to decline, the objective is to lock in the current, higher yield. Eurodollar futures prices are quoted as 100 minus the implied interest rate. If interest rates are expected to decline, the implied interest rate will fall, causing the Eurodollar futures price to rise. To profit from a rising futures price and offset the lower interest earned on the actual cash deposit, the treasurer should take a long position, meaning they should buy Eurodollar futures contracts. This gain from the futures position will compensate for the reduced interest income from the cash market deposit, effectively locking in a more favorable yield.

To calculate the premium percentage for a structured call warrant, the formula is: Premium (%) = [(nWP + X – S) / S] x 100. Given the details: Underlying share price (S) = $12.50 Exercise price (X) = $12.00 Warrant price (WP) = $0.40 Conversion ratio (n) = 4 First, calculate nWP: 4 x $0.40 = $1.60 Next, substitute the values into the formula: Premium (%) = [($1.60 + $12.00 – $12.50) / $12.50] x 100 Premium (%) = [($13.60 – $12.50) / $12.50] x 100 Premium (%) = [$1.10 / $12.50] x 100 Premium (%) = 0.088 x 100 = 8.80% This calculation reflects the cost of the warrant relative to its intrinsic value and the underlying share price, expressed as a percentage of the underlying share price. Understanding this calculation is crucial for evaluating the attractiveness and cost-effectiveness of a structured warrant.

Basis risk arises in hedging situations due to imperfections between the asset being hedged and the futures contract used. The provided text explicitly lists three such imperfections: (1) the underlying asset in the futures contract is not completely identical to the asset being hedged, (2) the hedger may be uncertain about the exact date when the asset will be bought or sold, and (3) the hedge may require the futures contract to be sold before the delivery month. The option stating that the specific grade of raw material required by the firm is not perfectly identical to the asset specified in the futures contract directly corresponds to the first imperfection listed, making it a direct cause of basis risk. The other options describe general market movements or internal operational changes that might affect the basis temporarily or impact the firm’s overall financial position, but they are not among the fundamental imperfections that give rise to basis risk in the context of the hedge’s structural design as defined in the syllabus material.

Foreign Exchange (FX) warrants allow investors to speculate on currency movements or hedge currency exposure. Similar to currency options, an FX warrant holder has the right to exchange one currency for another at a specified rate. When an investor is bullish on the base currency (the first currency in the pair) and expects it to appreciate against the quote currency (the second currency), they would purchase a call warrant on that currency pair. Conversely, if they are bearish on the base currency, they would purchase a put warrant. In this scenario, the investor anticipates the Euro (EUR) to appreciate against the US Dollar (USD). Therefore, they are bullish on EUR and bearish on USD. To profit from this view, they should buy EUR/USD call warrants, which gives them the right to buy EUR with USD at a predetermined strike price. If the EUR/USD exchange rate rises (meaning EUR strengthens), they can exercise the warrant, buy EUR at the lower strike price, and sell it at the higher market rate, thereby making a profit. Purchasing a put warrant on EUR/USD would be suitable if the investor expected EUR to depreciate. Purchasing warrants on the inverted pair (USD/EUR) would require a different interpretation of call/put options relative to the investor’s primary view.

Bond options are distinct from equity options in several ways. One key characteristic is their expiration date. As a bond approaches its maturity, its price tends to converge towards its par value, reducing price uncertainty. Therefore, the expiration of a bond option is typically set significantly before the bond’s maturity date to capture the period of greater price volatility. Regarding hedging strategies, an investor who anticipates an increase in interest rates would expect bond prices to fall. To protect against this decline, the investor would buy a bond put option, which gives them the right to sell the bond at a predetermined strike price, thereby limiting potential losses if bond prices drop.

For a Bear contract, a mandatory call event is triggered when the underlying asset’s spot price rises to or above the Call Price. In this scenario, the spot price of $11.80 has risen above the Call Price of $11.50, thus triggering the mandatory call. When a mandatory call event occurs, the payoff for a Bear contract is its Residual Value. The Residual Value is calculated as (Strike Price – Call Price) divided by the Conversion Ratio. Using the given figures: Strike Price = $13.00, Call Price = $11.50, Conversion Ratio = 5:1. Therefore, the Residual Value = ($13.00 – $11.50) / 5 = $1.50 / 5 = $0.30. The financial cost and time to maturity are not relevant for calculating the residual value in a mandatory call event. Other options represent common miscalculations, such as using the current spot price ($11.80) instead of the Call Price for settlement, forgetting the conversion ratio, or using the initial spot price.

The Constant Proportion Portfolio Insurance (CPPI) strategy is designed to protect a portion of the investor’s capital while allowing participation in market upside. A key feature of CPPI is its dynamic asset allocation. When the total portfolio value declines to the predetermined capital protection floor, the strategy dictates a specific action to preserve the remaining capital. At this critical point, the entire allocation to the risky asset is liquidated, and the proceeds are re-allocated into the risk-free asset. This ensures that the portfolio value does not fall below the floor, effectively ‘locking in’ the capital protection. Options suggesting multiplier recalculation, partial rebalancing to maintain a cushion, or deploying additional capital into risky assets are incorrect. The multiplier is typically fixed based on the crash size, partial rebalancing occurs above the floor, and deploying more into risky assets would contradict the capital protection objective when the floor is hit.

Reverse Convertibles are structured products designed for investors seeking enhanced yields. Their construction typically involves two main components: a long position in a zero-coupon bond and a short position in a put option. The zero-coupon bond provides a low-risk component, while the short put option generates premium income, contributing to the enhanced yield. However, the short put also exposes the investor to the downside risk of the underlying asset, as they would be obligated to buy the asset at the strike price if its market value falls below that level. The upside return for the investor is capped, usually at the sum of the interest from the zero-coupon bond and the premium received from selling the put option. This structure results in an asymmetric return profile, where potential gains are limited, but potential losses can be substantial if the underlying asset’s price declines significantly.

This question requires the application of the formula for hedging equity risks, which is used to determine the number of futures contracts needed to hedge a portfolio. The formula is N = (VP / (F T)) β, where N is the number of contracts, VP is the current value of the portfolio, F is the current futures quote, T is the value per tick, and β is the beta of the portfolio. In this scenario, the portfolio value (VP) is $5,000,000, the futures quote (F) is 3,000 points, the value per tick (T) is $10, and the portfolio beta (β) is 1.2. Substituting these values into the formula: N = ($5,000,000 / (3,000 $10)) 1.2. First, calculate the denominator: 3,000 $10 = $30,000. Then, divide the portfolio value by this amount: $5,000,000 / $30,000 = 166.666… Finally, multiply by the portfolio beta: 166.666… 1.2 = 200. Thus, the manager should consider 200 futures contracts.

Under direct issuance, the structured note represents a direct obligation of the issuing bank, and the debt is recorded on the bank’s balance sheet. This means that in the event of the bank’s default, the investor has a direct claim on the bank’s general assets as a creditor. In contrast, when a structured note is issued by a Special Purpose Vehicle (SPV) established by a bank, the SPV is a separate legal entity. The SPV’s assets and liabilities are distinct from the bank’s and are considered off-balance sheet from the bank’s perspective. Therefore, if the bank defaults, noteholders of SPV-issued notes can only make a claim on the SPV’s assets and have no recourse to the bank that set up the SPV. This fundamental difference in recourse is a key consideration for investors assessing the credit risk of structured notes.

The trading name of a structured warrant provides specific information about its features. In the designation ‘ALPHA DB ePW300625’, the ‘e’ prefix signifies that the warrant is of European style. A European-style warrant can only be exercised on its expiration date, not at any point before or during its life. An American-style warrant, in contrast, would typically have no prefix for its exercise style and would allow for exercise at any time up to and including the expiration date. The ‘e’ does not relate to the type of underlying asset or the geographical origin of the issuer. The ‘PW’ indicates it’s a Put Warrant, and ‘DB’ would typically refer to the issuer (e.g., Deutsche Bank), while ‘ALPHA’ would be the underlying instrument.