CMFAS RES6A Quiz 40

The question tests understanding of the daily price limit mechanism for equity index futures, specifically referencing the SiMSCI contract specifications. According to the provided text, when the price of an equity index futures contract moves by 15% in either direction from the previous day’s settlement price, trading at or within the price limit of +/- 15% is allowed for the next 10 minutes. After this cooling-off period, there shall be no price limits for the rest of the trading day. This rule is designed to manage dramatic price swings while allowing the market to find a new equilibrium. Option 1 accurately describes this process. Option 2 is incorrect because trading is not immediately suspended for the entire day; there’s a cooling-off period followed by the removal of limits. Option 3 is incorrect as the limit is not automatically widened to a specific percentage like 20%; instead, it is removed after the cooling-off period. Option 4 incorrectly combines the mark-to-market process and margin calls with the immediate response to price limits; while mark-to-market and margin calls are part of futures trading, they are not the immediate regulatory response to hitting a daily price limit in this specific manner.

A knock-out option is a type of barrier option designed to terminate when the price of the underlying asset reaches or crosses a specific predetermined barrier level. In the scenario described, the investor holds a knock-out call option. When the underlying equity index price rises and touches the knock-out barrier of 3,000 points, the ‘barrier event’ is triggered. For a knock-out option, this event causes the option to be immediately extinguished, meaning it ceases to exist. The outcome for the investor will then depend on the specific terms of the option agreement, which could range from a total loss of the premium paid to a small predetermined payoff. The option does not convert into a different type of option, nor does its strike price adjust, nor does it grant an immediate exercise right in this context; its defining feature is its termination upon hitting the barrier.

When an investor’s Customer Asset Value falls below the Required Margins due to mark-to-market losses on Extended Settlement (ES) contracts, a margin call is issued. The investor is obligated to deposit additional funds to restore their Customer Asset Value to at least the sum of their Initial Margins and Additional Margins. This must typically be done within two market days. If the investor fails to meet this margin call within the stipulated timeframe, they will be prohibited from placing new trades, although risk-reducing trades may still be permitted. This mechanism is crucial for limiting the exposure of the clearing house (CDP) to price changes and preventing the accumulation of significant losses.

The question differentiates between a long straddle and a long strangle, both of which are neutral volatility strategies. A long straddle involves simultaneously buying an at-the-money (ATM) call and an ATM put with the same strike price and expiration. ATM options generally have higher premiums because they are closer to being in-the-money, leading to a higher initial cost for the straddle. However, because the strike price is at the current market price, the underlying asset needs to move less significantly to surpass the break-even points and generate a profit. Conversely, a long strangle involves simultaneously buying an out-of-the-money (OTM) call and an OTM put with different strike prices but the same expiration. OTM options typically have lower premiums, resulting in a lower initial cost for the strangle. However, as these options are further from the current market price, the underlying asset must experience a larger price movement to reach the wider break-even points and become profitable. Therefore, the strategy with ATM options (straddle) has a higher initial premium but requires a less extreme price move for profitability compared to the strategy with OTM options (strangle).

The investor’s view is characterized by uncertainty regarding the underlying asset’s precise directional movement, coupled with an expectation that its price will remain confined within a specific upper and lower range. A Barrier Capital Preservation Certificate (Straddle) is specifically designed for such an investment outlook. It incorporates both an upper and a lower knock-out barrier, allowing investors to benefit from the underlying staying within a defined range without a strong directional bias. If the underlying breaches either the upper or lower barrier, the investor typically receives the agreed capital amount, providing a degree of capital preservation. In contrast, a standard Knock-Out Call option is suitable for a rising underlying, and a Barrier Capital Preservation Certificate (Shark’s Fin) is also primarily for a rising underlying with an up-and-out barrier. A Barrier Reverse Convertible involves being long a bond and short a knock-out put option, typically for investors seeking enhanced yield with a view that the underlying will not fall below a certain level, which doesn’t align with the ‘no firm view on direction’ aspect of the scenario.

Under the traditional valuation approach for convertible bonds, the minimum value is established as the greater of two components: its conversion value (the value if immediately converted into shares) and its straight value (the value it would have as a non-convertible bond with similar features). This ensures that the bond’s value is supported by either its equity potential or its fixed-income characteristics, providing a floor. The other options describe incorrect valuation methods or components that do not represent the minimum theoretical value of the convertible bond.

When the equity in an investor’s margin account falls below the maintenance margin level, a margin call is triggered. The purpose of an additional margin call is to bring the account balance back up to the initial margin level, not just the maintenance margin level. In this scenario, the initial margin was $12,000, the maintenance margin was $9,000, and the current account equity is $8,500. Since $8,500 is below the maintenance margin of $9,000, an additional margin call is issued. The investor must deposit funds to bring the account back to the initial margin level of $12,000. Therefore, the required deposit is $12,000 (initial margin) – $8,500 (current equity) = $3,500. Depositing only $500 would only bring the account to the maintenance margin level, which is insufficient for a margin call. Liquidating the position might be an eventual outcome if the margin call is not met, but the immediate requirement is to deposit funds. Waiting for market recovery is not an acceptable response to a margin call.

Contracts for Differences (CFDs) are financial instruments that allow investors to speculate on the price movement of an underlying asset without actually owning it. When a company declares a cash dividend, CFD holders are placed in an economically equivalent position to actual shareholders. For an investor holding a long CFD position, they would receive a credit equivalent to the dividend, mirroring the benefit of owning the shares. Conversely, if an investor holds a short CFD position, they are effectively betting against the share price and are economically obligated to compensate for any dividends paid out to actual shareholders. Therefore, their account would be debited the dividend amount. This mechanism ensures that the CFD reflects the true economic exposure to the underlying asset, including corporate actions.

A structured product using a zero plus option strategy is specifically designed for conservative investors who prioritize principal preservation. In the worst-case scenario, the investor is expected to receive their principal back at maturity, contingent on the creditworthiness of the issuing bank. While it allows for participation in the upside of the underlying asset, its returns will typically underperform a direct investment if the underlying asset performs exceedingly well. This strategy is suitable for investors with a moderate bullish view who seek principal protection. Options suggesting unlimited upside, substantial principal loss, or primary use for yield enhancement with significant downside risk describe different types of structured products or misrepresent the zero plus option strategy.

When the price of the underlying asset for a Callable Bull/Bear Certificate (CBBC) reaches or crosses the Call Price, a Mandatory Call Event (MCE) is triggered. This event leads to the immediate and irrevocable termination of the CBBC. For R-category CBBCs, investors may receive a small residual value, which is the difference between the Strike Price and the Call Price, adjusted by the conversion ratio and any financial costs. For N-category CBBCs, the payoff is zero. A critical aspect of the MCE is that once it occurs, the contract is terminated, and the investor cannot benefit from any subsequent recovery or rebound in the underlying asset’s price, even if it moves favorably after the call. The other options describe scenarios that do not align with the mechanics of a Mandatory Call Event for CBBCs.

The question tests the understanding of key differences between Contracts for Differences (CFDs) and equity futures, as outlined in the CMFAS Module 6A syllabus. Option 1 is correct because the syllabus explicitly states that CFD investors are entitled to dividends, while equity futures contracts typically do not confer such entitlement. Option 2 is incorrect because financing costs for CFDs are explicitly computed and added, whereas for equity futures, they are implicit and embedded in the quoted price. Option 3 is incorrect because CFDs can be extended or rolled over for as long as the investor wishes (subject to provider policy), while equity futures have fixed maturity dates. Option 4 is incorrect because CFDs are mostly traded Over-The-Counter (OTC) and carry counterparty risk, while equity futures are traded on exchanges, which generally mitigates counterparty risk.

The provided text on page 52, under ‘3.5 Portfolio Management Techniques,’ explicitly states that using futures to allocate assets can be more effective and less costly because ‘Brokerage costs for futures transactions are cheaper.’ This directly supports the idea that futures offer an economic advantage in rebalancing portfolios due to lower transaction expenses compared to dealing with the underlying cash market instruments. Option 2 is incorrect because futures contracts do require margin payments, which is a cash outlay, although it is typically a smaller percentage of the contract’s notional value compared to the full cost of buying the underlying asset. The text mentions ‘With margining, the cash outlay is smaller,’ not that it’s eliminated. Option 3 is incorrect. While futures can be used to hedge market (systematic) risk, they do not inherently remove all specific (non-market) risk from a portfolio, especially when dealing with a diversified portfolio or individual stock futures. The text on page 53 clarifies that ‘Market risk can be hedged with equity index options, and non-market risk with individual stock options,’ implying futures primarily address market risk when used broadly for portfolio hedging. Option 4 is incorrect. For portfolio rebalancing, the primary benefit of futures is not physical delivery. Futures are often cash-settled or closed out before maturity, and their advantage lies in their efficiency, liquidity, and lower transaction costs for adjusting exposure, not in simplifying physical asset transfer.

The question describes the core objective and mechanism of a ‘Zero Plus Option Strategy’ as outlined in the CMFAS 6A syllabus. This strategy is specifically designed to create a product that aims to maintain 100% of the capital invested at maturity while also providing a share in any gains of an underlying asset, such as a market index. This is achieved by investing a significant portion of the initial capital in fixed income assets, typically zero-coupon bonds, which are projected to grow to the full capital amount by maturity. The remaining portion of the capital is then used to purchase call options on the target index, allowing the fund to participate in its upside performance. The other options describe different investment strategies: a Total Return Swap (TRS) is a derivative strategy for synthetic index tracking but doesn’t inherently guarantee capital in the same way; Constant Proportion Portfolio Insurance (CPPI) is a portfolio insurance technique that dynamically adjusts asset allocation to protect a floor, which is distinct from the fixed allocation of a zero-plus option; and direct investment in underlying securities is a traditional approach that lacks the built-in capital guarantee mechanism of the structured fund strategy.

The Auto-Redeemable Structured Fund XYZ includes a specific auto-redemption feature. According to the product specifications, the fund becomes auto-redeemable from one year after the inception date and every six months thereafter. If the performance of the Nikkei 225 index is greater than or equal to the performance of the S&P 500 index at a relevant early redemption observation date, the product is redeemed at a pre-determined price. For the 1.5-year mark, the pre-determined redemption price is explicitly stated as 112.75%. Therefore, if the conditions are met at this observation date, the investor would receive 112.75% of their principal.

A synthetic short put position is constructed by combining a long position in the underlying asset with a short call option on that same asset, with the same expiration date and strike price. This strategy, often referred to as a covered call when the investor already owns the underlying shares, replicates the payoff profile of a direct short put. The investor profits from the premium received from selling the call and any appreciation in the underlying asset up to the call’s strike price. However, the upside profit is capped at the strike price, and the investor faces potential losses if the underlying asset’s price falls below the purchase price of the shares (adjusted for the premium received). This mirrors the limited profit (premium received) and potentially unlimited loss (if the stock falls to zero) of a direct short put position.

The investor’s objective is to achieve immediate, near 100% protection against a price decline without needing to predict a specific price level. Extended Settlement (ES) contracts are particularly suited for this because they offer a direct, delta-one (near 1.0) hedge. This means that for every dollar the underlying share price moves, the ES contract price moves by approximately the same amount, providing a very effective lock-in of a selling price. Crucially, unlike warrants, ES contracts do not require the selection of a strike price, which aligns perfectly with the investor’s desire to avoid predicting specific price levels for the hedge to be effective. Warrants, on the other hand, have a delta that is typically less than 1.0 (e.g., 0.5 for at-the-money warrants) and is dependent on factors like strike price and time to expiry, making them less direct for a full hedge. Warrants also involve an initial premium subject to time decay, which is a cost, whereas ES contract costs are primarily margin requirements that form part of the settlement.

A Constant Proportion Portfolio Insurance (CPPI) strategy aims to protect a predetermined capital floor while allowing participation in the upside potential of a risky asset. The strategy dynamically adjusts the allocation between a risky asset and a risk-free asset. When the value of the risky asset falls sharply and the portfolio value approaches its floor, the CPPI strategy dictates a significant reduction in exposure to the risky asset. In severe cases, such as a sharp, sudden market drop (often referred to as ‘gapping risk’ or a ‘deleveraging event’), the strategy may be forced to allocate the entire portfolio into the risk-free asset. This action ensures the capital floor is protected but, as a consequence, eliminates any future participation in the appreciation of the underlying risky asset. This is a critical risk of CPPI products. The strategy does not automatically increase risky asset exposure when prices fall; rather, it reduces it to protect the floor. The floor value is typically a fixed or pre-defined level, not dynamically lowered to avoid deleveraging in response to market declines. While CPPI assumes low volatility for optimal performance, a sharp, sudden decline indicates a violation of this assumption, leading to the deleveraging outcome rather than mitigation by the assumption itself.

The question tests the understanding of the underlying derivative components that constitute a Discount Certificate and a Reverse Convertible, as outlined in the CMFAS Module 6A syllabus. While both structured products can achieve similar risk-return profiles, particularly a capped upside and exposure to full downside risk, their construction differs significantly. A Discount Certificate is fundamentally built by combining a long zero-strike call option with a short call option. This structure allows the product to be issued at a discount to its face value, providing an upfront benefit to the investor. In contrast, a Reverse Convertible is typically composed of a bond or note combined with a short put option. The equivalence in their payoff profiles, despite different compositions, is a practical application of the put-call parity principle, which states that a call option plus the present value of the strike price equals a put option plus the underlying asset.

Exchange-traded options are characterized by their standardization and trading on organized, regulated exchanges. A key benefit is that they are settled through a clearing house, which guarantees performance and significantly mitigates counterparty risk. However, this standardization means that their terms (e.g., strike prices, expiration dates, contract size) are fixed and cannot be customized to meet highly specific, non-standard hedging requirements. Conversely, Over-the-Counter (OTC) options offer complete customization of terms but lack the clearing house guarantee, thereby exposing parties to greater counterparty risk. Therefore, the inherent challenge lies in the trade-off between robust counterparty protection offered by exchange-traded options and the bespoke flexibility available with OTC options.

For an R-CBBC Bear contract, when a Mandatory Call Event (MCE) occurs, the residual value is determined using a specific MCE Settlement Price. According to the guidelines, this settlement price for a Bear contract is established as not lower than the maximum trading price of the underlying asset observed between the period of the MCE and the next trading session. This means that the highest price reached during that specific observation window will be used as the settlement price for calculating the residual value. The other options represent either the rule for a Bull contract (minimum trading price), an incorrect calculation method (average trading price), or the settlement method for a CBBC held until maturity (closing price on settlement day).

The Interest Rate Parity Theory posits that the forward (or futures) premium or discount between two currencies should precisely reflect the difference in the domestic interest rates for securities of comparable maturity. If this relationship is violated, it creates an opportunity for arbitrageurs to engage in risk-free profit-making activities. These arbitrageurs would simultaneously borrow in the low-interest-rate currency, convert it to the high-interest-rate currency, invest it, and hedge the currency risk using a futures or forward contract. Their collective actions of buying and selling currencies and futures contracts would exert pressure on both the spot and futures exchange rates, ultimately forcing them back into alignment with the interest rate differential, thereby eliminating the arbitrage opportunity. Regulatory intervention or long-term investor reallocation are not the primary mechanisms described by the Interest Rate Parity Theory for correcting such a misalignment.

The investor’s objectives are to limit potential losses (downside protection), cap upside gains, and achieve a net zero initial premium outlay. A zero-cost collar, also known as a costless collar, is specifically designed to meet these criteria. It involves simultaneously purchasing a protective put option to guard against price declines and selling an out-of-the-money covered call option against the existing long stock position. The strike prices are typically adjusted such that the premium received from selling the call offsets the premium paid for buying the put, resulting in a net zero cost for establishing the hedge. This strategy provides a defined range of outcomes, protecting against significant drops while foregoing substantial gains beyond the call strike price.

A Bull Equity-Linked Note (ELN) with an embedded short put option means that the investor (noteholder) effectively takes on the obligation of a put writer. If, at maturity, the underlying share price (ST) falls below the strike price (X) of the embedded put option, the put option is ‘in-the-money’ and will be exercised. In this specific scenario, the XYZ Corp share price at maturity ($14.50) is less than the strike price ($15.00). Therefore, the noteholder will not receive the cash face value. Instead, they will receive shares of XYZ Corp. The number of shares is calculated by dividing the note’s face value by the strike price: $10,000 / $15.00 = 666.666… shares, which is approximately 667 shares. This outcome means the investor will likely incur a loss if the market value of these shares is less than the effective purchase price.

Delta measures the sensitivity of an option’s price to a change in the underlying asset’s price. For a long call option, delta is positive, typically ranging between 0 and 1. When an investor is short call options, their position inherently carries a negative delta exposure, meaning they will lose money if the underlying asset’s price increases. To establish a delta-neutral hedge, the manager needs to offset this negative delta with an equivalent positive delta. Given a short position of 1,000 call options, each with a delta of 0.60, the total delta exposure from the options is -1,000 0.60 = -600. To neutralize this, the manager must acquire an asset with a positive delta of +600. Since each share of the underlying asset has a delta of 1, buying 600 shares will provide the necessary +600 delta, thereby creating a delta-neutral position.

The Constant Proportion Portfolio Insurance (CPPI) strategy is a dynamic, rule-based approach designed to ensure a fixed minimum return or capital preservation at a future date. It achieves this by continuously re-balancing the investment portfolio between performance assets (e.g., equities) and safe assets (e.g., cash or bonds). When the value of performance assets declines, the strategy dictates a reduction in exposure to these riskier assets. This action protects the ‘cushion’ – the portion of the fund’s assets that can be exposed to risk – and ensures that the underlying portfolio can still meet the capital preservation target. Conversely, if performance assets perform well, the strategy would increase exposure to them. Therefore, in response to a substantial decline in performance assets, the CPPI strategy would decrease its allocation to these assets and increase its allocation to safe assets to safeguard the principal. Increasing exposure to performance assets would be contrary to the capital preservation objective in a declining market. Maintaining a static allocation or suspending trading would contradict the continuous re-balancing nature of CPPI.

Contracts for Differences (CFDs) are leveraged products, meaning investors typically only put up a fraction of the total trade value as margin. The CFD provider finances the remaining portion of the position. For this financing, the provider charges interest, known as financing costs. This interest is usually calculated daily on the full notional value of the CFD position and is based on a floating market benchmark rate (like LIBOR) plus a spread. Therefore, if the prevailing market interest rates increase, the benchmark rate will also rise, directly leading to higher daily financing charges for the investor. These increased holding costs will, in turn, reduce the investor’s potential profits or exacerbate losses, impacting the overall investment return. Counterparty risk relates to the CFD provider’s ability to meet its obligations, liquidity risk concerns the ease of trading the underlying asset, and currency risk pertains to foreign exchange rate fluctuations; while these are valid CFD risks, they are not the primary and direct consequence of a rise in market interest rates on the investor’s financing costs.

The question describes a structured product with an accrual coupon linked to the HSI’s performance relative to specific barriers. The yield formula is 0.50% + [4.00% x n/N], where ‘n’ is the number of days the HSI fixes within the accrual range (22,200 and 22,400), and ‘N’ is the total number of trading days (250). The investment principal is SGD 1 million. In the given scenario, the HSI fixed within the specified range for 150 days. For the remaining 100 days, it fixed below the accrual barrier (22,200). According to the product definition, only the days where the HSI fixes within the range contribute to ‘n’. Therefore, ‘n’ for this period is 150. Using the yield formula: Yield = 0.50% + [4.00% x 150/250] Yield = 0.50% + [4.00% x 0.6] Yield = 0.50% + 2.40% Yield = 2.90% The accrual coupon is calculated on the principal investment: Accrual Coupon = SGD 1,000,000 x 2.90% = SGD 29,000 The total redemption proceeds at maturity include the principal repayment and the accumulated accrual coupon: Total Redemption Proceeds = Principal + Accrual Coupon Total Redemption Proceeds = SGD 1,000,000 + SGD 29,000 = SGD 1,029,000. Incorrect options arise from misinterpreting the accrual conditions. For example, assuming the HSI was always within the range (n=250) would lead to a 4.50% yield and SGD 1,045,000. Assuming ‘n’ was 100 (the days below the barrier, or confusing with a different scenario) would lead to a 2.10% yield and SGD 1,021,000. Omitting the 0.50% base yield would lead to a 2.40% yield and SGD 1,024,000.

An accumulator is an equity-linked structured product designed for investors to purchase a pre-determined quantity of a reference stock at regular intervals, typically at a discount to the market 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 terminated, thereby limiting the investor’s potential gains from accumulating shares at the discounted strike price. Furthermore, accumulators do not include a capital preservation feature, meaning the investor is exposed to the full price risk of the reference stock and can lose their principal if the stock price falls significantly. Therefore, the statement that the investor’s potential gain is limited by a knock-out barrier and the product does not typically include a capital preservation feature accurately describes a core characteristic. Options suggesting guaranteed principal return or unlimited upside are incorrect, as these contradict the inherent risks and design of accumulators. Similarly, accumulators are not designed to provide consistent interim coupon payouts like some other structured products; their primary function is share accumulation.

A ‘worst of’ Equity Linked Note (ELN) is a type of structured note where the investor’s return at maturity is explicitly tied to the performance of the single worst-performing asset within a basket of underlying assets. This means that if any one of the linked shares performs poorly, the note’s payout will be determined by that poor performance, potentially leading to a lower return or even physical settlement of the worst-performing asset. This structure typically offers a higher coupon or yield compared to a standard ELN due to the increased risk borne by the investor, as the investor is exposed to the downside risk of all assets in the basket, not just an average or the best performer.

Basis risk arises in a hedging situation due to imperfections between the asset being hedged and the futures contract used. One primary cause is when the underlying asset in the futures contract is not completely identical to the asset the hedger intends to protect. This mismatch means their prices may not move in perfect tandem, leading to an unpredictable change in the basis (spot price minus futures price) over the hedging period. Other causes include uncertainty about the exact date the asset will be bought or sold, or the need to close out the futures contract before its delivery month. The convergence of futures and spot prices at expiration is a characteristic of futures, not a cause of basis risk. Market volatility is a general market condition, and while it can amplify basis movements, it is not the fundamental cause of basis risk as defined by hedging imperfections. Holding a futures contract until expiration, if the underlying asset perfectly matches the hedged asset, would actually eliminate basis risk at expiration, not cause it.