CMFAS RES6A Quiz 42

In the context of Contracts for Differences (CFDs), the treatment of corporate actions like cash dividends is designed to mirror the economic effect of holding the underlying asset. For an investor holding a long CFD position, they economically benefit from the price appreciation and receive dividend payments, hence a dividend credit. Conversely, an investor holding a short CFD position is essentially betting against the asset’s price and is obligated to cover the dividend payment, as if they had borrowed and sold the underlying shares. Therefore, when a company declares a cash dividend, an investor with a short CFD position on that company will have the dividend amount debited from their account. This ensures that the CFD position accurately reflects the financial outcomes associated with a short sale of the physical shares.

The core principle behind SGX’s adjustments to Extended Settlement (ES) contracts in the event of a corporate action is to maintain the economic equivalence of the contract before and after the event. Since ES contracts derive their value from underlying securities, corporate actions like bonus issues, share splits, or rights issues can alter the value of these underlying assets. Without adjustment, the ES contract’s value would be unfairly impacted. Therefore, SGX intervenes by adjusting factors such as the contract multiplier or the settlement price to ensure that the contract holder’s position is not materially disadvantaged or advantaged solely due to the corporate event, thereby preserving the original economic intent of the contract. The adjustments are not intended to force cash settlement, allow for renegotiation by participants, or simply standardize multipliers without considering the specific impact of the corporate action.

An Inverse Floater Note is specifically designed to pay coupons that are inversely linked to a floating interest rate index. This means that if the underlying floating interest rate index increases, the coupon payment for the noteholder will decrease. The formula provided, Coupon = [X% ― Leverage x Floating Rate Index], clearly illustrates this inverse relationship: as the ‘Floating Rate Index’ value rises, the subtracted amount increases, leading to a lower resulting coupon. The note may also include a minimum floor (Min Coupon), meaning the coupon cannot fall below this specified level, but it will still decrease until it reaches that floor. Therefore, a substantial upward movement in the floating interest rate index would lead to a decrease in the coupon payments.

A fund manager anticipating a future share purchase and concerned about a potential price increase would employ a long hedge strategy. This involves purchasing Extended Settlement (ES) contracts for the underlying shares. By doing so, the manager effectively locks in the purchase price, mitigating the risk of having to acquire the shares at a higher market price when the funds become available. This strategy protects against adverse price movements for an anticipated acquisition. Selling ES contracts, on the other hand, would be a short hedge, typically used to protect against a fall in the price of existing assets. Waiting for funds without any hedging exposes the manager to the full market risk. While other instruments like forward contracts exist for similar purposes, the question specifically asks about the application of ES contracts.

Equity index futures are derivative instruments that derive their value from an underlying equity index. Unlike direct ownership of the individual stocks that comprise an index, holding an equity index future does not confer ownership rights to the underlying companies. Consequently, investors holding equity index futures do not receive dividend payments distributed by the constituent companies. Conversely, direct ownership of shares in a company typically entitles the shareholder to receive dividends when declared. Therefore, the absence of dividend income for futures holders is a fundamental financial distinction when comparing equity index futures to direct stock ownership. The other options incorrectly state that futures pay dividends, or that stocks do not pay dividends, or that both instruments treat dividends identically.

An investor anticipating a significant upward price movement and seeking a lower premium while requiring the option to become active only after reaching a specific higher price level would find an Up-and-In call option most suitable. An Up-and-In option is designed to become active (knock-in) if the underlying asset’s price moves up and exceeds a predetermined barrier price. This aligns with the investor’s expectation of a large market move and the condition for activation. Barrier options, in general, are known to be cheaper than standard options, fulfilling the desire for a lower premium. Conversely, an Up-and-Out call option would terminate if the underlying asset moves up and beyond a barrier, which is contrary to the investor’s objective of the option becoming active for an upward move. Down-and-In and Down-and-Out call options involve barrier conditions related to downward price movements, which do not align with an anticipated significant upward price movement for activation.

Extended Settlement (ES) contracts are explicitly designed to offer an immediate, near 100% hedge (delta = 1.0) for underlying shares. This means their price movements closely track the underlying asset, providing a highly effective hedge. A key advantage highlighted is that ES contracts do not require the selection of a strike price, simplifying the hedging strategy and removing a layer of complexity. In contrast, warrants, while also derivatives, have a delta that depends on their strike price and time to expiry (e.g., an at-the-money warrant might have a delta of 0.5), making them less effective for a near-complete hedge. Warrants also necessitate the selection of a strike price, which can introduce additional considerations for the hedger. Equity call options are typically used for bullish strategies or to hedge short positions, not to protect a long equity holding from a fall. Exchange-traded funds (ETFs) are investment vehicles that track an index or sector, and while they can be part of broader portfolio hedging strategies, they do not offer the direct, high-delta, strike-price-independent hedge for a specific long equity position that an ES contract provides.

When a corporate treasurer anticipates receiving funds in the future that will be placed into a deposit, and expects interest rates to decline before the deposit date, the objective is to lock in the current, higher prevailing yield. If interest rates fall, the actual interest earned on the future deposit will be lower. To counteract this potential loss of interest income, the treasurer needs to generate a gain from the futures market. Eurodollar futures prices move inversely to implied interest rates; therefore, if interest rates are expected to decline, Eurodollar futures prices are expected to rise. To profit from rising futures prices, the appropriate strategy is to purchase Eurodollar futures contracts. The gain from this long futures position will then offset the lower interest earned on the cash deposit, effectively securing a yield closer to the current market rate.

Range Accrual Notes (RANs) are structured notes where the investor’s interest payout is contingent on a reference index (e.g., a stock index or interest rate benchmark) remaining within a predefined range during the observation period. The text explicitly states that ‘Interest is usually accrued and calculated on a daily basis for the days when the reference index falls within the range stipulated in the RAN’s terms and conditions.’ If the index closes outside this range, the investor typically receives less or no interest, although the principal sum is usually preserved. Therefore, the most accurate description of the coupon determination mechanism is that it accrues daily only when the reference index is within the agreed range. The other options describe different payout mechanisms not characteristic of a standard Range Accrual Note. A fixed coupon irrespective of benchmark movement (option 2) would be a standard bond or a very different structured product. Interest based on average performance (option 3) or amplified coupons for volatility outside the range (option 4) do not align with the specific daily accrual and range-bound nature of RANs.

The question tests the understanding of the structural differences between a Reverse Convertible and a Discount Certificate, despite their potential for similar risk-return profiles. According to the CMFAS Module 6A syllabus, a Reverse Convertible is typically constructed from a bond (or note) and a short put option. This means the investor sells a put option. In contrast, a Discount Certificate is constructed using a long zero-strike call option and a short call option. The premium from the short call, exceeding the cost of the long zero-strike call, is passed on as a discount to the investor. Therefore, the fundamental difference in their option components lies in the Reverse Convertible utilizing a short put, and the Discount Certificate utilizing a combination of a long zero-strike call and a short call.

The auto-redeemable feature of the structured fund specifies that the product becomes auto-redeemable after 1.5 years of inception, and every 6 months thereafter, if the closing level of any of the underlying indices at the time of valuation on the specified early redemption observation date is below 75% of its initial level. In the given scenario, the EURO STOXX 50 Index closed at 72% of its initial level, which is below the 75% threshold. Since the condition is met if any index falls below this level, the product would auto-redeem. Upon auto-redemption, the product is redeemed at 100% of the principal value, as stated in the product features.

Moneyness describes the relationship between an option’s strike price and the current market price of its underlying asset. For a put option, it is considered ‘in-the-money’ when the strike price is higher than the current market price of the underlying asset, allowing the holder to sell the asset at a price above its current market value. Conversely, a put option is ‘out-of-the-money’ when the strike price is lower than the current market price, as exercising it would mean selling the asset for less than its current market value. An option is ‘at-the-money’ when the strike price is equal to the current market price. In this scenario, the put option has a strike price of $55, while the current market price of Company X shares is $57. Since the strike price ($55) is lower than the current market price ($57), the put option is out-of-the-money. If the investor were to exercise the option, they would sell the shares at $55, when they could sell them in the open market for $57, which would not be profitable.

The gearing ratio of a structured warrant indicates how many more warrants an investor can purchase for a given amount of capital, compared to buying the underlying shares directly. A gearing ratio of 10 means that for the same capital outlay, the investor can achieve 10 times greater exposure to the underlying asset than if they had purchased the underlying shares. This highlights the leverage potential of warrants. Option 1 describes a consequence of gearing, often more accurately reflected by effective gearing, which incorporates delta, rather than the direct definition of gearing itself. Option 3 incorrectly relates gearing to delta and its implications. Option 4 discusses the warrant’s moneyness, which is not directly represented by the gearing ratio.

Value at Risk (VaR) is a widely used measure for assessing the potential loss of a portfolio of financial assets. It is characterized by three components: a confidence level (e.g., 95% or 99%), a time period (e.g., a day, a month), and an estimated investment loss (in dollar or percentage terms). When a portfolio has a 1-day 99% VaR of SGD 500,000, it means that there is a 1% probability (calculated as 100% minus the 99% confidence level) that the portfolio will experience a loss greater than SGD 500,000 over a single trading day. In simpler terms, on 1 out of 100 trading days, the portfolio is expected to lose more than SGD 500,000. It does not imply a guaranteed maximum loss, nor does it suggest that the portfolio will frequently lose a specific amount or generate profits.

This question tests the understanding of hedging a short position in an underlying asset by simultaneously buying a call option, as outlined in the CMFAS Module 6A syllabus, Chapter 4. When an investor short sells a stock, they profit if the stock price falls. However, they face unlimited risk if the stock price rises. To hedge this risk, buying a call option limits the upside loss. The maximum potential gain for this hedged strategy occurs when the underlying stock price falls to its lowest possible value, which is $0. In this scenario, the profit from the short sale is maximized, and the call option expires worthless (since the stock price is below the strike price). The formula for maximum gain in this strategy is the short sale price (S0) minus the premium paid for the call option (c0). Given: Short sale price (S0) = $25.00 Call premium (c0) = $1.50 Maximum Gain = S0 – c0 = $25.00 – $1.50 = $23.50. Other options represent common miscalculations: $25.00 would be the gain if no premium was paid. $26.00 is the strike price of the call option. $24.50 could be derived from subtracting the premium from the strike price ($26.00 – $1.50) or another incorrect combination.

When a corporate treasury department anticipates an increase in short-term interest rates, and they have floating rate debt, they face the risk of higher interest payments. Eurodollar futures contracts are priced based on the implied 3-month LIBOR. A rise in interest rates causes Eurodollar futures prices to fall (as the implied yield increases, the price, which is 100 minus the yield, decreases). To hedge against rising borrowing costs, the treasury manager should take a short position (sell) in Eurodollar futures contracts. If interest rates rise as expected, the profit from the short futures position (selling high and buying back lower) will offset the increased interest expense on the floating rate bond, effectively locking in a borrowing rate. Buying Eurodollar futures would be appropriate if rates were expected to fall, as it would profit from rising futures prices. Other options involve different instruments or incorrect hedging directions for this specific scenario and instrument.

The question describes a common scenario where a structured product’s maturity differs from that of its underlying assets, specifically a basket of high-yield bonds. The provided text explicitly states, ‘Another example is when there is a mismatch of maturity date between the structured product and the underlying assets, for example, a basket of high-yield bonds. In this case, the high-yield bonds have to be sold when the structured product matures. When that happens, the structured product is subject to liquidity risk as a buyer for the bond may not be readily available. In adverse conditions, the bond could be sold at a huge discount, resulting in a reduction to the investment returns.’ Therefore, the primary liquidity risk in this situation is the need to sell the underlying bonds prematurely, potentially at a discount, to facilitate the structured product’s redemption. The other options describe different types of risks or aspects of structured products that are not the most significant liquidity risk directly arising from the described maturity mismatch.

An investor who sells (shorts) a call option is essentially selling protection against an increase in the price of the underlying asset. In return for this protection, the investor receives a premium. If the price of the underlying asset (in this case, a securities index) rises significantly above the option’s strike price, the option becomes ‘in-the-money’. The investor, as the option seller, is then obligated to pay the option buyer the difference between the current market price of the underlying asset and the strike price. Since there is theoretically no upper limit to how high an asset’s price can rise, the potential loss for the call option seller is theoretically unlimited. The syllabus explicitly states, ‘As the upside value of the underlying asset is theoretically unlimited, the call writer could potentially be faced with unlimited losses.’ Therefore, facing a theoretically unlimited loss is the most critical financial risk in this scenario. The maximum gain for the investor is indeed the premium received, but this is not the risk when the market moves adversely. The loss is not capped at the initial capital invested; this is a common misconception for options selling. While the investor might need to take action to cover the obligation, the fundamental risk is the magnitude of the potential financial liability.

A structured note is fundamentally a debt instrument whose return characteristics, including coupon amounts or market value, are linked to the performance of underlying instruments through embedded derivatives. A key distinguishing feature from a conventional bond is that the note holder typically does not have a direct claim over these underlying instruments. Furthermore, the principal repayment of a structured note is often not guaranteed and can be contingent on the performance of the underlying assets or embedded derivatives, unlike many conventional bonds which offer guaranteed principal at maturity. The other options are incorrect: structured notes are issued by various entities, not exclusively governments; their coupon payments are often variable and linked to market performance, not always fixed; and while some structured notes may aim for capital preservation, many expose investors to significant market volatility and principal risk, making them unsuitable for minimal exposure or solely short-term capital preservation.

A knock-out option is a type of barrier option designed to terminate and become extinguished if the price of the underlying asset touches or crosses a predetermined barrier level during the option’s life. In the given scenario, the knock-out barrier for the call option was set at $80. When the equity price ascended to $81, it crossed this barrier. This event immediately triggered the termination of the option, rendering it inactive. Any subsequent price movements of the underlying asset, such as its decline to $78, do not reactivate the option, as it has already ceased to exist. The investor’s entitlement, if any, upon termination would be determined by the specific terms outlined in the option agreement, which could range from zero to a fixed payoff.

The question focuses on mechanisms designed to protect a structured product’s assets from the credit risk of the issuing institution. An independent trustee is specifically appointed to hold the assets and underlying financial instruments of the structured product. This trust arrangement segregates these assets from the issuer’s general balance sheet, thereby safeguarding them in the event of the issuer’s insolvency or default. While financial auditors verify the product’s valuation and financial statements, and exchange rules mandate reporting and disclosure, these functions primarily ensure transparency and informed decision-making rather than directly protecting the product’s assets from the issuer’s credit risk. Internal independent oversight functions ensure general due care in product management but do not provide the same level of asset segregation as an independent trustee.

A Range Accrual Note (RAN) pays a coupon only when a specified reference index falls within a predefined range during the observation period. The principal is typically preserved. The interest payout is calculated proportionally based on the number of days the index stays within the range. Given the parameters: – Nominal Investment: SGD 200,000 – Annual Coupon Rate: 4% p.a. – Basis of Calculation: Actual/365 – Total Calendar Days in Observation Period: 365 days – Number of Days SIBOR closed within range: 270 days – Coupon for days outside range: 0% To calculate the total interest payout, we apply the annual coupon rate to the nominal investment, adjusted by the fraction of days the reference index was within the specified range, using the Actual/365 day count convention. Calculation: Interest Payout = Nominal Investment × Annual Coupon Rate × (Number of Days in Range / Total Calendar Days) Interest Payout = SGD 200,000 × 0.04 × (270 / 365) Interest Payout = SGD 8,000 × (270 / 365) Interest Payout = SGD 8,000 × 0.739726027 Interest Payout = SGD 5,917.808219 Rounded to two decimal places, the total interest payout is SGD 5,917.81. Option 2 (SGD 8,000.00) is incorrect because it represents the full annual coupon, which would only be paid if the SIBOR remained within the range for all 365 days, or if the note did not have a range accrual feature. Option 3 (SGD 2,082.19) is incorrect. This amount would be calculated if the interest was paid for the days the SIBOR closed outside the range (365 – 270 = 95 days), i.e., SGD 200,000 × 0.04 × (95 / 365). However, the terms explicitly state that the coupon is 0% if the SIBOR closes outside the range. Option 4 (SGD 6,000.00) is incorrect. This result would be obtained if an Actual/360 day count convention was mistakenly used instead of the specified Actual/365 (SGD 200,000 × 0.04 × (270 / 360) = SGD 6,000.00). It is crucial to use the day count basis specified in the note’s terms.

Under the terms of an accumulator with a ‘1X2 gear’ scheme, the investor’s obligation depends on the daily closing price of the reference stock relative to the strike price and the knock-out barrier. If the daily closing price is below the strike price, the investor must purchase 2X the predefined quantity. If the daily closing price is above the strike price but below the knock-out barrier, the investor must purchase 1X the predefined quantity. The agreement terminates immediately if the daily closing price is at or above the knock-out barrier. In this scenario, the closing price of $55 is above the strike price of $50 but below the knock-out barrier of $60. Therefore, the investor is required to purchase 1X the predefined quantity, which is 100 shares, at the fixed strike price of $50.

The investor purchased a put option, which gives the right to sell the underlying asset at the exercise price. The exercise price (X) is $80, and the premium paid (P) is $6. At expiration, the share price (ST) is $70. Since the share price ($70) is below the exercise price ($80), the option is in-the-money and will be exercised. The gross payoff from exercising the option is the difference between the exercise price and the share price at expiry: $80 – $70 = $10. To determine the net financial outcome, the initial premium paid must be subtracted from this gross payoff. Therefore, the net outcome is $10 (payoff) – $6 (premium) = $4. This represents a net profit for the investor. A loss of $6 would occur if the option expired out-of-the-money (i.e., share price at or above $80), resulting in the loss of only the premium paid. A profit of $10 represents only the gross payoff, not the net profit after accounting for the premium. A loss of $10 is incorrect, as the maximum loss for a put option buyer is limited to the premium paid.

Rolling a position in futures contracts involves transferring an existing position from a near-term expiring contract to a longer-term contract. This is typically done by traders who wish to maintain their market exposure without having to take physical delivery or undergo cash settlement, and without a break in their market presence. For a trader holding a long position, rolling involves simultaneously selling the expiring contract and buying an equivalent number of contracts for the next desired expiry month. This action effectively closes the position in the current contract while establishing a new, equivalent position in the subsequent contract, thereby maintaining continuous market exposure. Allowing contracts to expire and then re-entering the market would result in a temporary loss of market exposure and potential price slippage. Buying additional contracts in the current month would only increase the exposure for that specific month, not extend it to the next. Selling the current contracts and waiting to re-enter would also break the continuity of the position.

Independent oversight functions are crucial for structured products to assure investors that their products are managed with due care. A key component of this oversight often involves a trust arrangement. In such an arrangement, an independent trustee is specifically appointed to safeguard and hold the assets and underlying financial instruments that comprise the structured product. This separation of asset holding from the issuer’s operational functions provides an additional layer of investor protection. The trustee’s role is not to assess the issuer’s creditworthiness (which is typically done by rating agencies or investors themselves), nor to manage the product’s trading activities or offer investment advice; these are distinct functions performed by other parties or the issuer itself.

For an investor who buys a put option, the breakeven point is the underlying asset price at which the investor’s net profit or loss is zero at expiration. This occurs when the intrinsic value of the option at expiration exactly covers the premium paid. The formula for the breakeven point for a put option buyer is the Exercise Price minus the Option Premium. In this scenario, the exercise price is $75 and the premium paid is $6. Therefore, the breakeven point is $75 – $6 = $69. If the share price falls to $69, the put option will have an intrinsic value of $75 – $69 = $6, which exactly offsets the $6 premium paid, resulting in a net profit of zero. If the share price is $75, the option is at-the-money and expires worthless, resulting in a loss equal to the premium paid. A share price of $81 would mean the option is out-of-the-money, also resulting in a loss of the premium. A share price of $0 represents the maximum possible gain for the put option buyer, not the breakeven point.

A put option grants the holder the right, but not the obligation, to sell an underlying asset at a specified exercise price on or before the expiration date. For a put option buyer, the option is profitable if the underlying asset’s price at expiration (ST) is below the exercise price (X). In this scenario, the exercise price is $85 and the underlying share price at expiration is $78. Since $78 is less than $85, the option is in-the-money and the investor will exercise it. The payoff from exercising the option is the difference between the exercise price and the underlying price: $85 – $78 = $7 per share. To determine the net profit or loss, the premium paid for the option must be subtracted from this payoff. The investor paid a premium of $6 per share. Therefore, the net profit per share is $7 (payoff) – $6 (premium) = $1 profit. Option 2 ($7 profit) represents only the gross payoff from exercising the option, without accounting for the premium paid. Option 3 ($6 loss) would be the maximum loss an investor would incur if the option expired worthless (i.e., if the share price was at or above the exercise price at expiration), but in this case, the option is in-the-money. Option 4 ($1 loss) would be the net result for a put option seller in this exact scenario, or an incorrect calculation for the buyer.

The product terms specify that the fund is call protected for an initial 1.5-year period, meaning the Call Barrier becomes operative only after this duration. Given the Initial Date of 16 December 2014, the fund becomes callable from 15 June 2016. The observation date of 15 December 2017 falls after this call protection period, so the call barrier is active. The Mandatory Call Event (knock-out trigger) is defined as occurring if the closing index level of ANY 4 of the underlying indices on the Early Redemption Observation Date is less than 75% of their initial level. In the provided scenario, Index 1 (70%), Index 2 (72%), and Index 4 (71%) are below 75% of their initial levels. However, Index 3 (78%) is above this threshold. This means only 3 out of the 4 underlying indices are below the 75% level. Since the condition explicitly requires ‘ANY 4’ indices to be below 75% for a knock-out event to be triggered, the condition is not met. Therefore, the fund does not terminate early. As the knock-out event has not occurred, the fund continues, and the scheduled variable quarterly coupon payments, which began after the first year (from 15 April 2016), will continue to be paid. The date 15 December 2017 is one of the specified quarterly coupon payment dates.

When an investor’s Contract for Differences (CFD) account balance falls below the maintenance margin level, a margin call is triggered, requiring the investor to deposit additional funds. If the investor fails to meet this margin call within the stipulated timeframe, the CFD provider will proceed with liquidation. Liquidation involves the forced selling of the investor’s CFD holdings, either partially or entirely, to cover the deficit and restore the margin position. This process is clearly outlined in the Risk Disclosure Statement (RDS) that investors must acknowledge upon opening a CFD account. Other options, such as converting the position into a loan, freezing the account until market recovery, or merely suspending new trading, are not the standard or required procedures for addressing an unmet margin call in the CFD market.