CMFAS RES6A Quiz 52

The Capital Protected Portfolio Insurance (CPPI) strategy determines the allocation to the risky asset based on the cushion value and a multiplier. First, calculate the cushion value, which is the difference between the total portfolio value and the floor value. In this scenario, the cushion value is $1,200,000 (total portfolio) – $960,000 (floor value) = $240,000. Next, calculate the multiplier, which is derived from the anticipated crash size. With a crash size of 20% (0.20), the multiplier is 1 / 0.20 = 5. Finally, the amount to be allocated to the risky asset is the multiplier multiplied by the cushion value. Therefore, 5 (multiplier) $240,000 (cushion value) = $1,200,000. This calculation is fundamental to how CPPI strategies manage risk and potential returns.

A Range Accrual Note (RAN) is designed such that interest accrues only when its reference index (e.g., a stock index or interest rate benchmark) closes within a pre-defined range. If the index closes outside this range, the investor typically receives less or no interest for that specific observation period (often daily). Therefore, the total interest earned over an observation period is directly dependent on the cumulative number of days the reference index’s closing value successfully remained within the stipulated range. The payout formula for a RAN where the payout is zero if the index is outside the range is P1 x (n/N), where ‘n’ is the total number of observations when the index is inside the range, and ‘N’ is the total number of observations within a period. Thus, ‘n’ is the critical determinant for actual interest earnings. The average daily closing level, maximum deviation, or total calendar days in the period do not directly determine the interest accrual mechanism for a RAN in this manner.

The investor’s market outlook indicates an expectation of significant price movement in the underlying stock, but without a clear prediction of direction (up or down). They also want to ensure their maximum potential loss is limited. A long strangle strategy is precisely suited for this scenario. It involves simultaneously purchasing an out-of-the-money call option and an out-of-the-money put option with the same expiration date. This strategy profits if the underlying asset’s price moves substantially either above the call strike price or below the put strike price. The maximum loss for a long strangle is limited to the total premiums paid for both options, fulfilling the investor’s objective of a predefined and contained maximum potential loss. In contrast, a bull call spread is employed when an investor anticipates a moderate upward movement in the stock price, offering limited profit and limited loss. A covered call is typically used by investors who are neutral to slightly bullish on a stock they own, aiming to generate income while limiting upside potential. A protective put is a hedging strategy used to protect against a decline in the value of an owned stock, not to profit from volatility in either direction.

The Trust Deed is a critical legal document that explicitly sets out the terms and conditions governing the relationship between investors, the fund manager, and the trustee. It details the fund’s investment objectives and outlines the obligations and responsibilities of both the fund manager and the trustee. Crucially, the trustee, being independent of the fund manager, acts as the custodian of the fund’s assets and is responsible for ensuring that the fund is managed strictly according to the provisions of the Trust Deed, thereby mitigating the risk of mismanagement. The Product Highlights Sheet is a summary of key features and risks, while the prospectus provides comprehensive information about the scheme. Neither of these documents, nor the annual financial statements, serve as the primary legal instrument defining the governance and oversight roles in the same manner as the Trust Deed.

The scenario describes a situation where the portfolio’s delta sensitivity changes drastically with minor market movements, making hedging challenging. This characteristic is precisely what Gamma measures: the rate of change of an option’s delta with respect to the underlying asset’s price. A high Gamma indicates that delta will change rapidly, leading to the described difficulty in maintaining a consistent hedge. The syllabus material explicitly states that Gamma is usually measured against a specified movement in the spot price and can be restricted by applying risk tolerance amounts expressed as maximum loss. Therefore, implementing controls for Gamma directly addresses the identified risk. Vega measures sensitivity to implied volatility, Theta measures sensitivity to time decay, and Rho measures sensitivity to interest rates; none of these directly address the rate of change of delta.

A zero-cost collar, also known as a costless collar, is an option strategy designed for investors who hold a long position in an underlying asset and wish to protect against downside risk without incurring a net premium cost. This strategy involves simultaneously buying a protective put option and selling an out-of-the-money covered call option. The strike prices of the put and call are typically adjusted such that the premium received from selling the call equals the premium paid for buying the put, resulting in a net zero cash outlay. The protective put provides a floor for the investor’s losses, while the covered call caps the potential upside gains on the stock. The other options describe different strategies: selling a naked call exposes the investor to unlimited upside risk and does not protect a long position; a long strangle is a volatility strategy that involves a net premium payment and profits from large price movements; and a bear put spread is a bearish directional strategy that also typically involves a net premium payment or receipt, but is not designed for zero-cost protection of a long stock holding.

For a Bull Knock-Out certificate, the Call Price (also known as the Knock-Out level) represents a predefined barrier. If the price of the underlying asset falls to or below this Call Price at any point during the certificate’s trading hours, a mandatory call event is triggered. This event results in the immediate termination of the certificate, regardless of its original maturity date. Upon termination, the investor receives a residual value, which is calculated based on the difference between the settlement price (which might be the strike price or a price close to it, or even zero) and the strike price, adjusted by the conversion ratio. In the given scenario, the spot price of Company Alpha’s shares ($15.50) has fallen below the Call Price ($16.00), thus triggering the mandatory call event and leading to the certificate’s early termination. The other options are incorrect because a mandatory call event explicitly terminates the certificate early, it does not increase its value when the price falls below the call level, nor does it typically involve margin calls or obligations to purchase underlying shares to prevent expiry in this context.

Structured products are typically designed for investors willing to hold them until maturity. They are often customized and incorporate underlying derivatives or assets that may not be actively traded, leading to a limited or non-existent secondary market. When an investor needs to liquidate such a product prematurely, they face significant liquidity risk. This means it can be difficult to find a buyer, and if a sale is forced, it often results in selling at a substantial discount, leading to a loss of principal. The issuer may or may not provide a secondary market, and even if they do, the price will depend on prevailing market conditions and the marked-to-market values of the underlying instruments. The other options describe scenarios that are either not directly related to liquidity risk, are generally incorrect for structured products, or represent the opposite of what would typically occur during a forced early liquidation.

The provided text on Extended Settlement (ES) Contracts, specifically under section 13.4.5 Corporate Actions, outlines two main methods of adjustment. For corporate events that result in shareholders obtaining an increase or decrease in the number of shares, such as a bonus share issue, the change is reflected by a similar increase or decrease in the contract multiplier for the respective ES contracts. A 1-for-2 bonus share issue means that for every 2 shares held, an additional 1 share is issued, effectively increasing the number of shares. Therefore, the contract multiplier would be adjusted upwards to reflect this increase in the underlying shares. Adjusting the settlement price is another method, but it is typically applied when the corporate event primarily affects the share value/price rather than the number of shares directly in this manner. Bringing forward the Last Trading Day is a measure considered for corporate actions not falling within the explicitly listed categories, determined with guidance from the Corporate Actions Adjustment Review Committee (CAARC). Suspending trading and re-issuing contracts is not the standard procedure for handling corporate actions on existing ES contracts; the objective is to adjust the existing contract to maintain value equivalence.

Early termination risk, as outlined in the CMFAS Module 6A syllabus, specifically refers to the possibility that if a structured product is withdrawn or liquidated before its maturity, the underlying assets may need to be sold at a discount. This action directly reduces the value recovered from the structured product. While counterparty risk (default by issuer), structure risk (complexity), and market risk (general market downturns) are all valid risks associated with structured products, they do not specifically describe the adverse impact on value due to an early exit. The core characteristic of early termination risk is the forced sale of underlying assets at a disadvantageous price.

The question describes a market participant who seeks to profit from temporary price discrepancies between related markets or instruments, specifically between a futures contract and its underlying asset, without taking a directional view on market movement. This activity, aimed at generating riskless profit from disequilibrium, is the defining characteristic of an arbitrageur. Arbitrageurs do not bet on the direction of the market but rather exploit pricing inefficiencies. Speculators, in contrast, take directional bets on market prices. Hedgers use futures to reduce or limit risk associated with an adverse price change in an existing underlying position. Market makers primarily provide liquidity to the markets by continuously offering bids and offers, profiting from the bid-ask spread, although they may also engage in arbitrage as a secondary activity.

The Constant Proportion Portfolio Insurance (CPPI) strategy aims to ensure a minimum portfolio value (the floor) while participating in the upside potential of a risky asset. The core of the strategy involves dynamically adjusting the allocation between a risky asset and a risk-free asset based on the portfolio’s current value relative to its floor. To determine the target allocation to the risky asset, follow these steps: 1. Calculate the Floor Value: This is the minimum value the portfolio is allowed to fall to. In this scenario, the initial portfolio value was $100,000, and the floor is 80% of this value. So, Floor Value = 0.80 $100,000 = $80,000. 2. Calculate the Cushion: The cushion is the difference between the current total portfolio value and the floor value. Current Portfolio Value = $92,000. Cushion = Current Portfolio Value – Floor Value = $92,000 – $80,000 = $12,000. 3. Calculate the Target Risky Asset Allocation: This is determined by multiplying the cushion by the specified multiplier. Multiplier = 4. Target Risky Asset Allocation = Multiplier Cushion = 4 $12,000 = $48,000. Therefore, after rebalancing, the target allocation to the risky asset would be $48,000. Other options represent common miscalculations, such as confusing the floor value with the target allocation, or failing to apply the multiplier to the cushion.

Arbitrage involves profiting from temporary price discrepancies between different markets or instruments without taking significant directional risk. In this scenario, the stock index futures contract is trading at a premium to its theoretical fair value, indicating it is overpriced relative to its underlying components. An arbitrageur would implement a cash-and-carry arbitrage strategy. This involves simultaneously selling the overpriced futures contract and buying the underlying constituent stocks of the index. This action locks in a risk-free profit because the arbitrageur is effectively selling high (futures) and buying low (underlying). At the futures contract’s expiration, its price will converge with the spot price of the underlying index, allowing the arbitrageur to close out both positions and realize the profit from the initial price discrepancy. The other options describe speculative positions, directional bets, or different derivative strategies that do not represent a risk-neutral arbitrage to capitalize on this specific price misalignment.

A structured note is fundamentally a debt instrument whose returns, such as coupon payments or principal redemption, are tied to the performance of one or more underlying assets through embedded derivative components. Unlike a conventional bond, its returns are not fixed or solely dependent on the issuer’s creditworthiness. The noteholder typically does not gain direct ownership or claim over the underlying assets. Furthermore, principal repayment is often not guaranteed, making it distinct from products that offer full principal protection. The derivative strategies embedded within the note are key to its unique risk-return profile, allowing for exposure to various asset classes like equities, indices, or interest rates.

The question pertains to the traditional valuation approach for convertible bonds, specifically focusing on how the minimum value is determined. According to the CMFAS Module 6A syllabus, the minimum value of a convertible bond is established by comparing two key figures: its conversion value and its straight value. The conversion value represents what the bond would be worth if immediately converted into shares. The straight value, on the other hand, is the value of an equivalent non-convertible bond, reflecting its worth purely as a fixed-income instrument without the embedded equity option. The higher of these two values is considered the minimum value of the convertible bond, providing a floor below which its price is unlikely to fall due to its fixed-income characteristics and its potential equity upside. The other options refer to different calculations or characteristics of convertible bonds, such as market conversion premium, downside risk, or general bond pricing, but not the specific components for determining the minimum value.

The zero-plus option strategy is a common approach for structured funds aiming to provide capital preservation while allowing for participation in potential market upside. In this strategy, a significant portion of the initial investment is allocated to a fixed-income instrument, typically a zero-coupon bond. The primary purpose of this zero-coupon bond is to grow in value over the investment horizon, eventually reaching an amount equal to the initial capital invested. This mechanism ensures that the principal amount is protected and returned to the investor at maturity, assuming the bond performs as expected. The remaining portion of the capital is then used to purchase call options on an underlying asset or index, which provides the fund with exposure to potential gains without risking the principal.

To calculate the Premium (%) for a put warrant, the formula is: Premium (%) = [(nWP – X + S) / S] x 100. Given the details: Underlying Share Price (S) = $15.50 Exercise Price (X) = $16.00 Warrant Price (WP) = $0.40 Conversion Ratio (n) = 4 First, calculate nWP: 4 $0.40 = $1.60 Now, substitute the values into the formula: Premium (%) = [($1.60 – $16.00 + $15.50) / $15.50] x 100 Premium (%) = [($1.10) / $15.50] x 100 Premium (%) = 0.0709677… x 100 Premium (%) = 7.10% (rounded to two decimal places). Option 2 would result from incorrectly using the call warrant premium formula [(nWP + X – S) / S] x 100. Option 3 might arise from using the exercise price (X) as the denominator instead of the share price (S). Option 4 represents the time value of the warrant as a percentage of the share price, not the premium percentage.

When a futures trader’s account equity for an open position falls below the maintenance margin level, it triggers an additional margin call. As per the CMFAS Module 6A syllabus, specifically under the section on ‘Leverage’ and ‘Additional Margin’, if the balance in the margin account drops below the maintenance level, the account must be restored to the initial margin level. It is not sufficient to only bring the account back to the maintenance margin level. Automatic liquidation by the broker or a lengthy grace period are typically consequences or incorrect assumptions, respectively, if the margin call is not met by the stipulated time, rather than the immediate requirement itself.

A short call option position has a negative delta exposure, meaning that as the underlying asset’s price increases, the value of the short call position decreases (becomes more negative). To establish a delta-neutral hedge, a trader needs to offset this negative delta exposure with a position that has a positive delta. Buying the underlying equity provides a positive delta. The number of shares of the underlying equity required to achieve a delta-neutral hedge is calculated by multiplying the number of options by the absolute value of the option’s delta. In this scenario, with 2,000 short call options and a delta of 0.65, the trader needs to buy 2,000 0.65 = 1,300 units of the underlying equity to create a delta-neutral position.

An Extended Settlement (ES) contract is a single stock future. For an investor holding a long position, the primary settlement mechanisms are either to close out the position before maturity through an offsetting trade (selling an equivalent ES contract) or, if held to expiration without being offset, to take physical delivery of the underlying shares at the contracted price. The provided text explicitly states that an investor ‘may choose to liquidate the position through an offsetting trade in the same ES contract’ or ‘At expiration, if the position has not been offset, the contract is settled by physical delivery at the contracted price.’ Options involving rolling over or cash settlement are not the standard primary settlement methods for these physically delivered single stock futures. Similarly, exercising an option or allowing a contract to expire worthless are characteristics of options contracts, not ES contracts. Selling underlying shares in the open market or converting the contract into a standard equity position are not direct settlement methods for the ES contract itself.

The question highlights a critical distinction in risk profiles between physical and synthetic replication Exchange Traded Funds (ETFs). Synthetic ETFs, which use swap agreements to replicate index performance, inherently introduce counterparty risk. This risk arises from the possibility that the swap dealer or derivative issuer may default on their obligations. However, synthetic replication can often achieve a lower tracking error because it doesn’t involve the complexities and transaction costs of physically holding and rebalancing a large portfolio of underlying securities, especially in volatile or illiquid markets. Conversely, physical replication ETFs directly hold the underlying assets. While this avoids the counterparty risk associated with swaps, it can lead to a higher tracking error due to factors such as transaction costs, rebalancing frequency, and the challenges of accurately mirroring an index with numerous components or illiquid securities. Therefore, an investor must weigh the trade-off between potentially lower tracking error and the introduction of counterparty risk when choosing a synthetic ETF, versus a potentially higher tracking error but direct asset ownership in a physical ETF.

The time value of an option represents the portion of its premium that exceeds its intrinsic value, reflecting the probability that the option will become profitable before expiration. This value is significantly influenced by the time remaining until expiration. As an option approaches its expiration date, the period during which the underlying asset’s price can move favorably diminishes. This reduction in uncertainty and potential for future price movement directly causes the time value to erode, eventually reaching zero at expiry. Therefore, the approaching expiration date is the most direct and significant factor contributing to the rapid decay of an option’s time value. Increased volatility, conversely, would generally increase an option’s time value due to the higher probability of significant price movements. Changes in risk-free interest rates or expected dividends affect the overall option premium but are not the primary drivers of the specific phenomenon of time value erosion due to the passage of time itself.

For a Category R Bull Callable Bull/Bear Contract (CBBC) that experiences a Mandatory Call Event (MCE), the residual value is determined by first establishing the MCE Settlement Price. According to the rules for a Bull contract, the MCE Settlement Price is determined as not lower than the minimum trading price of the underlying asset observed between the period of the MCE up to the next trading session. In this scenario, the minimum trading price observed was $48.50. Therefore, the MCE Settlement Price is $48.50. The residual value is then calculated using the formula: (MCE Settlement Price – Strike Price) / Conversion Ratio. Plugging in the given values: ($48.50 – $45.00) / 5 = $3.50 / 5 = $0.70. Other options represent common misconceptions, such as incorrectly using the highest trading price, the closing price, or the call price as the settlement price for the residual value calculation.

When a portfolio manager anticipates rising interest rates, the value of existing long-term bonds typically declines. To mitigate this risk without immediately liquidating the underlying bonds, the manager can use bond futures. By initiating a short position in bond futures contracts, the manager effectively hedges the interest rate exposure of their long bond portfolio. If interest rates rise, the value of the existing bonds will fall, but the short futures position will generate a profit, offsetting some or all of the loss. This strategy is described in the CMFAS Module 6A syllabus under ‘Fixed Income Portfolio’ and ‘Cash Management & Interest Rate Expectations,’ where selling bond futures is used to effectively shorten the maturities of holdings or convert bonds into synthetic money market instruments. Establishing a long position in bond futures would increase the portfolio’s exposure to rising interest rates, exacerbating potential losses. Purchasing equity index futures is a strategy for managing equity market exposure or diversification, not directly for hedging interest rate risk in a bond portfolio. Selling call options on existing bonds is an options strategy, not a futures strategy, and while it generates premium, it does not directly achieve the objective of shortening effective duration or creating a synthetic money market instrument in the same way selling bond futures does.

Delta represents the sensitivity of an option’s price to a change in the underlying asset’s price. For a call option, a positive delta indicates that as the underlying share price increases, the option’s value also increases. The change in the option price is calculated by multiplying the delta by the change in the underlying share price. In this scenario, the change in option price per share is 0.65 (delta) $2.00 (change in underlying price) = $1.30. Since the manager holds 500 call options, the total expected change in the value of the options is $1.30 500 = $650.00. As it is a call option and the underlying price increased, the option’s value is expected to increase.

A Dual Currency Investment (DCI) is a structured product that offers an enhanced yield in the base currency if the alternate currency performs favorably (i.e., does not weaken past a specified strike price). However, if the alternate currency weakens to or beyond the strike price at maturity, the investor’s initial principal in the base currency is converted into a predetermined fixed amount of the alternate currency. The investor then receives this fixed amount of alternate currency and must convert it back to the base currency at the prevailing spot rate at maturity. The primary risk to the initial principal arises if the spot rate at which the alternate currency is converted back to the base currency is lower than the breakeven rate. The breakeven rate is the exchange rate at which the fixed amount of alternate currency received would convert back to exactly the original principal amount in the base currency. If the actual spot rate at maturity falls below this breakeven rate, the investor will receive less than their initial principal in base currency terms, resulting in a principal loss. Options suggesting principal guarantee or only loss of yield are incorrect, as DCI carries significant principal risk due to currency fluctuations. While credit risk of the issuer is always a factor, the direct and primary risk for principal loss in a DCI stems from adverse currency movements relative to the breakeven point.

The TED spread is specifically designed to measure credit risk. It represents the difference between the interest rate on 3-month US Treasury bills (considered risk-free) and the 3-month Eurodollar futures contract (which reflects the credit risk of corporate borrowers). When market uncertainty increases and investors become more concerned about the creditworthiness of corporations, they tend to move towards safer assets like US Treasuries. This causes the Eurodollar rate to rise relative to the Treasury rate, leading to a widening of the TED spread. A wider TED spread indicates an increase in perceived default risk. Butterfly spreads and condor spreads are neutral trading strategies that profit from specific price relationships between different expiration months, not directly from changes in overall credit risk. A calendar spread involves buying and selling futures contracts of the same underlying asset but with different expiration dates, primarily used to profit from changes in the time value of the contracts or anticipated changes in the shape of the forward curve, but not specifically credit risk.

Synthetic replication methods for Exchange Traded Funds (ETFs), such as those using derivative instruments or swaps, introduce counterparty risk. This risk stems from the ETF’s reliance on a third-party counterparty to deliver the performance of the underlying index. To mitigate this risk and protect investors, Singapore’s regulatory framework, specifically under the Code on Collective Investment Schemes (CIS) or UCITS, imposes a strict limit on the net counterparty exposure. This requirement mandates that the net exposure to any single counterparty must not exceed 10% of the fund’s net asset value. This limit is typically managed by the counterparty providing collateral for the portion of the exposure that exceeds this 10% threshold, ensuring that in the event of a counterparty default, investors’ potential losses are capped at this percentage.

The ideal scenario for issuing an equity-linked structured note that aims to mitigate mark-to-market fluctuations and potentially increase the participation rate involves specific market conditions and product design choices. High prevailing interest rates are beneficial because they lower the present value of the zero-coupon bond component, thereby freeing up more capital (discount sum) to purchase the embedded call option. This additional capital can then be used to enhance the participation rate for the investor. Concurrently, low underlying asset price volatility is advantageous because it makes the cost of equity options cheaper, further allowing for a more attractive participation rate or better product terms. Incorporating a shorter-maturity barrier option, such as an ‘up-and-out’ call, is a key product design choice for mitigating investment risk. Shorter maturities inherently reduce the impact of interest rate changes on the mark-to-market value and allow investors to receive their capital back sooner. Barrier options are generally cheaper than conventional options and can reduce the impact of mark-to-market fluctuations, making the product more appealing. Conversely, low interest rates would mean less capital available for the option, and high volatility would make options more expensive. Longer maturities would increase mark-to-market risk and tie up investor capital for a longer duration, while conventional options might not offer the same cost efficiency or risk mitigation benefits as barrier options.

A Range Accrual Note (RAN) is designed to pay a coupon only when its reference index (e.g., a stock index or an interest rate benchmark) remains within a predefined range during the observation period. The interest is typically accrued and calculated on a daily basis for each day the reference index falls within this stipulated range. Therefore, the total interest payout an investor receives is primarily determined by the cumulative number of days the reference index stays within the agreed-upon boundaries. The overall appreciation or depreciation of the index (Option 2) is not the primary factor, as RANs are not typically designed to capture directional movements but rather range-bound stability. While the credit rating of the issuer (Option 3) is crucial for the safety of the principal and the ability to pay any coupon, it does not determine the calculation or amount of interest earned based on the index’s performance. The fixed annual coupon rate (Option 4) is the rate applied, but the total payout depends on how many days that rate is applied, making the number of days within range the critical variable.