CMFAS RES6A Quiz 19

When a company declares a cash dividend, investors holding Contracts for Differences (CFDs) are subject to adjustments that mirror the effect on physical shareholdings. For an investor holding a short CFD position, they are essentially betting on the price of the underlying asset to fall. If a dividend is paid out, the value of the underlying share is expected to drop by approximately the dividend amount on the ex-dividend date. To reflect this economic reality and ensure that the short CFD holder does not unfairly profit from this expected price drop (as their position would otherwise gain from the price fall without adjustment), their account is debited by the dividend amount. This means their account balance is reduced. Conversely, an investor holding a long CFD position would receive a credit for the dividend, as they would have received it if they owned the physical shares.

A bull put spread is initiated when an investor expects the underlying asset’s price to experience a moderate upward movement. This strategy involves selling a higher strike price put option (which is typically in-the-money) and buying a lower strike price put option (which is typically out-of-the-money) on the same underlying asset with the same expiration date. The investor receives a net credit when entering this position. The maximum potential profit for a bull put spread is limited to this net credit received. This occurs if the underlying asset’s price at expiration is above the higher strike price, causing both put options to expire worthless. In this scenario, the investor keeps the entire initial credit. The maximum loss, on the other hand, would be the difference between the two strike prices minus the net credit received.

An Equity Linked Exchange Traded Fund (ETF) generally offers a low total expense ratio (TER) and can be bought or sold on any trading day through an exchange, typically incurring only brokerage fees. This aligns with the investor’s desire for minimal ongoing administrative costs and flexibility to exit without substantial early redemption penalties. In contrast, Equity Linked Structured Notes often have high upfront and structuring fees due to their complexity, and while early redemption might be possible if barrier options are part of the structure, the overall cost might not be minimal. Equity Linked Structured Funds typically involve recurring management fees and can have back-end redemption fees, which would contradict the goal of avoiding substantial early exit penalties. An Equity Linked Investment-Linked Policy (ILP), while allowing for policy surrender, explicitly states that the earlier the surrender, the greater the potential loss is likely to be, due to insurance charges and administrative fees, making it unsuitable for an investor sensitive to early exit penalties.

When an investor holding a short Extended Settlement (ES) position fails to deliver the required shares by the due date, the Central Depository Pte Ltd (CDP) steps in to fulfill the delivery obligation. The buying-in process commences on the day immediately following the due date. The initial price for this buying-in is determined by taking two minimum bids above the highest of three specific market indicators: the closing price of the previous day, the current last done price, or the current bid price. This mechanism ensures that the delivery obligation is met, albeit at a potentially higher cost to the defaulting party. Other options describe incorrect timings or pricing methodologies for the CDP’s buying-in procedure.

The Trust Deed is a crucial legal document that outlines the terms and conditions governing the relationship between investors, the fund manager, and the trustee. Its primary purpose is to describe the investment objectives of the fund and, critically, the obligations and responsibilities of both the fund manager and the trustee. The trustee’s role, as specified in the Trust Deed, is to act as an independent custodian of the fund’s assets. This independence is vital as the trustee is responsible for ensuring that the fund manager operates the fund in strict accordance with the provisions of the Trust Deed, thereby mitigating the risk of mismanagement and safeguarding investors’ interests. Options related to defining investment strategy, marketing, or providing investment advice are typically responsibilities of the fund manager, investment adviser, or distributor, not the trustee’s primary function under the Trust Deed.

Rho measures the sensitivity of an option’s price to changes in the risk-free interest rate. An increase in interest rates generally increases the value of call options and decreases the value of put options. Therefore, for an analyst concerned about the impact of rising interest rates on their option premiums, Rho is the most crucial Greek to monitor. Delta measures the sensitivity of the option price to changes in the underlying asset’s price. Theta measures the sensitivity of the option price to the passage of time (time decay). Vega measures the sensitivity of the option price to changes in the underlying asset’s volatility.

A Credit Linked Note (CLN) is a structured product that exposes the investor to the credit risk of a specific reference entity. The syllabus explicitly states that if the reference entity experiences a credit default, the CLN investor is exposed to potential principal loss. The settlement of the underlying Credit Default Swap (CDS) determines the exact outcome. In a physical settlement, the CLN investor receives a defaulted debt obligation of the reference entity, which would likely have a market value significantly below its par value. In a cash settlement, the investor bears a loss equivalent to the difference between the par value and the market price of the specified debt obligation. Therefore, the investor will either receive a low-value defaulted bond or incur a direct financial loss on their principal. The CLN is not designed to preserve principal in the event of a credit default by the reference entity, nor does it typically convert into equity or offer enhanced coupon payments as a consequence of a credit event.

The intrinsic value of a put option is the amount by which the exercise price exceeds the underlying asset price, but only if the option is in-the-money. If the underlying asset price is at or above the exercise price, the intrinsic value is zero. In this scenario, the exercise price (X) is $75 and the underlying asset price (ST) is $72. Since X > ST, the put option is in-the-money. Therefore, the intrinsic value is calculated as X – ST = $75 – $72 = $3. The time value of an option is the difference between the option’s premium (total price) and its intrinsic value. The premium paid for the option is $5. With an intrinsic value of $3, the time value is calculated as Option Premium – Intrinsic Value = $5 – $3 = $2. Thus, the intrinsic value is $3 and the time value is $2.

Callable Bull/Bear Contracts (CBBCs) are structured products that allow investors to take a directional view on an underlying asset. For a Bear CBBC, an investor takes a bearish (negative) position on the underlying asset. The pricing mechanism of a CBBC is designed such that its price changes closely follow the price changes of the underlying asset, with a delta close to 1 (or -1 for a Bear CBBC). Therefore, if the underlying asset (in this case, the stock index) experiences a significant downward trend, a Bear CBBC would increase in value by approximately the same amount, assuming a 1:1 conversion ratio. This is because the investor profits when the underlying asset’s value declines.

The scenario describes a futures trader holding a long position who aims to secure profits by automatically selling their contract if the market price rises to a predetermined level above the current trading price, with the instruction to execute as a market order once that price is touched. A Market-if-Touched (MIT) order is specifically designed for this situation. According to the CMFAS Module 6A syllabus, an MIT sell order is placed above the current market price and is held in the system until the trigger price is touched, at which point it is submitted as a market order. This perfectly aligns with the trader’s objective. In contrast, a Stop order, particularly a sell stop order, is typically placed below the current market price to limit losses on a long position, not to sell above the market for profit-taking in this manner. While a Stop order can convert to a market order, its placement for a sell is the key differentiator. A Session State Order (SSO) triggers based on market session transitions, not specific price levels. A Limit order placed above the current market would simply sit in the order book and execute as a limit order if the price reaches it, but it would not convert from a trigger to a market order as specified in the scenario.

The Credit Support Annex (CSA) is a critical legal document commonly used in Over-The-Counter (OTC) derivative transactions, such as options. Its primary purpose is to define the terms and conditions under which collateral, typically cash or securities, is posted or transferred between the counterparties. This mechanism is specifically designed to mitigate counterparty credit risk by ensuring that there is security against potential losses should one party default on its obligations. While a Master Netting Agreement (MNA) is also relevant in derivatives for netting obligations, it does not primarily define the collateral exchange terms in the same way a CSA does. Futures Trading Mandate and Bilateral Portfolio Reconciliation are not the specific legal documents for establishing collateral terms to mitigate credit risk in OTC options.

When a structured product involves shorting a pay-fixed interest rate put swaption, the investor acts as the swaption seller. If the market interest rate rises above the strike rate, the swaption buyer will exercise the option. In this situation, the investor (seller) becomes liable to pay out the floating rate while receiving a fixed rate. As the floating rate can theoretically rise indefinitely, the potential losses for the swaption seller are unlimited and directly depend on how high the floating interest rate climbs. This is a key characteristic of the structure risk associated with certain derivative combinations, as highlighted in the CMFAS Module 6A syllabus.

A knock-out option is a type of barrier option that ceases to exist or is extinguished if the price of the underlying asset touches or crosses a predetermined barrier level during its life. In this scenario, the investor holds a knock-out call option with a knock-out barrier at $60. When the stock price surged to $62, it crossed the $60 barrier. At that moment, the barrier event occurred, and the option would have been knocked out, meaning it terminated and expired. Subsequent price movements below the barrier are irrelevant once the knock-out event has occurred. The payoff upon termination would depend on the specific terms of the option agreement, which could be zero, a fraction of the initial premium, or a fixed mandatory payoff. Therefore, the option would no longer be active. The other options describe scenarios that do not align with the fundamental characteristics of a knock-out option; they do not remain active after the barrier is hit, nor do their strike prices automatically adjust, nor do they convert into standard options.

A Credit Linked Note (CLN) exposes the investor to the credit risk of a ‘reference entity’. In the event of a credit default by this reference entity, the CLN’s payout mechanism is triggered. If the CLN specifies cash settlement, the issuing bank (which is the seller of the Credit Default Swap, or CDS, linked to the reference entity) pays the CDS buyer the difference between the par value and the market price of a specified debt obligation of the reference entity. This loss is then borne by the CLN investors. Therefore, the investor receives a payment that reflects this loss, meaning they will bear a loss equivalent to that difference. This contrasts with physical settlement, where the investor would receive the defaulted debt obligation itself. CLNs are not principal-protected in a credit default scenario, and the issuer does not absorb the loss; rather, the risk is transferred to the CLN investor in exchange for a higher coupon.

The scenario describes a situation where the issuer of a structured product faces financial difficulties unrelated to the product itself, leading to concerns about their ability to meet future obligations. This directly corresponds to ‘Issuer risk’. Issuer risk is the risk that the product provider may be unable to fulfill its liabilities due to bankruptcy or lack of liquidity, even if these issues arise from circumstances external to the structured product. Return risk relates to the performance of the return component’s underlying instruments, such as market or currency fluctuations. Principal risk refers to the likelihood of losing the initial investment due to adverse movements in the underlying assets or credit factors affecting those assets. Market risk is a component of return risk, referring to general market movements affecting the value of the underlying instruments.

To determine the number of futures contracts required for a delta-neutral hedge, we first calculate the hedge ratio. The hedge ratio (h) represents the sensitivity of the cash position relative to the futures contract. It is calculated as the negative of the change in the security’s value divided by the change in the futures contract’s value for a given change in the underlying factor (e.g., interest rates). Given: Change in security value (ΔS) for 1 basis point change = S$15,000 Change in futures contract value (ΔF) for 1 basis point change = S$12,000 Hedge Ratio (h) = – (ΔS / ΔF) h = – (S$15,000 / S$12,000) h = -1.25 Next, we calculate the number of contracts needed. The formula for the number of contracts is the negative of the hedge ratio multiplied by the value of the position to be hedged, divided by the notional value of one futures contract. Position Value = S$60,000,000 Contract Size = S$1,000,000 Number of contracts = – Hedge Ratio (Position Value / Contract Size) Number of contracts = – (-1.25) (S$60,000,000 / S$1,000,000) Number of contracts = 1.25 60 Number of contracts = 75 Therefore, 75 bond futures contracts are needed to establish a delta-neutral hedge.

When a corporate treasury manager anticipates receiving funds for a future deposit and expects interest rates to decline, they face the risk of earning a lower yield on that deposit. To hedge this risk using Eurodollar futures, the manager should take a long position, meaning they should buy Eurodollar futures contracts. Eurodollar futures prices are quoted as 100 minus the implied interest rate. Therefore, if interest rates decline, the Eurodollar futures price will rise. The profit generated from the long futures position will then offset the lower interest earned on the actual deposit when it is placed, effectively locking in a yield closer to the current implied market rate. For a USD 5 million deposit, typically 5 Eurodollar futures contracts would be used, as each contract is based on USD 1 million.

An arbitrageur’s primary role is to identify and exploit temporary price discrepancies between related markets, such as a futures contract and its underlying asset. They aim to secure risk-free profits by simultaneously buying in one market and selling in another, without taking on directional market risk. A speculator, in contrast, takes a directional view on market prices, aiming to profit from anticipated price movements and accepting associated risks. A hedger uses futures to mitigate or reduce existing price risk from an underlying asset or liability. A market maker provides liquidity to the market by continuously quoting both bid and offer prices, profiting from the bid-ask spread rather than from disequilibrium between distinct markets.

The question describes two distinct structured notes based on their payout mechanisms and underlying risks. The first note, whose payout is primarily contingent on a defined credit event of a specific reference entity, aligns with the characteristics of a Credit-Linked Note (CLN). A CLN’s performance is directly tied to the creditworthiness of a reference entity, and a credit event triggers its payout. The second note, whose payout is influenced by the market price fluctuations of an underlying bond and carries the possibility of the investor acquiring the bond at maturity even without a credit event, describes a Bond-Linked Note (BLN). A BLN embeds a short put option on a bond, meaning its payout depends on the bond’s price, and the investor might end up owning the bond if the put option is exercised, regardless of a credit event on the reference entity. The other options represent different structured products with distinct features not matching the descriptions provided.

The Trust Deed is the foundational legal document for a structured fund. It explicitly outlines the terms and conditions governing the relationship between investors, the fund manager, and the independent trustee. Crucially, it describes the fund’s investment objectives and delineates the specific obligations and responsibilities of both the fund manager and the trustee. The trustee’s role, as established by the Trust Deed, includes acting as the custodian of the fund’s assets and ensuring the fund is managed in accordance with the Trust Deed, thereby safeguarding investor interests against potential mismanagement. While the Fund Prospectus provides detailed information to potential investors, and the Product Highlights Sheet offers a summary, neither serves as the primary legal instrument defining the overarching governance and contractual obligations in the same way as the Trust Deed. A Custodian Agreement is a more specific contract related to the safekeeping of assets, often stemming from the trustee’s broader responsibilities defined in the Trust Deed.

Volatility is a measure of the expected fluctuation in the price of the underlying asset. Higher volatility indicates a greater likelihood of significant price movements, either upwards or downwards. For a call option, a large upward movement in the underlying share price is beneficial, increasing its potential intrinsic value. Similarly, for a put option, a substantial downward movement in the underlying share price is advantageous. Therefore, increased volatility enhances the probability that an option (whether a call or a put) will move into a profitable ‘in-the-money’ position before expiration. This higher probability translates into a greater time value component, and consequently, a higher premium for both call and put options, assuming all other factors remain constant.

The question describes the core features of a Zero Coupon Fixed Income Plus Option Strategy, also known as a ‘Zero Plus’ option strategy. This strategy typically involves a zero-coupon fixed income instrument, which aims to return the principal sum at maturity, combined with a call option on an underlying financial instrument. The call option provides the potential for upside returns if the underlying asset performs above a specified strike price, with returns determined by a participation rate. The text explicitly states that as long as there is no credit event in the issuing bank, the investor will at least get back 100% of the principal sum, making it a capital preservation strategy. Option 2, an Investment-Linked Policy (ILP), is incorrect because ILPs do not normally provide guaranteed cash values or principal return. Their value depends on the performance of the underlying sub-funds, and the investor bears all investment risk. Option 3, a structured deposit offering guaranteed interest with no market linkage, is incorrect because while structured products can take the form of structured deposits, the description in the question specifically mentions potential upside linked to an underlying asset’s performance, which implies market linkage through an option component, not just guaranteed interest without market exposure. The Zero Plus strategy is a specific mechanism for achieving principal preservation with market-linked upside. Option 4, a pure equity-linked note with full principal at risk, is incorrect as it directly contradicts the stated aim of returning the full principal sum at maturity. The Zero Plus strategy is designed for capital preservation.

When an Equity Linked Note (ELN) with physical settlement matures and the underlying share price is below the strike price, the investor receives the actual shares of the underlying company. If the investor chooses to hold these shares instead of selling them immediately, they transition from holding a structured product to directly owning the underlying equity. This means the investor is now fully exposed to the market risk associated with the shares, including potential future appreciation or depreciation. Their ultimate return will depend entirely on the subsequent performance of the share price and when they eventually decide to sell. Option 1 accurately describes this direct, ongoing market risk. Option 2 is incorrect because the return is no longer fixed; it becomes variable based on share performance. Option 3 is incorrect as holding shares provides no capital protection against further price declines. Option 4 is incorrect because physical settlement means receiving shares, not a cash equivalent based on the original strike price; a cash equivalent would only be realized if the shares were sold at the prevailing market price.

The question describes a neutral spread strategy involving four distinct, sequentially ordered delivery months, where the trader sells two different, adjacent middle months and buys the earliest and latest months. This structure, characterized by four unique delivery months and a ratio of +1 : -1 : -1 : +1 (buy nearest, sell second nearest, sell third nearest, buy furthest), is the defining characteristic of a condor spread. A condor spread is similar to a butterfly spread but crucially differs by not having a common middle delivery month. The butterfly spread, in contrast, involves three delivery months, with the middle month being sold twice (ratio +1 : -2 : +1). The TED spread is a different concept altogether, representing the difference between 3-month US Treasuries futures and 3-month Eurodollar futures with the same expiration month, used as an indicator of credit risk. A calendar spread typically involves buying and selling futures contracts of the same underlying asset but with different delivery months, usually a two-leg strategy, and does not fit the four-leg, distinct middle month structure described.

Structured products designed to offer a minimum return of principal at maturity typically achieve this by investing a portion of the investor’s capital into a zero-coupon bond. This bond is purchased at a discount and matures at par, ensuring the return of the initial principal amount at the product’s maturity. The remaining portion of the capital is then usually invested in a return component, such as derivatives (e.g., long-call options), to provide potential upside participation. A portfolio of equity index futures would be part of the return component, not the principal preservation mechanism. A series of short-term call options, particularly short options strategies, are generally employed in products that do not offer principal protection, or for generating income, not for guaranteeing the initial capital. While credit default swaps can be used within structured products for credit risk exposure or yield enhancement, they are not the foundational instrument for ensuring the return of the investor’s principal at maturity.

The investor’s objective is to profit from significant price movement in either direction (volatility) while limiting maximum loss. A long strangle strategy involves simultaneously buying an out-of-the-money call option and an out-of-the-money put option with the same expiration date. This strategy profits if the underlying asset’s price moves significantly above the call strike or significantly below the put strike. The maximum loss is limited to the total premiums paid for both options, which aligns with the investor’s requirement to strictly limit financial exposure. A bull call spread is suitable for a moderately bullish outlook with limited profit and limited loss. A covered call is typically used by investors who own the underlying shares and wish to generate income or slightly hedge against a small price decline, not for profiting from high volatility. A naked short put strategy profits if the price stays above the strike or rises, but carries significant downside risk if the price falls substantially, contradicting the desire for strictly limited maximum financial exposure.

Gamma measures the sensitivity of an option’s delta to changes in the underlying asset price. For a net short option position, the gamma is negative. The provided text states that gamma is highest when an option is at-the-money and close to expiry. In such a scenario, if the underlying asset price moves unfavorably, the delta of the short option position will change rapidly in a direction that exacerbates losses. This rapid change in delta means that the initial delta hedge (if any) quickly becomes inadequate, exposing the trader to significant risk. Therefore, the most significant risk for a trader with a net short option position, when the options are at-the-money and nearing expiry, is the rapid and potentially unfavorable change in their delta exposure. The other options are incorrect because: Vega, while also high at-the-money, describes sensitivity to volatility, not the direct impact of underlying price movement on delta. Theta, or time decay, is typically most significant for at-the-money options nearing expiry, meaning value is lost rapidly, not preserved. Rho, the sensitivity to interest rates, is generally a less significant factor for option prices compared to Gamma, especially in a dynamic market movement scenario.

The final settlement price for the 5-year Singapore Government Bond Futures is derived through a specific methodology to ensure fairness and accuracy. A critical step in this process involves calculating the arithmetic mean of the bid and offer prices contributed by the Singapore Government Securities Dealers. To prevent extreme values from skewing the average, the methodology explicitly states that the three highest and three lowest bid prices, as well as the three highest and three lowest offer prices, are discarded before this mean calculation. This filtering ensures that the resulting yield, which is then used to determine the final settlement price, is representative of the market. Other options describe incorrect or incomplete aspects of the settlement process, such as directly averaging all prices without adjustment, considering only bid prices, or relying solely on the benchmark bond’s yield.

The question describes an auto-redeemable structured fund with a knock-out feature. The scenario indicates that a mandatory call event (knock-out trigger) occurs on the second early redemption observation date because the performance of the Nikkei 225 is greater than or equal to the performance of the S&P 500. When a mandatory call event occurs, the fund is redeemed early, and the investor receives a payout calculated as the Terminal Value. The Terminal Value is defined as the Redemption Value multiplied by the Payout Price. The Redemption Value is 100% of the initial investment, which is SGD 100,000. The Payout Price is calculated as the Periodic Yield multiplied by the number of observations. The Periodic Yield is 4.25%. Since the early redemption occurs on the second early redemption observation date, the number of observations is 2. Therefore, the Payout Price component is (4.25% 2) = 8.5%. This means the investor receives their initial investment plus an additional 8.5% yield. The total payout is SGD 100,000 (1 + 0.085) = SGD 108,500. This calculation is distinct from the final payout at maturity if the product does not terminate early, which has different percentage payouts based on index performance.

The structured fund includes an auto-redeemable feature that activates after 1.5 years from inception and subsequently every six months until maturity. The condition for this early redemption is met if the closing level of any of the underlying indices falls below 75% of its initial level on a specified observation date. In the given scenario, two years after inception is a valid auto-redemption observation date. The Nikkei 225 Stock Index is observed at 72% of its initial level, which is below the 75% threshold. Since the condition is met by at least one index, the product auto-redeems. Upon auto-redemption, the product terms specify that the investor receives 100% of the principal value.