CMFAS RES6A Quiz 45

A Credit Linked Note (CLN) is a structured product that exposes the investor to the credit risk of a ‘reference entity’. In the event of a credit default by this reference entity, the CLN’s terms dictate the settlement method. When physical settlement is specified, the CLN investor receives the actual defaulted debt obligation (e.g., a bond) of the reference entity. This bond is likely to have a market value substantially below its par value, leading to a loss for the investor. The investor then has the choice to hold the defaulted bond or sell it in the market at its reduced value. Cash settlement, on the other hand, would involve the investor receiving a cash payment representing the difference between the par value and the market price of the defaulted debt. CLNs are not designed for principal preservation; instead, they offer enhanced yield in exchange for bearing the credit risk of the reference entity. Therefore, the investor is exposed to potential losses, including a substantial portion or even all of their principal investment, if a credit event occurs.

At the expiration of a futures contract, a fundamental principle of futures markets is that the futures price and the spot price of the underlying asset converge. This convergence occurs because, at expiry, the futures contract essentially becomes a claim on the immediate delivery of the underlying asset, making its value identical to the asset’s current market price. Consequently, the basis, which is the difference between the spot price and the futures price, is expected to be zero if the underlying asset of the futures contract perfectly matches the physical commodity being hedged or traded. Options suggesting a persistent difference, whether higher or lower, or a constant initial basis, contradict this principle of convergence at expiry.

A diagonal spread is characterized by using options on the same underlying security but with different strike prices and different expiration dates. This strategy is considered a combination of a vertical spread (which uses options with the same expiration month but different strike prices) and a horizontal or calendar spread (which uses options with the same strike price but different expiration dates). The question describes precisely these characteristics: same underlying, different strike prices, and different expiration dates, which directly points to a diagonal spread. A vertical spread would have the same expiration date. A horizontal (calendar) spread would have the same strike price. A ratio spread involves buying and selling options in specific quantities (e.g., 2:1), which is a different classification method.

When establishing a hedge using futures contracts, the primary objective is to offset the risk of an existing portfolio. The number of futures contracts required for this purpose is critically dependent on two main quantitative factors: the beta of the portfolio and its modified value. The portfolio’s beta measures its sensitivity to market movements, indicating how much the portfolio’s value is expected to change for a given change in the market. The modified portfolio value accounts for the value of the portfolio that needs to be hedged. Together, these two factors allow for the calculation of the appropriate hedge ratio, which determines the number of futures contracts needed to achieve the desired risk reduction. Other factors like interest rate differentials, time to expiry, historical or implied volatilities, or bid-ask spreads are relevant for futures pricing, risk assessment, or trading execution, but they are not the primary quantitative determinants for calculating the number of contracts for a basic hedge.

The question tests the understanding of the ‘Minimum Price Fluctuation’ specification for futures contracts on the Straits Times Index, as outlined in the CMFAS Module 6A syllabus. According to the specifications, one minimum price fluctuation is equivalent to 1 index point, which has a monetary value of SGD 10. Therefore, if a contract’s price shifts by 3.5 minimum price fluctuations, the total monetary value of this change is calculated by multiplying 3.5 by SGD 10. This results in a total monetary change of SGD 35.

Gamma measures the rate of change of an option’s delta with respect to the underlying asset price. It indicates how much the delta will change for a given movement in the underlying. The CMFAS Module 6A syllabus, Chapter 9, explicitly states that one method to restrict gamma is by ‘limiting the absolute change in delta’. This directly addresses the scenario where a risk manager observes significant fluctuations in the portfolio’s delta sensitivity to underlying price movements. The other options relate to different risk parameters or general risk management techniques. Establishing limits on potential loss due to a 1% shift in market volatility is a method for managing Vega risk. Executing swap transactions to reduce the impact of interest rate fluctuations is a method for managing Rho risk. Imposing a cap on the total number of open contracts is a general market risk control, often applied to futures, but not a specific method for managing gamma in an options portfolio.

When an investor holds a long position in a knock-out barrier option, the option is designed to terminate and become worthless if the underlying asset’s price reaches or crosses a predetermined barrier level. This event, known as a ‘knock-out,’ means the option ceases to exist and can no longer be exercised or traded. Consequently, the investor loses the entire premium paid for the option, as it no longer holds any value. The investor does not become obligated to buy or sell the underlying asset, as the option has expired worthless. Furthermore, the capital is not tied up until the original expiration date because the contract has terminated. Margin calls are generally not applicable for a long option position that has already been paid for upfront and then terminates.

An investor anticipating a significant decline in the market price of an underlying equity holds a bearish view. To profit from a downward movement, a put warrant is the appropriate instrument. A put warrant gives the holder the right, but not the obligation, to sell the underlying asset at a specified exercise price. If the market price of the underlying asset falls below the exercise price, the put warrant gains intrinsic value, allowing the investor to profit. Conversely, a call warrant is used for a bullish view, as it profits from an increase in the underlying asset’s price. Yield-enhanced securities are generally suited for investors with a neutral market outlook, aiming for enhanced returns within a specific range. Convertible bonds are typically associated with a bullish view, offering potential upside participation in the underlying stock while providing bond-like income.

The basis in futures contracts is defined as the difference between the actual futures price and the spot price of the underlying asset. As a futures contract approaches its expiration date, a fundamental principle of futures markets dictates that the futures price and the spot price must converge. This convergence means that the difference between them, the basis, will progressively narrow and eventually reach zero at the contract’s settlement or expiry date. This phenomenon is known as convergence. The net financing cost, which is part of the cost of carry, declines as the expiry date draws near, forcing the basis towards zero. Therefore, the expectation is for the basis to narrow and become negligible at expiry. The other options describe scenarios that contradict this established market behavior; the basis does not typically widen, remain constant, or fluctuate wildly due to inherent mechanics as expiry approaches, though short-term volatility can occur, the overarching trend is convergence.

When an investor holding a short Extended Settlement (ES) position fails to deliver the required underlying shares by the due date, the Central Depository Pte Ltd (CDP) initiates a buying-in process to fulfill the delivery obligation. According to the CMFAS Module 6A syllabus, the buying-in process starts at a price determined by taking 2 minimum bids above the highest of three values: the closing price of the previous day, the current last done price, or the current bid. This mechanism ensures that the shares are acquired to cover the shortfall, often at a premium to incentivize sellers. The other options describe incorrect methods of price determination or actions not directly related to setting the initial buying-in price.

The question describes two types of derivative instruments. The first instrument, characterized by highly specific and tailored terms negotiated directly, is a forward contract. The second instrument, which features standardized contracts traded on a regulated exchange with daily settlement procedures, is a futures contract. A fundamental distinction between futures and forwards lies in their counterparty risk. Futures contracts are traded on exchanges, and a clearing house (often associated with the exchange) interposes itself as the counterparty to every trade. This mechanism effectively eliminates the direct counterparty risk between the original buyer and seller, as the clearing house guarantees performance. In contrast, forward contracts are private agreements, and parties are directly exposed to the default risk of their counterparty. Options 2, 3, and 4 describe characteristics of forward contracts: direct counterparty risk, flexible and negotiated terms, and typically no interim partial settlements.

The question describes a scenario where a derivatives trader seeks a neutral futures strategy involving four distinct delivery months, specifically avoiding the concentration of two short positions in a single middle delivery month. A condor spread is characterized by having four contracts with equally distributed delivery months, and crucially, ‘there is no common middle month, as the expiration dates of the futures contracts are all different.’ Its ratio is +1 : -1 : -1 : +1, meaning two distinct short positions across two different middle months. This perfectly matches the trader’s objective. In contrast, a butterfly spread involves selling one month twice, creating a concentration of two short positions in a single middle delivery month, which the trader explicitly wishes to avoid. A calendar spread typically involves only two legs with different expiration dates, not four distinct delivery months in the manner described. A straddle is an options strategy, not a futures strategy, and is therefore irrelevant to the context of futures delivery months.

To determine the new exercise price of a call warrant after a dividend adjustment, the specified formula from the CMFAS 6A syllabus must be applied. The formula for the Adjustment Factor is (P – SD – ND) / (P – ND). In this scenario, P (the last cum-date closing price) is $10.00, SD (Special Dividend per Share) is $0.50, and ND (Normal Dividend per Share) is $0.20. First, calculate the Adjustment Factor: Adjustment Factor = (10.00 – 0.50 – 0.20) / (10.00 – 0.20) Adjustment Factor = (9.30) / (9.80) Adjustment Factor ≈ 0.94897959 Next, apply this factor to the Old Exercise Price: New Exercise Price = Old Exercise Price x Adjustment Factor New Exercise Price = $5.00 x 0.94897959 New Exercise Price ≈ $4.74489795 Rounding to two decimal places, the new exercise price is $4.74.

The scenario describes a portfolio manager seeking an immediate and near-complete hedge against potential price declines, specifically without the need to select a strike price. According to the CMFAS Module 6A syllabus, Extended Settlement (ES) contracts offer an immediate, near 100% hedge (delta = 1.0) and do not require the selection of a strike price. This makes them highly effective for locking in a price for existing physical shares. In contrast, warrants, while offering downside protection, have hedging effectiveness that depends on the strike price and time to expiry (at-the-money delta = 0.5), and necessitate selecting a strike price. A forward contract, while locking in a future price, might lack the liquidity of exchange-traded ES contracts. A covered call strategy, involving selling call options, primarily generates premium income and offers limited downside protection, rather than a near-complete hedge against significant drops.

Structured products are designed to meet specific investor needs, often by combining a principal component (typically a fixed income instrument like a bond for capital preservation) and a return component (often linked to options or other derivatives for potential gains). When an investor desires partial capital protection along with the opportunity for enhanced returns, a trade-off is typically made. The study material explains that it is possible to ‘trade-off some of the preservation features for more attractive returns, by reducing investment in the principal component and increasing investment in the return component.’ Therefore, to achieve partial protection while aiming for higher returns, the allocation to the principal component would be decreased, allowing a larger portion of the investment to be directed towards the return component, which carries higher potential but also higher risk. Fully investing in the principal component would maximize preservation but limit returns, while investing solely in the return component would forgo principal protection entirely. Diversifying the principal component across various fixed-income instruments is a strategy for managing risk within that component, but it does not directly address the fundamental trade-off between the proportion of capital allocated to preservation versus growth potential.

Global Connect Pte Ltd expects to receive USD 1,500,000 in three months. To hedge against the risk of USD depreciation (meaning the SGD/USD exchange rate falling), the company needs to lock in a future exchange rate for converting USD to SGD. This is achieved by selling USD futures contracts. The relevant rate for the hedge is the three-month SGD/USD futures rate, which is 1.3450. Therefore, the net amount in SGD received by Global Connect Pte Ltd, after successfully implementing the hedging strategy, is calculated by multiplying the expected USD amount by the futures rate: USD 1,500,000 x 1.3450 = SGD 2,017,500. If the company had not hedged, they would have converted the USD at the spot rate of 1.3200 at the time of settlement, resulting in SGD 1,980,000 (USD 1,500,000 x 1.3200), which is a lower amount.

The hedge ratio for long-term interest rate risk is determined by comparing the Price Value of a Basis Point (PVBP) of the security being hedged against the PVBP of the most deliverable bond, adjusted by its conversion factor. The formula used is: Hedge ratio = PVBP of hedge security / (PVBP of most deliverable bond x Conversion factor for most deliverable bond). Given the PVBP of the bond to be hedged as 0.7250, the PVBP of the cheapest-to-deliver bond as 0.0750, and its conversion factor as 0.95, the calculation is: 0.7250 / (0.0750 x 0.95) = 0.7250 / 0.07125 = 10.1754. Rounded to two decimal places, the hedge ratio is 10.18.

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 outcome for the CLN investor depends on the mode of settlement specified in the note’s terms. If physical settlement is stipulated, the CLN investor will receive the defaulted debt obligations of the reference entity, which are likely to be trading at a substantial discount to their par value, leading to a loss. If cash settlement is specified, the investor will bear a loss equivalent to the difference between the par value and the market price of the defaulted debt. Therefore, the investor is directly exposed to the downside risk of the reference entity’s default. The CLN does not guarantee principal protection in such a scenario, nor does it provide for increased coupon payments or full insulation of the investor by the issuer.

The firm’s action of identifying a temporary price discrepancy between related markets and executing simultaneous buy and sell orders to secure a riskless profit, without taking a directional view, is the defining characteristic of an arbitrageur. Arbitrageurs specifically seek to capitalize on such market inefficiencies. A speculator, in contrast, takes a directional bet on future price movements. A hedger uses futures to mitigate or reduce risk from an existing position in the underlying asset. A market maker’s primary role is to provide liquidity by continuously quoting bid and offer prices, profiting from the bid-ask spread.

The investor has a moderately bullish outlook and wants to implement a credit spread strategy. A Bull Put Spread is the appropriate strategy for a moderately bullish market view and results in a net credit upon initiation. This strategy involves selling an in-the-money (ITM) put option and buying an out-of-the-money (OTM) put option with the same expiration date. Given the current stock price of $50, selling a put with a strike price of $55 (which is ITM as $55 > $50) and buying a put with a strike price of $45 (which is OTM as $45 < $50) correctly constructs a Bull Put Spread. This combination generates a net credit because the ITM put option sold will have a higher premium than the OTM put option bought. Option 2 describes a Bear Call Spread, which is also a credit spread but is employed when an investor has a moderately bearish outlook, not a bullish one. Option 3 describes a Bull Call Spread, which is suitable for a moderately bullish outlook but is a debit spread, meaning it requires a net cash outlay to initiate, rather than generating a credit. Option 4 describes a Bear Put Spread, which is a debit spread and is used for a moderately bearish outlook.

The CMFAS Module 6A syllabus, specifically Chapter 10, highlights the distinct compositions of structured products like the Reverse Convertible and the Discount Certificate, even when they achieve similar risk-return profiles. A Reverse Convertible is fundamentally constructed by combining a bond (or note) with a short put option. This structure allows the investor to receive a coupon from the bond while taking on the risk of the underlying asset’s decline through the short put. In contrast, a Discount Certificate is built using a long zero-strike call option and a short call option. The premium received from selling the call option, exceeding the cost of the zero-strike call, is passed to the investor as a discount at issuance. Therefore, the core difference lies in the specific derivative components embedded within each product.

The product terms state that a Mandatory Call Event (knock-out event) is triggered if the closing index level of ANY 4 of the underlying indices (Index1-4) on the Early Redemption Observation Date is < 75% of the initial level. Since there are exactly four underlying indices, 'ANY 4' implies that all four indices must fall below the 75% threshold for the event to be triggered. In the given scenario, Index 3 is at 80% of its initial level, which is not below 75%. Therefore, the condition for the Mandatory Call Event is not met. As the knock-out event is not triggered, the fund continues, and the investor will receive the scheduled quarterly variable coupons, as the fixed coupon period (Year 1) has already passed by December 2017. The call protection period (initial 1.5 years) also ended on 15 June 2016, making the fund callable, but the specific trigger condition was not met. Options suggesting the event is triggered are incorrect because not all four indices met the <75% condition. Option 4 is incorrect because the product pays variable coupons after Year 1, not fixed coupons.

When a corporate treasurer expects to receive funds for a deposit in the future and anticipates that interest rates will decline, their future deposit will earn less interest. To hedge against this risk and effectively lock in a higher current yield, they should sell Eurodollar futures contracts. Eurodollar futures prices move inversely to interest rates (100 minus the implied LIBOR rate). If interest rates decline, Eurodollar futures prices will increase. By selling futures now, the treasurer can buy them back later at a higher price (or let them expire if the hedge is perfectly timed), generating a profit from the futures position. This profit will then offset the lower interest earned on the actual deposit, thereby locking in a yield closer to the current market rate. Buying Eurodollar futures would be appropriate if the treasurer expected rates to rise, or if they were hedging a floating-rate borrowing cost. An interest rate swap is a different instrument typically used for converting floating-rate liabilities to fixed rates, or vice versa, over longer periods, and not the primary tool for hedging a single future deposit in this manner. Delaying action would expose the deposit to the full risk of declining interest rates.

This question tests the understanding of a Bull Equity-Linked Note (ELN) with an embedded short put option. An ELN is a structured product designed to offer an enhanced yield compared to a plain vanilla note, but it comes with equity risk. The key feature is the embedded short put option, which dictates the payoff at maturity. In this scenario, the ELN has a face value of $10,000 and an embedded short put with a strike price of $54. At maturity, the underlying shares of Global Dynamics Ltd. are trading at $50. Since the market share price ($50) is less than the strike price ($54), the embedded put option is ‘in-the-money’ for the put buyer (and ‘exercised’ against the ELN holder). According to the structure of such an ELN, when the underlying share price is less than the strike price at maturity, the noteholder does not receive the full face value in cash. Instead, they are obligated to take delivery of the underlying shares. The number of shares received is calculated by dividing the face value of the note by the strike price of the put option: $10,000 / $54 = 185.185… shares. Therefore, the investor receives approximately 185 shares. Since the market price of these shares ($50) is lower than the strike price ($54) at which the shares are effectively ‘bought’ (by taking delivery), the investor will incur a loss on their principal amount compared to the face value of the note. The value of the shares received (185 shares $50/share = $9,250) is less than the face value of the note ($10,000), indicating a loss. Option 2 is incorrect because the full face value is only received if the share price is greater than or equal to the strike price. Option 3 is incorrect as ELNs are not principal-protected when the underlying falls below the strike price. Option 4 is incorrect because the put option is in-the-money and would be exercised, not expire unexercised.

The question addresses the consequences of failing to meet a margin call for Extended Settlement (ES) contracts. According to the regulations, if an investor’s Customer Asset Value (CAV) falls below the Required Margins, a margin call is issued. The investor is then required to top up their account to at least the sum of their Initial Margins and Additional Margins within two market days. Failure to comply with this requirement results in a specific restriction: the investor will not be allowed to place orders for new trades. However, an important exception exists for trades that are risk-reducing, which are still permitted. This measure is in place to manage the investor’s exposure and prevent further accumulation of losses, while still allowing them to mitigate existing risks. Immediate liquidation of all positions, indefinite account suspension, or mandated broker coverage with penalty fees are not the direct and immediate consequences stipulated by the regulations for failing to meet a margin call within the initial timeframe.

In a Constant Proportion Portfolio Insurance (CPPI) strategy, the allocation to the risky asset is determined by the formula: Allocation to Risky Asset = Multiplier x Cushion Value, where Cushion Value = Total portfolio value – Floor Value. The provided text highlights that a CPPI strategy assumes the underlying asset appreciates over time, has low volatility, and limited drawdown. A significant risk of CPPI products is their performance in a prolonged range-bound market. In such a scenario, the underlying risky asset’s value may fluctuate without a sustained upward trend. This can cause the total portfolio value to stagnate or decline, leading to a reduction in the cushion value. As the cushion shrinks, the allocation to the risky asset is progressively reduced. If the portfolio value drops to the floor value, the strategy dictates that the entire fund must be allocated to the risk-free asset to ensure principal preservation, thereby forfeiting any potential future appreciation from the risky asset. This outcome is often referred to as the ‘buy high and sell low’ phenomenon in a range-bound market, as the strategy forces selling risky assets as their value declines or stagnates and buying them when they are appreciating. Option 1 is incorrect because a prolonged range-bound market, especially without a clear upward trend, would likely lead to a shrinking or fluctuating cushion, not a stable one that allows for consistent increases in risky asset allocation. The strategy would reduce risky asset exposure as the cushion diminishes. Option 3 is incorrect because in a standard CPPI strategy, the multiplier is a constant number (1 / Crash Size). Dynamic adjustment of the multiplier is a feature of Dynamic Proportion Portfolio Insurance (DPPI), not CPPI. Option 4 is incorrect because in a range-bound market, the cushion value is unlikely to expand significantly. It would more likely shrink or fluctuate, leading to a reduction in risky asset allocation, not an increase in risk-taking capacity.

Knock-out products are structured products designed to terminate when the price of the underlying asset reaches a predetermined barrier level. In the context of a knock-out call option, if the underlying asset’s price rises to and touches or crosses the specified knock-out barrier, the option is immediately extinguished or ‘knocked out’. This means the option ceases to exist, and the investor’s position is closed. The payoff, if any, upon termination is determined by the specific terms of the option agreement, which could be zero, a fraction of the premium, or a fixed amount. It does not transform into a standard option, nor does it lead to an adjustment of the strike price or a mandatory exercise at the barrier price. The fundamental characteristic of a knock-out option is its conditional termination.

A Credit-Linked Note (CLN), represented by Product X in this scenario, fundamentally involves the investor selling a Credit Default Swap (CDS) on a specific reference entity. Consequently, its payout structure is primarily contingent upon the occurrence of a credit event related to that reference entity. If a credit event, such as a default, occurs, the investor typically faces a loss of principal. Conversely, a Bond-Linked Note (BLN), represented by Product Y, embeds a short put option on an underlying bond. The payout for a BLN is therefore dependent on the price movement of that underlying bond, rather than solely a credit event. The bond’s price can be influenced by various factors beyond just a credit event, including interest rate changes, credit downgrades, or widening spreads. The other options describe characteristics of different structured products or misrepresent the core features of CLNs and BLNs. For instance, the concept of regularly buying or selling a fixed quantity of an asset relates to accumulators and decumulators, while distinctions about exchange-traded nature or holding diversified portfolios pertain to Exchange-Traded Notes (ETNs) and Exchange-Traded Funds (ETFs).

The structured product described includes a capital preservation feature at maturity. According to the ‘Payout at Maturity’ section, if early redemption does not occur, the payout depends on the relative performance of the two underlying indices. Specifically, if the Returns Performance of Index 1 (Nikkei 225) is less than the Returns Performance of Index 2 (S&P 500) (i.e., R1 < R2), the payout is the 'Redemption Value,' which is explicitly defined as 100% of the initial investment. This mechanism ensures the return of the initial capital under these specific unfavorable conditions at maturity. The product terms explicitly state that there is no explicit guarantee from the issuer for capital return, and the capital preservation is contingent on no credit event on the underlying asset. The early redemption mechanism is triggered by R1 >= R2 and results in a higher payout percentage, not a return of initial capital due to underperformance. Underlying indices themselves do not inherently have minimum return floors.

A standard stop-loss order is contingent upon a specific price being reached. Once this ‘stop price’ is hit, the order typically converts into a market order. In highly volatile market conditions, especially with sudden price gaps, there might not be any buyers or sellers at the exact stop-loss price. Consequently, the market order will be executed at the next available price, which could be significantly different (worse) than the specified stop-loss price. This phenomenon is known as ‘slippage’. Option 1 describes a ‘guaranteed stop-loss’ service, which usually incurs an additional premium and ensures execution at the exact specified price. Options 3 and 4 do not accurately reflect the mechanism of a standard stop-loss order in such market conditions.