CMFAS RES6A Quiz 81

The question assesses understanding of the practical advantages of using futures contracts in portfolio management, particularly for asset allocation adjustments. 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 makes the first option the correct answer. The second option is incorrect because while futures can be used to manage positions, they do not inherently simplify tax reporting or guarantee immediate realization of gains/losses in a way that is a primary benefit for efficient rebalancing. The third option is an overstatement; while the futures market is generally more liquid and can result in ‘less impact on the market’ compared to direct cash market transactions for large trades, it does not ‘eliminate all market impact’. The fourth option is incorrect because futures contracts are derivatives whose value fluctuates with the underlying asset; they do not provide a guaranteed fixed return and can introduce volatility, although they can be used as part of strategies to manage overall portfolio risk.

In a Capital Protection Principal Investment (CPPI) strategy, the allocation to the risky asset is dynamically adjusted based on the ‘cushion’ available. The cushion is calculated as the difference between the current portfolio value and the floor value. The formula for the target allocation to the risky asset is: Risky Asset Allocation = Multiplier × (Current Portfolio Value – Floor). Given the parameters: Initial Portfolio Value = $100 Floor = $80 Multiplier = 4 Current Portfolio Value = $105 First, calculate the cushion: Cushion = Current Portfolio Value – Floor = $105 – $80 = $25. Next, calculate the target risky asset allocation: Risky Asset Allocation = Multiplier × Cushion = 4 × $25 = $100. Therefore, the target allocation to the risky asset would be $100. This means the manager would rebalance the portfolio to ensure $100 is invested in the risky asset, with the remainder in the risk-free asset (or cash). The other options represent either the floor value, the current portfolio value, or a miscalculation of the cushion or multiplier application.

The question asks for a key benefit of using futures contracts for asset allocation adjustments. Option 1 correctly identifies two significant advantages: lower brokerage costs and a reduced initial capital commitment due to the margining system. The provided text explicitly states that ‘Brokerage costs for futures transactions are cheaper’ and ‘With margining, the cash outlay is smaller,’ making futures an effective and less costly tool for rebalancing. Option 2 is incorrect because futures, while useful for hedging and managing risk, do not completely eliminate all market risk exposure. Investment in any financial instrument carries inherent market risk. Option 3 is incorrect for several reasons. While the text mentions that futures can be used to ‘delay loss realisation’ in ‘certain countries, where the accounting system permits,’ this is not described as the primary advantage for efficient asset allocation adjustments. Furthermore, the claim of ‘indefinitely defer’ and ‘regardless of jurisdiction’ is an overstatement and not universally applicable. Option 4 is incorrect. The text states that using futures leads to ‘less impact on the market since the futures market is more liquid.’ Therefore, futures markets are generally more liquid for large transactions, not less, which helps to minimize market impact, contrary to what this option suggests.

The daily mark-to-market (MTM) process for Extended Settlement (ES) contracts is a critical risk management mechanism. Its primary objective, as stated in the syllabus, is to limit the exposure of the Central Depository (CDP) to potential losses arising from price changes in open ES contract positions. By revaluing these positions daily, CDP aims to prevent the accumulation of significant unrealized losses that could otherwise materialize at the contract’s maturity, thereby safeguarding the integrity of the clearing system. While other activities like determining margin requirements or facilitating market opportunities are related to ES contracts, they are not the core purpose of the daily MTM process itself. Initial margins are collected for new positions, and arbitrage is a market strategy, distinct from the daily risk management function of MTM.

Exchange-Traded Notes (ETNs) are debt instruments issued by banks, and their performance is linked to an underlying market benchmark or strategy. A key characteristic is that they are backed by the creditworthiness of the issuer, and there is generally no regulatory requirement for an independent trustee, although some may choose to have one. In contrast, Exchange-Traded Funds (ETFs) are investment funds that hold a proportional stake in the financial products they track, offering instant diversification. As investment funds, ETFs are subject to regulations that typically require them to have an independent trustee to safeguard investor interests. Therefore, the statement accurately distinguishing their fundamental nature and regulatory requirement for a trustee is that an ETN is a debt instrument without a mandatory trustee, while an ETF is an investment fund that must have an independent trustee. The other options incorrectly describe the fundamental nature of one or both products or misstate the regulatory requirements for a trustee.

The scenario describes a situation where a financial advisory firm experiences issues with its internal systems (software glitch) and human factors (new staff member’s unfamiliarity with procedures), leading to a failure in business operations (delayed client instructions). This aligns directly with the definition of operational risk, which encompasses risks arising from the failure of internal processes, people, and systems. Liquidity risk, in the context of the provided material, refers to the difficulty in offsetting a futures position or the drying up of market liquidity for financial instruments. It is not related to internal system or staff failures. Issuer risk is a component of counterparty risk, specifically the risk that the issuer of a financial product may be unable to fulfill its obligations due to bankruptcy or lack of liquidity. This is distinct from the operational failures of an advisory firm. Leverage risk is associated with futures contracts, where a small price movement can lead to significant profits or losses due to the high degree of leverage. This is a market-related risk specific to leveraged products, not an internal operational breakdown.

Interest rate options are distinct from bond options primarily because their underlying asset is an interest rate itself, not a bond. A key characteristic highlighted in the CMFAS Module 6A syllabus is that interest rate options are cash-settled. This means that upon exercise, the underlying securities (bonds) do not need to be delivered. Instead, the difference between the exercise interest rate and the prevailing market interest rate is settled in cash. This mechanism inherently limits the buyer’s risk to the premium paid and ensures there is no risk of losing the principal value of a debt instrument, as the investor never takes ownership of the underlying bond. Bond call or put options, conversely, grant the right to buy or sell the actual bond, meaning an investor would be exposed to the bond’s principal value if the option is exercised, even if the primary intent is to speculate on interest rate movements. Options on futures involve futures contracts as their underlying, which is a different instrument altogether.

Interest rate options are specifically designed to address the criteria outlined in the question. The provided text states that ‘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 directly matches the requirement for direct cash settlement based purely on interest rate differentials, without physical delivery. In contrast, bond options give the buyer the right to buy or sell a bond, meaning they involve the underlying bond itself and its price, and are typically OTC-traded with more complex pricing. Currency options are used to hedge foreign exchange risk, not interest rate risk. Options on futures provide a position in a futures contract, which, while potentially cash-settled, does not directly focus on interest rate differentials in the same manner as a dedicated interest rate option.

The question assesses understanding of the four main components of a structured fund as outlined in the CMFAS Module 6A syllabus. The client’s preferences directly articulate three of these components. The desire for ‘exposure to global renewable energy trends’ clearly defines the ‘Choice of the Underlying Asset’. The request for ‘a fixed income stream for the first two years’ directly specifies a part of the ‘Degree of Payout Schedule’ (fixed coupons). Furthermore, ‘a total investment period of five years’ explicitly states the ‘Choice of Maturity’. However, while the client’s desire for ‘capital preservation alongside potential for significant growth’ implies a certain market outlook or strategy, they do not explicitly articulate their ‘Anticipated View on Market Scenarios’ in terms of being bullish, bearish, or market-neutral. Instead, they state desired outcomes. The fund designer would then select or construct a fund based on these outcomes, which would inherently incorporate a specific market scenario view. Therefore, this component is the least directly articulated by the client’s explicit preferences.

In a Capital Protected Portfolio Insurance (CPPI) strategy, the allocation to the risky asset is determined by multiplying a fixed multiplier by the cushion. The cushion is the difference between the current portfolio value and the floor value. When the portfolio’s total value increases, the cushion expands. To maintain the target allocation to the risky asset, which is a function of this expanded cushion, the portfolio manager must increase their exposure to the risky asset. This is typically achieved by selling a portion of the risk-free assets and investing the proceeds into the risky asset. Selling risky assets and buying risk-free assets would be the action taken if the portfolio value decreased and the cushion contracted. Increasing the floor value is not a standard rebalancing action based on portfolio performance; the floor is usually a predefined constant or adjusted by a specific, separate rule. Reducing the multiplier is a strategic decision that changes the risk profile of the CPPI strategy, not a periodic rebalancing action in response to portfolio value fluctuations.

Tracking error refers to the disparity in performance between an ETF and its underlying index. The provided syllabus explicitly lists several factors that can cause tracking errors. These include the impact of transaction fees and expenses incurred by the ETF, changes in the composition of the underlying index, index replication costs resulting from liquidity and ownership restrictions on the underlying assets, cash drag, and the structured ETF manager’s replication strategy. Therefore, the costs associated with replicating the underlying index, including those due to liquidity and ownership restrictions, are a direct contributor to tracking error. The other options describe distinct risks associated with ETFs: foreign exchange risk, NAV trading at a discount or premium, and counterparty risk, which are separate from the specific definition and causes of tracking error.

The treasurer’s objective is to lock in a current higher deposit yield because they anticipate interest rates will decline before the funds are available for investment. Eurodollar futures contracts are priced at 100 minus the implied 3-month LIBOR rate. Therefore, if interest rates are expected to fall, the price of Eurodollar futures contracts is expected to rise. To profit from this anticipated rise in futures prices and offset the lower interest earned on the actual deposit, the treasurer should buy Eurodollar futures contracts. This strategy creates a profit from the futures position that compensates for the reduced interest income from the cash market deposit, effectively hedging the interest rate risk and locking in a yield closer to the current market rate. Selling Eurodollar futures would be the appropriate strategy if the expectation was for interest rates to rise, or if hedging a floating-rate borrowing cost against rising rates. While Forward Rate Agreements (FRAs) are also used for interest rate hedging, the question specifically asks about Eurodollar futures, and an FRA to ‘sell interest rates’ typically implies fixing a borrowing rate, which is not the objective here. Waiting without hedging would leave the company exposed to the risk of lower yields.

Equity Linked Investment-Linked Policies (ILPs) are hybrid products that combine investment with insurance coverage. A significant component of their ongoing expenses is the insurance charge, which is deducted from the premium to provide a death benefit. Consequently, the Net Asset Value (NAV) of an ILP is determined not only by the performance of its underlying investment portfolio but also by these recurring insurance and administrative charges. In contrast, Equity Linked Exchange Traded Funds (ETFs) are designed to track the performance of a specific underlying asset, basket, or index as closely as possible. Their value is primarily driven by the price movements of this underlying asset. ETFs are generally known for having a lower Total Expense Ratio (TER) and lower recurring management and administration fees compared to more complex structured products or insurance-linked products like ILPs.

A zero-cost collar is an options strategy designed to provide downside protection for an existing long stock position while generating income, with the unique feature of having no net upfront premium cost. This is achieved by simultaneously purchasing an out-of-the-money put option (for downside protection) and selling an out-of-the-money covered call option (to generate premium income). The strike prices of these options are specifically chosen so that the premium received from selling the call equals the premium paid for buying the put, resulting in a zero net cash outlay. This strategy is ideal for investors who hold a stock, anticipate a stable or range-bound market, and wish to limit potential losses without incurring an initial cost, though it also caps potential upside gains. Implementing only a covered call generates income but offers limited downside protection beyond the premium received. Purchasing only a protective put provides downside protection but requires an upfront premium payment. A long strangle is a strategy used to profit from high volatility, which contradicts the stable market outlook mentioned in the scenario, and it involves a net premium cost.

Structured products are typically tailored for investors intending to hold them until maturity. A significant liquidity challenge arises because these products are often highly customised, leading to a limited or non-existent secondary market. This makes it difficult for an investor to find a buyer if they need to sell before maturity. Consequently, attempting an early liquidation can result in selling the product at a substantial discount, potentially leading to a significant loss of the principal invested. While issuers or their affiliates might offer a secondary market, they are not obligated to do so, and the price would still be subject to prevailing market conditions and the value of underlying instruments. This is distinct from credit risk, which relates to the default of an underlying entity, or general market risk, which refers to price fluctuations without necessarily impacting the ability to sell.

Barrier options are generally cheaper than standard options because of the inherent conditions tied to their activation or termination. For a knock-out barrier option, there is a possibility that the underlying asset’s price will hit the barrier level, causing the option to terminate prematurely and become worthless before its expiration date. Similarly, for a knock-in barrier option, there is a chance that the barrier condition will never be met, meaning the option never becomes active. This possibility of early termination or non-activation reduces the risk for the option seller, allowing them to charge a lower premium compared to a standard option which remains active until expiration regardless of intermediate price movements (unless exercised). While barrier options can offer higher returns on capital due to their lower cost, this is an outcome, not the fundamental reason for the reduced premium. Their OTC nature introduces counterparty risk and does not directly explain the lower premium based on the option’s intrinsic structure. The complexity of valuation models is also not the primary driver for the premium difference.

The Credit Support Annex (CSA) is a crucial legal document used in Over-The-Counter (OTC) derivative transactions, including options. It defines the terms under which collateral is posted or transferred between counterparties. This mechanism is specifically designed to mitigate the credit risk that arises when one party might default on its contractual obligations, thereby reducing the potential financial exposure to the other party. While margin requirements are common in derivatives, a central clearing house is typically involved for exchange-traded or centrally cleared OTC products. In contrast, a CSA directly addresses bilateral counterparty credit risk in non-centrally cleared OTC transactions. Market-wide circuit breakers are tools for managing market disruption risk, and maturity concentration limits are a type of market risk control, neither of which directly addresses specific counterparty credit risk in an OTC options trade.

This question assesses the understanding of a hedged short stock position using a long call option. When an investor short sells a stock, they profit if the stock price falls, but face unlimited loss if the stock price rises. To cap this potential unlimited loss, a call option is purchased. Let’s break down the profit/loss for the combined strategy: 1. When the stock price (ST) at expiration is at or below the call option’s strike price (X): The call option expires worthless, and the investor loses the premium paid for the call. The profit or loss from the short stock position is (Short Sale Price – ST). The total profit for the combined position is (Short Sale Price – ST – Call Premium). In this scenario, as ST decreases, the profit increases, leading to a maximum gain if ST falls to zero. 2. When the stock price (ST) at expiration is above the call option’s strike price (X): The call option is in-the-money and will be exercised. The investor can buy the stock at the strike price (X) using the call option to cover their short position. The profit/loss from the short stock position is (Short Sale Price – ST). The profit from the call option is (ST – Strike Price). The total profit for the combined position is (Short Sale Price – ST) + (ST – Strike Price) – Call Premium. This simplifies to (Short Sale Price – Strike Price – Call Premium). Using the given values: Short Sale Price (S0) = $50.00 Call Strike Price (X) = $52.00 Call Premium (c0) = $3.00 When ST > X, the maximum loss occurs. The profit/loss is calculated as: S0 – X – c0 = $50.00 – $52.00 – $3.00 = -$5.00. This indicates a maximum loss of $5.00 per share. The call option effectively caps the loss from the rising stock price at this level. Option 1 is correct because it represents the calculated maximum loss for the hedged position. Option 2 ($3.00) is the premium paid, which is the maximum loss for a standalone long call, but not for this combined strategy. Option 3 ($2.00) is the difference between the strike price and the short sale price (X – S0), which is part of the calculation but not the total maximum loss. Option 4 ($47.00) represents the maximum potential gain for this strategy (when ST drops to $0: $50.00 – $0.00 – $3.00 = $47.00), not the maximum loss.

Structured products designed to offer a minimum return of principal at maturity typically employ specific strategies to achieve this capital preservation. One such strategy is the Constant Proportion Portfolio Insurance (CPPI) strategy, which dynamically adjusts the allocation between a risky asset and a risk-free asset to ensure the principal is protected while allowing for participation in market gains. Another common approach for principal protection involves combining a zero-coupon bond with a long-call option. Conversely, structured products that do not offer a minimum return of principal often utilize short options strategies, which expose the investor to potential losses of their initial capital. Coupon structures, such as step-up or inverse floating, relate to how periodic payments are determined, not directly to the principal protection mechanism at maturity. Similarly, features like first-to-default redemption or physical settlement describe specific maturity types or settlement methods, rather than the core strategy for guaranteeing principal.

This question assesses understanding of the key differences between physical and synthetic replication methods for Exchange Traded Funds (ETFs), a core topic in CMFAS Module 6A. Synthetic replication ETFs typically achieve a lower tracking error because they use total return swaps to replicate the index performance, which can be more precise than physically holding all underlying securities. However, this method introduces counterparty risk, as the ETF’s performance is dependent on the swap provider’s ability to meet its obligations. Physical replication ETFs, while avoiding direct swap counterparty risk, often experience higher tracking error due to factors like transaction costs, rebalancing, and the challenges of perfectly mirroring an index by holding all its components, especially in volatile or illiquid markets. Therefore, the statement that synthetic ETFs generally have lower tracking error but introduce counterparty risk is accurate.

To determine the correct arbitrage strategy, we first need to calculate the theoretical forward rate using the Interest Rate Parity (IRP) formula provided in the syllabus. The formula is: F = S x [1 + Rc(n/360)] / [1 + Rb(n/360)], where S is the spot rate, Rc is the interest rate of the counter currency, and Rb is the interest rate of the base currency. Given: Spot rate (S) for AUD/USD = 0.7000 (meaning 1 AUD = 0.7000 USD) Counter currency (USD) interest rate (Rc) = 2.00% Base currency (AUD) interest rate (Rb) = 3.50% Market 1-year forward rate (F_market) for AUD/USD = 0.6950 Period (n) = 360 days (for one year) Step 1: Calculate the theoretical forward rate (F_theoretical). F_theoretical = 0.7000 [1 + 0.020(360/360)] / [1 + 0.035(360/360)] F_theoretical = 0.7000 (1 + 0.020) / (1 + 0.035) F_theoretical = 0.7000 1.020 / 1.035 F_theoretical = 0.7000 0.985507246 F_theoretical ≈ 0.689855 USD/AUD Step 2: Compare the market forward rate with the theoretical forward rate. F_market (0.6950 USD/AUD) > F_theoretical (0.689855 USD/AUD) Since the market forward rate is higher than the theoretical forward rate, the forward AUD is overvalued in the market. An arbitrageur would profit by selling the overvalued asset in the market and simultaneously creating a synthetic position to buy the undervalued asset. Step 3: Determine the arbitrage strategy. To exploit the overvalued forward AUD in the market, the arbitrageur should: 1. Sell AUD forward at the market rate (0.6950 USD/AUD). This means entering a forward contract to deliver AUD and receive USD in the future. 2. Create a synthetic position to buy AUD forward at the theoretical rate. This involves: Borrowing the counter currency (USD) at its interest rate (Rc). Converting the borrowed USD to the base currency (AUD) at the spot rate (S). Investing the base currency (AUD) at its interest rate (Rb). Let’s trace the cash flows for this strategy, assuming an initial borrowing of 1 USD: Today: Borrow 1 USD at the US interest rate of 2.00%. Convert the 1 USD to AUD at the spot rate: 1 USD / 0.7000 USD/AUD = 1.42857 AUD. Invest the 1.42857 AUD in Australia at 3.50% for one year. Simultaneously, enter a forward contract to sell the future AUD proceeds (1.42857 AUD (1 + 0.035) = 1.47857 AUD) at the market forward rate of 0.6950 USD/AUD. In one year: The AUD investment matures to 1.47857 AUD. Convert the 1.47857 AUD to USD using the forward contract: 1.47857 AUD 0.6950 USD/AUD = 1.0275 USD. Repay the USD loan: 1 USD (1 + 0.020) = 1.02 USD. Profit: 1.0275 USD (from forward sale) – 1.02 USD (loan repayment) = 0.0075 USD. This strategy generates a risk-free profit. Therefore, the correct action is to borrow USD, convert to AUD, invest AUD, and simultaneously sell AUD forward.

Yield Enhanced Securities, also known as Discount Certificates, have a specific payout structure at maturity. If the underlying asset’s closing price on the expiration or valuation date is at or above the exercise price, the holder receives a cash settlement equal to the exercise price. However, if the closing price is below the exercise price, the holder receives a cash settlement equal to the value of the underlying on that date (i.e., the closing price). In this scenario, the exercise price is $5.30 and the underlying asset’s closing price at maturity is $5.00. Since the closing price ($5.00) is below the exercise price ($5.30), the investor would receive the value of the underlying, which is $5.00.

The scenario describes a problem where longer-dated futures contracts, which are typically less liquid, lead to unexpected losses due to price volatility and difficulty in unwinding. A maturity limit is specifically designed to address this issue by restricting exposure to such contracts. The text explicitly states that ‘Maturity limit is set for trading purposes to limit losses from poor liquidity. The reason for doing so is because liquidity is normally better for the near-month contracts and thins as we move out to the further months. As further contracts normally have lower liquidity, they are more volatile and in times of adverse conditions, these contracts may be difficult to unwind. Putting a limit on maturity can reduce the risks of such an eventuality.’ While other limits like open contracts limit, maximum loss limit, and stress test limit are important for overall risk management, they do not directly target the specific problem of illiquidity in longer-dated futures contracts as effectively as a maturity limit does.

Constant Proportion Portfolio Insurance (CPPI) strategies are designed to maintain a minimum capital floor while participating in the upside potential of a risky asset. However, they are susceptible to specific market conditions. When an underlying asset experiences a sharp decline, especially if followed by a prolonged period of range-bound or sideways trading, there is a heightened risk that the portfolio’s value may drop to its predetermined floor. Once this floor is breached, the CPPI strategy dictates that the entire fund must be reallocated into a risk-free asset to protect the remaining capital. A critical consequence of this deleveraging event is that the portfolio will no longer participate in any subsequent appreciation of the underlying risky asset, effectively capping its future growth potential. This is a key risk for investors in CPPI products, as it means they can miss out on market recoveries after a significant downturn.

A long Extended Settlement (ES) contract is a hedging strategy employed by investors who anticipate purchasing shares in the future but are concerned about a potential increase in the share price before their funds become available. By entering into a long ES contract, the investor effectively locks in a purchase price for the underlying shares at the time the ES contract is initiated. This action protects them from the adverse impact of a rising market price, ensuring that they can acquire the shares at a predetermined cost, regardless of subsequent market appreciation. The primary objective is price certainty and risk mitigation against upward price movements, not to profit from a decline, defer fees as a primary goal, or solely to leverage for speculative gains.

The scenario describes a need for highly specific and non-standard hedging requirements for a niche raw material, along with a willingness to manage direct counterparty relationships. A forward contract is a private agreement negotiated directly between two parties, allowing for complete customization of terms such as the underlying asset, quantity, quality, delivery date, and location. This flexibility makes it ideal for unique hedging needs that are not met by standardized exchange-traded contracts. While forward contracts expose parties to counterparty risk, the scenario indicates a willingness to manage this aspect for the benefit of precise customization. Futures contracts, on the other hand, are standardized and exchange-traded, making them less suitable for highly specific, non-standard requirements. Exchange-traded options provide flexibility but are different instruments and may not offer the direct, specific hedging profile or delivery for a niche commodity. Swap agreements are typically used for exchanging cash flows, often related to interest rates or currencies, and are not the primary instrument for direct physical commodity hedging with specific delivery needs in this context.

A Bull Equity-Linked Note (ELN) with an embedded short put option means the investor, as the noteholder, has effectively sold a put option. This strategy offers an enhanced yield compared to a plain vanilla note but exposes the investor to downside risk of the underlying stock. At maturity, if the underlying stock’s market price (ST) is less than the put strike price (X), the put option is in-the-money and will be exercised by the put buyer. In this scenario, the strike price is $9.00, and the market price at maturity is $8.50, which is below the strike price. Therefore, the put option will be exercised. The ELN structure dictates that the investor receives shares of the underlying stock, calculated as the face value of the note divided by the strike price ($10,000 / $9.00 = 1,111 shares). The value of these shares at maturity is determined by the prevailing market price, which is $8.50 per share. Thus, the total value received by the investor is 1,111 shares $8.50/share = $9,443.50. Since the investor initially paid $9,900 for the note, receiving shares worth $9,443.50 results in a capital loss. The first option is incorrect because the full face value is only received if the stock price is at or above the strike price. The third option is incorrect because the investor is the put writer (having received the premium at inception) and the strike price was met, leading to exercise. The fourth option is incorrect as the settlement mechanism for this ELN involves receiving shares, not an additional cash payment.

The financial cost component of a Callable Bull/Bear Contract (CBBC) is a crucial element in its pricing. As outlined in the CMFAS Module 6A syllabus, this cost is incurred by the issuer for structuring the CBBC. It specifically includes the issuer’s cost of borrowing, necessary adjustments for dividends if the underlying asset is equity-related, and the issuer’s profit margin. This cost is higher for CBBCs with longer maturities and progressively declines as the CBBC moves closer to its expiration date. It is not a static value, nor is it primarily driven by daily supply and demand, which are market factors, or increasing towards expiry.

The scenario presents a situation where the current spot price of a commodity is $100, and the three-month futures contract is trading at $98. The net cost of carrying the commodity for three months is $3. According to the cost-of-carry model, the fair futures price should be the spot price plus the net cost of carry. Therefore, the fair futures price is $100 (spot price) + $3 (cost of carry) = $103. Since the actual futures price ($98) is lower than the fair futures price ($103), the futures contract is considered undervalued relative to the spot market and its carrying costs. This discrepancy creates an arbitrage opportunity. A reverse cash-and-carry arbitrage is designed to profit from an undervalued futures contract. The steps for a reverse cash-and-carry arbitrage involve selling short the commodity in the spot market, lending the proceeds from the short sale, simultaneously buying the futures contract, accepting delivery of the commodity when the futures contract matures, and then using the delivered commodity to cover the initial short sale. This sequence of actions locks in a risk-free profit from the pricing inefficiency. The other options describe either a cash-and-carry arbitrage (which would be used if the futures contract were overvalued) or other unrelated trading strategies.

The premium of a warrant is defined as the difference between its market price and its intrinsic value. This premium is largely attributed to the time value of the warrant, which reflects the remaining time until expiry and the volatility of the underlying asset. It represents the additional amount an investor is willing to pay above the warrant’s immediate exercise value, hoping for future price appreciation of the underlying asset. The conversion ratio indicates how many warrants are needed to acquire one unit of the underlying security. The exercise price is the predetermined price at which the underlying asset can be bought or sold. The underlying asset’s volatility is a factor that influences the time value (and thus the premium) but is not the premium itself.