CMFAS RES6A Quiz 41

Pairs trading is a strategy designed to be ‘market-neutral,’ meaning its objective is to remove the market risk by taking offsetting long and short positions. The intention is that the direction of the overall market should not significantly affect the investment position’s outcome. Because the strategy involves opening two distinct positions—one long and one short—it inherently incurs double commissions and finance charges, as each leg of the trade is treated separately for transactional purposes. Other options misrepresent the market-neutral characteristic, the nature of the costs involved, or introduce risks specific to certain variations of pairs trading rather than the general strategy’s inherent operational costs.

The portfolio manager holds a diversified equity portfolio, which represents a long position in the stock market. When an investor anticipates a market downturn and wishes to reduce the portfolio’s exposure to systematic risk, the appropriate strategy is to implement a short hedge. This involves selling equity index futures contracts. Equity index futures are suitable because they track the overall market, allowing for efficient hedging of systematic risk across a diversified equity portfolio. The number of futures contracts needed for such a hedge is determined by key factors such as the portfolio’s beta, which measures its sensitivity to market movements, and the total market value of the portfolio. Buying equity index futures would constitute a long hedge, which would increase market exposure, contrary to the objective of reducing risk during an anticipated correction. Hedging a diversified portfolio by selling individual stock futures for each component stock is generally impractical and inefficient for systematic risk. Interest rate futures are used to manage interest rate risk, not the systematic equity market risk of an equity portfolio.

The question describes a scenario where an investor anticipates significant price movement in an underlying asset but is uncertain about the direction. This calls for a neutral options strategy designed to profit from increased volatility, regardless of whether the price rises or falls. 1. Long Straddle: This strategy involves simultaneously buying an at-the-money (ATM) call and an at-the-money (ATM) put with the same strike price and expiration date. It is a classic neutral strategy employed when an investor expects a substantial price movement but has no directional bias. Profits are generated if the underlying asset’s price moves significantly above or below the strike price, exceeding the total premium paid. 2. Covered Call: This strategy involves selling a call option against shares of stock already owned. It is typically used to generate income or to slightly enhance returns in a neutral to moderately bullish market, but it limits upside potential and does not profit from large, uncertain movements in either direction. 3. Protective Put: This strategy involves buying a put option on shares of stock already owned. It is a hedging strategy used to protect against potential downside risk in a bearish market, not to profit from large movements in either direction. 4. Long Strangle: This strategy involves simultaneously buying an out-of-the-money (OTM) call and an out-of-the-money (OTM) put with the same expiration date but different (OTM) strike prices. Like a long straddle, it is a neutral strategy that profits from significant price movements. However, because the options are OTM, it typically has a lower initial premium cost but requires a larger price movement in the underlying asset to become profitable compared to a long straddle. While also a neutral strategy for volatility, a long straddle is often considered the most direct and common strategy for profiting from general ‘uncertainty’ of direction around the current price, as it captures movements closer to the current market price more readily than a strangle.

The scenario describes a corporate treasury department requiring an option contract with highly specific, non-standard terms, including a precise maturity date and a custom strike price, which are explicitly stated as not being available on public exchanges. This immediately points to the characteristics of Over-the-Counter (OTC) options. OTC options are known for their flexibility, allowing parties to fully customise contract terms, such as the underlying asset, strike price, and expiration date, to meet bespoke hedging or investment needs. In contrast, exchange-traded options are standardised in terms of contract size, expiration dates, and strike prices, and are subject to extensive regulation and clearing house settlement. Therefore, the ability to customise contract terms is the primary reason for choosing an OTC option in this situation. The other options describe features of exchange-traded options, which are precisely what the scenario indicates are not suitable for the investor’s specific requirements.

To calculate the premium payback period for a convertible bond, we first need to determine the total premium paid for the bond over its conversion value, and then the annual income differential an investor receives by holding the convertible bond instead of the underlying shares. 1. Calculate the Conversion Value: This is the value of the bond if it were immediately converted into shares. Conversion Value = Market price of share × Conversion ratio Conversion Value = SGD 5.00 × 20 = SGD 100 2. Calculate the Total Premium (per bond): This is the difference between the market price of the convertible bond and its conversion value. Total Premium = Market price of convertible bond – Conversion Value Total Premium = SGD 105 – SGD 100 = SGD 5 3. Calculate the Annual Income Differential (per bond): This is the difference between the annual coupon income from the bond and the annual dividend income from the equivalent number of shares. Annual Coupon Income = SGD 4 Annual Dividend Income from equivalent shares = Conversion ratio × Dividend per share Annual Dividend Income = 20 × SGD 0.10 = SGD 2 Income Differential = Annual Coupon Income – Annual Dividend Income Income Differential = SGD 4 – SGD 2 = SGD 2 4. Calculate the Premium Payback Period: This is the total premium divided by the annual income differential. Premium Payback Period = Total Premium / Income Differential Premium Payback Period = SGD 5 / SGD 2 = 2.5 years Therefore, the premium payback period for this convertible bond is 2.5 years. Other calculations might arise from misinterpreting the premium (e.g., using only the market conversion premium per share without adjusting the denominator) or miscalculating the income differential (e.g., ignoring the dividend offset or incorrectly calculating the coupon equivalent).

Knock-out products are a type of structured product designed to terminate when the price of the underlying asset reaches a predetermined barrier level. In the scenario described, the knock-out call option on Company X shares has a barrier set at $55. When the share price hits this level, a ‘barrier event’ occurs. For a knock-out option, this event leads to the option being extinguished and expiring. The specific payoff to the investor upon termination, which could be zero, a fraction of the initial premium, or a fixed mandatory amount, is determined by the explicit terms outlined in the option agreement. It does not convert into another type of option, require additional premium, or have its strike price adjusted.

The question describes a consistent, minor divergence between an ETF’s returns and its benchmark index, which is characteristic of tracking difference or tracking error. The syllabus explicitly states that tracking error arises from ‘Transaction costs – the cost of buying and selling of securities… thereby causing a reduction in performance from its underlying.’ These costs are an ongoing operational factor as the ETF rebalances its portfolio to match the index. While the Total Expense Ratio (TER) is also an operational cost that causes a performance drag, transaction costs are specifically identified as a dynamic contributor to tracking error arising from portfolio adjustments. The daily fluctuation of the ETF’s market price relative to its published Net Asset Value (NAV) pertains to whether the ETF is trading at a premium or discount, which is a market-driven phenomenon for the ETF unit itself, not a direct cause of the ETF’s internal performance deviation from its underlying index. Similarly, the spread between the bid and ask prices of the ETF units on the secondary market primarily impacts the cost for investors trading the ETF, rather than being an internal operational factor causing the ETF’s performance to deviate from its index.

To calculate the hedge ratio for long-term interest rate risk, the formula used is: Hedge ratio = (PVBP of hedge security) / (PVBP of most deliverable bond x Conversion factor for most deliverable bond). In this scenario, the PVBP of the bond to be hedged is 0.6500, the PVBP of the cheapest-to-deliver issue is 0.0750, and its conversion factor is 0.92. Plugging these values into the formula: Hedge ratio = 0.6500 / (0.0750 x 0.92) = 0.6500 / 0.0690 = 9.420289… which rounds to 9.42. This calculation determines the appropriate ratio of futures contracts needed to offset the interest rate risk of the bond position.

The CMFAS Module 6A syllabus, specifically Chapter 10, details the construction of various structured products. A Discount Certificate is explicitly described as being composed of a long zero-strike call option and a short call option. This structure allows the product to be issued at a discount to its face value, providing a portion of the return upfront, while also capping the potential upside and exposing the investor to the full downside risk of the underlying asset. This composition, when viewed through the lens of put-call parity, can achieve a similar risk-return profile to a Reverse Convertible, even though their underlying components differ. The other options describe different structured products or incorrect combinations of derivatives. For instance, a zero-coupon bond combined with a short put option describes a Reverse Convertible. A zero-coupon bond combined with a long call option typically describes an Equity-Linked Structured Note, which aims for capital preservation and participation in upside potential.

Note P, which is structured like a Credit Linked Note (CLN), involves selling a Credit Default Swap (CDS) on a reference entity. Its payout is primarily contingent on a credit event (like default) of that specific reference entity. The investor is exposed to the credit risk of both the note issuer and the reference entity. Note Q, structured like a Bond Linked Note (BLN), involves selling a put option on a bond. Its payout depends on the market price of that bond. The key distinction, as highlighted in the CMFAS Module 6A syllabus, is that the bond’s price can be adversely affected by a wider range of factors beyond just a credit default of the bond issuer. These factors include credit downgrades, widening credit spreads, and changes in interest rates. Therefore, an investor in Note Q could incur losses or end up owning the bond even if the bond issuer has not officially defaulted, simply due to these market-driven price movements. This makes the potential loss triggers for Note Q broader than for Note P, which is more directly tied to a specific credit default event.

CDP computes margin requirements for Members on a gross basis. This means that long and short positions belonging to different customers are not offset against each other when calculating the Member’s overall margin requirement. In this scenario, Customer P’s 700 long contracts, Customer Q’s 500 short contracts, and Customer R’s 200 long contracts are all considered separate open positions from CDP’s perspective. Therefore, the Member is margined for the sum of all these positions (700 + 500 + 200 = 1400). The concept of netting or offsetting positions only applies in specific circumstances, such as spread margining for a single customer’s account or when a customer offsets their own position, but CDP’s calculation for the Member remains gross.

The question assesses understanding of counterparty risk in different ETF replication strategies, as outlined in the CMFAS Module 6A syllabus, specifically section 8.2.11, point 6. For physically replicated ETFs, counterparty risk primarily emerges if the fund engages in securities lending and the borrowers default on their obligations. This means the ETF could suffer losses if the loaned securities are not returned or compensated for. In contrast, synthetically replicated ETFs achieve their index exposure through financial instruments like swaps. Therefore, their primary counterparty risk is linked to the solvency and reliability of the swap dealers or derivative issuers. If these counterparties fail to honor their contractual commitments, the synthetic ETF could incur significant losses. The other options describe different types of risks or misattribute the specific counterparty risks to incorrect parties. For example, market-maker failure relates more to liquidity risk, and risks from underlying asset issuers or index providers are not the primary counterparty risks associated with the replication strategy itself as defined in the context.

Indirect Investment Policy Funds, also known as Swap-based Funds, are characterized by their method of gaining exposure to underlying assets without directly investing in them. As described in the syllabus, these funds achieve exposure primarily through derivative transactions. They may invest part or all of their net proceeds into derivatives to synthetically link their performance to an underlying asset. Alternatively, they might invest in a hedging asset and then use derivative instruments to exchange the performance or income of this hedging asset for a performance linked to the desired underlying asset. Therefore, an investor’s return is contingent on both the performance of the underlying asset and the efficacy of the derivative instruments employed. The other options describe different fund structures or incorrect methods of exposure for this specific type of fund.

The question describes a structured product strategy characterized by principal protection at maturity (assuming no credit event) combined with potential upside linked to an underlying asset like an equity index. This precisely matches the definition and features of a Zero Coupon Fixed Income Plus Option Strategy, also known as a ‘Zero Plus’ option or capital preservation strategy, as outlined in the CMFAS Module 6A syllabus. This strategy typically involves a zero-coupon bond that provides the principal return and a call option on an underlying asset for the upside potential. Investment-Linked Policies (ILPs), while having an investment component, do not normally provide guaranteed cash values or principal return. Reverse Convertible Notes and Accumulator Products are other types of structured products, but they do not typically offer principal protection; instead, they carry risks such as receiving the underlying asset at a loss or being obligated to buy more of the underlying asset, respectively.

To determine the payout, we first need to calculate the returns performance for both underlying indices from their initial values to the observation date of 15 September 2016. For Nikkei 225 (Index 1): Initial Value = 15,000 Observed Value = 17,500 Returns Performance (R1) = ((17,500 – 15,000) / 15,000) 100% = (2,500 / 15,000) 100% = 16.67% For S&P 500 (Index 2): Initial Value = 1,800 Observed Value = 2,000 Returns Performance (R2) = ((2,000 – 1,800) / 1,800) 100% = (200 / 1,800) 100% = 11.11% Next, we check the early redemption condition: an early redemption occurs if the Returns Performance of Index 1 (R1) is greater than or equal to the Returns Performance of Index 2 (R2). In this case, 16.67% (R1) is indeed greater than or equal to 11.11% (R2). Therefore, the early redemption condition is met. According to the product terms, for the early redemption observation date of 15 September 2016, the corresponding payout percentage is 121.25% of the initial investment.

The basis in futures contracts is the difference between the actual futures price and the spot price. Typically, as a futures contract approaches its expiry date, the futures price and spot price converge, meaning the basis narrows towards zero. This phenomenon is known as convergence. The question describes an unusual scenario where the basis is widening significantly near expiry, contradicting this normal behavior. Option 1 states a sudden, unexpected surge in the net cost of carrying the physical asset, combined with severe illiquidity in the cash market. The ‘cost/return of carry’ is a key factor affecting the basis, and a greater net cost of carry generally leads to a greater basis. If this cost suddenly increases instead of declining as expiry approaches, it would counteract the normal convergence. Furthermore, ‘relative liquidity of cash & futures markets’ also influences the basis. Severe illiquidity in the cash market could prevent the spot price from adjusting efficiently, causing the basis to diverge from the futures price, especially if the futures market is reacting differently. Therefore, this combination of factors would most likely contribute to an unusual widening of the basis near maturity. Option 2 suggests a general market expectation that the spot price will stabilize at the current futures price upon expiry. Such an expectation would typically encourage convergence, as market participants align their views, leading to the basis narrowing, not widening. Option 3 mentions a significant flattening of the yield curve, reducing long-term financing costs. Financing costs are a component of the cost of carry. A reduction in financing costs would generally decrease the net cost of carry, which would lead to a narrowing of the basis, thus supporting convergence rather than causing it to widen. Option 4 describes an increase in the relative liquidity of the futures market compared to the cash market. While relative liquidity affects the basis, an increase in futures market liquidity alone, without a corresponding severe disruption in the cash market or a significant change in cost of carry, would not inherently cause the basis to widen as expiry approaches. In fact, improved liquidity can sometimes facilitate more efficient price discovery, which might aid convergence.

The ‘zero plus option strategy’ is a method used in structured funds to achieve both capital preservation and participation in potential market upside. This is typically accomplished by allocating the initial investment into two distinct parts. A significant portion of the capital is invested in fixed income assets, such as zero-coupon bonds, which are designed to mature at the original capital amount by the end of the investment period, thereby ensuring capital return. The remaining, smaller portion of the capital is then used to purchase call options on a specified underlying asset or index. These call options provide the fund with exposure to any positive performance of the underlying asset, allowing investors to participate in market gains. This strategy differs from using a Total Return Swap (TRS), which synthetically replicates the total return of an underlying asset, or Constant Proportion Portfolio Insurance (CPPI), which dynamically adjusts asset allocation between fixed income and risky assets based on market conditions and a defined cushion.

Structured warrants listed on SGX-ST employ an ‘Asian style’ expiry settlement. A defining feature of this style, as per the CMFAS Module 6A syllabus, is that the last trading day of the structured warrant is distinct from its expiry date. This allows for a period between the cessation of trading and the actual settlement calculation. The other options describe characteristics that are either incorrect for SGX-ST structured warrants (e.g., physical settlement, as SGX-ST structured warrants are cash-settled) or misrepresent the nature of expiry and market-maker roles (expiry dates are fixed, and market-makers provide liquidity, not dynamic adjustment of expiry dates).

To calculate the net profit for the CFD trade, we need to determine the total sales value, total purchase cost, and all associated expenses. 1. Calculate Total Purchase Cost: Units Opening Price = 8,000 $4.50 = $36,000.00 2. Calculate Total Sales Value: Units Closing Price = 8,000 $4.80 = $38,400.00 3. Calculate Transaction Costs (Buy): Commission (Buy) = $36,000.00 0.35% = $126.00 GST on Commission (Buy) = $126.00 8% = $10.08 Total Transaction Cost (Buy) = $126.00 + $10.08 = $136.08 4. Calculate Transaction Costs (Sell): Commission (Sell) = $38,400.00 0.35% = $134.40 GST on Commission (Sell) = $134.40 8% = $10.75 Total Transaction Cost (Sell) = $134.40 + $10.75 = $145.15 5. Calculate Financing Interest: Financing is typically based on the initial value of the position. Daily Interest = ($36,000.00 5.5%) / 360 days = $5.50 per day Total Financing Interest = $5.50 7 days = $38.50 6. Calculate Total Expenses Incurred: Total Expenses = Transaction Cost (Buy) + Transaction Cost (Sell) + Financing Interest Total Expenses = $136.08 + $145.15 + $38.50 = $319.73 7. Calculate Net Profit/Loss: Net Profit = Total Sales Value – Total Purchase Cost – Total Expenses Net Profit = $38,400.00 – $36,000.00 – $319.73 = $2,080.27 The net profit from this CFD trade is $2,080.27.

The daily adjustment process for Contracts for Differences (CFDs) is referred to as ‘mark-to-market’. This fundamental mechanism ensures that an investor’s account accurately reflects the current profit or loss of their open positions. When the underlying asset’s price moves adversely, leading to a loss on the investor’s CFD position, this loss is directly and immediately subtracted from the investor’s account balance at the close of each trading day. This direct deduction is the primary and immediate effect of the mark-to-market process. A margin call is a subsequent action, triggered only if, following the mark-to-market adjustment, the investor’s account balance falls below the predetermined maintenance margin level. Liquidation is an even further step, undertaken by the CFD provider if a margin call is not fulfilled within the stipulated period. The initial margin requirement is established when the position is opened and does not automatically increase solely due to daily price fluctuations.

Arbitrage is a trading strategy that seeks to profit from temporary price differences of the same or similar financial instruments across different markets or forms. The core characteristic of arbitrage is that it aims to generate risk-free profit by simultaneously buying the undervalued asset in one market and selling the overvalued asset in another. This strategy exploits market inefficiencies and does not involve taking on directional market risk. Hedging, in contrast, aims to reduce or mitigate risk in an existing portfolio. Speculation involves taking on risk in anticipation of future price movements to achieve capital appreciation. While arbitrage activities can contribute to market efficiency by bringing prices into alignment, the primary objective of an arbitrageur is to secure a guaranteed profit from the observed discrepancy.

The CMFAS Module 6A syllabus, specifically Chapter 5 on Warrants & Other Investment Products, states that for structured warrants listed on SGX-ST with Asian style expiry settlement, the settlement price is based on the arithmetic average of the official closing price of the underlying for five market days prior to the expiration date. To calculate the settlement price, sum the closing prices for the five specified days and then divide by five. In this scenario, the sum of the closing prices ($15.20 + $15.35 + $15.10 + $15.45 + $15.30) is $76.40. Dividing this sum by 5 yields a settlement price of $15.28.

The Interest Rate Parity (IRP) theory states that the forward exchange rate (F) is determined by the spot exchange rate (S) and the interest rates of the two currencies involved. The formula is: F = S (1 + Rc (n/360)) / (1 + Rb (n/360)), where Rc is the annualized interest rate of the quote currency, Rb is the annualized interest rate of the base currency, and n is the number of days in the period. In this scenario: Spot rate (S) USD/SGD = 1.3520 Base currency (USD) interest rate (Rb) = 2.80% = 0.028 Quote currency (SGD) interest rate (Rc) = 0.70% = 0.007 Number of days (n) = 90 First, calculate the interest rate factors for the 90-day period: For SGD (Rc): 0.007 (90/360) = 0.007 0.25 = 0.00175 For USD (Rb): 0.028 (90/360) = 0.028 0.25 = 0.007 Now, apply these to the IRP formula: F = 1.3520 (1 + 0.00175) / (1 + 0.007) F = 1.3520 (1.00175) / (1.007) F = 1.3520 0.9947865005 F = 1.34499999… Rounding to four decimal places, the theoretical 90-day forward exchange rate for USD/SGD is 1.3450.

Contracts for Differences (CFDs) are derivative products that allow investors to gain exposure to the price movements of an underlying asset without actually owning the asset. As per the characteristics of CFDs, an investor holding a long position in an equity CFD will typically receive cash dividends and participate in corporate actions such as share splits, similar to a direct shareholder. However, a fundamental and significant difference is that the CFD investor does not possess voting rights for the underlying company’s decisions, as they do not hold the actual shares. The other options incorrectly suggest that CFD investors either have voting rights or do not receive dividends/participate in splits, which is contrary to the established features of CFDs.

When an investor purchases a put option, they acquire the right, but not the obligation, to sell the underlying asset at a predetermined exercise price. The cost of obtaining this right is the premium paid upfront. If the market price of the underlying asset at expiration is above the exercise price, the put option will expire worthless, as it would not be rational for the investor to exercise the right to sell at a lower price than the market. In such a situation, the investor simply loses the premium paid. This premium represents the maximum possible loss for the put option buyer, as they have no further obligations beyond this initial payment. The potential gain, however, is theoretically substantial, as the underlying asset’s price can fall significantly, even to zero, leading to a large payoff less the premium.

An Equity-Linked Note (ELN) with an embedded put option offers an enhanced yield compared to a plain vanilla note, but this comes with equity risk. The noteholder, by effectively writing a put option, takes on the obligation to buy the underlying shares at the strike price if the market price falls below it at maturity. In this scenario, the underlying stock price of InnovateTech (IT) Ltd falls to S$40.00, which is below the embedded put option’s strike price of S$45.00. When the underlying stock price is less than the strike price at maturity, the put option will be exercised against the noteholder. Consequently, Ms. Chen, as the ELN holder, will not receive the full face value of the note in cash. Instead, she will receive a predetermined number of shares of InnovateTech (IT) Ltd. This quantity is calculated by dividing the note’s face value by the strike price (S$10,000 / S$45.00 = approximately 222.22 shares). Since the market price of these shares (S$40.00) is lower than the strike price at which she effectively ‘bought’ them (S$45.00), the total market value of the shares received (222.22 shares S$40.00 = S$8,888.80) will be less than her initial investment of S$9,900, resulting in a loss. The other options describe scenarios that either misrepresent the ELN’s payoff structure under these conditions or incorrectly assign obligations.

According to the Capital Markets and Financial Advisory Services (CMFAS) Module 6A syllabus, specifically section 13.7.8 ‘Acceptance of Orders during Margin Calls’, if a customer fails to obtain the necessary margins by the close of the market on T+2 (two market days from the date the margin call is triggered), the Member and Trading Representative shall not accept orders for new trades for that customer. However, there is a crucial exception: orders which would result in the customer’s Required Margins being reduced may still be accepted. This typically refers to risk-reducing trades, such as the liquidation of an open position, which decreases the maintenance margin requirements. Therefore, only trades that actively reduce the margin deficiency are permitted after the T+2 deadline if the margin call remains unmet. Other types of trades, including risk-neutral trades or any new trades, are generally not allowed under these circumstances until the margin call is fully satisfied.

Under direct issuance, the bank issues the notes directly to investors, making the debt a direct obligation of the bank. Consequently, investors bear the credit risk of the bank and have direct recourse to the bank in case of default. In contrast, when a Special Purpose Vehicle (SPV) issues the notes, the SPV is a separate legal entity from the bank. The SPV’s assets and liabilities are not reflected on the bank’s balance sheet. Therefore, noteholders can only make a claim on the SPV’s assets and have no recourse to the bank that established the SPV. Thus, investors in Alpha Note, being directly issued by Global Capital Bank, would have a claim against the bank, while investors in Beta Note, issued by Venture SPV, would be limited to the assets of Venture SPV.

The scenario describes a fund that aims to provide returns linked to an underlying asset but achieves this exposure not by directly investing in the asset, but by utilizing derivative transactions. This method is the defining characteristic of an Indirect Investment Policy Fund, also known as a Swap-based Fund, as outlined in the CMFAS Module 6A syllabus. These funds use derivatives to exchange the performance of a hedging asset for a performance linked to the desired underlying asset. Capitalized Funds, on the other hand, are characterized by the automatic reinvestment of dividends. Formula Funds determine payouts based on a pre-defined, rule-based formula, often tracking indices. Funds with Features that Aim to Preserve Capital Invested prioritize capital conservation, which is a different primary objective, even if they might also use derivatives.

Pairs trading, a strategy involving simultaneous long and short positions in CFDs, is fundamentally designed to achieve a market-neutral stance. This means the investor aims to profit from the relative performance of the two underlying assets, rather than the overall direction of the broader market. The objective is to remove or significantly reduce market risk, as the opposing long and short positions are intended to neutralize each other against general market movements. It is not about guaranteeing profit from one leg, as the net outcome must be positive, meaning any profit on one leg must exceed any loss on the other. Furthermore, this strategy typically involves double commissions and finance charges due to the two separate positions, rather than reducing them. Capitalizing on dividend stripping opportunities is a distinct trading strategy and not the primary objective of pairs trading.