CMFAS RES6A Quiz 58

Auto-callable structured products are designed such that the issuer has the discretion to call the product early, not the investor. While this feature can lead to a higher yield for the investor, it also introduces call risk, meaning the investor has no control over the exact holding period. If the product is called early, especially in a declining interest rate environment, the investor faces reinvestment risk, as they may have to reinvest their capital at a lower rate. The redemption amount can vary based on the product’s terms and underlying asset performance, and capital protection is not universally guaranteed upon early call; it depends on the specific product’s payout structure and barrier events.

To determine the required rebalancing action in a Constant Proportion Portfolio Insurance (CPPI) strategy, first, calculate the new total portfolio value after the risky asset’s decline. The initial risky asset allocation was $130. A 20% decline means the risky asset value becomes $130 (1 – 0.20) = $104. The risk-free asset position remains -$10 (a liability due to leverage). Therefore, the new total portfolio value is $104 (risky assets) + (-$10) (risk-free assets) = $94. Next, calculate the ‘cushion,’ which is the difference between the current portfolio value and the floor. Cushion = $94 (current portfolio value) – $85 (floor) = $9. Assuming a multiplier of 5 (as commonly used in CPPI examples, including the provided context), the target allocation to risky assets is Multiplier Cushion = 5 $9 = $45. The current value of risky assets is $104. To reach the target allocation of $45, the manager must sell $104 – $45 = $59 of risky assets. These proceeds are then used to adjust the risk-free asset position. The risk-free asset position was -$10. Adding the $59 from the sale of risky assets brings the risk-free asset position to -$10 + $59 = $49. Therefore, the correct action is to sell $59 of risky assets and allocate the proceeds to the risk-free asset, resulting in $45 in risky assets and $49 in risk-free assets. This maintains the CPPI structure and keeps the portfolio above the floor. Other options are incorrect because: – Liquidating all risky assets and paying off leverage would only be necessary if the portfolio value had fallen to or below the floor, which is not the case here ($94 is above $85). – Increasing allocation to risky assets would be contrary to the CPPI rebalancing rule when the portfolio value declines. – Maintaining the current allocation would violate the dynamic rebalancing principle of CPPI, which requires adjustments as the portfolio value changes relative to the floor.

To create a synthetic short stock position, an investor aims to replicate the payoff profile of directly shorting the underlying asset. This involves unlimited downside risk (profit as the stock price falls) and limited upside (loss as the stock price rises). The correct way to construct this is by combining a short position in at-the-money call options with a long position in an equal number of at-the-money put options, both on the same underlying share and with the same expiration date. This combination effectively mimics the risk and reward characteristics of a short stock position. Option 2 describes a synthetic long call (long underlying + long put). Option 3 describes a synthetic long put (short underlying + long call). Option 4 describes a synthetic long stock (long call + short put), which is the opposite of what is desired.

To determine the net profit from the CFD trade, all associated costs must be calculated and subtracted from the gross profit. 1. Calculate Gross Profit: Purchase Value = 5,000 shares $1.50 = $7,500.00 Sale Value = 5,000 shares $1.65 = $8,250.00 Gross Profit = Sale Value – Purchase Value = $8,250.00 – $7,500.00 = $750.00 2. Calculate Commission: Commission on Buy = $7,500.00 0.3% = $22.50 Commission on Sell = $8,250.00 0.3% = $24.75 Total Commission = $22.50 + $24.75 = $47.25 3. Calculate GST on Commission (using current 9% rate): GST on Buy Commission = $22.50 9% = $2.025 (rounded to $2.03) GST on Sell Commission = $24.75 9% = $2.2275 (rounded to $2.23) Total GST = $2.03 + $2.23 = $4.26 4. Calculate Financing Interest: Daily Financing Rate = 6% / 360 days = 0.0001666… Daily Interest = Purchase Value Daily Financing Rate = $7,500.00 (6% / 360) = $1.25 Total Financing Interest (for 15 days) = $1.25 15 = $18.75 5. Calculate Total Expenses: Total Expenses = Total Commission + Total GST + Total Financing Interest Total Expenses = $47.25 + $4.26 + $18.75 = $70.26 6. Calculate Net Profit: Net Profit = Gross Profit – Total Expenses Net Profit = $750.00 – $70.26 = $679.74

The 3-month Singapore Dollar Interest Rate Futures contract, as per its specifications, is cash settled. Its final settlement price is specifically based on the Association of Banks in Singapore’s USD/SGD Swap Offered Rates, which are determined at 11.00 am, Singapore time, on the last trading day of the contract. The other options describe the final settlement price determination for different futures contracts mentioned in the CMFAS Module 6A syllabus, such as Eurodollar Futures (British Bankers’ Association rates), Euroyen TIBOR Futures (TFX’s final settlement price), and Full-sized 10-year Japanese Government Bond Futures (TSE’s 10-year JGB futures official opening price).

Arbitrage between Interest Rate Swaps (IRS) and Eurodollar futures strips fundamentally relies on a discrepancy between the implied fixed rate derived from the futures contracts and the market-quoted fixed rate of an equivalent IRS. When these two rates are not equal, an arbitrageur can simultaneously buy the cheaper instrument and sell the more expensive one, locking in a risk-free profit. The other options describe aspects related to IRS or futures but are not the direct condition that creates the arbitrage opportunity based on rate differentials. The type of floating rate index, the notional principal alignment, or the perfect alignment of settlement/payment dates are important for structuring and hedging, but the core of rate arbitrage lies in the market price (rate) difference.

The Statement of Investments, which is a component of the Semi-annual Accounts and Reports to Unitholders, is explicitly designed to list out the details of the investment portfolio of the company. This document provides a comprehensive breakdown of the specific assets held by the fund. The Investment Manager Report primarily focuses on the performance of the underlying assets and the fund’s overall performance outlook, rather than a detailed itemized list of individual holdings. The Monthly Performance Report offers an overview of the fund’s investment policy, methodology, and various performance and risk metrics, but it does not typically include a granular list of all investments. The Factsheet provides a concise summary of key fund information, including asset allocation, but it is not intended to offer a detailed, itemized listing of the fund’s specific investment portfolio.

Moneyness describes the relationship between an option’s strike price and the current trading price of its underlying security. For a call option, it is considered ‘in-the-money’ (ITM) if the current market price of the underlying asset is higher than the strike price, as exercising it would result in an immediate profit. It is ‘out-of-the-money’ (OTM) if the current market price is lower than the strike price, meaning it would not be profitable to exercise. For a put option, it is ITM if the current market price is lower than the strike price, as exercising it would allow selling at a higher price than the market. Conversely, a put option is OTM if the current market price is higher than the strike price. An option is ‘at-the-money’ (ATM) if the current market price is equal to the strike price. In the given scenario, the call option has a strike price of $55, and the current market price is $52. Since the current market price ($52) is less than the strike price ($55), the call option is out-of-the-money. For the put option, the strike price is $50, and the current market price is $52. Since the current market price ($52) is greater than the strike price ($50), the put option is also out-of-the-money. Therefore, both options are out-of-the-money.

The concept of ‘rolling a position’ in futures trading is employed by investors who wish to maintain their market exposure beyond the expiration of their current contract. This involves simultaneously closing out the existing position in the expiring contract month and opening an equivalent new position in a subsequent contract month. For example, a long position in a December contract would be rolled by selling the December contract and buying a March contract. This action allows the investor to continue their market view without interruption due to contract expiry. Simply holding to expiry would result in cash settlement or physical delivery, ending the specific contract’s exposure. Offsetting the position without opening a new one in a later month would close out the market exposure entirely. Purchasing options contracts is a different strategy involving a different financial instrument.

The question highlights a scenario where a firm needs to hedge an exposure in an illiquid, exotic currency but prioritizes mitigating counterparty default risk. Futures contracts, unlike forward contracts, are standardized and traded on regulated exchanges, with transactions cleared through a central clearing house. This central clearing house acts as the counterparty to every buyer and seller, effectively guaranteeing the performance of the contract and eliminating the bilateral counterparty risk that exists between the original parties. While forward contracts offer the flexibility to tailor terms for unique or illiquid underlying assets (as mentioned in option 2 and 3), they are bilateral agreements and thus expose parties to the default risk of their direct counterparty. The absence of daily settlement procedures (mark-to-market) in forwards (option 4) also means that potential losses due to counterparty default might not be recognized until maturity, further highlighting the risk.

A bear put spread is a limited-risk, limited-profit strategy designed for a mildly bearish market view. It involves buying a higher-strike put option and simultaneously selling a lower-strike put option, both with the same expiration date. This strategy results in a net debit (cash outlay) at the time of execution. The maximum loss for a bear put spread occurs if the underlying asset’s price rises above the higher strike price by expiration. In this scenario, both put options expire worthless, and the investor loses the initial net debit paid to establish the position. The difference between the strike prices is relevant for calculating the maximum profit, not the maximum loss. The risk is not unlimited, as it is a spread strategy with defined parameters.

The question describes an investor shorting a pay-fixed interest rate swaption. According to the CMFAS Module 6A syllabus (Section 9.4.7, Figure 9.4.7(b)), when an investor shorts a pay-fixed interest rate swaption, they are liable to pay out a floating rate when the option is exercised. In this scenario, the losses to the swaption seller (the investor) are unlimited and directly depend on how high the floating rate is when the option is exercised. Therefore, the potential for unlimited losses tied to the floating rate is a significant risk. The other options describe different types of risks: a limited loss scenario (which applies to shorting a receive-fixed swaption, Section 9.4.7(a)), reinvestment risk (Section 9.4.8), and early termination risk (Section 9.4.6).

The question tests the understanding of how futures positions are managed when a trader wishes to extend their market exposure beyond the current contract’s expiry date. This specific strategy is known as ‘rolling a position’. To roll a long position, the trader simultaneously sells their expiring contract and buys a new contract for a future month. This action effectively transfers their market exposure from the near-month contract to a deferred-month contract without interrupting their overall market view. Allowing a contract to expire would result in either cash settlement or physical delivery, terminating the futures market exposure. Executing an offsetting trade for the same expiry month would close out the existing position entirely, removing the market exposure. Initiating a stop-limit order is a risk management technique used to close a position under specific price conditions, not a method for extending market exposure.

In a First-to-Default Credit Linked Note (CLN), the note holders are exposed to the risk of the first default among a basket of reference entities. The yield required by note holders is inversely related to the perceived risk. When the correlation between the underlying reference entities is higher, the probability of multiple entities defaulting independently is reduced, and the basket’s default probability approaches that of a single entity. For example, if entities are perfectly correlated, the risk is effectively that of only one company defaulting, which is lower than the collective risk of multiple uncorrelated companies. A lower effective default probability for the basket means lower risk for the note holder, and thus a lower yield is required to compensate for that risk. Conversely, if the entities have low or zero correlation, the probability of a first default occurring within the basket increases significantly (as it’s closer to the sum of individual default probabilities), leading to a higher required yield. Therefore, higher correlation generally reduces the overall risk of a first default in the basket from the perspective of the note holder, leading to a lower demanded yield. The other options are incorrect because correlation is explicitly stated as a yield determinant, and higher correlation in this specific product structure reduces the effective default risk, rather than increasing it or having no impact.

In highly volatile market conditions, especially when there are significant price gaps or ‘jumps’ where no transactions occur at intermediate prices, a standard stop-loss order may not be executed at the investor’s specified stop price. Instead, it will be triggered and executed at the next available market price, which could be substantially worse than the intended stop-loss level. This phenomenon is often referred to as ‘slippage’. The provided syllabus material explicitly states that ‘Even if a stop-loss price has been set, the CFD provider may not always execute the stop-loss order at the price. This can happen in volatile market conditions where there may be price jumps and there is no transaction taking place at the set order price.’ Option 1 is incorrect because execution at the exact specified price is not guaranteed under such conditions. Option 3 is incorrect as the order is designed to be automatic, not cancelled due to volatility, unless specific platform rules dictate otherwise, which is not the general outcome for a stop-loss. Option 4 is incorrect because the stop-loss is an automatic contingent order, not one requiring manual re-entry upon being bypassed.

Arbitrage between Interest Rate Swaps (IRS) and futures contracts arises when there is a temporary discrepancy between the market price of an IRS and the rate implied by a strip of futures contracts that cover the same period. An arbitrageur seeks to profit from this mispricing without taking significant market risk. If the market price of the IRS is higher than the rate implied by the futures strip, it means the IRS is relatively ‘expensive’ compared to its synthetic equivalent constructed from futures. To profit, the arbitrageur would sell the overpriced IRS (receiving the fixed rate) and simultaneously buy the relatively underpriced futures strip (locking in the lower implied rate). This creates a risk-free profit as the arbitrageur effectively receives a higher fixed rate from the IRS while paying a lower fixed rate through the futures strip, with the expectation that these prices will converge. Conversely, if the IRS market price were lower than the futures strip implied rate, the arbitrageur would buy the IRS and sell the futures strip.

The investor’s objective is to profit from a moderate upward movement in the underlying security’s price, while also limiting potential losses and reducing the initial premium outlay compared to a simple long call. A bull call spread is specifically designed for a moderately bullish market view. It involves buying a lower strike call (often in-the-money) and simultaneously selling a higher strike call (out-of-the-money) with the same expiration date. This strategy reduces the net premium paid (as the premium received from selling the higher strike call offsets part of the cost of buying the lower strike call) and caps the maximum potential loss to this net debit. The maximum profit is also limited, which aligns with the ‘moderate’ outlook. A long strangle, on the other hand, is suitable for investors expecting significant price volatility (either up or down) and has potentially unlimited profit but also a higher initial outlay for two options. A bear call spread is a bearish strategy, designed to profit from a decline or stagnation in the underlying price. A single long call option benefits from price appreciation, but it typically involves a higher initial premium and does not inherently cap the maximum loss beyond the premium paid, nor does it reduce the net premium in the way a spread does.

Hedge effectiveness is a measure of how well a hedged position reduces the risk compared to an unhedged position. If a hedge is 85% effective, it means that the hedged position retains only 15% (100% – 85%) of the risk that the unhedged position would have carried. Therefore, the risk of the hedged position is 15% of the risk of the unhedged position. The other options misinterpret the definition of hedge effectiveness, either by reversing the relationship, incorrectly stating the scope of risk reduction, or misapplying units of measurement.

The question describes a scenario where a fund manager has a bond portfolio with a known investment horizon and aims to protect it from interest rate fluctuations by minimizing the variance in the expected total return. This precisely matches the definition and purpose of a strong form cash hedge, also known as immunization. This strategy involves creating and maintaining a cash and futures portfolio that has the same interest rate sensitivity as a zero-coupon bond with a maturity equal to the investment period. Adjustments are made by buying or selling futures to maintain this sensitivity match. The other options describe different hedging strategies that do not fit the specific criteria of a known investment horizon and minimizing total return variance.

This question tests the understanding of how Extended Settlement (ES) contracts are adjusted in response to corporate actions on the underlying securities, as detailed in the CMFAS Module 6A syllabus. According to the guidelines, when a corporate event, such as a bonus issue, leads to an increase in the number of shares held by shareholders, the primary adjustment mechanism for the corresponding ES contract is to modify the contract multiplier. This adjustment aims to ensure that the contract’s value after the corporate event remains, as far as practicable, equivalent to its value before the event. Adjusting the settlement price is typically applied when a corporate event directly impacts the share’s value or price, rather than just the number of shares. Bringing forward the Last Trading Day is a measure considered for corporate actions that do not fall within the explicitly listed categories and is determined with guidance from the Corporate Actions Adjustment Review Committee. Changes in margin requirements are separate from the direct adjustments made to the ES contract’s terms due to corporate actions.

The question requires the calculation of a ‘strip value’ by blending two consecutive futures rates, as demonstrated in the provided CMFAS Module 6A material. The formula used is: Strip Value = Near Futures Rate + (Far Futures Rate – Near Futures Rate) (Days from Current Date to Near Futures Expiry / Days between Futures Expiries). Given data: – Near Futures Rate (June futures) = 0.80% – Far Futures Rate (September futures) = 1.50% – Days from Current Date to June futures expiry = 61 days – Days from June futures expiry to September futures expiry = 92 days Applying the formula: Strip Value = 0.80% + (1.50% – 0.80%) (61 / 92) Strip Value = 0.80% + (0.70%) (0.663043478) Strip Value = 0.80% + 0.4641304346% Strip Value = 1.2641304346% Rounding to three decimal places, the computed value of the strip is 1.264%.

When a structured note is issued directly by a financial institution, the debt is reflected on its balance sheet as a liability. This means the note represents a direct obligation of the bank, and investors bear the credit risk of the bank, having a claim against its general assets in case of default. Conversely, when a structured note is issued through a Special Purpose Vehicle (SPV), the SPV is a separate legal entity. The SPV’s assets and liabilities are not reflected on the parent bank’s balance sheet (off-balance sheet). In the event of a default, noteholders can only make a claim on the SPV’s assets and have no recourse to the bank that set up the SPV. Therefore, the primary difference lies in the scope of recourse available to the investor.

The corporate treasury’s need for a precise, non-standard strike price and a unique expiration date that aligns with a specific project milestone points directly to the characteristics of an Over-The-Counter (OTC) option. Unlike exchange-traded options, OTC contracts are not standardised and can be fully customised to suit the specific requirements of the parties involved. The concern about the reliability of the counterparty fulfilling its obligations is a critical aspect of OTC transactions, as they do not involve a central clearing house. Therefore, managing counterparty risk through careful selection and due diligence of the counterparty’s financial standing is paramount. Option 2 is incorrect because exchange-traded options are highly standardised regarding terms like strike prices and expiration dates, making them unsuitable for bespoke hedging needs. While a clearing house associated with an exchange does guarantee performance and mitigates counterparty risk, this benefit comes at the cost of customisation. Option 3 is incorrect because European-style options refer to the exercise procedure (only at expiration), not the ability to customise strike prices or expiration dates. The mention of a guaranteed settlement via an associated clearing house primarily applies to exchange-traded options, not typically to customised OTC contracts. Option 4 is incorrect because American-style options refer to the exercise procedure (exercisable at any time up to and including expiration), not the customisation of contract terms like strike prices. Furthermore, daily mark-to-market procedures may not be readily available for OTC options, and private dealings inherently have less transparency compared to exchange-traded markets.

The adjustment for dividends on a warrant’s exercise price is calculated using a specific adjustment factor. The formula for the Adjustment Factor is (P – SD – ND) / (P – ND), where P is the last cum-date closing price of the underlying share, SD is the Special Dividend per Share, and ND is the Normal Dividend per Share. The New Exercise Price is then found by multiplying the Old Exercise Price by this Adjustment Factor. Given: Old Exercise Price = $10.00 P (last cum-date closing price) = $12.00 SD (Special Dividend) = $0.50 ND (Normal Dividend) = $0.20 First, calculate the Adjustment Factor: Adjustment Factor = (12.00 – 0.50 – 0.20) / (12.00 – 0.20) Adjustment Factor = (11.30) / (11.80) Adjustment Factor ≈ 0.957627 Next, calculate the New Exercise Price: New Exercise Price = Old Exercise Price × Adjustment Factor New Exercise Price = $10.00 × 0.957627 New Exercise Price ≈ $9.57627 Rounding to two decimal places, the new adjusted exercise price is $9.58.

Auto-callable structured products grant the issuer the discretion to redeem the product early. This means that while investors may benefit from a potentially higher yield, they lose control over the investment’s exact holding period. If the product is called early, the investor receives their capital and any accrued returns, but then faces the challenge of finding a suitable new investment for the redeemed funds, which is known as reinvestment risk. The other options describe features or benefits not inherent to the investor’s position in an auto-callable product; the investor does not gain exclusive redemption rights, capital preservation is not guaranteed regardless of underlying performance, and automatic adjustments for market volatility are not a standard feature of the auto-callable mechanism itself.

An investor who anticipates purchasing shares in the future but fears a rise in price before funds become available would employ a long hedge strategy. This involves buying Extended Settlement (ES) contracts. By purchasing ES contracts, the investor effectively locks in the ‘purchase’ price for the underlying shares at the current ES contract price. This protects them against the risk of having to pay a higher price for the shares when their funds are eventually available. Selling ES contracts, on the other hand, is a short hedge strategy typically used to protect against a decline in the value of existing assets. Waiting to purchase shares without any hedging exposes the investor to the full risk of price fluctuations. While forward contracts are a form of hedging, the question specifically asks about strategies involving ES contracts, making the direct purchase of ES contracts the most appropriate answer in this context.

The provided syllabus material explicitly states that when a hedge is lifted and evaluated, the main sources of error are typically due to the projected value of the basis at the lift date and the parameters estimated for cross hedges. Basis risk refers to the risk that the relationship between the spot price of an asset and the futures price of the hedging instrument changes unexpectedly. If the actual basis (spot price minus futures price) at the time the hedge is closed out differs from the basis that was projected when the hedge was initiated, the hedge will not perfectly offset the underlying exposure, leading to a deviation from the target outcome. While changes in interest rate differentials can influence market prices and thus the basis, the direct and primary source of error in hedge effectiveness, as defined in the context, is the basis itself. Counterparty default is a credit risk associated with the futures contract, not a source of error in the effectiveness of the hedge in mitigating price risk. An incorrect initial calculation of the number of contracts would be an error in the initial structuring of the hedge, rather than a source of error identified during the post-lift evaluation of an otherwise correctly structured and managed hedge.

A term sheet serves as a non-binding agreement that outlines the essential terms and conditions of a proposed transaction. Its main function is to ensure that all parties involved agree on the fundamental aspects of the deal, thereby clarifying expectations and reducing potential misunderstandings before committing to a legally binding contract. This preliminary step helps to save time and avoid unnecessary legal costs associated with drafting detailed formal documents prematurely. It acts as a foundational template upon which the comprehensive, binding legal agreements are subsequently built.

To lock in a future deposit yield when interest rates are expected to decline, a corporate treasurer should implement a long hedge using Eurodollar futures. A decline in interest rates will cause Eurodollar futures prices to rise. By purchasing Eurodollar futures contracts, the treasurer can profit from this price increase, which will offset the lower interest earned on the actual deposit when the funds become available. The number of contracts should match the notional value of the deposit. For a USD 5,000,000 deposit, and assuming a standard Eurodollar futures contract size of USD 1,000,000, five contracts would be needed. The expiry of the futures contracts should align with the date the deposit is expected to be placed.

Arbitrage involves simultaneously buying an asset in one market where its price is lower and selling an identical or highly similar asset in another market where its price is higher. This strategy aims to lock in a risk-free profit from temporary price discrepancies. In the given scenario, the cash market price for the interest rate instrument is lower than its corresponding futures contract price. To exploit this, the arbitrageur would purchase the cheaper instrument in the cash market and simultaneously sell the more expensive futures contract. This action not only generates a profit for the arbitrageur but also contributes to the efficiency of the markets by pushing the prices in both markets towards equilibrium.