CMFAS RES6A Quiz 73

When market interest rates are expected to increase, bond prices typically fall due to the inverse relationship between interest rates and bond prices. To profit from falling bond prices or to hedge an existing bond portfolio against such a decline, an investor would purchase a bond put option. A bond put option gives the buyer the right, but not the obligation, to sell a bond at a predetermined strike price. If bond prices fall below this strike price due to rising interest rates, the put option becomes profitable. Purchasing an option limits the buyer’s maximum loss to the premium paid for the option. Conversely, purchasing a bond call option would be appropriate if interest rates were expected to fall, leading to an increase in bond prices. Selling options, whether calls or puts, exposes the seller to potentially unlimited losses, which contradicts the objective of strictly limiting maximum potential loss to the premium paid. An interest rate put option benefits from falling interest rates, as demonstrated by the SIBOR example where the investor exercises if the prevailing rate is lower than the strike.

The strategy described involves short selling a stock and simultaneously purchasing a call option, which is a common method to hedge a short position against unexpected upward price movements. The investor anticipates a price decline but wants to limit potential losses if the stock price rises instead. The overall profit or loss for this hedged position is calculated by combining the profit/loss from the short stock and the profit/loss from the long call option. The profit from the short stock position is (Short Sale Price – Stock Price at Expiration) or (S0 – ST). The profit from the long call option is (Maximum of 0 or (Stock Price at Expiration – Strike Price)) – Call Premium, or (Max(0, ST – X) – c0). Therefore, the total profit = (S0 – ST) + (Max(0, ST – X) – c0). To determine the maximum potential loss, we consider the scenario where the stock price (ST) rises significantly above the call option’s strike price (X). In this situation, the call option will be exercised, and its value will help to cap the losses from the short stock position. When ST > X, the total profit formula simplifies to: Total Profit = (S0 – ST) + (ST – X – c0) Total Profit = S0 – X – c0 Using the given values: Short Sale Price (S0) = $50 Call Strike Price (X) = $52 Call Premium (c0) = $3 Maximum Loss (which is a negative profit) = $50 – $52 – $3 = -$5.00. Thus, the maximum potential loss per share the investor could incur is $5.00. This loss occurs because the stock price has risen above the strike price, but the long call limits the loss to the difference between the short sale price and the strike price, plus the premium paid.

The fund trustee’s main role is to act in a fiduciary capacity, safeguarding the interests of the unit holders. This includes ensuring that the fund manager operates strictly in accordance with the investment objectives and restrictions stipulated in the trust deed and prospectus. If the fund manager deviates from these parameters, even if the investments are profitable, the trustee’s primary responsibility is to ensure that the fund manager rectifies the investment strategy to comply with the established mandate. Furthermore, a crucial aspect of their oversight is the obligation to inform the Monetary Authority of Singapore (MAS) within three business days if they become aware of any material breaches. Option 2 is incorrect because the trustee’s role is not to retrospectively approve deviations or amend legal documents based on performance; their role is to ensure adherence to the existing mandate. Option 3 is incorrect as the trustee holds legal ownership of the assets but does not directly manage the fund’s investment portfolio; that is the fund manager’s responsibility. Option 4 is incorrect because while rectification is necessary, immediate liquidation of assets without considering market conditions or a structured approach might not always be in the best interest of the unit holders and is not the primary, immediate action for the trustee.

The scenario describes an Exchange Traded Fund (ETF) that uses futures contracts to gain exposure to a commodity index and experiences a consistent divergence from its underlying index. One significant source of tracking error for ETFs that invest in futures contracts is rollover risk. Futures contracts have expiry dates, requiring the ETF to continuously sell expiring contracts and buy new ones. If the price of the next contract (further out in time) is higher than the expiring one, a situation known as contango, the ETF incurs losses during this rollover process. Conversely, if the price of the next contract is lower (backwardation), gains are recorded. These gains and losses from rolling contracts directly affect the ETF’s performance and can cause a persistent deviation from the spot price or a theoretical index that doesn’t account for these costs, thus increasing tracking error. The other options describe general characteristics or other potential issues but are not the most direct or specific cause of persistent divergence in an ETF primarily using futures contracts for commodity exposure. While NAV can differ from market price, and TER contributes to tracking error, and illiquid underlying assets can widen bid-ask spreads, the specific mechanism of futures contracts introduces rollover risk as a distinct and often significant source of tracking error.

The structured fund has an investment objective of capital preservation, meaning the initial investment capital is payable to the investor, along with an attractive yield. When a mandatory call event is triggered before maturity, the investor receives their initial investment plus an accumulated periodic yield. In this scenario, the initial investment is SGD 100,000. The fund is called on the first early redemption observation date, which means one observation period has passed. The Periodic Yield is stated as 4.25%. Therefore, the total payout received by the investor would be the initial investment plus the yield for one period: SGD 100,000 + (SGD 100,000 4.25% 1) = SGD 100,000 + SGD 4,250 = SGD 104,250. The option of SGD 100,000 represents only the principal, without any yield. SGD 4,250 represents only the yield component, not the total payout including principal. SGD 125,500 is the payout percentage if the product reaches maturity and the Nikkei 225 outperforms the S&P 500, not for an early redemption.

For a Bull Knock-Out Certificate, a mandatory call event is triggered when the underlying asset’s spot price falls to or below the specified Call Price (knock-out barrier). When this occurs, the certificate is terminated, and the residual value is calculated based on the settlement price at the time of the event. The formula for the residual value of a Bull Knock-Out Certificate is (Settlement Price – Strike Price) / Conversion Ratio. In this scenario, the spot price of ABC Ltd shares falls to $27.50, which becomes the settlement price. The Strike Price is $25.00, and the Conversion Ratio is 5:1. Therefore, the residual value is calculated as ($27.50 – $25.00) / 5 = $2.50 / 5 = $0.50. Other options might result from incorrectly using the Call Price as the settlement price, or from miscalculating the difference, or from applying an incorrect conversion ratio.

The ‘roll position’ strategy is employed by longer-term traders who wish to maintain their market exposure beyond the expiration of their current futures contract. This involves simultaneously closing the expiring contract and opening an equivalent position in a new contract month for the same underlying asset. In this scenario, the investor is long the June Nikkei 225 futures and wants to extend this exposure. Therefore, they would sell their June contracts to offset the expiring position and simultaneously buy September contracts to establish a new long position, effectively rolling their exposure forward. Allowing the contract to expire without action would lead to cash settlement, closing the position. Liquidating and re-entering later does not maintain continuous exposure. Requesting the clearing house to defer settlement is not a valid action for an investor to roll a position; the investor must execute the trades.

The premium of a structured warrant is defined as the difference between the warrant’s market price and its intrinsic value. This premium largely represents the time value of the warrant. Time value is the portion of a warrant’s price that is attributed to the remaining time until its expiry and the expected volatility of the underlying asset. It reflects the potential for the warrant to increase in intrinsic value before it expires. The total cost an investor pays for the warrant is its market price, which comprises both its intrinsic value and its premium (time value). The intrinsic value for a call warrant is the positive difference between the underlying asset’s market price and the warrant’s exercise price. The breakeven price, which indicates profitability, is a different calculation involving the exercise price and the warrant’s cost.

The question tests the understanding of synthetic positions, specifically how to create a synthetic long stock using options, as outlined in the CMFAS Module 6A syllabus. A synthetic long stock aims to replicate the risk-reward profile of directly owning the underlying share. This is achieved by combining a long call option and a short put option on the same underlying asset, with identical strike prices and expiration dates. This strategy provides unlimited profit potential if the underlying asset’s price rises and unlimited loss potential if it falls, mirroring the characteristics of holding the stock itself. The other options represent different option strategies: selling a call and buying a put creates a synthetic short stock; buying both a call and a put creates a long straddle or strangle, which profits from high volatility; and selling both a call and a put creates a short straddle or strangle, which profits from low volatility.

An Equity Linked Note (ELN) with a physical settlement option is often chosen by investors who have a long-term bullish view on an underlying share but believe its current market price is too high. By purchasing an ELN at a discount (e.g., 90% of notional), they effectively sell a put option. If, at maturity, the underlying share price falls below the strike price, the put option is exercised, and the investor receives the underlying shares instead of cash. The key benefit in this scenario is that the investor acquires the shares at an effective price per share (calculated by dividing their initial investment in the ELN by the number of shares received) that is lower than the market price at the time they initially bought the ELN, and potentially even lower than the strike price. This aligns with their strategy of acquiring the shares at a more favourable entry point. Option 2 is incorrect because it describes a cash settlement or a best-case scenario for physical settlement where the price is above the strike. Option 3 is incorrect as ELNs do not offer guaranteed fixed coupon payments; their returns are linked to the underlying asset’s performance and carry downside risk. Option 4 is incorrect because if the share price is below the strike at maturity, selling the received shares immediately would be at the lower prevailing market price, not the higher strike price, and would likely result in a loss compared to the notional value.

The question tests understanding of the specific settlement basis for the 3-month Singapore Dollar Interest Rate Futures contract, as detailed in the CMFAS Module 6A syllabus. According to the provided specifications, the Final Settlement Price for this contract is explicitly stated to be ‘Based on the Association of Banks in Singapore’s USD/SGD Swap Offered Rates determined at 11.00 am, Singapore time, on the last trading day.’ The other options present plausible but incorrect methods or rates for settlement, designed to challenge the candidate’s precise knowledge of this particular futures contract’s specifications. Understanding these specific details is crucial for participants in the Singapore financial markets.

A standard stop-loss order is designed to limit potential losses by triggering a market order when a specified price is reached. However, it does not guarantee execution at that exact price. In highly volatile markets or during significant price gaps (slippage), the order will be triggered at the stop price but will be executed at the next available market price. If the market opens significantly below the stop-loss price, as in this scenario, the order will be filled at the first available price, which is $45.00 or lower. A ‘guaranteed stop-loss’ service, which usually incurs an additional premium, would ensure execution at the specified stop price, but this scenario explicitly mentions a ‘standard stop-loss order’. Therefore, the order will be triggered and executed at the prevailing market price after the gap.

The question focuses on the mechanisms issuers use to provide assurance to investors regarding the diligent management of structured products. According to the CMFAS 6A syllabus, a common feature of issuer oversight is the appointment of an independent trustee. This trustee is responsible for holding the assets and underlying financial instruments associated with the structured product, thereby providing an independent layer of assurance to investors. While other options touch upon aspects related to structured products or investor protection, they do not directly represent a primary mechanism of issuer oversight for product management as described in the syllabus. Mandating advice for retail investors is a sales restriction, not an issuer’s product management oversight. A full capital guarantee is a product feature, not a general oversight mechanism. Relying solely on internal compliance, while important, does not provide the independent assurance highlighted in the context of issuer oversight.

A Market-if-Touched (MIT) sell order is specifically designed for situations where a trader wants to sell a contract if its price rises to or above a specified trigger price, which is above the current market price. Once this trigger price is touched, the order is converted into a market order and executed. This aligns with the scenario where the trader wants to initiate a short position only if the price reaches a level above the current market. A Stop sell order, conversely, is typically placed below the current market price to limit losses on a long position or to initiate a short position if the price falls to a certain level. A sell limit order is used to sell at a specified price or higher, but it does not convert to a market order upon touching a trigger; it simply waits for the market to reach that price or better. A Session State Order (SSO) triggers based on market session transitions, not specific price levels relative to the current market, making it unsuitable for this price-based strategy.

Structured warrants listed on the SGX-ST are characterized by their settlement and expiry mechanisms. They are exclusively cash settled, meaning that upon exercise, the holder receives a cash payment equivalent to the intrinsic value, rather than physical delivery of the underlying asset. Furthermore, these warrants employ an ‘Asian style’ of expiry settlement, which dictates that the last day an investor can trade the warrant on the exchange is different from its actual expiry date. Typically, the last trading day occurs before the expiry date, allowing for a period for final settlement calculations. Therefore, the statement indicating cash settlement and Asian-style expiry where the last trading day precedes the expiry date is accurate. Other options incorrectly suggest physical settlement, identical last trading and expiry dates, or European-style expiry, which do not align with the characteristics of structured warrants on SGX-ST.

A structured note is fundamentally a debt instrument that incorporates one or more derivative components. Its return characteristics, such as coupon payments or principal repayment, are directly linked to the performance of an underlying asset or a basket of assets. Unlike traditional bonds, the principal repayment for structured notes is often not guaranteed, exposing investors to potential capital loss. The note holder typically does not have direct claim over the underlying instruments. This combination of debt and derivatives allows for customized risk-return profiles but also introduces complexities and risks beyond those of a plain vanilla bond.

Tracking error refers to the disparity in performance between an ETF and its underlying index. This can arise from several factors, including the impact of transaction fees and expenses incurred by the ETF, changes in the composition of the underlying index, index replication costs, cash drag, and the manager’s replication strategy. Therefore, the ETF’s internal transaction costs and operational expenses directly contribute to this underperformance relative to its benchmark. A significant increase in overall market volatility (Option 2) can make tracking more challenging and potentially increase the magnitude of tracking error, but it is not the root cause of the disparity itself; the ETF is designed to track a volatile index. The designated market-maker failing to provide continuous bid and offer prices (Option 3) relates to liquidity risk, affecting an investor’s ability to trade the ETF, but not directly causing its performance to diverge from the benchmark. An ETF’s shares trading at a persistent premium to its Net Asset Value (NAV) (Option 4) is a pricing discrepancy between the market price and the intrinsic value of the underlying assets, which arbitrageurs typically correct. A premium would imply the ETF is trading above its NAV, not necessarily underperforming its benchmark due to internal operational factors.

A bear put spread is a vertical options strategy designed for investors who anticipate a moderate decline in the underlying asset’s price. It involves simultaneously purchasing a put option with a higher strike price (typically in-the-money) and selling a put option with a lower strike price (typically out-of-the-money), both for the same underlying security and expiration date. This combination results in a net debit position, meaning the investor pays a premium upfront. The strategy limits both the potential profit (to the difference in strike prices minus the net debit) and the potential loss (to the net debit paid). The other options describe different strategies: selling a higher strike put and buying a lower strike put would be an inverse of a bear put spread or part of a bull put spread. Purchasing a call option with a higher strike and selling a call option with a lower strike describes a bear call spread. Selling a call option with a higher strike and purchasing a call option with a lower strike describes a bull call spread.

The provided text clearly distinguishes between ‘principal preservation’ and ‘principal guarantee’ in structured products. Principal preservation typically involves investing a portion of the product’s capital in fixed income securities (like zero-coupon bonds) with the expectation that they will mature at the initial investment amount. However, this is not a full guarantee, as the underlying fixed income security may default, impacting the principal. In contrast, a principal guarantee is described as a form of investment insurance, often backed by collateral, which explicitly guarantees the investor’s initial investment. The text states that ‘The cost of the principal guarantee feature… is priced into the structured product’ and that ‘For the same principal amount, a product with a guarantee feature will cost more than a product with a principal preservation feature.’ Therefore, a principal guarantee offers a higher degree of certainty for principal return but comes at a higher cost.

The CMFAS Module 6A syllabus, specifically Chapter 4 on Options, details the concept of synthetic positions derived from the put-call parity theory. A synthetic long stock position is designed to replicate the risk and payoff profile of directly owning the underlying asset. According to the principle, this is achieved by combining a long call option with a short put option, provided both options share the same strike price and expiration date. This combination effectively simulates the unlimited profit potential and downside risk associated with holding the actual shares. The other options represent different strategies: selling a call and buying a put creates a synthetic short stock position; buying both a call and a put creates a long straddle, which benefits from significant price movement in either direction; and selling both a call and a put creates a short straddle, which profits from low volatility and stable prices.

The investor’s objective is to profit from a substantial price fluctuation in either direction, without a specific directional bias, while limiting potential losses to the initial premium paid. This market outlook, characterized by high expected volatility but no clear direction, is best addressed by a neutral strategy designed to profit from large moves. A long straddle involves simultaneously buying an at-the-money (ATM) call option and an at-the-money (ATM) put option with the same underlying asset, strike price, and expiration date. This strategy profits if the underlying asset’s price moves significantly up or down from the strike price, exceeding the total premium paid for both options. The maximum loss is limited to the total premiums paid. Option 2 describes a short strangle, which involves simultaneously selling out-of-the-money (OTM) call and put options. This strategy profits when the underlying asset’s price remains within a narrow range (low volatility) and the options expire worthless, which is contrary to the investor’s expectation of substantial price fluctuation. Option 3 describes a bull call spread, which is a directional strategy used when an investor expects a moderate upward movement in the underlying asset’s price. It involves buying a call with a lower strike and selling a call with a higher strike, both with the same expiration. This does not align with a non-directional outlook. Option 4 describes a collar, which is a hedging strategy typically used to protect gains in a long stock position while generating some income. It involves buying a protective put and writing an out-of-the-money covered call. While it limits downside risk, it also caps potential upside gains and is not designed to profit from large, non-directional price movements.

Arbitrage between an Interest Rate Swap (IRS) and a strip of futures contracts aims to profit from temporary discrepancies in pricing. If the fixed rate offered by an IRS in the market is notably lower than the average fixed rate implied by a strip of futures contracts, it suggests that the IRS is relatively ‘cheap’ compared to the futures. To capitalize on this, an arbitrageur would simultaneously take opposing positions in the two instruments to lock in a risk-free profit. Specifically, they would enter the IRS as a fixed-rate receiver (effectively ‘buying’ the fixed rate that is undervalued) and simultaneously sell the strip of Eurodollar futures contracts (effectively ‘selling’ the implied fixed rate that is overvalued). This combination allows the arbitrageur to profit from the spread between the two rates. The other options involve either taking the opposite, loss-making positions, or engaging in speculative strategies rather than pure arbitrage.

The question tests the understanding of how the ‘Payout Price’ is calculated for an early redemption in the described structured fund. According to the product terms, the fund is call protected for the initial 1-year period. The first early redemption observation date is after 1 year, and thereafter, it occurs every 6 months. The ‘Payout Price’ is determined by the formula: Periodic Yield x No. of Observations. Given the Initial Date is 16 March 2014: – The first early redemption observation date would be 15 March 2015 (after 1 year). At this point, the ‘No. of Observations’ would be 1. – The second early redemption observation date would be 15 September 2015 (after 1 year and 6 months, or 1.5 years). At this point, the ‘No. of Observations’ would be 2. If the Mandatory Call Event occurs on the second early redemption observation date, the ‘No. of Observations’ is 2. The Periodic Yield is given as 4.25%. Therefore, the Payout Price = 4.25% x 2 = 8.50%. This means the investor would receive their initial investment plus an additional 8.50% of the initial investment.

A Bond-Linked Note (BLN) is a structured product that embeds a short put option on a bond. Consequently, its payout is directly tied to the market price of that underlying bond. The price of a bond can be influenced by various factors beyond a credit event, such as changes in interest rates, credit downgrades, or widening credit spreads. This means that an investor in a BLN faces market price risk and could end up owning the bond even if no credit event occurs. In contrast, a Credit-Linked Note (CLN) sells a Credit Default Swap (CDS) on a reference entity, and its payout is primarily dependent on the occurrence of a credit event for that specific entity. Therefore, the scenario describing a payout contingent on bond price movement and the possibility of acquiring the bond without a credit event points to a BLN, with widening credit spreads being a key additional factor affecting bond prices.

When an investor implements a long hedge using Extended Settlement (ES) contracts, they are taking a long position in the ES contracts to protect against a potential rise in the price of the underlying shares they intend to purchase later. If the underlying share price does indeed increase, the value of the ES contracts also rises, resulting in a gain for the investor from their ES position. This gain effectively offsets the higher cost the investor would incur when purchasing the physical shares at the elevated market price, thereby locking in a more favorable effective purchase price. The investor still pays brokerage and clearing fees for the ES contract, and the ES contract’s primary purpose in this context is price protection, not avoiding transaction costs or forcing delivery at an outdated price if the investor chooses to close the ES position and buy spot.

An increase in expected dividends generally leads to a reduction in the underlying share price when the stock goes ex-dividend. For call options, a decrease in the underlying share price makes the option less valuable, causing its premium to fall. Conversely, for put options, a decrease in the underlying share price makes the option more valuable, causing its premium to rise. Therefore, higher expected dividends negatively impact call option values and positively impact put option values, assuming all other factors are constant.

The scenario describes a situation where an Exchange Traded Fund’s (ETF) returns consistently deviate from its benchmark index’s performance, especially during volatile periods. This phenomenon is precisely what ‘tracking error’ refers to. Tracking error is the disparity in performance between an ETF and its underlying index. It can be caused by various factors such as transaction fees, expenses, changes in index composition, index replication costs, cash drag, and the ETF manager’s replication strategy. While other options like NAV trading at a premium, counterparty risk, or foreign exchange risk are valid risks associated with ETFs, they do not directly describe the observed consistent divergence of the ETF’s performance from its benchmark index.

For Extended Settlement (ES) contracts, the permissible trading activities are strictly regulated based on the timing of margin receipt. If a customer indicates to their Trading Representative that the required margins will be provided within the T+2 period, then all types of trading activities – risk-increasing, risk-neutral, and risk-reducing – are generally allowed. However, if the customer indicates that the margins will be forthcoming only after the T+2 period, or if there is no indication of funds being provided, then only risk-reducing activities are permitted. This same restriction applies to any trading activity conducted beyond the T+2 period. Risk-reducing activities are those that serve to decrease the overall exposure or potential loss associated with the existing ES position, such as partially or fully closing out an open contract.

A structured product employing a Zero Coupon Fixed Income Plus Option strategy is designed to offer both capital preservation and potential for upside returns. This is achieved by combining two main components. A significant portion of the investment is allocated to a zero-coupon fixed income instrument, typically a zero-coupon note. This component is intended to mature at the initial principal amount, thereby ensuring the return of the investor’s capital, provided there is no credit event with the issuing bank. The remaining portion of the investment is used to purchase a call option on an underlying financial instrument (such as an equity security, index, or commodity). This call option provides the potential for upside returns if the underlying asset’s price performs favorably above a predetermined strike price. The investor’s return from this option component is determined by the performance of the underlying asset, the strike price, and the participation rate. Therefore, the strategy effectively separates the capital preservation aspect (via the zero-coupon bond) from the growth potential (via the call option).

The scenario describes a trader taking positions in two different commodities (Wheat and Corn), which makes it an inter-commodity spread. The trades are executed on two different exchanges (CBOT and KCBOT), classifying it as an inter-market spread. Furthermore, the contracts have different delivery months (September and December), indicating an inter-delivery spread. Therefore, the strategy encompasses all three characteristics: inter-commodity, inter-market, and inter-delivery.