CMFAS RES6A Quiz 59

The Capital Markets and Financial Advisory Services (CMFAS) Module 6A syllabus, specifically Chapter 13 on Extended Settlement Contracts, outlines that the Central Depository (CDP) computes margin requirements on a gross basis. This means that long and short positions belonging to different customers do not cancel each other out when calculating a Member’s overall margin requirement. Therefore, for Horizon Brokers, CDP would sum all open positions across its different clients for the same underlying security to determine the total marginable exposure. In this case, 700 long contracts for Client A and 400 short contracts for Client B would result in a total of 1,100 open positions for which Horizon Brokers would be margined. Netting positions across different customers is not permitted for the Member’s overall margin calculation.

The question describes a scenario where a firm requires a highly specific, non-standardized transaction and is concerned about the reliability of the other party. This directly points to the characteristics of a forward contract. Forward contracts are privately negotiated agreements, allowing for customization of terms (e.g., specific currency, odd delivery dates, non-standard amounts) to meet unique business needs. However, because they are bilateral agreements between two parties, they carry counterparty risk. The firm is directly exposed to the creditworthiness and potential default of the other party. In contrast, futures contracts are standardized, traded on regulated exchanges, and have a central clearing house as the counterparty, which effectively eliminates counterparty risk for the participants. Futures also involve daily mark-to-market procedures and margin calls, which are typically absent in forward contracts. Therefore, the ability to customize terms and the direct exposure to counterparty risk are primary differentiators for a forward contract in such a situation.

Structured warrants listed on SGX-ST typically employ an Asian style expiry settlement, particularly those with an automatic exercise feature. A fundamental aspect of this settlement mechanism is the determination of the final settlement price. To ensure a fair and less volatile settlement, the settlement price is not based on a single day’s closing price. Instead, it is calculated by taking the arithmetic average of the official closing prices of the underlying asset over the five market days immediately preceding the warrant’s expiry date. This method smooths out potential price spikes or dips on any single day, providing a more robust and representative value for settlement. Other methods, such as using only the last trading day’s price, the highest price, or an average of opening and closing prices on the expiry date, do not align with the established settlement procedures for these warrants on SGX-ST.

The trading name of a structured warrant provides key information about its features. For ‘GHI JKL PW250915’: 1. Underlying Instrument (‘GHI’): This indicates that GHI Ltd Shares are the underlying asset for this warrant. 2. Issuer (‘JKL’): This identifies JKL financial institution as the issuer of the warrant. 3. Exercise Style (no prefix before ‘PW’): According to the standard interpretation, if there is no prefix before the ‘Type of Warrant’ (like ‘e’ for European style), it signifies an American-style warrant. Therefore, this is an American-style warrant. 4. Type of Warrant (‘PW’): This clearly denotes that it is a Put Warrant. 5. Expiration Date (‘250915′): The format is YYMMDD. So, ’25’ refers to the year 2025, ’09’ refers to September, and ’15’ refers to the 15th day. Thus, the expiration date is 15 September 2025. Combining these elements, the warrant is an American-style Put Warrant, issued by JKL, with GHI as the underlying, expiring on 15 September 2025.

The Dual Currency Investment (DCI) terms specify that if the AUD/SGD spot rate at maturity is below the strike price, the principal is converted into AUD at a pre-determined amount. In this scenario, the strike price is 0.9000, and the AUD/SGD spot rate at maturity is 0.8950. Since 0.8950 is below 0.9000, the conversion condition is met. The investor will receive the pre-determined AUD payout amount, which is AUD 85,227.27. To determine the payout in SGD terms, this AUD amount must be converted back to SGD at the prevailing spot rate at maturity. Payout in SGD = Pre-determined AUD payout amount × AUD/SGD spot rate at maturity Payout in SGD = AUD 85,227.27 × 0.8950 Payout in SGD = SGD 76,288.88 This outcome represents a moderate case scenario where the investor receives more than the initial principal in SGD terms, but less than the full principal plus interest that would have been received if no conversion occurred (SGD 75,000 + (SGD 75,000 0.028) = SGD 77,100).

The scenario describes a firm that identifies and exploits temporary price discrepancies between a futures contract and its underlying asset across different markets, executing simultaneous trades to secure a risk-free profit without taking a directional market view. This activity is the defining characteristic of an arbitrageur. Arbitrageurs do not take directional bets on the market but instead capitalize on price differences between related markets that have a fixed relationship, ensuring market efficiency. Speculators, on the other hand, 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 provide liquidity to the markets by continually providing bids and offers, typically profiting from the bid-ask spread.

The question asks about the replication method that primarily involves acquiring the actual constituent securities of an index. This describes direct replication, also known as physical replication. In direct replication, the ETF manager either purchases all the securities in the index (full replication) or a representative sample of them (representative sampling) to mirror the index’s performance. Synthetic replication, on the other hand, uses derivative instruments like swaps or futures to gain exposure to the index without directly holding the underlying assets. Leveraged ETFs and Inverse ETFs are types of ‘Exotic ETFs’ that employ specific investment strategies (e.g., amplifying returns or profiting from declines) rather than being fundamental index replication methodologies themselves.

The question assesses understanding of the specific criteria for selecting bonds into the basket used to determine the final settlement price of the 5-year Singapore Government Bond Futures. The contract specifications clearly state that for a bond to be included in this basket, it must have a minimum issuance size of SGD 1 billion and a term-to-maturity between 3 and 6 years on the first calendar day of the contract month. This ensures that the basket comprises relevant and sufficiently sized government bonds. Other options either misstate these criteria, confuse them with the characteristics of the notional futures contract itself (e.g., the 3% coupon of the notional bond), or introduce irrelevant conditions like active trading on a specific exchange or different maturity ranges.

The CMFAS Module 6A syllabus, specifically Chapter 12 on Contracts for Differences (CFDs), outlines key differences between CFDs and equity futures contracts. For dividends, the syllabus states that CFD investors are generally entitled to dividends declared by the underlying company when holding a long position. Conversely, investors holding equity futures contracts are typically not entitled to receive these dividends. This distinction is crucial for investors considering the income aspect of their positions. Therefore, an investor with a long CFD position would expect to receive the cash dividend, while an investor with a long equity futures contract would not.

The CMFAS Module 6A syllabus, specifically Chapter 13 on Extended Settlement Contracts, outlines that a profit (mark-to-market gain) derived from an ES trade can be utilised to offset other margin requirements for the same customer. In this situation, Ms. Lim’s S$750 profit from her Tech Innovations Ltd. ES contract can be directly applied to reduce the Maintenance Margin needed for her new Global Connect Corp. ES contract position. Therefore, the amount she needs to provide is the difference between the new Maintenance Margin (S$1,200) and her realised profit (S$750), which equals S$450. The profit is not restricted from being used to offset new margin requirements, nor is it held separately until the new position is closed. There is also no provision for a temporary credit facility from the Member to cover the remaining margin in this context; the customer is expected to meet the required margin.

A bear put spread is a strategy implemented by buying a higher strike put option and selling a lower strike put option on the same underlying asset with the same expiration date. This strategy is used when an investor anticipates a moderate decline in the underlying asset’s price. The maximum potential profit for a bear put spread is calculated by taking the difference between the two strike prices and subtracting the net debit paid to establish the position. In this scenario, the difference in strike prices is $55 (higher strike) – $45 (lower strike) = $10. The net debit is the premium paid for the purchased put ($4.00) minus the premium received for the sold put ($1.50), which equals $2.50. Therefore, the maximum profit is $10.00 – $2.50 = $7.50. This maximum profit is achieved if the underlying asset’s price falls to or below the lower strike price ($45) at expiration.

Structured products are typically customized and have low liquidity. The provided text explicitly states that investors purchasing such products must be prepared to hold them until their maturity dates to maximize the full value of their investments. If an investor terminates early, they would likely suffer losses on their initial investment, especially if the return component has not yet become sufficiently profitable. This is because the principal component is structured to realize its full returns only upon maturity. Furthermore, early withdrawal may result in a loss of part of the investment principal and returns. The notion that structured products always include a principal guarantee is incorrect; many feature principal preservation, which is not a guarantee and depends on the underlying fixed income securities. Issuers may provide limited liquidity, but they are not obligated to ensure redemption at fair market value without significant loss, especially given the customized nature of these products. Losses upon early termination can affect both the principal and return components.

Exchange Traded Notes (ETNs) are fundamentally different from Exchange Traded Funds (ETFs) in their legal structure. ETNs are unsecured debt securities issued by a financial institution, typically a bank. This means that an investor in an ETN is exposed to the credit risk of the issuing bank; if the bank defaults, the investor could lose their principal. In contrast, a physically backed ETF holds the actual underlying assets (or derivatives in the case of synthetic ETFs) in a trust or similar structure, which generally insulates investors from the credit risk of the fund manager or custodian. While ETFs do have other risks, such as tracking error and market risk, the direct counterparty credit risk of the issuer is a distinguishing feature of ETNs. The other options contain inaccuracies: ETNs are generally not subject to fund diversification rules, unlike ETFs. The NAV for both ETFs and ETNs is typically calculated at the end of each trading day, not continuously. Tracking error is a concern for both ETFs and ETNs, and neither product guarantees perfect replication of its underlying index.

Yield Enhanced Securities, also known as Discount Certificates, have a specific cash settlement mechanism 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 closing price of $11.50 is below the exercise price of $12.00. Therefore, the investor would receive the value of the underlying, which is $11.50.

The Credit Support Annex (CSA) is a standard legal document used in Over-The-Counter (OTC) derivative transactions, including options. Its primary purpose is to define the terms and conditions under which collateral is posted or transferred between counterparties. This mechanism is crucial for mitigating counterparty credit risk, which is the risk that one party to the transaction may default on its obligations. While a Master Netting Agreement (MNA) allows for the offsetting of mutual obligations, the CSA specifically governs the exchange of collateral to reduce exposure. Futures Commission Merchant (FCM) agreements and Exchange Clearing Mandates (ECM) are relevant to exchange-traded or cleared derivatives and their intermediaries, not directly to the bilateral management of credit risk through collateral in OTC transactions between two financial institutions.

A CFD pairs trading strategy involves simultaneously taking a long position in one asset and a short position in another, typically related, asset. The core objective of this strategy is to profit from the relative price movement between the two assets, rather than their absolute price movements driven by the overall market. By balancing a long and a short position, the strategy aims to be ‘market-neutral,’ meaning its performance is intended to be largely independent of the general direction of the broader market. The investor’s gain is based on the outperformance of the long position over the short position, or vice versa, irrespective of whether the overall market is rising or falling. Therefore, the strategy is designed to be largely indifferent to the general upward or downward movement of the broader market. It does not primarily seek to profit from a strong bull market, a widespread market downturn, or to magnify the impact of broad market trends.

Callable Bull/Bear Contracts (CBBCs) are structured products with a unique feature known as a Mandatory Call Event (MCE). If the price of the underlying asset reaches a pre-determined call price at any point before the CBBC’s expiry, an MCE is triggered. This event leads to the immediate early termination of the CBBC, and its trading ceases. For N-CBBCs (No residual value), the investor will typically receive no cash payment, resulting in a total loss of the investment. For R-CBBCs (Residual value), a small residual cash payment may be received. This mandatory call mechanism is a critical risk factor for investors, as it can lead to premature termination and significant capital loss, distinguishing CBBCs from standard warrants or options that typically allow investors to hold until expiry or exercise at their discretion.

Arbitrage is a trading strategy that aims to generate risk-free profits by exploiting temporary price discrepancies of the same or extremely similar financial instruments across different markets. The fundamental characteristic involves the simultaneous execution of offsetting trades – buying in one market where the price is lower and selling in another where the price is higher. This simultaneous action effectively hedges against market risk, as any adverse movement in one position is typically offset by a favorable movement in the other, locking in a profit from the initial price difference. This distinguishes it from speculation, which involves taking on market risk in anticipation of future price movements, or long-term investment strategies that rely on gradual market corrections rather than immediate price imbalances.

This question tests the understanding of two distinct order types in futures trading: Stop orders and Market-if-Touched (MIT) orders, focusing on their placement relative to the current market price for sell orders and their market visibility. For a trader holding a long position, setting an order to sell below the current market price to limit potential losses is typically achieved with a Stop Sell order. The CMFAS Module 6A syllabus indicates that a Stop Sell order is placed below the current market price. To capture profit on an upward breakout by selling above the current market price, a Market-if-Touched (MIT) Sell order is appropriate, as an MIT sell order is placed above the current market price. Furthermore, the syllabus specifies that MIT orders are not shown to the market before they are converted to the specific order, fulfilling the requirement for the breakout-capturing order to remain undisclosed until triggered. Therefore, the combination of a Stop Sell order for loss limitation and an MIT Sell order for breakout capture, with its inherent non-visibility until triggered, is the most suitable approach.

Over-The-Counter (OTC) options are specifically designed for customization. Unlike exchange-traded options, which have standardized terms like strike prices, expiration dates, and contract sizes, OTC options are privately negotiated between two parties. This allows for the terms of the contract, including the strike price and expiration date, to be fully tailored to meet the precise and unique requirements of the parties involved, such as aligning with a specific project timeline. Exchange-traded options, while offering liquidity and a clearing house guarantee, lack this flexibility due to their standardized nature. Listed futures options are a type of exchange-traded option and thus also standardized. Structured warrants, while issued by financial institutions, typically have a fixed set of terms upon issuance and are not generally customizable on an ad-hoc basis for a specific client’s unique needs in the same way an OTC option can be.

The Barrier Capital Preservation Certificate (Straddle) is designed for investors who do not have a firm view on the direction of the underlying asset but expect it to remain within a specific price range, without large swings that would breach either an upper or lower barrier. Crucially, it is also suitable when an investor expects realised volatility to be higher than current implied volatility, making the strategy potentially cheap relative to its likely payout. This product contains both a barrier call and a barrier put, offering participation in both rising or falling movements until a barrier is breached, while also providing a degree of capital preservation at maturity if no knock-out event occurs. A standard Knock-Out Call is suitable for a rising underlying view. A Barrier Capital Preservation Certificate (Shark’s Fin) primarily targets a rising underlying, featuring an up-and-out barrier. A Barrier Reverse Convertible involves being effectively long a bond and short a knock-out put option, typically for enhanced yield with conditional principal repayment, which does not align with the described range-bound, higher-realised-volatility outlook.

Gamma measures the sensitivity of an option’s delta to changes in the underlying asset price. When an option is at-the-money and nearing its expiration date, its gamma value is typically at its highest. A high gamma implies that the option’s delta will change very rapidly and significantly with even small movements in the underlying asset’s price. For a trader employing a delta-hedging strategy, especially with short option positions, this rapid change in delta means that the hedge will quickly become unbalanced. To maintain delta neutrality and an effective hedge, the trader must make frequent and often substantial adjustments to their position in the underlying asset. This makes the delta hedging process more dynamic and demanding, as the hedge needs constant rebalancing to counteract the accelerating change in delta. Therefore, high gamma increases the operational complexity and potential costs of maintaining a delta-neutral position.

This question assesses the understanding of a covered call strategy, specifically its maximum profit potential. A covered call involves buying the underlying stock and simultaneously selling a call option against it. The investor collects a premium for selling the call. The maximum profit occurs if the stock price rises to or above the strike price of the call option. In this scenario, the stock is bought at $45 (S0) and a call with a strike price of $48 (X) is sold for a premium of $2.50 (c0). The profit consists of the appreciation of the stock up to the strike price, plus the premium received. Therefore, the maximum profit per share is calculated as: (Strike Price – Purchase Price of Stock) + Premium Received = ($48 – $45) + $2.50 = $3 + $2.50 = $5.50. The other options represent common misconceptions, such as only considering the premium, only the stock appreciation up to the strike, or a miscalculation related to the breakeven point.

Structured funds and Exchange Traded Funds (ETFs) employ various methods to replicate the performance of an underlying index or asset. Synthetic replication methods, such as swap-based ETFs or derivative-embedded ETFs, involve entering into agreements with third-party financial institutions (counterparties) to achieve the desired index performance. In these cases, the ETF’s ability to deliver the index return is dependent on the creditworthiness of these counterparties. If a counterparty defaults, the ETF’s performance could be adversely affected, leading to counterparty risk. In contrast, direct replication methods, also known as physical replication, involve the ETF directly investing in the actual constituents of the underlying index. A full replication strategy, a specific type of direct replication, entails holding all assets underlying an index in the exact proportion. By directly owning the underlying assets, the ETF’s performance is tied to the market value of these assets, significantly minimizing reliance on the creditworthiness of third-party financial institutions for the delivery of the index’s performance. While representative sampling is also a direct replication method, it involves investing in a subset of the index constituents. Full replication offers the most direct and comprehensive way to mitigate counterparty risk related to performance replication.

A ‘Worst of’ Equity Linked Note (ELN) is a type of structured product linked to the performance of multiple underlying assets, such as a basket of shares. Unlike a standard ELN that might be linked to a single share or index, the unique characteristic of a ‘Worst of’ ELN is that its return is solely dependent on the performance of the single worst-performing underlying asset within the specified basket. This means that even if most of the underlying shares perform well, the investor’s return will be dictated by the one that performs the poorest. This structure exposes the investor to a higher level of risk compared to a normal ELN, as the downside risk is not limited to a single stock but is amplified by the possibility of any one of the multiple stocks performing poorly. Due to this increased risk, ‘Worst of’ ELNs typically offer a higher potential yield to compensate investors for taking on this additional exposure to the weakest link in the basket. Therefore, in a scenario where some shares perform positively and one declines, the declining share’s performance will be the critical factor.

The Constant Proportion Portfolio Insurance (CPPI) strategy determines the allocation to risky assets based on a calculated cushion and a multiplier. First, the cushion value is determined by subtracting the floor value from the total portfolio value. In this scenario, the cushion value is $1,200,000 (Total portfolio value) – $1,000,000 (Floor value) = $200,000. Next, the multiplier is calculated as 1 divided by the anticipated crash size. With a crash size of 25% (or 0.25), the multiplier is 1 / 0.25 = 4. Finally, the allocation to the risky asset is found by multiplying the cushion value by the multiplier. Therefore, the allocation to the risky asset is $200,000 (Cushion value) 4 (Multiplier) = $800,000.

When a financial institution issues structured notes through a Special Purpose Vehicle (SPV), the SPV is established as a separate legal entity. This means that the structured notes are issued directly by the SPV to investors, and the SPV’s assets and liabilities are not reflected on the originating bank’s balance sheet. Consequently, in the event of a default, the noteholders’ claim is limited solely to the assets held by the SPV. They do not have any direct recourse to the bank that set up the SPV. This arrangement effectively isolates the credit risk, making the investor exposed to the credit risk of the SPV itself, rather than the originating bank. This is a key distinction from direct issuance, where the investor bears the credit risk of the issuing bank.

The adjustment for dividends on a structured warrant’s exercise price is calculated using a specific formula to account for the dilutive effect of the dividend. The new exercise price is determined by multiplying the old exercise price by an adjustment factor. The adjustment factor is calculated as (P – SD – ND) / (P – ND), where P represents the last cum-date closing price of the underlying security, SD is the special dividend per share, and ND is the normal dividend per share. Given the information: Original Exercise Price = $20.00 Last cum-date closing price (P) = $25.00 Special dividend per share (SD) = $1.00 Normal dividend per share (ND) = $0.50 First, calculate the Adjustment Factor: Adjustment Factor = ($25.00 – $1.00 – $0.50) / ($25.00 – $0.50) Adjustment Factor = ($23.50) / ($24.50) Adjustment Factor ≈ 0.959183673 Next, calculate the New Exercise Price: New Exercise Price = Original Exercise Price × Adjustment Factor New Exercise Price = $20.00 × 0.959183673 New Exercise Price ≈ $19.183673 Rounding to two decimal places, the adjusted exercise price is $19.18.

The scenario describes a need for an options contract to hedge a highly specific, irregular cash flow exposure that does not align with standard market maturities or strike price intervals. This requirement for precise customisation is the defining characteristic that points towards an Over-The-Counter (OTC) option. OTC options are private agreements between two parties, allowing for the full customisation of terms such as strike price, expiration date, and underlying asset specifications to perfectly match unique risk profiles. In contrast, exchange-traded options are standardised contracts designed for liquidity and ease of trading on an organised exchange, making them unsuitable for highly bespoke hedging needs. A crucial aspect of OTC options, due to the absence of a clearing house, is the increased counterparty risk, which requires careful selection of a financially sound counterparty. While exchange-traded options benefit from a clearing house that guarantees performance and reduces counterparty risk, their lack of customisation is a significant drawback for the described situation. Futures contracts are also standardised derivatives and do not offer the required flexibility. Although synthetic customisation with multiple exchange-traded options is possible, it is often more complex and may not achieve the exact precision of a single, tailor-made OTC contract.

Forward contracts are private agreements negotiated directly between two parties, allowing for highly customised terms regarding the underlying asset, quantity, delivery date, and settlement procedures. This inherent flexibility makes them particularly suitable for hedging unique, non-standardised exposures that do not fit the rigid specifications of exchange-traded futures contracts. Futures contracts, on the other hand, are standardised and traded on regulated exchanges, which provides benefits like liquidity and the elimination of counterparty risk through a clearing house, but limits customisation. Futures also involve daily mark-to-market procedures and margin calls, which are not typical features of forward contracts.