CMFAS RES6A Quiz 32

Delta measures the sensitivity of an option’s price to a change in the underlying asset’s price. For a call option, delta is positive, meaning that as the underlying share price increases, the call option’s premium also increases. The change in the option’s premium is calculated by multiplying the delta by the change in the underlying share price. In this scenario, with a call option delta of 0.60 and an underlying share price increase of $3.00, the expected change in the option’s premium is 0.60 $3.00 = $1.80. Since it’s a call option and the underlying price increased, the option premium will increase. Therefore, an increase of $1.80 is the correct outcome. A decrease would be incorrect for a call option when the underlying price rises. Other magnitudes would indicate a misunderstanding of the delta calculation.

Company warrants are typically issued by listed companies, often alongside bonds or rights issues, and are generally American-style, meaning they can be exercised at any time up to their expiry. Structured warrants, on the other hand, are issued by third-party financial institutions and are based on various underlying assets such as individual stocks, equity indices, or commodities. In Singapore, structured warrants are European-style, which means they can only be exercised on their expiry date. Therefore, the first instrument described, issued by a listed corporation and exercisable anytime, aligns with the characteristics of a company warrant with American-style exercise. The second instrument, originated by a third-party financial entity and exercisable only on its maturity date, matches the description of a structured warrant with European-style exercise.

The question describes a put option because the holder has the right to sell the underlying asset. The strike price is S$50, and the current market price of the underlying asset is S$48. For a put option, it is considered in-the-money (ITM) when the strike price is higher than the current market price. In this case, S$50 > S$48, so the option is in-the-money. The intrinsic value of a put option is calculated as: Option Strike Price – Current Market Price. Therefore, the intrinsic value is S$50 – S$48 = S$2. The option’s premium (or option price) is S$3. The time value of an option is the difference between its premium and its intrinsic value: Time Value = Option Price – Intrinsic Value. Thus, the time value is S$3 – S$2 = S$1. Based on these calculations, the option is in-the-money, has an intrinsic value of S$2, and a time value of S$1. The other options contain incorrect assessments of moneyness, intrinsic value, or time value calculations.

The question describes two types of derivative contracts: one traded on an organised exchange with daily settlement (futures) and another privately arranged (forwards). Futures contracts are characterised by their standardisation, meaning their terms (such as underlying asset, quantity, and delivery date) are predefined by the exchange. A key feature of exchange-traded futures is the role of a clearing house, which acts as a counterparty to both the buyer and seller, effectively eliminating bilateral counterparty risk between the original parties. Furthermore, futures positions are subject to daily mark-to-market procedures, where gains and losses are settled daily, and margin accounts are adjusted to reflect these changes. This ensures that positions are adequately collateralised and reduces the risk of default. Option 2 describes characteristics of a forward contract, which is typically customised, negotiated directly between two parties, carries counterparty risk, and usually settles only at its expiry date. Option 3 also describes features more aligned with forward contracts (non-transferable, flexible terms). While futures can be used for speculation, stating they are ‘primarily used for speculative purposes rather than hedging’ is an oversimplification and not a defining differentiator in this context, as futures are extensively used for hedging. Option 4 incorrectly states that the initial margin is the full contract value. Futures contracts are known for their leverage, requiring only a small initial margin (a fraction of the contract value) to open a position, not the full amount. This allows investors to gain significant exposure with a relatively small capital outlay.

A Credit Linked Note (CLN) exposes investors to two distinct credit risks. Firstly, there is the credit risk of the ‘reference entity’ (Company X in this scenario), whose credit performance dictates the contingent payout of the note. If this entity experiences a credit event, the investor’s return or principal may be adversely affected. Secondly, the investor is exposed to the credit risk of the entity that issues the note itself or the entity whose debt instrument holds the principal (Bank Y in this scenario). This is because the principal’s safety depends on the creditworthiness of the issuer of the underlying bond or the note itself. Therefore, a default by either Company X or Bank Y could lead to losses for the investor. The other options incorrectly limit the credit exposure or introduce a different type of risk (market risk) when the question specifically asks for credit risks.

A synthetic long stock position is designed to replicate the risk and reward characteristics of directly owning the underlying asset, but through the use of options. According to the principles of synthetic positions, this is achieved by simultaneously buying a call option and selling a put option on the same underlying asset, with identical strike prices and expiration dates. This combination provides the investor with unlimited profit potential if the underlying asset’s price rises, and unlimited downside risk if it falls, mirroring the payoff of a long stock position. Other combinations of options create different risk-reward profiles; for instance, selling a call and buying a put would create a synthetic short stock position, while buying both a call and a put creates a long straddle, and selling both creates a short straddle.

The fund is call protected for the initial 1-year period, meaning the first early redemption observation date is after 1 year. Thereafter, observation dates occur every 6 months. If the Mandatory Call Event is triggered on the second early redemption observation date, it means it occurred after 1 year and 6 months. Therefore, the ‘No. of Observations’ for calculating the payout price would be 2 (one for the first year, and one for the subsequent 6-month period). The Periodic Yield is 4.25%. The total yield component for early redemption is calculated as Periodic Yield multiplied by the No. of Observations, which is 4.25% 2 = 8.50%. Since the fund has a capital preservation objective, the investor receives 100% of the initial investment plus this accumulated yield. Thus, the total payout percentage of the initial investment would be 100% + 8.50% = 108.50%.

The question describes a fund structure where exposure to an underlying asset is gained primarily through derivative transactions, rather than direct or full investment in the underlying asset itself. This mechanism is characteristic of an Indirect Investment Policy Fund, also known as a Swap-based Fund, as detailed in the CMFAS Module 6A syllabus under ‘Overview of Common Fund Structures’. These funds use derivatives to link the fund’s performance to the underlying asset. A Capitalized Fund, on the other hand, focuses on automatically reinvesting dividends back into the fund. A Formula Fund’s payout depends on a pre-defined, rule-based formula, often tracking an index, but the core mechanism described in the question (indirect exposure via derivatives) is not its defining feature. A Target Date Fund is designed to adjust its asset allocation over time, typically becoming more conservative as the investor approaches retirement, which is unrelated to the method of gaining exposure to an underlying asset.

The fund trustee’s primary role is to act in a fiduciary capacity, safeguarding the interests of the unit holders. This includes ensuring that the fund manager adheres to the investment objectives and restrictions outlined in the trust deed and prospectus. If the trustee becomes aware of any breaches, they are legally obligated to inform the Monetary Authority of Singapore (MAS) within three business days. While the fund manager is responsible for managing the assets, and the administrative agent handles operational processes, and the auditor performs annual checks, it is the trustee who holds the legal ownership of the fund’s assets on behalf of unit holders and has the direct oversight and reporting responsibility for such breaches to the regulator.

When a financial institution issues structured notes through a Special Purpose Vehicle (SPV), the SPV is established as a separate legal entity. This means that the SPV’s assets and liabilities are distinct from the financial institution’s main balance sheet. Consequently, in the event of a default, noteholders can only make a claim on the assets held by the SPV. They have no recourse to the financial institution that set up the SPV. This structure is often referred to as ‘off-balance sheet’ from the bank’s perspective. Options suggesting recourse to the parent institution, coverage by the Deposit Insurance Scheme (which does not apply to structured notes or even structured deposits in this context), or the debt remaining on the parent’s balance sheet are incorrect based on the principles of SPV issuance.

When a structured note is issued through a Special Purpose Vehicle (SPV), the SPV operates as a distinct legal entity separate from the bank that established it. The notes are issued directly by the SPV to investors. A fundamental aspect of this off-balance sheet arrangement is that the SPV’s assets and liabilities are not consolidated onto the bank’s balance sheet. Therefore, should a default occur, the noteholders’ claims are restricted to the assets held by the SPV itself, and they possess no legal recourse against the parent bank that created the SPV. This structure means the investor’s credit risk is primarily tied to the SPV and its specific assets, rather than the creditworthiness of the bank directly. Structured notes are not covered by the Deposit Insurance Scheme, and the bank does not provide an implicit guarantee for the SPV’s obligations, nor is the SPV merely an extension implying direct bank liability.

The Constant Proportion Portfolio Insurance (CPPI) strategy is designed to dynamically manage risk by adjusting the allocation between a risky asset and a risk-free asset. A core component of this strategy is the ‘cushion,’ which is calculated as the total portfolio value minus the floor value. The allocation to the risky asset is determined by multiplying this cushion value by a fixed multiplier. Therefore, if the total portfolio value experiences a substantial decrease, the cushion value will consequently diminish. A smaller cushion directly results in a reduced allocation to the risky asset, as the strategy aims to decrease risk exposure when the portfolio value moves closer to the floor, thereby protecting the principal. This mechanism is a characteristic of CPPI, where the strategy ‘sells low’ in a declining market to preserve capital. Option 2 is incorrect because CPPI is a capital preservation strategy that reduces exposure to risky assets as the portfolio value declines, rather than increasing it to recover losses. Such an action would contradict the risk-management objective of CPPI. Option 3 is incorrect because, while the multiplier in a CPPI strategy is constant, the actual allocation to the risky asset is not. It is a product of the constant multiplier and the variable cushion value. As the cushion changes with the portfolio’s performance, so does the allocation to the risky asset. Option 4 is incorrect because the entire portfolio is typically reallocated to the risk-free asset only when the portfolio value drops to or below the floor value, effectively breaching the floor. The question specifies that the floor value has not yet been breached, indicating that a full reallocation to the risk-free asset is not yet mandated.

The investor’s primary objectives are to hedge against rising interest rates, avoid the complexities of physical delivery of underlying bonds, and limit exposure to principal value fluctuations. An interest rate put option directly addresses these needs. It is an option where the underlying asset is an interest rate, and the exercise price is also an interest rate. Upon exercise, interest rate options are cash-settled based on the difference between the exercise interest rate and the prevailing market rate, meaning no physical delivery of bonds occurs. Furthermore, because only the interest rate differences are settled, there is no risk of losing the principal amount of a bond. A bond call option would be used if the investor expected interest rates to fall, causing bond prices to rise, and it involves the underlying bond’s price. A bond put option would hedge against rising interest rates by protecting against falling bond prices, but it still relates to the bond’s value and potential delivery or cash settlement based on the bond’s price, not solely the interest rate difference. An option on a bond futures contract provides liquidity and tracks bond price movements, but the underlying is a futures contract on a bond, not the interest rate itself, and while cash-settled, it doesn’t isolate the interest rate difference in the same way an interest rate option does to explicitly avoid principal risk on the underlying bond.

An Equity-Linked Structured Note (ELSN) typically consists of a zero-coupon bond for capital preservation and a call option for potential equity upside. The ‘discount sum’ is the difference between the bond’s face value and its present value (issue price). This discount sum is used to purchase the equity call option. If the discount sum generated from the bond component is less than the premium required for the desired call option, the product issuer will not have enough funds to purchase the full number of option contracts that would provide 100% participation. Consequently, the issuer will buy fewer option contracts, leading to a participation rate that is less than 100% in the underlying equity’s upside performance. The 100% principal payout is a forecasted number and is subject to various risks, including counterparty and credit risk, and is not guaranteed. A participation rate exceeding 100% would occur if the discount sum were greater than the call option premium. The bond’s accretion to par is a function of its interest rate and maturity, and while its principal payout is a primary objective, its ability to fully accrete is separate from the option premium cost, though both are subject to issuer solvency.

A Bull Equity-Linked Note (ELN) incorporates an embedded short put option. When the underlying share price (ST) at maturity is less than the put strike price (X), the embedded put option is in-the-money and will be exercised. In this scenario, the investor, as the put writer (through the ELN structure), is obligated to take delivery of the underlying shares. The number of shares received is calculated by dividing the note’s face value by the strike price ($10,000 / $9.00 = 1,111.11 shares, typically rounded to 1,111 shares as per the example). Since the actual market price of the shares ($8.50) is below the strike price ($9.00) at which the investor effectively ‘buys’ them, the investor incurs a capital loss on the shares received. The full face value in cash is only received if the share price is at or above the strike price. Options involving additional payments, extensions, or renegotiations are not standard features of how an ELN with an embedded put option settles at maturity under these conditions.

The question addresses the risk management of option Greeks, specifically gamma and theta, and their interconnected nature as outlined in the CMFAS Module 6A syllabus. Gamma measures the rate of change of an option’s delta, indicating how sensitive the delta is to changes in the underlying asset’s price. Theta measures the potential loss due to time decay, meaning the erosion of an option’s value as it approaches expiration. The syllabus explicitly states that gamma, vega, and theta are sometimes controlled together by setting a maximum loss for all three combined. This approach is beneficial because the positive effects of theta (as options lose value over time, which can be a gain for an option seller) can automatically offset the negative effects of gamma (which can lead to larger losses as the underlying moves). Therefore, setting a consolidated maximum loss threshold for these combined Greeks is a recognized strategy for managing their interplay. The other options describe individual limits, hedging strategies, or general market risk controls that do not specifically capture the combined risk management approach for gamma and theta as described in the syllabus.

The UCITS regulations, which govern many European Exchange Traded Funds (ETFs), stipulate specific limits on counterparty risk exposure for funds that use derivative instruments like swaps for replication. According to these regulations, an ETF is not permitted to invest more than 10% of its prevailing Net Asset Value (NAV) in derivative instruments, including swaps, issued by a single counterparty. This means the amount that a single swap counterparty owes to the fund is limited to a maximum of 10% of the fund’s prevailing NAV. This limit is crucial for managing the credit risk associated with synthetic replication strategies, ensuring that the fund is not overly exposed to the default risk of any single counterparty.

A covered call strategy involves purchasing the underlying stock and simultaneously selling a call option on that stock. This strategy aims to generate income from the option premium while limiting potential upside gains. The maximum profit for a covered call strategy is realized when the underlying stock price at expiration is at or above the strike price of the written call option. The calculation for maximum profit is the strike price (X) minus the initial stock purchase price (S0), plus the premium received (c0). In this specific scenario, the initial stock purchase price (S0) is $45.00, the call option’s strike price (X) is $48.00, and the premium received (c0) is $2.50. Applying the formula: Maximum Profit = X – S0 + c0 = $48.00 – $45.00 + $2.50 = $3.00 + $2.50 = $5.50. This represents the highest possible profit per share the investor can achieve with this strategy.

The S&P 500 Equal Weight Index (EWI) typically exhibits higher volatility compared to the S&P 500 Market Weight Index (MWI). This characteristic stems from the EWI’s construction, which allocates an equal weight to each of its constituent stocks, regardless of their market capitalization. Consequently, the EWI has a greater effective exposure to smaller capitalization stocks. Smaller cap stocks are generally known to be more volatile than larger, more established companies. Therefore, the EWI’s tilt towards these inherently more volatile smaller companies results in a higher overall volatility for the index. In contrast, the MWI is dominated by a few large-cap stocks, which tend to be less volatile individually, leading to a lower overall index volatility.

Structured funds are fundamentally different from traditional mutual funds in their operational strategy. Structured funds aim to replicate an underlying asset or provide a synthetic return linked to it, primarily by incorporating derivatives. Their investment allocation is typically static or rule-based, allowing them to realize various anticipated market views, such as long, short, or market neutral positions, and to systematically adjust exposure as markets change. In contrast, traditional mutual funds typically rely on the manager’s expertise and discretion for active allocation of investments directly into underlying assets, generally without using derivatives. Therefore, the use of derivatives for synthetic returns and a rule-based allocation strategy are key distinguishing features of structured funds.

Gearing in warrants signifies that an investor can gain a larger exposure to the underlying asset for a given amount of capital compared to buying the underlying shares directly. The most significant consequence of this, as highlighted in the CMFAS Module 6A syllabus, is the amplification of percentage price movements. A small percentage change in the underlying share price can lead to a substantially larger percentage change in the warrant’s price, both for gains and losses. Therefore, the investor’s potential percentage gain or loss on the warrant investment is magnified. The other options are incorrect: while gearing does allow for greater exposure (as mentioned in one of the incorrect options), it explicitly leads to amplified, not identical, percentage price movements. Gearing does not imply a more stable or less volatile movement; in fact, it implies the opposite. Lastly, gearing is not an indicator of intrinsic value being a multiple of the market price.

When a Credit Linked Note (CLN) is structured with physical settlement and its reference entity experiences a credit default, the note is typically subject to early termination. In such a scenario, the issuing bank, which acts as the seller of credit default swaps (CDS) linked to the reference entity, will use the underlying collateral to acquire the defaulted debt obligation of the reference entity. This defaulted debt is then delivered to the CLN investor in lieu of their principal investment. Since defaulted debt instruments usually trade at a significant discount to their face value in the market, the investor is highly likely to incur a substantial loss on their initial principal. Coupon payments also cease upon the early termination of the note due to the credit event. CLNs are not designed to offer principal protection in the event of a reference entity default, nor do they typically convert into diversified portfolios or continue coupon payments under such circumstances.

A ‘worst of’ Equity Linked Note (ELN) is structured such that its return or settlement depends on the performance of the single worst-performing underlying asset in its basket. In this scenario, Gamma Inc. experienced a 12% decrease, making it the worst performer compared to Alpha Corp’s 15% increase and Beta Ltd’s 5% increase. Since the ELN specifies physical settlement, the investor will receive shares of the worst-performing underlying asset, which is Gamma Inc. The number of shares would be determined by dividing the nominal amount by Gamma Inc.’s strike price. The other options are incorrect because they either misinterpret the ‘worst of’ feature by considering the performance of all assets or the majority, or they incorrectly assume a cash settlement or a basket of shares.

The question addresses ‘Legal risk’ associated with structured products, as outlined in the CMFAS Module 6A syllabus, Chapter 9, paragraph 30. This risk highlights that investors in structured products own units of the product itself, not the underlying financial instruments. Therefore, in the event of an issuer’s default, investors do not automatically gain ownership or legal rights to the underlying assets. They are exposed to the legal contracts relating to the structured product and its issuer. The first option correctly identifies this specific legal risk. The second option describes counterparty risk, which is also relevant to structured products but is distinct from the legal ownership of underlying assets. The third option describes early termination risk, another risk for structured products, but not the specific legal risk concerning asset ownership. The fourth option represents a common misconception that structured product investors have direct claims on underlying assets, which is incorrect.

The theoretical price of a Bull Callable Bull/Bear Contract (CBBC) is calculated by first determining the intrinsic value and then adding the financial cost, all adjusted by the conversion ratio. The financial cost itself is typically calculated based on the strike price, the annual financial cost rate, and the time to maturity. First, calculate the financial cost component: Financial Cost = Strike Price × Annual Financial Cost Rate × Time to Maturity (in years) Financial Cost = $45.00 × 0.08 × (6/12) Financial Cost = $45.00 × 0.08 × 0.5 Financial Cost = $1.80 Next, calculate the theoretical price of the Bull CBBC using the formula: Theoretical Price = (Underlying Asset Price – Strike Price + Financial Cost) / Conversion Ratio Theoretical Price = ($50.00 – $45.00 + $1.80) / 5 Theoretical Price = ($5.00 + $1.80) / 5 Theoretical Price = $6.80 / 5 Theoretical Price = $1.36

Auto-callable structured products are callable at the issuer’s discretion, not the investor’s. This means the investor has no control over when the product might be redeemed early, leading to an uncertain holding period. If the product is called early, the investor receives their capital and any accrued returns, but then faces the challenge of finding a new investment for those funds, potentially at less favorable market rates. This is known as reinvestment risk. The payout upon early redemption can be higher or lower than the initial investment, depending on the product’s terms and performance. The auto-callable feature does not inherently guarantee enhanced liquidity on a secondary market; liquidity risk is a general concern for many structured products.

Yield Enhanced Securities, also known as Discount Certificates, have a specific settlement mechanism. If, at maturity, the underlying asset’s closing price is at or above the exercise price, the holder receives a cash settlement equal to the exercise price. However, 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 this scenario, the closing price of $11.50 is below the exercise price of $12.00. Therefore, the investor would receive the value of the underlying, which is $11.50, for each warrant.

The question tests the understanding of the daily price limit mechanisms for different futures contracts as specified in the CMFAS Module 6A syllabus. For Nikkei 225 Index Futures, the daily price limit mechanism is multi-tiered. Initially, if the price moves by 7% from the previous day’s settlement price, trading is allowed within this limit for 10 minutes. Subsequently, if the price moves further, an intermediate price limit of 10% applies, allowing trading for another 10-minute cooling-off period. Finally, a 15% price limit is enforced for the remainder of the trading day. In contrast, for MSCI Singapore Index Futures, the daily price limit mechanism is simpler. If the price moves by 15% from the previous day’s settlement price, trading is allowed within this limit for 10 minutes. After this initial cooling-off period, there are no further price limits for the rest of the trading day. It is important to note that for both contracts, there are no price limits on the last trading day of the expiring contract month, a condition explicitly excluded by the question.

A Bond-Linked Note (BLN) embeds a short put option on a bond. This means the investor’s payout, or potential loss, is directly tied to the market price of that underlying bond. The price of a bond can be influenced by a wide array of factors, including changes in interest rates, credit downgrades of the bond issuer, and widening credit spreads, not solely the occurrence of a credit event. In contrast, a Credit-Linked Note (CLN) sells a Credit Default Swap (CDS) on a reference entity, and its payout is specifically contingent upon a defined credit event occurring for that reference entity. Therefore, the primary risk driver for a BLN investor is the bond’s market price movements due to various factors, making it distinct from a CLN’s reliance on a credit event.

To determine the total expenses incurred for the CFD trade, we need to calculate the commission, GST on commission, and financing interest for both the opening and closing of the position. 1. Calculate Commission and GST on Purchase (Opening Position): Total Value of Purchase = Quantity × Opening Price = 5,000 units × $1.50 = $7,500 Commission on Purchase = Total Value of Purchase × Commission Rate = $7,500 × 0.3% = $22.50 GST on Purchase Commission = Commission on Purchase × GST Rate = $22.50 × 7% = $1.575 (rounded to $1.58) Total Transaction Cost (Buy) = Commission on Purchase + GST on Purchase Commission = $22.50 + $1.58 = $24.08 2. Calculate Commission and GST on Sale (Closing Position): Total Value of Sale = Quantity × Closing Price = 5,000 units × $1.65 = $8,250 Commission on Sale = Total Value of Sale × Commission Rate = $8,250 × 0.3% = $24.75 GST on Sale Commission = Commission on Sale × GST Rate = $24.75 × 7% = $1.7325 (rounded to $1.73) Total Transaction Cost (Sell) = Commission on Sale + GST on Sale Commission = $24.75 + $1.73 = $26.48 3. Calculate Financing Interest: The financing interest is typically calculated on the initial value of the purchase. The annual rate is 6% and the position was open for 15 days, using a 360-day year. Daily Interest Rate = Annual Financing Rate / 360 = 6% / 360 = 0.0001666… Financing Interest per day = Total Value of Purchase × Daily Interest Rate = $7,500 × (6% / 360) = $1.25 Total Financing Interest = Financing Interest per day × Number of Days = $1.25 × 15 days = $18.75 4. Calculate Total Expenses Incurred: Total Expenses = Total Transaction Cost (Buy) + Total Transaction Cost (Sell) + Total Financing Interest Total Expenses = $24.08 + $26.48 + $18.75 = $69.31