CMFAS RES6A Quiz 69

Index-linked notes are debt securities where the return is tied to the performance of an underlying market index. A common feature, as described, is principal preservation, meaning the initial investment amount is protected at maturity. Additionally, these notes often include a mechanism to determine the investor’s return, which can be the greater of a specified minimum total return or a participation rate in the index’s performance. In this scenario, the note guarantees a minimum total return of 28%. The alternative is a 100% participation in the average performance of the underlying index, which was calculated at 22%. Since the note pays the ‘greater of’ these two figures, the investor will receive the 28% minimum total return, as it is higher than the 22% index performance.

To determine the participation rate for an Equity-Linked Structured Note, one must first calculate the present value (PV) of the zero-coupon bond component. The formula for present value is PV = Face Value / (1 + r)^T, where r is the discount rate and T is the number of periods. Given: Face Value = $100 Discount Rate (r) = 6.00% or 0.06 Maturity (T) = 5 years PV = $100 / (1 + 0.06)^5 PV = $100 / (1.3382255776) PV ≈ $74.73 Next, calculate the discount sum, which is the difference between the face value and the present value of the bond. This sum is typically available for the purchase of the call option component. Discount Sum = Face Value – PV Discount Sum = $100 – $74.73 Discount Sum = $25.27 Finally, the participation rate is calculated by dividing the discount sum by the call option premium and multiplying by 100%. Call Premium = $20.00 Participation Rate = (Discount Sum / Call Premium) 100% Participation Rate = ($25.27 / $20.00) 100% Participation Rate = 1.2635 100% Participation Rate = 126.35% The other options represent either values from illustrative examples in the study material or a general assumption about principal preservation, not the calculated participation rate for the given parameters.

The Constant Proportion Portfolio Insurance (CPPI) strategy is designed to protect a certain percentage of the initial principal (the floor) while allowing participation in market upside. The floor value is calculated as a percentage of the initial investment. In this scenario, the initial investment is $500,000, and the floor is set at 85%, which means the floor value is $500,000 0.85 = $425,000. When the total value of the CPPI structure declines to exactly the floor value, the strategy mandates a ‘de-risking’ action. This involves liquidating all holdings in the risky asset and re-allocating the entire portfolio to the risk-free asset. This ensures that the principal amount (up to the floor) is preserved, even though it means the investor will no longer benefit from any future appreciation in the risky asset. Increasing the risky asset allocation, maintaining the current allocation, or adjusting the multiplier are not the standard actions when the portfolio hits the floor in a CPPI strategy.

Tracking error refers to the disparity in performance between an ETF and its underlying index. The continuous pricing mechanism of an ETF on a public exchange is a characteristic related to its liquidity and flexibility, allowing it to be traded throughout the day. This feature is a benefit of ETFs and does not directly contribute to the performance difference between the ETF and its benchmark index. In contrast, expenses and transaction fees incurred by the ETF, costs associated with adjusting the ETF’s holdings to reflect index changes (replication costs), and the impact of uninvested cash (cash drag) are all well-documented factors that can lead to tracking error, causing the ETF’s performance to deviate from its underlying index.

The investor’s objective is to achieve a direct, almost complete offset to their existing long stock exposure, aiming to lock in a current price with minimal basis risk. Extended Settlement (ES) contracts are designed to provide an immediate, near 100% hedge, characterized by a delta of 1.0. This means their price movement closely mirrors that of the underlying share, offering a direct offset. Furthermore, ES contracts do not require the selection of a strike price, simplifying the hedging process and ensuring the breakeven point is directly from the buy or sell price. In contrast, warrants typically offer a delta of around 0.5 (at-the-money) and require the selection of a strike price, making their hedging effectiveness dependent on both the strike price and time to expiry. Warrants are also subject to time decay and their cost is an initial premium, whereas ES contract costs primarily involve maintaining margin. Therefore, for a direct and near-perfect hedge, ES contracts are the more suitable instrument.

The question asks for the specific component within the semi-annual accounts and reports to unitholders that details the fund’s investment portfolio. According to the syllabus, the ‘Statement of Investments’ explicitly lists out the details of the investment portfolio of the company. The ‘Statement of Net Assets’ provides an account of assets and liabilities and NAV per share, but does not detail the individual holdings within the portfolio. The ‘Statement of Changes in Net Assets’ shows how the net assets have changed over past reporting periods, focusing on income, dividends, and redemptions, not the current composition of the portfolio. The ‘Investment Manager Report’ is a separate report detailing performance and outlook, and while it might touch upon underlying assets, it is not categorized as a component of the ‘Semi-annual Accounts and Reports to Unitholders’ as per the provided syllabus structure.

Structured warrants, as described in the CMFAS Module 6A syllabus, are issued by third-party financial institutions and are typically ‘European-style’ options. This means they can only be exercised on their expiry date. In contrast, company warrants are generally ‘American-style’ options, allowing exercise at any time during their life. Furthermore, structured warrants listed on the Singapore Exchange are settled in cash, not by physical delivery of shares. They are also not primarily issued by listed companies as a ‘sweetener’ for existing shareholders; that characteristic applies to company warrants.

Before an investor or portfolio manager decides to implement a hedging strategy, a fundamental initial step is to thoroughly identify and measure the risks that need to be addressed. This involves evaluating the likelihood of adverse price movements and estimating the potential magnitude of such changes. This assessment is critical for understanding the ‘risk value’ associated with not hedging and forms the basis for deciding whether hedging is necessary and worthwhile. Without first understanding the probability and probable size of potential adverse changes, it is difficult to justify or design an effective hedge. Determining the precise historical beta of a portfolio and selecting a liquid futures contract are steps related to developing an effective hedge program and choosing the appropriate instrument, which typically occurs after the initial decision to hedge has been made based on the identified risks. Calculating the total expected profit cap is a consequence of hedging, as hedging aims to reduce risk but may limit upside potential; however, this calculation is not the primary initial consideration for deciding whether to hedge. Identifying potential counterparties for over-the-counter derivative contracts is a step in the execution phase, after the decision to hedge and the choice of instrument have been made.

Interest rate options are distinct from other types of options, particularly in their settlement mechanism and risk profile for the buyer. As outlined in the CMFAS Module 6A syllabus, ‘Interest rate options are cash settled. Upon exercise, the underlying securities do not have to be delivered, but the differences between the interest rates are settled using a scale of 100.’ This means that there is no physical delivery of any underlying asset, and consequently, ‘there is no risk of losing the principal.’ For the buyer of an interest rate option, the ‘risk is limited to the option premium but the upside potential is unlimited.’ Furthermore, these options are typically ‘exercised in the European style,’ meaning they can only be exercised on a specified date, not before. Therefore, the correct option accurately reflects the cash settlement based on interest rate differences and the buyer’s limited risk to the premium paid. Options suggesting physical delivery, principal risk, American-style exercise, or capped profit for the buyer are incorrect based on these characteristics.

The effectiveness of a futures hedge is often evaluated by comparing the actual outcome to the target outcome. A primary reason for any deviation, or ‘source of error,’ when a hedge is lifted, is the uncertainty surrounding the basis. The basis is the difference between the spot price of the underlying asset and the futures price. When a hedge is set up, the basis at the future lift date is projected. If the actual basis at the time the hedge is closed out differs significantly from this projection, it can lead to an imperfect hedge and residual risk. This is because the hedge’s objective is to achieve equivalent dollar movement in cash and futures, and changes in the basis affect this equivalence. Other factors like interest rate differentials might influence futures prices, but the basis risk is explicitly identified as a main source of error in hedge effectiveness.

To determine the fund’s participation rate in the index’s gains, first calculate the capital available for purchasing call options. The total initial capital is S$1,000,000. If 85% is invested in a zero-coupon bond, then 15% (100% – 85%) of the initial capital is allocated to call options. This amounts to S$150,000 (15% of S$1,000,000). The question states that the cost of the call options represents 30% of the notional exposure required for full participation. Therefore, the participation rate is calculated by dividing the percentage of the total initial capital allocated to options by the call option price percentage. In this case, 15% divided by 30% equals 0.5, or 50%.

Callable Bull/Bear Contracts (CBBCs) have a mandatory call feature, meaning they can be terminated early if the underlying asset’s price reaches a specified call price. For a Bull Contract, a Mandatory Call Event (MCE) is triggered when the spot price of the underlying asset touches or falls below the call price. The distinction between N-Category and R-Category CBBCs lies in their settlement upon an MCE. An N-Category CBBC (No residual value) has its call price equal to its strike price, and the holder receives no cash payment once the MCE occurs. Conversely, an R-Category CBBC (Residual value) has a call price different from its strike price, and the holder may receive a small cash payment, known as a ‘Residual Value,’ when the CBBC is called. Therefore, the primary difference in outcome for the investor is the potential to receive a residual cash payment with an R-Category contract, which is absent in an N-Category contract.

The final settlement price for the 5-year Singapore Government Bond Futures contract is determined through a specific methodology. This involves collecting bid and offer prices for a selected basket of Singapore Government Bonds from Singapore Government Securities Dealers, which are then contributed to the Monetary Authority of Singapore (MAS) on the last trading day. After discarding the highest and lowest outliers, the arithmetic mean of these bid and offer prices is calculated and converted into a yield. A final yield for the entire basket is then derived by applying a weighting, where the benchmark bond’s yield receives a significant portion, and the remaining weight is distributed among other bonds. The final settlement price is then computed from this derived final yield using a specific formula. This process ensures the settlement price reflects a broad market consensus for the underlying bonds rather than a single price point or an internal exchange decision. Options suggesting reliance on only the last traded price, physical delivery, or an internal exchange model are incorrect as they do not align with the specified cash settlement and calculation methodology.

A bear put spread is a strategy implemented by buying a higher striking in-the-money put option and selling a lower striking out-of-the-money put option on the same underlying security 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 occurs when the underlying asset’s price falls below the lower strike price at expiration. In such a scenario, both put options expire in the money. The maximum profit is calculated as the difference between the two strike prices, less the net debit paid to establish the position. In this case, the difference in strike prices is $50 – $45 = $5. The net debit paid was $2. Therefore, the maximum potential profit is $5 – $2 = $3.

The scenario describes a need for an option contract with highly specific, non-standard terms (strike price, expiration date) and a preference for direct counterparty selection to manage default risks. Over-The-Counter (OTC) options are ideal for such situations because they are not traded on an exchange and their terms can be fully customised to suit the precise needs of the parties involved. This directly addresses the requirement for a non-standard strike price and a unique expiration date. Furthermore, OTC options do not involve a clearing house, meaning counterparty risk must be directly managed through the selection of a reputable and financially sound counterparty, aligning with the investor’s priority for direct engagement to mitigate default risks. Exchange-traded options, in contrast, have standardised terms and are settled through a clearing house, which would not meet the customisation requirements.

When a customer fails to meet a margin call by the close of the second market day (T+2) after it was triggered, the Member or Trading Representative is generally prohibited from accepting orders for new trades. However, there is a specific exception: orders that would result in a reduction of the customer’s Required Margins are still permissible. This is typically achieved through ‘risk-reducing trades,’ such as the liquidation of an existing open position, which decreases the overall margin requirement. Risk-increasing trades (which increase Maintenance Margins) and risk-neutral trades (which do not impact Maintenance Margins requirements but are still new positions) are not allowed under these circumstances. The broker also has the discretion to liquidate collateral or offset positions to reduce their exposure, but this is a separate action from accepting new customer orders.

A covered call strategy involves purchasing shares of an underlying stock and simultaneously writing (selling) a call option on the same stock. The investor owns the underlying shares, which ‘covers’ their obligation to deliver the stock if the call option is exercised. This strategy aims to generate income from the option premium while limiting potential downside risk on the stock. The maximum potential gain for a covered call strategy occurs when the stock price at expiration is at or above the strike price of the written call option. In this situation, the investor profits from the stock’s appreciation up to the strike price, in addition to the premium received from selling the call option. The calculation for maximum gain per share is (Strike Price – Initial Stock Price) + Premium Received. Using the given figures: ($48 – $45) + $2.50 = $3 + $2.50 = $5.50. The other options represent either only the premium received, only the stock appreciation up to the strike, or the maximum potential loss for the strategy, which are incorrect interpretations for the maximum gain.

Modified duration is a key measure of a bond’s price sensitivity to changes in interest rates. A higher modified duration indicates that the bond’s price will fluctuate more significantly with a given change in interest rates, thus implying greater interest rate risk. The factors that contribute to an increase in a bond’s modified duration are: 1. Increase in time to maturity: Bonds with longer maturities have more distant cash flows, making their present value more sensitive to changes in the discount rate (interest rates). 2. Fall in coupon rates: Bonds with lower coupon rates pay out less cash flow earlier in their life. This means a larger proportion of their total return comes from the principal repayment at maturity, effectively extending the weighted average time to receive cash flows and increasing interest rate sensitivity. 3. Fall in bond yields: When bond yields fall, the present value of future cash flows increases. This effect is more pronounced for longer-dated cash flows, which again extends the effective duration and increases sensitivity to further yield changes. Therefore, a bond with an extended time to maturity, a reduced coupon rate, and a lower prevailing bond yield will exhibit a higher modified duration, making it more sensitive to interest rate fluctuations.

A Callable Bull/Bear Contract (CBBC) is a structured product with a mandatory call feature. For a Bull CBBC, this means that if the price of the underlying asset falls to or below a pre-determined call price at any point before maturity, a Mandatory Call Event (MCE) is triggered. When an MCE occurs, the CBBC terminates immediately, and trading ceases. This early termination can result in a significant, or even total, loss of the investor’s initial capital, especially for N-CBBCs (No residual value). This characteristic is a critical risk and a key differentiator from traditional warrants, which typically do not have such a mandatory early termination mechanism. The other options describe features or risks that are either incorrect for CBBCs or not the primary mechanism for early termination as described. The issuer does not have discretionary early redemption rights based on market volatility; termination is based on a pre-set barrier. Implied volatility is generally considered insignificant to CBBC pricing, unlike warrants. Lastly, CBBCs typically do not have margin requirements, and the maximum loss is limited to the initial investment amount.

Under Section 25 of the Securities and Futures (Financial and Margin Requirements for Holders of Capital Markets Services Licences) Regulations, a Member (which includes a CMS Licence holder who is also an SGX-ST Member) is required to immediately notify both the Monetary Authority of Singapore (MAS) and SGX if any customer’s account (excluding proprietary accounts) becomes under-margined by an amount that exceeds the Member’s aggregate resources. The scenario explicitly states that the CMS Licence holder is an SGX-ST Member and the under-margined amount surpasses the Member’s aggregate resources, triggering this dual notification requirement. Notifying only MAS would be applicable if the CMS licence holder were not an SGX-ST member. There is no provision for delayed notification or for waiving notification based on customer commitment to rectify the shortfall; the requirement is for immediate action once the specified conditions are met.

Pairs trading is explicitly described as a ‘market-neutral’ strategy. Its fundamental characteristic is to minimize or remove the impact of the overall market direction on the investment outcome. This is achieved by taking both a long and a short position, which are expected to neutralize each other against broad market movements, allowing the investor to profit from the relative performance or convergence of the two assets. It does not eliminate all risks; for instance, the anomaly between the underlying shares might persist, or the market could move against both legs of the trade. As CFDs are leveraged products, losses can indeed exceed the initial margin. Furthermore, taking two distinct positions (long and short) in a pairs trade inherently involves double commissions and finance charges, not minimized costs.

The Interest Rate Parity (IRP) theory establishes a relationship between the spot exchange rate, forward exchange rate, and the interest rates of two currencies. The formula to calculate the forward rate (F) is: F = S x (1 + Rc(n/360)) / (1 + Rb(n/360)). In this formula, S represents the current spot exchange rate, Rc is the annualized interest rate of the counter currency (in this case, the US Dollar), Rb is the annualized interest rate of the base currency (Singapore Dollar), and n is the number of days for the forward contract. Given the spot rate (S) of USD/SGD 1.3500, the US interest rate (Rc) of 3.00% (or 0.03), the Singapore interest rate (Rb) of 2.00% (or 0.02), and a period (n) of 90 days, we substitute these values into the formula. First, calculate the daily interest factors: (90/360) = 0.25. Then, for the numerator: (1 + 0.03 0.25) = (1 + 0.0075) = 1.0075. For the denominator: (1 + 0.02 0.25) = (1 + 0.0050) = 1.0050. Finally, F = 1.3500 x (1.0075 / 1.0050) = 1.3500 x 1.002487562. This calculation yields approximately 1.353358. When rounded to four decimal places, the theoretical 90-day forward rate is 1.3534. Other options represent common misapplications of the formula, such as swapping the interest rates in the numerator and denominator, or incorrectly applying the time factor to the interest rates.

CFDs are leveraged investments, and providers charge interest for the financing extended to the investor. This interest is typically calculated daily based on a floating market benchmark rate, such as LIBOR, plus a spread. Therefore, if the underlying market interest rates rise, the financing cost for the CFD position will also increase. This higher cost directly impacts the investor’s total holding cost, reducing the eventual net returns from the investment. The financing costs are not fixed at inception, nor are they typically absorbed by the provider in such scenarios; they are passed on to the investor.

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 held for different customers by a Member firm do not offset each other in the calculation of the Member’s overall margin requirement. Therefore, if a Member firm has 750 long contracts for one client and 500 short contracts for another client, the CDP will sum these positions to determine the total open positions for which the Member must provide margin. The margin will be calculated for all 1250 contracts, treating each client’s position independently from the perspective of the Member’s total obligation to CDP.

The scenario describes a mechanism that temporarily suspends trading when price movements exceed predefined thresholds to allow market participants to absorb information and restore order. This precisely matches the definition and function of ‘Circuit Breakers’ as a market disruption mitigation measure. Circuit breakers are designed to trigger trading halts in cash and derivative markets. ‘Shock Absorbers’ slow down trading during significant volatility but do not halt it completely. ‘Daily Price Limits’ impose limits on price volatility without slowing or halting trading activity. Counterparty risk management relates to the risk that a party to a contract will not fulfill its obligations, which is a different type of risk altogether and not a market disruption mitigation measure for price volatility.

The Interest Rate Parity (IRP) theory posits that the forward premium or discount between two currencies should equate to the difference in their domestic interest rates for securities of the same maturity, excluding minor transaction costs. If this relationship is violated, it creates an opportunity for arbitrageurs to execute risk-free trades. These arbitrage activities, driven by the pursuit of profit from the discrepancy, would increase demand for one currency and supply of another in the spot and forward markets. This market action would then naturally push the spot and futures exchange rates back into alignment with the interest rate differential, thereby eliminating the arbitrage opportunity. Therefore, arbitrageurs’ actions are the mechanism by which the market corrects an IRP violation. Other options do not accurately describe the direct market response to an IRP violation.

For a First-to-Default Credit Linked Note (CLN), the yield to note holders is influenced by the number of companies in the basket, their creditworthiness, and the correlation among them. When the correlation between the companies in the basket is lower, it implies that their default events are more independent. This effectively increases the number of distinct risk factors that could trigger a ‘first default’ event within the basket. Consequently, the probability of any company defaulting first increases, leading to a higher overall risk for the note holder. To compensate for this elevated risk, note holders would require a higher yield. Conversely, if the companies were perfectly correlated, the risk would be akin to a single company defaulting, as they would all likely default together or not at all. Therefore, lower correlation necessitates a higher yield.

The question pertains to the advantages of using financial futures in portfolio management, specifically for asset allocation and rebalancing, as discussed in CMFAS Module 6A. The provided text explicitly states that ‘Brokerage costs for futures transactions are cheaper’ as one of the reasons why using futures to allocate assets can be more effective and less costly. This directly supports the first option. The second option is incorrect because futures contracts do not inherently provide a guaranteed profit margin; they are subject to market price fluctuations and carry risk. The third option, while mentioning a potential use of futures (‘delay loss realisation’), is qualified in the text by ‘In certain countries, where the accounting system permits’ and is not presented as the primary or universal benefit for enhancing efficiency and cost-effectiveness of rebalancing. Furthermore, it’s not about indefinitely deferring losses. The fourth option is incorrect; futures markets can be highly volatile, and while the text mentions ‘less impact on the market since the futures market is more liquid,’ this refers to market depth and ease of execution, not necessarily lower price volatility.

The provided text on ‘Managing the Hedge’ explicitly states that ‘Normally the main sources of error are due to the projected value of the basis at the lift date and the parameters estimated for cross hedges.’ Basis refers to the difference between the spot price of an asset and the futures price of the same asset. When a hedge is implemented, the expectation is that the basis will behave in a certain way. If the actual basis at the time the hedge is lifted (closed out) deviates significantly from this projection, it can lead to an imperfect hedge and residual exposure or gain/loss. Therefore, the divergence between the anticipated basis and the actual basis is a primary factor contributing to hedging errors. Unexpected shifts in correlation (Option 2) are indeed a concern, particularly in cross-hedges, as mentioned in the text under ‘parameters estimated for cross hedges,’ making it a strong distractor. However, basis risk is a more general and fundamental source of error in many types of futures hedges. Transaction costs (Option 3) reduce the net profit but are not typically considered a ‘source of error’ in the hedge’s effectiveness in offsetting risk. Inaccurate initial calculation (Option 4) is a potential issue, but the question implies careful initial structuring, and the text specifically points to basis and cross-hedge parameters as main sources of error after the hedge is lifted.

The scenario describes a fund manager protecting an existing fixed-income portfolio over a predefined investment horizon with the objective of 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, thereby protecting the portfolio’s total return against interest rate fluctuations. The other options are incorrect because: a weak form cash hedge is for an indefinite holding period and aims to minimize price variance of an existing asset, not necessarily total return over a specific horizon; a strong form anticipated hedge is used when a known amount of cash will be received at a certain date to acquire securities, not for an already held portfolio; and a weak form anticipated hedge is for cashflows to be received at an unknown date, again for an anticipated position, not an existing one.