CMFAS RES6A Quiz 38

Arbitrage between futures and Forward Rate Agreements (FRAs) is considered risk-free only when the value dates for the two instruments correspond precisely. If the value dates do not align, there will always be residual basis risks or fixing risks, meaning the arbitrage is not truly risk-free. While having access to powerful computers and sophisticated trading programs is beneficial for executing arbitrage strategies quickly, it does not inherently make the arbitrage itself risk-free. Similarly, ensuring sufficient liquidity to cover margin calls is crucial for managing futures positions but is a liquidity management aspect, not a condition for the fundamental risk-free nature of the arbitrage. Lastly, avoiding major calendar events or economic data releases is a measure taken to minimize residual basis risks when the value dates for FRAs and futures do not correspond, rather than being the primary condition for a truly risk-free arbitrage.

The question pertains to ‘Structure Risk’ as outlined in CMFAS Module 6A, specifically concerning structured products involving shorting a pay-fixed interest rate swaption. When an investor shorts a pay-fixed interest rate swaption, they are essentially selling protection against an increase in interest rates. If market interest rates rise significantly, the swaption buyer will exercise the option, obligating the investor (swaption seller) to pay out a floating rate while receiving a fixed rate. As the floating rate increases with market rates, the investor’s liability also increases without a cap, leading to potentially unlimited losses. This contrasts with shorting a receive-fixed interest rate swaption, where losses are typically limited to a pre-determined fixed rate. Therefore, the most significant structural risk in this specific scenario is the exposure to unlimited potential losses tied to the rising floating interest rate. The other options describe different types of risks: limited loss for a receive-fixed swaption seller, early termination risk, and reinvestment risk, none of which accurately describe the primary structural risk of shorting a pay-fixed interest rate swaption in a rising interest rate environment.

The scenario describes an investor seeking ‘100% principal preservation’ being recommended a structured product where underlying bonds are used as collateral in a Credit Default Swap (CDS). The provided syllabus material explicitly uses this exact example to illustrate the ‘Risk of Mis-selling (Incongruence to Investment Strategy)’. This risk arises when the product’s true nature and risks are not adequately disclosed or understood by the investor, leading to a mismatch with their investment objectives. Foreign Exchange Risk would only be relevant if the product involved different currencies, which is not specified as the primary issue here. Maturity Limit Risk and Open Contracts Limit Risk are types of market risk controls typically set by firms for futures trading, not direct investment risks faced by a retail investor in a structured product in this context.

Daily mark-to-market (MTM) valuation is conducted on all open ES contract positions. Any losses incurred from this valuation directly increase the ‘Additional Margins’ component of an investor’s ‘Required Margins’. The ‘Required Margins’ are calculated as the sum of ‘Maintenance Margins’ and ‘Additional Margins’. If the investor’s ‘Customer Asset Value’ subsequently falls below these ‘Required Margins’, a margin call is issued. The investor is then obligated to deposit sufficient funds to bring their ‘Customer Asset Value’ up to at least the combined sum of their ‘Initial Margins’ and ‘Additional Margins’. This action must typically be completed within two market days. Failure to meet a margin call within this timeframe can lead to restrictions on new trades, except for those that reduce risk.

To determine the number of index futures contracts required to hedge a diversified equity portfolio against market risk, the standard formula used is: Number of Contracts (N) = (Portfolio Value (VP) × Portfolio Beta (β)) / (Futures Price (F) × Value per Tick (T)). This formula calculates the total market exposure of the portfolio (adjusted by its beta) and divides it by the value of a single futures contract to find the number of contracts needed for a delta-neutral hedge. Given the values: Portfolio Value (VP) = S$10,000,000 Portfolio Beta (β) = 1.2 Futures Price (F) = 3,500 points Value per Tick (T) = S$50 per point First, calculate the value of one futures contract: F × T = 3,500 × S$50 = S$175,000. Next, apply the formula: N = (S$10,000,000 × 1.2) / S$175,000 N = S$12,000,000 / S$175,000 N = 68.57 contracts Since futures contracts must be traded in whole numbers, the manager would typically round to the nearest whole number, which is 69 contracts. Common errors include omitting the portfolio beta, incorrectly placing the beta in the denominator, or applying the beta multiple times, leading to different results.

The scenario describes a fund manager needing to quickly adjust asset allocation from equities to fixed income, complicated by illiquid equity holdings. Futures contracts offer an efficient solution for such rebalancing. By selling equity index futures, the manager can synthetically reduce the fund’s equity exposure, effectively taking a short position against the market. Simultaneously, by buying bond futures, the manager can gain immediate, synthetic exposure to fixed income. This strategy allows the portfolio’s overall asset allocation to be adjusted to the desired mix without the need to immediately sell the illiquid cash equities, which can be liquidated at a more opportune time without market disruption. This aligns with the principle that futures can be used for efficient and less costly asset allocation adjustments, especially when dealing with illiquid underlying assets or needing to lock in current market conditions.

The product terms clearly state that a Mandatory Call Event (knock-out trigger) occurs if the closing index level of ANY 4 of the underlying indices on an Early Redemption Observation Date is less than 75% of its initial level. In the given scenario, Index 1 (70%), Index 2 (72%), and Index 4 (71%) are all below 75% of their initial levels. However, Index 3’s level is 78%, which is not below 75%. Therefore, only 3 out of the 4 indices have met the condition for the knock-out trigger. Since the condition requires ‘ANY 4’ indices to be below the 75% barrier, the Mandatory Call Event is not triggered. According to the product terms, if the Mandatory Call Event does not occur, then variable quarterly coupons continue to be paid after Year 1. Thus, the product continues its term, and the investor will receive the next scheduled variable quarterly coupon. The option stating the fund terminates immediately describes the outcome if the knock-out was triggered. The options suggesting suspension of coupons or redemption at 75% of invested capital are incorrect as they contradict the specified product terms regarding coupon payment continuation and redemption value (which is 100% if a knock-out occurs).

The provided text explicitly states that ‘There are some situations where the trading price may differ from the NAV, in particular for ETFs that provide access to restricted markets such as China A-shares. Persistent premiums or discounts in ETF prices reflect inefficiencies in the underlying markets. Furthermore, prices are likely to be farther away from NAVs when an ETF is not trading in the same time zone as its underlying assets.’ This indicates that under such conditions (restricted markets, different time zones), the ETF’s market price is prone to persistent deviations, manifesting as either premiums or discounts relative to its NAV. This is due to underlying market inefficiencies and market makers pricing in risk. Therefore, the option stating that the market price is prone to persistent deviations, showing either premiums or discounts, is the most accurate description. Other options are incorrect because they suggest consistent alignment (which is contradicted), an exclusive premium or discount (when both are possible), or efficient arbitrage eliminating discrepancies (which is not the case in these inefficient conditions).

According to SGX regulations for Extended Settlement (ES) contracts, specifically referencing the guidelines for allowable trading activity when customer margins are forthcoming after the T+2 period or beyond the T+2 period, a Member or Trading Representative is only permitted to allow the customer to undertake risk-reducing activities. This measure is in place to manage and mitigate further exposure for the client and the Member when the account is under-margined and the margin call is not met within the standard T+2 timeframe. Risk-increasing or risk-neutral activities are generally prohibited under such circumstances to prevent the accumulation of greater risk.

Constant Proportion Portfolio Insurance (CPPI) is a trading strategy specifically designed to ensure a fixed minimum return, typically at a future date. A fundamental aspect of CPPI is its rule-based, non-discretionary approach to asset allocation. It involves the continuous re-balancing of the investment portfolio between performance assets (which offer potential for higher returns) and safe assets (which provide capital preservation). This re-balancing is guided by a predetermined mathematical algorithm or formula, not by a fund manager’s discretionary judgment or static allocations. The strategy dynamically adjusts exposure to performance assets to ensure that the portfolio can absorb defined decreases in value without jeopardizing the principal preservation target. Therefore, continuous, algorithm-driven re-balancing is a core characteristic.

The accumulator product obligates the investor to purchase the underlying shares at the agreed strike price for the entire tenor, provided the price remains below the knock-out barrier. If the market price falls below the strike price, the investor still has to buy at the higher strike price, leading to potential losses. The text explicitly states, ‘If the closing price of the reference share is below the knock-out barrier at any time during the tenor of the accumulator, the investor has to buy the underlying shares at the strike price for the tenor even if the market price of the underlying shares remains substantially below the strike price for most or all of the tenor, which could result in a substantial loss.’ Option 2 is incorrect because automatic termination typically occurs if the knock-out barrier is hit (price at or above the barrier), not simply when the price falls below the strike. Losses are also not limited to initial margin; they can be substantial, as the investor is obligated to buy shares at a higher price than their market value. Option 3 is incorrect. The investor cannot unilaterally terminate the agreement without the bank’s consent, and even with consent, ‘break’ costs can be substantial, as mentioned in the syllabus material. Option 4 is incorrect. Financial institutions do not adjust the strike price downwards to protect investors from market losses. Adjustments to terms like strike price or knock-out barrier are typically triggered by specific corporate actions (e.g., share splits, rights issues) as defined in the agreement, not to mitigate investor losses due to adverse market movements.

Range Accrual Notes (RANs) are structured notes where the investor’s interest payment is contingent on a reference index (e.g., a stock index or interest rate benchmark) remaining within a predefined range during an observation period. A fundamental characteristic of RANs, as outlined in the CMFAS Module 6A syllabus, is that they typically offer a degree of principal preservation. This means that even if the market conditions are unfavorable and the reference index consistently falls outside the agreed range, the investor is expected to receive their full principal sum back at maturity, subject to the credit risk of the issuer. However, the interest or coupon payment is directly affected by the index’s performance relative to the range. If the index closes outside the range for a significant number of observation days, the accrued interest will be reduced, or in many common structures, become zero for those days or the entire period. Therefore, the correct outcome is that the principal is returned, but the interest payment is diminished or eliminated. Options suggesting principal erosion, forfeiture, or an unconditional full coupon payment misrepresent the core features of a Range Accrual Note.

Arbitrage opportunities between an Interest Rate Swap (IRS) and a strip of Eurodollar futures contracts emerge when the market’s fixed rate for the IRS deviates from the implied fixed rate calculated from the futures strip. In this scenario, the market fixed rate for the IRS is observed to be lower than the implied fixed rate from the futures strip. This indicates that the IRS is relatively undervalued in the market, while the futures strip is relatively overvalued. To execute an arbitrage, the participant would ‘buy’ the undervalued asset and ‘sell’ the overvalued asset. Therefore, the arbitrageur would buy the IRS (agreeing to receive the fixed rate and pay the floating rate) and simultaneously sell the strip of Eurodollar futures contracts. This strategy aims to lock in a risk-free profit by exploiting the temporary pricing inefficiency.

For a put warrant, the cash settlement per warrant is calculated using the formula: (Exercise Price – Settlement Price) / Conversion Ratio. In this scenario, the Exercise Price (X) is $15.00, the Settlement Price (S) is $12.50, and the Conversion Ratio (N) is 10. Therefore, the cash settlement per warrant = ($15.00 – $12.50) / 10 = $2.50 / 10 = $0.25. The warrant price is a cost to the investor and is not directly used in calculating the cash settlement amount.

A Credit Linked Note (CLN) exposes the investor to the credit risk of a specified reference entity. In the event of a credit default by this reference entity, the settlement mechanism outlined in the CLN’s terms dictates the outcome for the investor. When physical settlement is specified, the issuing bank, which acts as the seller of the credit default swap (CDS) embedded in the CLN, uses the collateral to acquire the defaulted debt obligation (e.g., a bond) of the reference entity. Subsequently, the CLN investor receives this defaulted bond. Such a bond, post-default, is highly unlikely to trade at its par value and will typically be worth significantly less, leading to a substantial loss for the investor. The fixed income collateral primarily serves to back the CDS sold by the issuer, not to directly protect the CLN investor’s principal in case of a credit event. Cash settlement, on the other hand, would involve the investor receiving a cash payment reflecting the loss, rather than the defaulted asset itself. CLNs are not designed to convert into equity or senior secured loans upon default; they are debt instruments linked to credit risk.

Basis risk in a hedging situation arises from imperfections between the asset being hedged and the futures contract used. The provided text outlines three primary reasons for these imperfections: (1) the underlying asset in the futures contract is not completely identical to the asset being hedged, (2) uncertainty about the exact date when the asset will be bought or sold, and (3) the need to sell the futures contract before its delivery month. The question describes a scenario where a portfolio manager is hedging and identifies basis risk. The correct option directly reflects one of these stated imperfections. When the asset underlying the futures contract is not perfectly identical to the asset being hedged, their prices may not move in perfect correlation, leading to an unpredictable basis at the time the hedge is closed, thus creating basis risk. The other options describe either a general market characteristic (futures leading cash market) or ideal hedging conditions (precise certainty of date, holding to expiration) that would typically reduce or eliminate basis risk, rather than cause it.

The scenario describes a need for hedging a highly specific, illiquid foreign currency exposure with a unique delivery date, for which no standardized exchange-traded contracts exist. A forward contract is a private agreement negotiated directly between two parties, allowing for complete customization of terms such as the underlying asset, quantity, delivery date, and settlement procedures. This makes it ideal for hedging non-standard or exotic exposures that are not available in the standardized futures market. Exchange-traded futures contracts, while offering liquidity and central clearing, are standardized in terms of contract size, quality, and delivery dates, making them unsuitable for highly specific, non-standard requirements. A currency option provides the right but not the obligation to exchange currencies, offering flexibility, but for a known future transaction requiring a direct hedge with specific terms, a forward contract is generally more direct and tailored. A spot currency transaction involves immediate exchange and is not suitable for hedging a future payment.

When a standard stop-loss order is placed, it becomes a market order once the specified stop price is reached. In highly volatile market conditions, especially when there are significant price gaps (slippage), the market may move past the stop price without any trades occurring at that exact level. In such cases, the stop-loss order, now a market order, will be executed at the next available price, which could be significantly worse than the intended stop price. This is a known risk of standard stop-loss orders. A guaranteed stop-loss service, often offered at an additional premium, would ensure execution at the specified price, but this scenario describes a standard stop-loss.

The primary distinguishing risk for a writer of an American option, compared to a European option, is the flexibility of exercise. American options can be exercised by the holder at any time before or on the expiration date. This means the option writer has no control over when they might be called upon to fulfill their obligation (e.g., deliver shares for a call option or buy shares for a put option). This introduces uncertainty regarding the timing and magnitude of their liabilities. European options, conversely, can only be exercised at expiration, providing the writer with a predictable timeframe for their obligations. While unlimited losses for naked calls are a general risk for option writers regardless of style, and time decay affects all options, the specific timing risk is unique to American options from the writer’s perspective.

The question describes the distinct construction of two structured products, Product Alpha and Product Beta, both of which share a similar payoff profile of capped upside and significant downside risk. Product Alpha is characterized by its composition of a long zero-coupon bond and a short put option. This specific combination is the defining structure of a Reverse Convertible, designed to offer enhanced yields through bond interest and put option premium while exposing the investor to the underlying asset’s full downside if its price falls below the strike. Product Beta is described as being constructed from a long zero-strike call option and a short call option. This construction is characteristic of a Discount Certificate, which also aims to provide a capped return with downside exposure. Although both products can have similar payoff diagrams, their underlying derivative components differ significantly. Therefore, Product Alpha is a Reverse Convertible, and Product Beta is a Discount Certificate. The other options present incorrect classifications or introduce unrelated structured products.

Callable Bull/Bear Contracts (CBBCs) are structured products with a mandatory call feature. For a bull contract, a mandatory call event (MCE) occurs if the underlying asset’s price falls to or below a pre-determined call price. When an MCE is triggered, the CBBC terminates immediately, and trading ceases. The investor’s recovery depends on the type of CBBC. An N-CBBC (No residual value) means the holder will receive no cash payment once the MCE occurs and the CBBC is called. Conversely, an R-CBBC (Residual value) allows the holder to receive a small residual cash payment when the CBBC is called. The other options describe scenarios that do not align with the mandatory call mechanism of CBBCs, such as temporary halts, automatic conversions, or capital preservation guarantees.

Futures contracts offer several advantages for portfolio management and asset allocation adjustments. Firstly, brokerage costs for futures transactions are generally lower compared to trading the equivalent value in the underlying cash market. Secondly, futures markets are typically highly liquid, which means that large transactions can be executed with minimal impact on the prices of the underlying assets. This reduces market disruption and allows for more efficient rebalancing. While futures do require margin payments, the initial cash outlay is smaller than purchasing the full value of the underlying assets, offering capital efficiency. Futures do not guarantee fixed returns or eliminate market risk, nor do they primarily facilitate immediate physical delivery for rebalancing purposes. Furthermore, they do not allow for the complete avoidance of margin requirements.

A bull call spread is a strategy specifically designed for investors who anticipate a moderate upward movement in the price of an underlying asset. It is constructed by simultaneously purchasing an in-the-money (ITM) call option and selling a higher strike out-of-the-money (OTM) call option, both with the same underlying asset and expiration date. This structure results in a limited maximum profit, which is the difference between the strike prices minus the net premium paid, and a limited maximum loss, which is the net premium paid. This perfectly aligns with the investor’s objective of capping both potential maximum loss and maximum profit. A long strangle, while also involving two options, profits from significant price volatility in either direction and has unlimited upside potential, not a capped maximum gain. A naked call option sale is a bearish strategy with potentially unlimited loss, directly contradicting the goal of limiting maximum loss. A long call option provides unlimited upside potential but does not cap the maximum gain, only the maximum loss (to the premium paid).

The daily mark-to-market (MTM) process for Extended Settlement (ES) contracts, conducted by the Central Depository (CDP), serves a critical purpose in risk management. Its fundamental objective is to revalue all open positions at the end of each day to their respective valuation prices. This revaluation is specifically designed to limit the CDP’s exposure to potential losses arising from price fluctuations in the underlying assets. By preventing the accumulation of significant losses over the contract’s duration, MTM helps maintain financial stability within the clearing system. While MTM indirectly contributes to overall market integrity and risk management for participants, its primary stated goal is to protect the clearing house (CDP) from substantial financial exposure.

The structured product’s yield calculation is dependent on the HSI fixing within the specified accrual barrier range (22,200 and 22,400). The variable ‘n’ represents the number of days the HSI fixes within this range. In the given scenario, the HSI consistently fixes below the accrual barrier of 22,200 for the entire 250-day period. This means that for all 250 trading days, the HSI did not fix within the range of 22,200 and 22,400. Therefore, the value of ‘n’ for the yield calculation is 0. The yield formula is 0.50% + [4.00% x n/N]. Substituting n = 0 and N = 250: Yield = 0.50% + [4.00% x 0/250] = 0.50% + 0% = 0.50%. The investment amount is SGD 1 million principal, which is repaid at maturity. The accrual coupon is calculated based on this yield. Accrual coupon = 0.50% of SGD 1,000,000 = SGD 5,000. Total redemption proceeds = Principal + Accrual Coupon = SGD 1,000,000 + SGD 5,000 = SGD 1,005,000. The other options represent different scenarios: SGD 1,000,000 would imply no coupon is paid at all, which is incorrect as there is a base yield of 0.50%. SGD 1,045,000 would be the outcome if the HSI fixed within the accrual barrier range for all 250 days (n=250), leading to a 4.50% yield. SGD 1,021,000 would be the outcome if the HSI fixed within the range for only 100 days (e.g., due to a knock-out event), leading to a 2.10% yield.

This question assesses the understanding of Extended Settlement (ES) contracts, specifically their use in a long hedging strategy and the calculation of net financial impact, including clearing fees, as per the CMFAS Module 6A syllabus. A long hedge is employed to protect against a rise in the price of shares an investor intends to purchase in the future. By buying ES contracts, the investor aims to lock in a purchase price. First, calculate the gain from the ES contract. Ms. Lee bought the ES contract at S$4.95 per share and the shares settled at S$5.20 per share. The gain per share is S$5.20 – S$4.95 = S$0.25. For 20,000 shares, the total gain from the ES contract is S$0.25 20,000 = S$5,000. Next, calculate the clearing fee. The clearing fee is 0.04% of the contract value. The contract value when entered was 20,000 shares S$4.95 = S$99,000. The clearing fee is 0.04% of S$99,000 = 0.0004 S$99,000 = S$39.60. This amount is below the maximum fee of S$600, so S$39.60 is the applicable fee. Finally, determine the net financial benefit. The gain from the ES contract (S$5,000) represents the savings achieved by effectively locking in a lower price compared to the higher spot price at the time of purchase. From this gain, the clearing fee must be deducted. Therefore, the net financial benefit is S$5,000 – S$39.60 = S$4,960.40. This is the amount saved by using the hedging strategy compared to simply waiting and buying the shares at the higher spot price.

Structured products are designed to cater to specific investor needs, often combining features like principal preservation with potential market upside. The principal component of a structured product is typically allocated to a low-risk, fixed-income instrument to ensure the initial capital is returned at maturity. As described in the syllabus, a common method for achieving principal preservation is by investing this component in a zero-coupon bond. This bond is structured such that its value at maturity will be equivalent to the initial investment amount, thereby protecting the principal. The remaining portion of the investment is then used to gain exposure to the underlying assets, often through options, to generate potential returns.

The question assesses understanding of option Greeks and their application in risk management, specifically focusing on how to manage the risk associated with changes in market volatility. Vega is the appropriate Greek for this scenario. Vega measures the sensitivity of an option’s price to a 1% change in the volatility of the underlying asset. When managing Vega risk, limits are typically established as the maximum tolerable loss that would be incurred due to specified movements in market volatility. This allows a portfolio manager to control the potential impact of unexpected shifts in volatility on their options positions. Other Greeks address different types of risk: Delta measures sensitivity to changes in the underlying asset’s price, Gamma measures the rate of change of Delta, and Theta measures the sensitivity to the passage of time (time decay). Each of these has distinct methods for setting limits.

When a company declares dividends, the exercise price of a warrant on its shares needs to be adjusted to reflect the change in the underlying share’s value. The adjustment factor accounts for both normal and special dividends. The formula for the Adjustment Factor is (P – SD – ND) / (P – ND), where P is the last cum-date closing price of the underlying share, SD is the Special Dividend per Share, and ND is the Normal Dividend per Share. Once the Adjustment Factor is calculated, the New Exercise Price is determined by multiplying the Old Exercise Price by this Adjustment Factor. In this scenario, the Old Exercise Price is S$6.50. The last cum-date closing price (P) is S$15.00. The Special Dividend (SD) is S$0.80, and the Normal Dividend (ND) is S$0.30. First, calculate the Adjustment Factor: (15.00 – 0.80 – 0.30) / (15.00 – 0.30) = 13.90 / 14.70 ≈ 0.945578. Then, calculate the New Exercise Price: S$6.50 0.945578 ≈ S$6.146257, which rounds to S$6.15.

For a Bull Contract, a Mandatory Call Event (MCE) is triggered when the underlying asset’s spot price touches or falls below the call price. When an MCE occurs, the Callable Bull/Bear Contract (CBBC) expires early, and its trading terminates immediately. The key distinction for a Category R-CBBC (Residual value) is that its call price is different from its strike price, which means the holder may receive a small cash payment, referred to as the ‘Residual Value,’ when the CBBC is called. This contrasts with a Category N-CBBC (No residual value), where the call price equals the strike price, and the holder would not receive any cash payment upon an MCE. Therefore, in the described scenario, an MCE occurs, leading to early expiry and potential residual payment.