CMFAS RES6A Quiz 66

The question describes a fund manager’s objective to replicate a broad market index’s performance while avoiding the operational complexities of direct asset management, such as frequent rebalancing and dividend reinvestment. A Total Return Swap (TRS) is specifically designed for this purpose. In a TRS, the fund (the receiver) agrees to pay a floating interest rate (e.g., SIBOR + spread) to a counterparty and, in return, receives the total return of the underlying index (including price appreciation and dividends) on a notional amount. This provides synthetic exposure to the index’s performance without the need to physically hold the underlying assets or manage their operational aspects. The other options represent strategies that either involve the operational complexities the fund manager wishes to avoid (direct equity portfolio management, active futures rolling) or serve a different primary objective (zero plus option strategy focuses on capital guarantee plus participation, not just total return replication with minimal operational burden).

A bear put spread is a vertical options strategy employed by investors who hold a mildly bearish view on an underlying asset. It is constructed by buying an in-the-money (ITM) put option with a higher strike price and simultaneously selling an out-of-the-money (OTM) put option with a lower strike price, both with the same expiration date and on the same underlying asset. This strategy results in a net debit (cash outlay) upon initiation. One of its fundamental characteristics is that it limits both potential profit and potential loss. The maximum potential loss for a bear put spread occurs if the underlying asset’s price rises above the strike price of the higher-strike (bought) put option at expiration. In this scenario, both put options expire worthless, and the investor’s total loss is limited to the initial net debit paid to establish the position. Conversely, the maximum profit is achieved if the underlying asset’s price falls below the strike price of the lower-strike (sold) put option at expiration, and this profit is equal to the difference in strike prices minus the initial net debit. The strategy does not offer unlimited profit potential, nor does it generate a net credit at inception.

Auto-callable structured products grant the issuer the discretion to redeem the product early. This means investors essentially sell their right to early redemption to the issuer in exchange for a potentially higher yield. Consequently, a primary risk for the investor is the uncertainty surrounding the actual holding period of their investment, as they have no control over when the product might be called. If the product is called early, the investor then faces reinvestment risk, meaning they may have to reinvest their capital at a potentially lower prevailing interest rate or in less attractive opportunities. Options that suggest investor control over early redemption or guaranteed capital return upon early call are incorrect, as the terms of redemption can vary, and the issuer holds the call right. While other risks like market risk or risks from short option positions exist, the question specifically asks about the primary risk due to the auto-callable feature.

Credit Linked Notes (CLNs) and Bond Linked Notes (BLNs) are both structured products designed for yield enhancement, but they achieve this through different underlying derivative mechanisms and expose investors to distinct primary risks. A CLN’s enhanced yield is generated by the investor effectively selling credit default swap (CDS) protection on a specified ‘reference entity’. The investor receives periodic payments (like an insurance premium) and faces a potential payout obligation if a credit event (e.g., default) occurs for that reference entity. This exposes the investor to the credit risk of both the note issuer and the reference entity. In contrast, a BLN’s yield enhancement comes from the investor selling a put option on a specific bond. The payout for a BLN is primarily influenced by the market price of that underlying bond relative to the put option’s strike price. This means a BLN investor is exposed to the bond’s price movements, which can be affected by various factors beyond just default, such as credit downgrades, widening spreads, and interest rate volatility. The other options misrepresent the fundamental derivative structure or the primary risk exposures of these products. For example, CLNs do not primarily involve direct investment in high-yield bonds or equity indices, nor are they always ‘first to default’ instruments. Neither CLNs nor BLNs inherently guarantee principal return.

The correct answer is the daily mark-to-market process. In CFD trading, the investor’s account balance is adjusted in real-time or at the end of each trading day to reflect the current market value of the underlying asset. Any gains or losses from the price movement are immediately added to or subtracted from the account. This continuous revaluation is known as ‘mark-to-market’ and is the primary mechanism that determines the account’s equity and whether it falls below the maintenance margin, potentially triggering a margin call. Initial margin calculation occurs at the start of the trade to determine the required deposit. A stop-loss order is a risk management tool designed to limit potential losses by automatically closing a position at a specified price, but it is not the mechanism for daily account balance adjustment. Liquidation protocol is the procedure followed by the CFD provider if a margin call is not met, resulting in the forced closure of positions.

When a company announces a bonus share issue, it means existing shareholders receive additional shares without any payment. For Extended Settlement (ES) contracts, SGX implements adjustments to ensure that the contract’s value remains consistent before and after such corporate events, provided the Book Closure Date is before the ES contract’s settlement day. According to SGX guidelines, for corporate actions that lead to an increase or decrease in the number of underlying shares, such as a bonus issue or a share split, the adjustment is typically made to the contract multiplier. This increase in the contract multiplier reflects the higher number of shares, thereby preserving the economic value of the ES contract. Adjustments to the settlement price are usually reserved for corporate events that directly impact the share’s value or price, rather than just the quantity of shares.

This question assesses the candidate’s understanding of the auto-redeemable feature common in structured funds, specifically how the redemption price is determined based on the timing of the auto-call event. The fund’s terms specify a graduated redemption price schedule. When the auto-redemption condition is met precisely 1.5 years after inception, the investor receives the principal amount plus the pre-determined premium corresponding to that specific observation date. In this case, the redemption price for an auto-call at 1.5 years is 112.75% of the principal amount. The other options represent redemption prices for different auto-call periods or the maximum payout at maturity, which would not be applicable if the fund auto-redeems at 1.5 years.

Contracts for Differences (CFDs) are derivative products that allow investors to speculate on the price movements of an underlying asset without owning the asset itself. A key characteristic of equity CFDs is that investors holding a long position are typically entitled to receive cash dividends and participate in corporate actions such as share splits, similar to direct share ownership. However, a crucial distinction is that CFD investors do not possess any voting rights associated with the underlying shares, as they are not the legal owners of those shares. Therefore, while they benefit from the economic exposure, they do not have the shareholder rights that come with direct ownership.

A ‘worst of’ Equity Linked Note (ELN) is a structured product where the investor’s return or redemption amount at maturity is determined by the performance of the poorest performing asset among a basket of multiple underlying assets. This means that even if some of the underlying assets perform well and are above their strike prices, the investor’s payout will be dictated by the one asset that has performed the worst. This significantly increases the downside risk compared to a standard ELN linked to a single asset, as the probability of at least one asset falling below its strike price is higher with multiple assets. Therefore, the most significant additional risk is that the investor’s return is tied to the single worst performer. Other options describe general ELN characteristics or features not specifically defining the ‘worst of’ risk. For instance, settlement mode is typically predefined, not automatically triggered by a single asset’s performance in a ‘worst of’ context. While coupon payments can be contingent, the defining characteristic of a ‘worst of’ ELN relates to the final redemption based on the worst-performing underlying. ELNs generally do not offer principal protection unless explicitly structured to do so, and the ‘worst of’ feature amplifies the risk of principal loss, rather than removing a non-existent protection.

The question pertains to the management and evaluation of futures hedges, specifically identifying sources of error that can lead to a discrepancy between the targeted and actual realized rates. When a hedge is implemented, the objective is to lock in a future price or rate. However, the actual realized outcome can sometimes differ from the perfectly hedged target. One of the most common and significant reasons for this discrepancy, particularly when the general market movement aligns with expectations, is basis risk. Basis risk refers to the risk that the relationship between the spot price of the underlying asset and the futures price changes unexpectedly. The basis is the difference between the spot price and the futures price. If this difference at the time the hedge is lifted (terminated) is not what was anticipated when the hedge was initiated, it will lead to a deviation between the targeted and actual realized rates. The CMFAS Module 6A syllabus material explicitly states that ‘Normally the main sources of error are due to the projected value of the basis at the lift date’. Other options, while potentially relevant to hedging in broader contexts, are less direct or primary causes for the specific scenario described. For instance, an incorrect initial hedge ratio (Option 2) would lead to under or over-hedging, but the question implies a ‘slight discrepancy’ even with expected market movement, pointing more towards basis fluctuation. Changes in volatility (Option 3) can affect futures prices but basis risk is a more direct explanation for the final difference. Counterparty risk (Option 4) is largely mitigated in exchange-traded futures.

To determine the payout percentage at maturity, we first need to calculate the returns performance for each underlying index from the initial date to the maturity date. For Nikkei 225 (R1): Initial Index Value = 15,000 Observed Index Value = 16,000 R1 = ((16,000 – 15,000) / 15,000) 100% = (1,000 / 15,000) 100% = 6.67% For S&P 500 (R2): Initial Index Value = 1,800 Observed Index Value = 2,200 R2 = ((2,200 – 1,800) / 1,800) 100% = (400 / 1,800) 100% = 22.22% Next, we compare the returns performance of the two indices. In this scenario, R1 (6.67%) is less than R2 (22.22%). According to the product terms for payout at maturity, if the performance of Index 1 (Nikkei 225) is less than the performance of Index 2 (S&P 500), the payout is the Redemption Value, which is 100% of the initial investment. The product did not experience an early redemption event, so the early redemption payout percentages are not applicable.

The structured product’s yield formula is 0.50% + [4.00% x n/N]. The variable ‘n’ represents the number of days the HSI fixes within the range of 22,200 and 22,400. In the given scenario, the HSI spot price consistently fixes below the Accrual Barrier of 22,200 for the entire 12-month period. This means that the condition for ‘n’ is never met, so ‘n’ is 0. Therefore, the yield calculation becomes 0.50% + [4.00% x 0/250] = 0.50%. For an initial investment of SGD 1 million, the accrual coupon would be SGD 1,000,000 multiplied by 0.50%, which equals SGD 5,000. The total redemption proceeds at maturity are the principal amount plus the accrual coupon, resulting in SGD 1,000,000 + SGD 5,000 = SGD 1,005,000. Other options represent scenarios where no coupon is paid, the full maximum coupon is paid, or a partial coupon due to a knock-out event, none of which apply to the described situation.

Before an investor decides to implement a hedging strategy, a critical step involves evaluating the potential consequences of not hedging at all. According to the CMFAS Module 6A syllabus, one of the key factors to identify and measure risks before actual hedging is to determine the ‘Risk Value’ associated with NOT hedging. This assessment helps the investor understand the exposure and potential losses if no protective measures are taken. Other factors like assessing correlation coefficients, calculating transaction costs, or setting a target rate are typically considered during the development of the hedge program or as part of the cost-benefit analysis of the hedge itself, rather than being the primary assessment of the implications of choosing not to hedge.

A Hang Seng Index (HSI) Daily Range Accrual Note (RAN) specifies conditions under which interest accrues. A critical feature is the knock-out barrier. As per the product description, a knock-out event occurs if the HSI trades at or above the knock-out barrier during the investment period. Once this event is triggered, the accrual of new coupons immediately ceases. However, it is explicitly stated that any coupon that has already been accrued up to the point of the knock-out event will still be paid to the investor on the periodic interest payment dates. The principal amount of the note is typically preserved and recovered at maturity, unless otherwise specified, which is a standard feature of RANs. Therefore, the correct outcome is the cessation of future interest accrual while preserving previously earned interest.

The product terms explicitly state that a Mandatory Call Event (knock-out event) is triggered ‘if the closing index level of ANY 4 of the underlying indices (Index1-4) on the Early Redemption Observation Date is < 75% of initial level'. Since there are only four underlying indices (Index1-4) mentioned, the condition 'ANY 4' effectively means that all four of these indices must have their closing levels fall below 75% of their respective initial levels for the event to occur. If this condition is met, the fund terminates early. The other options describe conditions that do not align with the product's defined knock-out trigger. For instance, requiring only one index to fall below the threshold is insufficient, and using an average or a different number of indices (like three) does not match the specified criteria.

In a First-to-Default Credit Linked Note (CLN), the yield offered to the note holder is influenced by several factors, including the correlation among the underlying reference entities. When the corporate entities in the basket exhibit perfect correlation in their credit risk, it implies that they are highly likely to default together or not at all. From the perspective of the note holder, who is selling credit protection, this scenario is akin to assuming the default risk of only a single company within the basket. This is because if one defaults, the others are expected to follow, or if one doesn’t, the others won’t either. Consequently, the overall probability of a ‘first default’ occurring across the basket is effectively reduced to the probability of default of a single entity, rather than the cumulative risk of multiple independent entities. A lower perceived risk for the note holder typically translates to a lower yield offered on the note, as less compensation is required for the credit protection provided. Conversely, if the entities had zero correlation, the probability of a first default would be the sum of individual default probabilities, leading to a higher overall risk and thus a higher yield.

This question tests the understanding of the Mandatory Call Event (MCE) and its implications for R-category Callable Bull/Bear Certificates (CBBCs), a core concept in knock-out products. When the underlying asset’s price breaches the Call Price, an MCE is triggered, leading to the immediate termination of the CBBC. For an R-category CBBC, the investor receives a ‘residual value,’ which is calculated based on the difference between the strike price and the settlement price (typically the lowest/highest price reached after the MCE for a Bull/Bear contract, respectively, or a pre-defined settlement mechanism). A critical aspect is that once an MCE occurs, the CBBC is irrevocably terminated. This means the investor cannot benefit if the underlying asset’s price subsequently recovers or moves favorably. Option 1 correctly captures these two key elements: the receipt of a residual value for an R-category CBBC and the irrevocable termination, preventing future participation in price movements. Option 2 is incorrect because an MCE results in termination, not an adjustment of the CBBC’s terms to continue trading. The product ceases to exist. Option 3 is incorrect. CBBCs are leveraged derivative products that provide exposure to the underlying asset’s price movements but do not grant direct ownership or conversion rights into the underlying shares. Option 4 is incorrect. While N-category CBBCs typically offer zero residual value upon an MCE, R-category CBBCs are designed to provide a residual value, which, although potentially small, is not necessarily a complete loss of the entire invested capital.

The scenario describes two critical developments impacting a CFD investor. Firstly, rising global interbank lending rates directly increase the daily financing costs associated with holding a leveraged CFD position, as these costs are typically calculated based on a spread over such benchmarks. This directly erodes potential returns or exacerbates losses. Secondly, a sharp decline in the underlying foreign market, especially due to unexpected regulatory shifts, can lead to a significant reduction in market liquidity. When trading through a market-maker CFD provider, their discretion over the bid-ask spread becomes a crucial factor. In illiquid conditions, the market-maker may widen the spread, making it challenging for the investor to close their position at a favorable or even reasonable price. Therefore, the combined effect of increased financing costs and potential difficulty in exiting the position at a fair price due to liquidity issues and the market-maker’s pricing discretion is a primary concern. Other options are incorrect because the market-maker model does not offer enhanced pricing transparency (it gives the provider discretion over spreads), financing rates are typically floating, not fixed, and market downturns generally reduce, rather than assure, liquidity. While counterparty and currency risks are inherent in international CFD trading, the specific triggers in the scenario (rising interest rates and market decline affecting liquidity/pricing) point more directly to financing costs and the challenges of trading in an illiquid market via a market-maker.

Index-Linked Notes are debt securities where the coupon payments and/or the principal are tied to the movements of a market index or an asset price. A common feature, especially in notes with principal preservation, is that the redemption amount at maturity is calculated to be the greater of a pre-determined minimum total return or the return derived from the underlying index’s performance, often based on an average over the tenor. This structure aims to protect the investor’s initial capital while still offering exposure to potential market gains. The other options are incorrect because Index-Linked Notes do not necessarily guarantee fixed interest payments; their returns are linked to the index. They also typically involve a trade-off for principal preservation, meaning the upside potential might be slightly less or capped, not uncapped. Lastly, the scenario explicitly describes a product with 100% principal preservation, directly contradicting the idea of full exposure to downside risk.

A Credit Linked Note (CLN) is a structured product that exposes the investor to the credit risk of a specific reference entity. In exchange for taking on this risk, the investor typically receives an enhanced yield. When a credit event, such as a failure to pay interest or principal, occurs for the reference entity, the CLN’s terms are triggered. If the CLN specifies physical settlement, the issuing bank, which acts as the seller of credit default swaps (CDS) linked to the reference entity, will use the collateral (the fixed income investment backing the CLN) to acquire the defaulted debt obligations of the reference entity. These defaulted obligations are then passed on to the CLN investor. Since the reference entity has defaulted, its debt obligations are highly unlikely to trade at their par value, meaning the investor will likely incur a substantial loss on their principal investment. The CLN will also terminate, and coupon payments will cease. Receiving a cash amount representing the difference between par and market price would be characteristic of cash settlement, not physical settlement. CLNs do not typically offer principal protection in the event of a reference entity’s default, and the investor is directly exposed to this credit risk, meaning coupon payments would not continue.

The question describes a situation where trading is temporarily halted due to a rapid and widespread decline in asset values, aiming to prevent further panic and disorderly conditions. This aligns precisely with the function of ‘Circuit Breakers’. Circuit breakers are systems in cash and derivative markets designed to trigger trading halts when markets experience significant volatility, specifically to prevent widespread panic and disorderly market conditions. ‘Shock Absorbers’ are systems that slow down trading during volatility but do not halt it completely. ‘Limits’ (or price limits) impose maximum allowable price movements to limit volatility without slowing or halting trading activity. ‘Counterparty risk controls’ relate to the risk that a party to a financial contract will not fulfill its obligations, which is a different type of risk entirely and not a mechanism for managing market-wide price volatility or disruption.

A bear put spread is established by buying a higher strike put option and simultaneously selling a lower strike put option, both for the same underlying asset and 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 as the difference between the two strike prices minus the net debit paid to enter the position. In this scenario, the difference in strike prices is $50 – $45 = $5.00. The net debit paid is $2.00. Therefore, the maximum profit is $5.00 – $2.00 = $3.00. This maximum profit is achieved if the underlying stock price falls to or below the lower strike price ($45) at expiration.

In an unfunded swap-based ETF structure, the ETF directly utilizes the proceeds from the sale of its units to acquire a pool of collateral. This collateral is then held with a third-party custodian and pledged to the ETF. The returns generated from this collateral are subsequently exchanged with the swap counterparty for the performance of the underlying index. This arrangement ensures that the ETF itself holds the collateral to manage its exposure to the swap counterparty. Conversely, in a fully funded swap structure, the ETF transfers its sale proceeds to the swap counterparty, which then purchases the collateral and pledges it in favour of the ETF. The other options describe different or incorrect methods of collateral management that do not align with the defined unfunded swap mechanism.

The question describes a scenario where an investor wants to establish a position across several consecutive short-term interest rate futures contracts, specifically to avoid ‘legging risk’ by executing all parts simultaneously. Both futures packs and futures bundles are designed for this purpose, allowing the purchase or sale of a series of futures representing a segment along the yield curve in a single transaction, thereby eliminating legging risk. A futures pack is defined as a type of order enabling the simultaneous purchase or sale of an equally weighted, consecutive series of four futures contracts. A futures bundle, while serving a similar purpose, typically involves quarterly contracts over two or more years. Given the description of ‘several consecutive contracts’ and the direct definition of a pack covering a specific series of four, the futures pack is the most fitting description for this objective. The mutual offset system is a facility for transferring positions between exchanges, and cash-and-carry arbitrage is a specific trading strategy involving spot and futures markets, neither of which directly addresses the simultaneous execution of a series of futures contracts to mitigate legging risk.

When an investor takes a short Extended Settlement (ES) position and fails to deliver the required shares by the settlement due date (which is the 3rd business day after the Last Trading Day), the Central Depository Pte Ltd (CDP) is responsible for initiating a buying-in process. This process begins on the day immediately following the settlement due date. The purpose of the buying-in is to acquire the necessary shares from the market to fulfill the investor’s delivery obligation. The other options describe incorrect procedures or consequences. The investor’s broker does not personally cover the position, ES contracts are primarily physically settled, and trading suspension by SGX is typically for broader market or security-specific issues, not an individual investor’s delivery failure.

In a First-to-Default Credit Linked Note (CLN), the note holders are effectively selling credit protection for a basket of companies. The yield they receive is compensation for assuming the risk that any one of these companies might default first. When there is lower correlation among the reference entities, their default events are considered more independent. This means there are effectively more distinct risk factors that could trigger a default within the basket, increasing the overall probability of any single default occurring. Consequently, to compensate for this higher collective risk, note holders will demand a higher yield. Conversely, if the companies are highly correlated, their default probabilities move in tandem, effectively reducing the number of independent risk factors and making the basket’s default probability closer to that of a single entity, thus requiring a lower yield. Therefore, lower correlation leads to a higher required yield.

An Up-and-Out Call option is specifically designed for an investor who anticipates a modest upward movement in the underlying asset’s price. As a call option, it benefits from rising prices. The ‘Up-and-Out’ feature means that the option will automatically terminate and become worthless if the underlying asset’s price rises to or above a predetermined upper barrier. This characteristic allows the option to be priced lower than a comparable standard call option, aligning with the investor’s objective of acquiring an option at a reduced premium. The investor accepts the risk of early termination if the price moves too far upwards, which is consistent with a strategy focused on small, contained market movements, as knock-out options are ideal for small moves in a sideways market. Conversely, a Down-and-Out Call would terminate if the price falls below a lower barrier, which does not match the described termination condition of rising above an upper barrier. Up-and-In and Down-and-In options are ‘knock-in’ options, meaning they only become active if a barrier is breached, and are typically used for speculating on large market moves, rather than offering a reduced premium for small, anticipated movements with a termination condition.

A Knock-Out Event, also known as a Mandatory Call Event (MCE), is triggered if any of the underlying index levels falls below a specified percentage of its initial level on an observation date. In this scenario, the threshold is 75% of the initial level. We must calculate 75% of the initial level for each index and compare it to the observed level. 1. Index P: Initial Level = 1200. 75% of Initial Level = 1200 0.75 = 900. Observed Level = 910. Since 910 > 900, Index P has NOT triggered a Knock-Out Event. 2. Index Q: Initial Level = 800. 75% of Initial Level = 800 0.75 = 600. Observed Level = 605. Since 605 > 600, Index Q has NOT triggered a Knock-Out Event. 3. Index R: Initial Level = 2500. 75% of Initial Level = 2500 0.75 = 1875. Observed Level = 1850. Since 1850 < 1875, Index R HAS triggered a Knock-Out Event. 4. Index S: Initial Level = 150. 75% of Initial Level = 150 0.75 = 112.5. Observed Level = 110. Since 110 < 112.5, Index S HAS triggered a Knock-Out Event. Because at least one index (in this case, Index R and Index S) fell below 75% of its initial level, a Knock-Out Event has occurred. The other options are incorrect because they either misinterpret the condition ('any' versus 'all'), focus on indices that did not trigger the event, or introduce irrelevant criteria like the fund's weighted average return.

A strong form cash hedge, also known as immunization, is a strategy used by financial institutions and fund managers to protect their portfolios against interest rate fluctuations over a known investment period. The core objective is to minimize the variance in the expected total return on the portfolio for that specific investment period. This is achieved by creating and maintaining a cash and futures portfolio that has the same interest rate sensitivity as a zero-coupon bond with an initial maturity equal to the investment period. Futures contracts are bought or sold to adjust the portfolio’s interest rate sensitivity as needed to match that of the theoretical zero-coupon bond. Option 1 accurately describes this objective and method. Option 2 describes a weak form cash hedge, which is for an indefinite period and focuses on minimizing price variance of an existing inventory. Option 3 relates to the concept of locking in a target rate for a hedge held until expiry, which is a different aspect of futures strategies. Option 4 incorrectly states that the hedge eliminates credit and sector risks; immunization primarily addresses interest rate risk. Furthermore, a strong form cash hedge explicitly involves the use of futures to manage interest rate sensitivity, contrary to the claim of not using derivative instruments.

The primary factor contributing to liquidity risk in structured products, especially when an investor needs to liquidate prematurely, is their customized nature and the illiquidity of their underlying components. Structured products are often tailored to specific risk/reward profiles, leading to a limited secondary market. Furthermore, underlying derivatives like exotic options and assets such as unlisted high-yield bonds may not be actively traded, making it difficult to find a buyer quickly without incurring significant losses. While credit risk of the issuer, market interest rate fluctuations, and lock-up periods are relevant considerations for structured products, they do not primarily define the liquidity risk associated with the ability to sell the product in a secondary market. Credit risk relates to the issuer’s ability to meet obligations, market interest rate fluctuations affect valuation, and a lock-up period restricts withdrawal but the fundamental lack of marketability stems from the product’s design and its underlying assets.