CMFAS RES6A Quiz 48

Arbitrage opportunities arise when there is a temporary pricing discrepancy between two equivalent financial instruments. In this scenario, the fixed rate of the Interest Rate Swap (IRS) is higher than the rate implied by the strip of Eurodollar futures contracts. This indicates that the IRS is relatively ‘overpriced’ compared to the futures strip. To execute an arbitrage strategy, an arbitrageur would aim to sell the overpriced instrument and buy the underpriced components. Therefore, the arbitrageur would sell the IRS, thereby receiving the higher fixed rate. Simultaneously, to hedge and complete the arbitrage, they would buy the corresponding strip of Eurodollar futures contracts, which are priced at a lower implied rate. This combination allows the arbitrageur to lock in a risk-free profit by receiving a higher fixed rate from the IRS and effectively paying a lower floating rate through the futures strip.

When an investor takes a short position in a Contract for Differences (CFD), they are essentially borrowing the underlying asset to sell it, hoping to buy it back at a lower price. This borrowing incurs a financing charge, often referred to as financing interest. The financing interest is typically calculated daily based on the total value of the shorted position, not just the margin deposited. The formula for daily financing interest is (Total Value of Position x Annual Financing Rate) / 360 days (assuming a 360-day year for calculation). To find the total financing interest over a period, this daily rate is multiplied by the number of days the position is held. In this scenario, the total value of the short position is 12,000 units $2.80/unit = $33,600. The daily financing interest is ($33,600 5.8%) / 360 = $5.4266… per day. For 6 days, the total financing interest is $5.4266… 6 = $32.56. The margin requirement is relevant for calculating the capital investment, but not for the financing interest itself, which is based on the full notional value of the trade.

The trading name ‘TECH Corp SGX PW241231’ provides key information about the structured warrant. ‘TECH Corp’ identifies the underlying asset, and ‘SGX’ indicates the issuer. The absence of a prefix before ‘PW’ signifies that it is an American-style warrant, meaning it can be exercised at any time up to its expiry. ‘PW’ clearly denotes a Put Warrant. The numerical sequence ‘241231’ represents the expiry date, which is December 31, 2024. For a put warrant, if the underlying share price experiences a substantial increase, moving it significantly above its strike price, the warrant becomes deep out-of-the-money. In such a scenario, its intrinsic value (which is the maximum of zero or the difference between the strike price and the underlying price, divided by the conversion ratio) would be zero. The warrant’s market price would then primarily consist of its time value, also referred to as its premium. As a put warrant moves further into an out-of-the-money position, the likelihood of it becoming profitable diminishes, which typically leads to a decrease in its time value or premium.

The question pertains to the concept of ‘basis’ in futures contracts, which is the difference between the spot price and the futures price. A key characteristic of basis, as described in the CMFAS Module 6A syllabus, is its convergence. As a futures contract approaches its expiry date, the futures price and the spot price of the underlying asset tend to converge. This convergence occurs because, at the exact moment of expiry, the futures contract becomes equivalent to the spot asset, and therefore their prices must be identical. Consequently, the basis, which is the difference between these two prices, will narrow and eventually reach zero at the contract’s expiration. The cost of carry, which includes financing costs, also declines as maturity nears, contributing to this convergence.

Company warrants are typically issued directly by the underlying company, often as a ‘sweetener’ for bond or rights issues. When these warrants are exercised, the company issues new shares, leading to physical delivery and potential dilution of existing shares. In contrast, structured warrants are issued by third-party financial institutions, not the underlying company, and are based on various underlying assets. Structured warrants listed on the SGX-ST are predominantly cash-settled, meaning the holder receives a cash payment equivalent to the intrinsic value rather than physical delivery of the underlying asset. The other options incorrectly describe the issuers or typical settlement methods for either company warrants or structured warrants.

The scenario describes a need for a highly customized, non-standardized hedging solution for a unique industrial component. Forward contracts are specifically designed for such situations, as they are private, negotiated agreements between two parties, allowing for tailored terms regarding quality, quantity, delivery time, and place. They are traded Over-The-Counter (OTC) and do not have an active secondary market, contrasting with futures contracts which are standardized and traded on regulated exchanges. Therefore, a forward contract is the suitable derivative for GlobalTech Innovations’ specific needs. Regarding the preliminary document, a term sheet is defined as a non-binding agreement that outlines the basic terms and conditions of a deal. Its purpose is to ensure parties agree on major aspects before proceeding to draft formal, binding legal documents, thereby saving time and costs. Thus, the preliminary document used to outline key commercial terms before a binding contract is finalized is accurately described as a non-binding term sheet.

Structured products often involve complex structures, including Special Purpose Vehicles (SPVs) and various derivative agreements like swaps. The credit risk for an investor in such a product is not always straightforward. When an SPV issues a structured product and subsequently enters into a swap agreement with another financial institution, the investor’s exposure can extend beyond just the SPV. The syllabus highlights that in some swap structures, the investor may bear the credit risk of both the issuer (the SPV) and the swap counterparty. This means that if either the SPV or the swap counterparty defaults on their obligations, the investor’s returns or principal could be adversely affected. It is crucial for investors to understand the full chain of credit risk. The credit rating of a parent company only provides recourse if the SPV’s obligations are explicitly guaranteed by the parent. Holding highly-rated underlying assets by the SPV does not eliminate the credit risk of the SPV itself or its counterparties. Listing on an exchange provides liquidity but does not mitigate credit risk.

For an issuer of an equity-linked structured note, the goal is to provide an attractive participation rate to investors while managing the costs of the note’s components. The note typically consists of a zero-coupon bond and an embedded call option. Higher interest rates reduce the present value of the zero-coupon bond component, meaning a smaller portion of the investor’s capital is needed to secure the capital guarantee. This leaves a larger ‘discount sum’ available to purchase the embedded call option. Concurrently, lower volatility in the underlying asset’s price makes the cost of purchasing the equity call option cheaper. When both these conditions (higher interest rates and lower volatility) are present, the issuer can acquire more options for the same amount of capital, or acquire the necessary options at a lower cost, thereby enabling them to offer a more competitive or higher participation rate to investors.

Index-linked notes with principal preservation are designed to protect the investor’s initial capital at maturity. This means the investor is guaranteed to receive at least their principal back. However, this feature often comes with a trade-off: the upside potential, or the maximum return an investor can achieve from the underlying index’s performance, may be slightly limited or capped. This is explicitly stated in the provided text: ‘In exchange for slightly less upside potential, index-linked notes may incorporate a minimum return at maturity in additional to the original principal.’ Therefore, the assurance of principal return at maturity, often balanced against a reduced maximum gain, is a key characteristic. The other options describe features that are generally not true for index-linked notes with principal preservation. Index-linked notes typically have returns linked to the index, not fixed coupons, and they often have limited liquidity.

Vega measures the sensitivity of an option’s price to changes in the underlying asset’s implied volatility. When a trader is concerned about unexpected fluctuations in market volatility, establishing risk limits based on Vega is the most direct and appropriate strategy. These limits are typically set in terms of the maximum loss that would be tolerated given certain movements in volatility, in either direction. Delta measures the sensitivity to the underlying asset’s price, Gamma measures the rate of change of Delta, and Theta measures the potential loss due to time decay. While all are important risk parameters for options, Vega specifically addresses volatility risk.

The scenario describes a situation where an investor holds a CFD on a foreign equity, and due to geopolitical events, trading activity for that underlying asset significantly diminishes. This makes it difficult to find buyers or sellers, impacting the investor’s ability to close their CFD position. This specific challenge is characteristic of liquidity risk. Liquidity risk in CFDs arises when there are not enough trades being made in the market for an underlying asset, potentially leading to the CFD provider declining to fill a trade, processing it at an inferior price, or leaving the investor with an open position they cannot close. Counterparty risk relates to the CFD provider’s ability to meet its obligations, which is not the primary issue described. Currency risk pertains to adverse movements in exchange rates, while financing costs are related to interest charges on the leveraged position, neither of which directly addresses the inability to trade due to low market activity.

The scenario describes a portfolio manager aiming to mitigate price fluctuations for an existing inventory of fixed-income securities held for an unspecified duration, with the primary objective of minimizing the variance in the market value of this current portfolio. This aligns precisely with the definition of a weak form cash hedge, also known as an inventory hedge. This type of hedge is designed to minimize the price variance of an existing asset portfolio that is to be held for an indefinite period. A strong form cash hedge (immunization), while also for currently held positions, is applied when the portfolio’s time horizon is known, and its goal is to minimize the variance in the expected total return by matching the durations of assets and liabilities. Weak form and strong form anticipated hedges are strategies used for future or anticipated cash positions, not for currently held portfolios.

A structured note is fundamentally a debt instrument where the return characteristics are tied to the performance of other underlying instruments. The structure typically involves combining a principal component (often a debt instrument) with a return component that uses one or more derivatives. The derivative component’s main purpose is to create this linkage, allowing the note’s payouts (like coupons or final principal) to fluctuate based on the performance of a chosen asset class, index, or other reference. It does not typically grant direct ownership of the underlying assets to the note holder, nor does it inherently guarantee principal repayment, as this is often not guaranteed in structured notes. While issuers may use derivatives for hedging, the primary function of the derivative component from the product’s design perspective for the investor is to provide the specified market exposure and link the returns.

Yield Enhanced Securities, often marketed as Discount Certificates, have a specific payout structure at maturity. If the underlying asset’s closing price on the expiration or valuation date is at or above the exercise price, the holder receives a cash settlement equal to the exercise price. However, if the closing price is below the exercise price, the holder receives a cash settlement equal to the value of the underlying on that date. In this scenario, the underlying asset’s closing price of $7.80 is below the exercise price of $8.50. Therefore, the investor would receive the value of the underlying asset, which is $7.80, per warrant.

The investor’s objective is to profit from a bearish outlook while mitigating the complexities and potential costs of traditional short selling, specifically the risk of buying-in. Extended Settlement (ES) contracts are explicitly designed to allow investors to take short positions, offering an advantage over shorting in the ready market by reducing the possibility of buying-in unless the position is held until settlement and then fails to deliver. This aligns perfectly with the investor’s stated goal. Contra trading primarily focuses on short-term, often intra-day, positions and while it can involve short selling, it does not offer the same specific benefit of reduced buying-in risk for a potentially longer view as ES contracts. Margin financing is generally used for leveraged long positions and the provided text explicitly states ‘No short selling’ for margin financing. Direct short selling in the ready market is precisely what the investor aims to avoid due to its associated complexities and buying-in risks.

The provided text states that ‘tracking error is generally lower for synthetic replication ETFs than physical replication ETFs’. It also mentions that ‘the error tends to be higher for benchmarks with higher volatility, such as emerging markets’. Therefore, while the high volatility of an emerging market index would likely increase the tracking error for both types of ETFs, the synthetic replication method (Fund B) is generally expected to result in a lower tracking error compared to the physical replication method (Fund A). The other options either incorrectly assert that physical replication has lower tracking error, downplay the impact of replication methodology, or incorrectly link counterparty risk as the primary driver for higher tracking error in synthetic ETFs compared to physical, when the text explicitly states synthetic generally has lower tracking error.

A portfolio with a net negative gamma position, typically held by sellers of options (short positions), means that the delta of the portfolio will move in an unfavorable direction at an accelerating rate if the underlying asset price moves adversely. For example, if a short call position has negative gamma and the underlying price increases, the delta (which is negative for a short call) will become even more negative, leading to greater losses than initially indicated by the delta alone. This makes the portfolio highly vulnerable to rapid and significant price movements in the underlying asset. The provided text states, ‘If the market moves unfavourably, investors with a net short option position can suffer significant losses.’ Option 2 describes the effect of Theta, which is the time decay of an option’s value. While relevant to options, it is not the primary implication of negative gamma concerning rapid price movements. Option 3 describes the effect of Vega, which is the sensitivity to changes in implied volatility. For a short option position, an increase in implied volatility would typically lead to a decrease in the portfolio’s value, not an increase, as short positions have negative Vega. Therefore, this option is incorrect. Option 4 describes the effect of Rho, which is the sensitivity to changes in risk-free interest rates. Options are generally not very sensitive to this variable, and it is distinct from the implications of gamma regarding price movements.

For over-the-counter (OTC) options, counterparty credit risk is a significant concern because there is no central clearing house guaranteeing performance. To mitigate this risk, financial institutions and their counterparties typically sign a legal document known as a Credit Support Annex (CSA). The CSA defines the specific terms and conditions under which collateral is posted or transferred between the parties, thereby reducing the exposure to potential losses if one party defaults on its obligations. A standard exchange-clearing agreement is relevant for exchange-traded derivatives, not OTC contracts. A market disruption protocol is designed to address risks arising from sudden, large market price changes, not counterparty creditworthiness. A portfolio maturity concentration limit is a market risk control measure, focusing on the overall exposure to instruments maturing within certain periods, rather than directly mitigating bilateral counterparty credit risk.

The question tests the understanding of gearing, delta, and effective gearing for warrants. First, calculate the gearing ratio: Gearing Ratio = Share Price / (Warrant Price x Conversion Ratio). Given Share Price = $10.00, Warrant Price = $0.50, and Conversion Ratio = 5, the Gearing Ratio = $10.00 / ($0.50 x 5) = $10.00 / $2.50 = 4 times. Next, calculate the effective gearing: Effective Gearing = Delta x Gearing. Given Delta = 0.60 and Gearing = 4, the Effective Gearing = 0.60 x 4 = 2.4 times. This means that for every 1% change in the underlying share price, the warrant price is expected to change by 2.4%. If the underlying share price increases by 5%, the approximate change in the warrant price would be 5% x 2.4 = 12%. Therefore, the warrant price would likely increase by approximately 12%.

The Constant Proportion Portfolio Insurance (CPPI) strategy is designed to dynamically adjust asset allocation between a risky asset and a risk-free asset. A core mechanism involves the ‘cushion,’ which is the difference between the total portfolio value and the floor value. When the underlying risky asset trades in a narrow, range-bound pattern for an extended period, the cushion can gradually erode, potentially due to minor drawdowns or the impact of fees. If the cushion shrinks to a critical level, the CPPI mechanism will mandate a reduction in the allocation to the risky asset. In an extreme scenario, if the cushion approaches zero, the strategy will compel the fund manager to move the entire portfolio into the risk-free asset to ensure principal protection. This action, while safeguarding the initial capital, means the investor will no longer participate in any potential upside if the risky asset subsequently breaks out of its range and appreciates in value, effectively ‘selling low’ relative to potential future gains. The multiplier in a CPPI strategy is typically determined by the expected crash size and is not automatically increased to capitalize on stable markets. While the floor value is dynamic, it does not automatically enhance the principal guarantee beyond its initial design in response to range-bound trading. Furthermore, CPPI products are known for their higher fee structures, which are generally not reduced by periods of low market volatility or range-bound trading.

To limit potential losses on a long position when the price falls, a Stop Sell order is appropriate. A Stop Sell order is placed below the current market price and triggers a sell order once that price is touched or breached. In this scenario, setting a Stop Sell order at 31,800 would achieve the objective of limiting losses. To automatically sell and secure profits if the price rises to a specific level above the current market price, a Market-if-Touched (MIT) Sell order is used. An MIT Sell order is placed above the current market price and converts to a market order when the trigger price is touched. Therefore, an MIT Sell order at 32,500 would secure profits. The other options either use incorrect order types for the intended action (e.g., Buy orders for selling), place the orders at the wrong price relative to the current market for their type, or use order types that do not fulfill the conditional trigger requirements described.

Synthetic replication ETFs typically achieve a lower tracking error compared to physical replication ETFs because they use derivatives, such as total return swaps, to replicate the index performance without needing to physically hold all underlying securities. This reduces transaction costs and rebalancing issues that can contribute to tracking error in physical ETFs. However, this method introduces counterparty risk, as the ETF’s performance is dependent on the swap dealer’s ability to fulfill its obligations. Physical replication ETFs, while avoiding the counterparty risk of swaps, are exposed to other factors that can increase tracking error, such as transaction costs, portfolio rebalancing, and cash holdings.

The syllabus explicitly states that most structured product issuers have independent oversight functions to assure investors that their products are managed with due care. This typically involves the appointment of an independent trustee to hold the assets and underlying financial instruments, and the engagement of financial auditors to verify that the product’s financial statements are true and fair and to ensure fair valuation. Option 1 accurately reflects these two key independent mechanisms. Option 2 describes internal controls, which are important but do not constitute the independent oversight specifically mentioned for investor assurance. Option 3 refers to exchange oversight, which applies to exchange-traded products and focuses on reporting and disclosure, but it does not encompass the independent trustee and auditor roles for asset holding and valuation verification. Option 4 describes a form of guarantee, not an independent oversight mechanism for product management and valuation.

In the described credit derivative transaction, the investor plays the role of a credit protection seller to the Special Purpose Vehicle (SPV) issuer. The SPV, in turn, sells credit protection to a bank. When the reference entity defaults, the SPV, as the protection seller to the bank, must liquidate its AAA-rated securities to pay the bank. Concurrently, the investor, having sold credit protection to the SPV, is obligated to make a contingent payment to the SPV. This payment helps the SPV cover its obligations to the bank. The investor then recovers the remaining sum (par minus losses) from the SPV. Therefore, the investor’s direct obligation upon a credit event is to pay the contingent amount to the SPV.

Operational risk refers to the risk of business operations failing due to human errors, breakdown of internal procedures, or system failures. The scenario describes a critical internal database becoming corrupted during routine system maintenance, leading to an inability to process client requests and administrative backlog. This directly aligns with examples of operational risk, such as the breakdown of a company’s computer system or failure to make timely transactions due to cumbersome internal procedures or system issues. Issuer risk relates to the counterparty’s ability to fulfill its obligations, basis risk is specific to futures contracts and the difference between cash and futures prices, and concentration risk arises from a lack of diversification in an investment portfolio. Therefore, the situation described is a clear example of operational risk.

The question tests understanding of the specific final settlement price determination mechanisms for different futures contracts as outlined in the CMFAS Module 6A syllabus, Appendix C. For the 3-month Singapore Dollar Interest Rate Futures contract, the final settlement price is explicitly stated to be based on the Association of Banks in Singapore’s USD/SGD Swap Offered Rates, determined at 11:00 am, Singapore time, on the last trading day. Other options describe the final settlement price determination for different futures contracts mentioned in the syllabus: the British Bankers’ Association’s rates are for Eurodollar futures (implied from the text), TFX’s final settlement price is for Euroyen TIBOR futures, and the Official Opening Price of TSE’s 10-year JGB futures is for the Full-sized 10-year Japanese Government Bond Futures.

The question tests the understanding of key differences between Contracts for Differences (CFDs) and equity futures, as outlined in the CMFAS Module 6A syllabus, specifically section 12.6.9. CFDs are characterized by their ability to be extended or rolled over for as long as the investor desires, subject to the CFD provider’s policy on corporate actions, and CFD holders are generally entitled to receive dividends. In contrast, equity futures have fixed maturity dates and their holders are typically not entitled to dividends. Furthermore, CFDs have explicit financing costs, while futures have implicit financing costs embedded in their quoted price. CFDs are mostly traded Over-The-Counter (OTC), leading to counterparty risk, whereas futures are traded on exchanges, which mitigates counterparty risk. The correct option accurately reflects these distinctions regarding maturity and dividend entitlement for CFDs.

A ‘Worst of’ Equity Linked Note (ELN) is a type of structured note where the investor’s return at maturity is determined by the performance of the poorest-performing asset within a basket of multiple underlying assets. This means that regardless of how well the other underlying assets perform, the final payout will be linked to the one that delivers the lowest positive return or the highest negative return. This structure exposes the investor to a higher degree of risk, as the overall return is capped by the weakest link in the basket. The other options describe different potential payout mechanisms that do not align with the specific ‘Worst of’ ELN structure.

GlobalTech Pte Ltd’s requirement for a highly customized hedge for a specific amount and exact future date in a less commonly traded currency (Zylarian Dinar) points directly to the characteristics of a forward contract. Forward contracts are private agreements negotiated directly between two parties, allowing for precise customization of the underlying asset, amount, and delivery date. This contrasts with futures contracts, which are standardized in terms of quality, quantity, delivery time, and place, and are traded on regulated exchanges. While futures offer advantages like liquidity and reduced counterparty risk (due to the exchange acting as a counterparty), their standardized nature makes them unsuitable for highly specific, non-standardized hedging needs, especially for exotic currencies not typically available on futures exchanges. Exchange-traded options are also standardized instruments and may not be available for exotic currencies or offer the exact customization needed. Currency swaps are generally used for longer-term management of principal and/or interest exchanges across different currencies, not typically for a single, precise short-term payment hedge.

The financial cost is a crucial component of a Callable Bull/Bear Contract’s (CBBC) theoretical price, covering the issuer’s funding expenses, adjustments for dividends (if equity-related), and their profit margin. A fundamental principle regarding this cost is its direct relationship with the CBBC’s time to maturity. Specifically, the longer the maturity period of a CBBC, the higher the financial cost incurred by the issuer. This higher cost is then incorporated into the initial price of the CBBC at the time of issuance. Conversely, as a CBBC approaches its expiration date, the financial cost component declines. Therefore, a CBBC with a longer maturity will typically have a higher financial cost embedded in its initial price compared to an otherwise identical CBBC with a shorter maturity.