CMFAS RES6A Quiz 86

Extended Settlement (ES) contracts are designed to provide an immediate, near 100% hedge, meaning their delta is approximately 1.0. This characteristic allows them to directly offset the price movements of the underlying shares, making them a highly effective tool for hedging a long equity position. In contrast, warrants have a delta that is typically less than 1.0 (for example, 0.5 for at-the-money warrants) and is influenced by factors such as the chosen strike price and the time remaining until expiry. This means warrants do not offer a direct, one-to-one hedge against the underlying asset’s price changes. Furthermore, ES contracts do not require the selection of a strike price, simplifying their use as a hedging instrument compared to warrants. While ES contracts require margin, this forms part of the settlement if held to maturity, whereas warrants involve an initial premium that is subject to time decay. ES contracts are also generally expected to offer greater liquidity and tighter bid/offer spreads.

This question assesses the understanding of a put option seller’s obligation and the calculation of intrinsic value. A put option grants the buyer the right, but not the obligation, to sell the underlying asset at the strike price. Conversely, the seller of a put option has the obligation to purchase the underlying asset at the strike price if the buyer chooses to exercise. In the given scenario, the strike price is $75 and the market price has fallen to $70. When the buyer exercises, the seller must purchase the shares at the strike price of $75. The intrinsic value for a put option is calculated as the Option Strike Price minus the Current Market Price. Therefore, the intrinsic value is $75 (strike price) – $70 (market price) = $5. The seller’s obligation is to buy the shares at the strike price, and the option has a positive intrinsic value.

A Callable Bull/Bear Contract (CBBC) includes a mandatory call feature, which means it can be called by the issuer under specific conditions, leading to early expiry. This event is termed a Mandatory Call Event (MCE). For a Bull Contract, an MCE is triggered if the underlying asset’s spot price falls to or below the specified call price. When an MCE occurs, the CBBC’s trading terminates immediately. Category N-CBBCs are specifically defined as having no residual value (N = No residual value), meaning that if an MCE occurs, the holder will not receive any cash payment. Therefore, for a Category N Bull CBBC, an MCE due to the underlying asset price hitting the call price results in immediate early expiry and no payout.

An Equity-Linked Structured Note typically consists of a zero-coupon bond and an equity call option. The zero-coupon bond is purchased at a discount to its face value, and the difference between the face value and the present value (the ‘discount sum’) is used to purchase the call option. The present value (PV) of a zero-coupon bond is inversely related to the prevailing interest rate (r) and directly related to its face value and maturity. Specifically, PV = Face Value / (1+r)^T. If interest rates for comparable zero-coupon bonds rise, the present value of the bond component decreases. Consequently, the ‘discount sum’ (Face Value – PV) available to purchase the equity call option increases. Assuming the premium for the call option remains constant, a larger discount sum allows the issuer to purchase more call option contracts, thereby increasing the investor’s potential equity participation rate. Therefore, higher interest rates, in this context, lead to a higher potential equity participation rate.

The zero-plus option strategy is designed to preserve initial capital while allowing participation in the upside potential of an underlying asset. This is typically achieved by investing a significant portion of the capital in a fixed-income instrument, such as a zero-coupon bond, which is projected to grow to the initial capital amount by maturity. The remaining portion of the capital is then used to purchase a call option on the underlying asset. The participation share in the underlying asset’s gains is determined by the ratio of the capital available for the option to the actual price of the call option. In this specific case, 85% of the initial capital is allocated to the zero-coupon bond, leaving 15% (100% – 85%) of the initial capital available for the call option. The cost of the call option is stated as 25% of the total initial capital. Therefore, the participation share is calculated by dividing the capital allocated to the call option (15%) by the cost of the call option (25%), which results in (15 / 25) = 0.60, or 60%.

An investor who holds a structured product involving the shorting (selling) of an interest rate call swaption is essentially selling protection against a decrease in interest rates. The buyer of an interest rate call swaption benefits when market interest rates fall below the strike rate, as they gain the right to enter into a swap where they receive a predetermined fixed rate and pay a declining floating rate. When interest rates decline substantially below the strike rate, the swaption becomes ‘in-the-money’ for the buyer. Consequently, the seller of this swaption (the investor in the structured product) will incur a loss and have an obligation to make a payment to the swaption buyer. This is because the seller is on the losing side of the ‘protection’ they sold.

A vertical spread is characterized by using options of the same underlying security and the same expiration month, but with different strike prices. The scenario describes an investor using two call options on the same underlying security, both having the same expiration month but different strike prices, which perfectly aligns with the definition of a vertical spread. A horizontal (or calendar) spread involves options with the same underlying security and strike prices but different expiration dates. A diagonal spread combines elements of both, featuring options with different strike prices and different expiration dates. A ratio spread involves buying and selling option contracts in specified ratios, which is not indicated by the scenario’s description of same-class options with different strikes and same expiration.

Structured funds are governed by the Code on Collective Investment Schemes (CIS) under the Securities & Futures Act (SFA). This regulatory oversight imposes specific requirements that differentiate them from structured notes and structured deposits. One critical requirement for structured funds is the provision of regular Net Asset Values (NAVs). This ensures transparency and allows investors to monitor the fund’s performance and valuation consistently. In contrast, structured notes and structured deposits are not mandated to provide regular NAVs. Furthermore, structured funds typically have separate fund management and administration fees, whereas fees for structured notes and deposits are often embedded into the product’s pricing. While some structured funds may offer principal protection, it is not a universal regulatory requirement for all structured funds, nor is the restriction of underlying assets to solely Singapore-listed securities.

The adjustment to the exercise price of a structured warrant due to a special dividend is crucial to maintain the warrant’s theoretical value and compensate for the dilutive effect of the dividend on the underlying share price. The formula for adjusting the exercise price for dividends, as per CMFAS Module 6A syllabus, is: New Exercise Price = Old Exercise Price x Adjustment Factor Where the Adjustment Factor = (P – SD – ND) / (P – ND) Given the details: Old Exercise Price = $10.00 P (Last cum-date closing price of the underlying) = $12.00 SD (Special dividend per share) = $0.50 ND (Normal dividend per share) = $0.00 (as no normal dividend was declared) First, calculate the Adjustment Factor: Adjustment Factor = ($12.00 – $0.50 – $0.00) / ($12.00 – $0.00) Adjustment Factor = $11.50 / $12.00 Adjustment Factor ≈ 0.958333 Next, calculate the New Exercise Price: New Exercise Price = $10.00 x 0.958333 New Exercise Price ≈ $9.58333 Rounding to two decimal places, the new adjusted exercise price is $9.58. Option $9.50 would result from a direct subtraction of the special dividend from the original exercise price, which is an oversimplification and does not correctly apply the adjustment factor. Option $10.00 implies no adjustment was made, which is incorrect as special dividends necessitate an adjustment to the warrant’s terms. Option $10.42 would result from an incorrect application of the adjustment factor, possibly by adding the dividend in the numerator or denominator, leading to an increase in the exercise price, which is contrary to the dilutive effect of a dividend.

An investor seeking to implement a precise and immediate hedge against a long position in physical shares requires an instrument that directly offsets price movements. Extended Settlement (ES) contracts are particularly well-suited for this purpose because they offer a near 100% hedge, meaning their delta is approximately 1.0. This characteristic ensures that for every dollar the underlying share price moves, the ES contract’s value moves by a similar amount in the opposite direction, providing a direct and immediate offset to the physical share position. While warrants can also be used for hedging, their effectiveness is often less precise for immediate, direct hedging. Warrants typically have a delta less than 1.0 (e.g., around 0.5 for at-the-money warrants), and their value is influenced by factors like strike price, time to expiry, and implied volatility, making them less direct and precise for a full hedge against an existing physical position. The cost of warrants is an initial premium, which is subject to time decay, whereas ES contracts involve margin requirements. Although not having to select a strike price for ES contracts simplifies the process, the primary advantage for achieving ‘maximum precision’ and ‘immediate downside risk mitigation’ lies in the near 100% delta.

To determine the total expenses incurred for the CFD transaction, several components must be calculated: commission on both the buy and sell transactions, Goods and Services Tax (GST) on these commissions, and daily financing interest. First, calculate the total value of the purchase: 5,000 units $1.50/unit = $7,500. Next, calculate the commission on the purchase: $7,500 0.3% = $22.50. Then, calculate the GST on the purchase commission: $22.50 8% = $1.80. Now, calculate the total value of the sale: 5,000 units $1.65/unit = $8,250. Calculate the commission on the sale: $8,250 0.3% = $24.75. Calculate the GST on the sale commission: $24.75 8% = $1.98. Finally, calculate the financing interest. This is based on the total value of the purchase, the annual financing rate, and the number of days the position was open. Assuming a 360-day year for financial calculations: $7,500 5.5% / 360 days 15 days = $6.875, which rounds to $6.88. Summing all these expenses: $22.50 (buy commission) + $1.80 (GST on buy commission) + $24.75 (sell commission) + $1.98 (GST on sell commission) + $6.88 (financing interest) = $57.91. This represents the total expenses incurred for the transaction.

To determine the total redemption proceeds, first calculate the accrual coupon rate based on the number of days the HSI fixed within the specified barriers. The formula for the yield is 0.50% + [4.00% x n/N], where ‘n’ is the number of days the HSI fixes within the range and ‘N’ is the total number of trading days. In this scenario, n = 150 and N = 250. Accrual coupon rate = 0.50% + [4.00% x 150 / 250] Accrual coupon rate = 0.50% + [4.00% x 0.6] Accrual coupon rate = 0.50% + 2.40% Accrual coupon rate = 2.90% The investment amount is SGD 1 million. The accrual coupon amount is calculated by applying this rate to the principal: Accrual coupon amount = SGD 1,000,000 x 2.90% = SGD 29,000 The total redemption proceeds at maturity include the principal plus the accumulated accrual coupon: Total redemption proceeds = SGD 1,000,000 (Principal) + SGD 29,000 (Accrual Coupon) Total redemption proceeds = SGD 1,029,000

A calendar spread, also known as a horizontal or time spread, involves simultaneously taking a long and a short position in futures contracts on the same underlying asset but with different delivery months. The strategy is designed to profit from changes in the relationship between the prices of the near and far month contracts. When a trader anticipates the yield curve will flatten or invert, the appropriate strategy is to sell the nearer delivery month contract and simultaneously buy the further delivery month contract. This position aims to profit if the price difference between the two contracts narrows, which typically occurs during a flattening yield curve scenario. Conversely, if a trader expects the yield curve to steepen, they would buy the nearer contract and sell the further contract.

The Auto-Redeemable Structured Fund XYZ specifies that the product becomes auto-redeemable if the performance of the Nikkei 225 at the valuation time on the relevant early redemption observation date is greater or equal to the performance of the S&P 500. In the given scenario, the Nikkei 225’s performance is identical to the S&P 500, which satisfies the ‘greater or equal to’ condition. For an auto-redemption occurring after 2.0 years, the pre-determined redemption price is 117.00% of the principal. Therefore, the product would auto-redeem, and the investor would receive 117.00% of their principal. The other options are incorrect because they either misinterpret the auto-redemption condition, use an incorrect redemption price for the specified period, or confuse it with the minimum payout at maturity.

A Callable Bull/Bear Certificate (CBBC) is a leveraged product with a built-in ‘knock-out’ feature. When the price of the underlying asset reaches or breaches the pre-determined Call Price, a Mandatory Call Event (MCE) is triggered. For R-category CBBCs, this results in the immediate and irrevocable termination of the contract, and the investor receives a residual value. A crucial consequence of this irrevocability is that the investor loses any opportunity to benefit from a subsequent recovery in the underlying asset’s price, even if it bounces back significantly after the MCE. The other options describe scenarios that do not occur: there is no automatic conversion to a different position, no temporary suspension with a grace period for decision-making, and no option to reset the Call Price by paying an additional premium after an MCE has occurred.

Arbitrage involves exploiting temporary price discrepancies between two or more markets by simultaneously buying the undervalued asset and selling the overvalued asset. This strategy aims to lock in a risk-free profit as the prices converge. In the context of interest rate futures and cash markets, if the futures contract is overpriced relative to the implied forward rate from cash market instruments, an arbitrageur would sell the futures and simultaneously take an offsetting position in the cash market (e.g., lending and borrowing) to capture the difference. Conversely, if the futures contract is underpriced, the arbitrageur would buy the futures and take an opposite cash market position. The key is the simultaneous execution to eliminate market risk. Options that involve waiting for prices to adjust or taking a single directional position are speculative, not arbitrage. Advising clients on portfolio adjustments is a different financial service altogether.

The scenario describes a situation where the asset being hedged (a specialized industrial metal) is not perfectly identical to the underlying asset of the futures contract used for hedging. This mismatch is a classic cause of basis risk. Basis is defined as the difference between the spot price of the asset to be hedged and the futures price of the contract used. When the underlying asset in the futures contract is not completely identical to the asset being hedged, the correlation between their price movements may not be perfect, leading to fluctuations in the basis. This uncertainty in the basis at the time the hedge is lifted is precisely what constitutes basis risk, making the hedge imperfect. Liquidity risk pertains to the ease of buying or selling the futures contract without significantly affecting its price, which is not the primary issue described. Counterparty risk (or credit risk) relates to the default of a party to a contract, typically mitigated by the clearing house in exchange-traded futures, and is not the core problem here. Settlement risk is the risk that one party fails to deliver on the settlement date, which is also not the direct consequence of the asset mismatch described.

For structured notes offered to retail investors, the financial institution is mandated to provide both a Prospectus and a Product Highlights Sheet (PHS). The PHS serves as a concise summary of key terms and risks, complementing the more detailed Prospectus. According to regulatory guidelines, the core information within the PHS should not exceed 4 pages. If the PHS includes diagrams and a glossary, the total length can extend to 8 pages, but the information not contained in diagrams or a glossary must still be limited to 4 pages. The text in the PHS must be in a font size of at least 10-points Times New Roman, and it should avoid technical terms or provide a glossary if they are unavoidable. Crucially, the PHS must not contain any information that is not also present in the Prospectus, nor any false or misleading information. The exemption from providing a Prospectus or PHS only applies when structured notes are offered to institutional or accredited investors.

A Market Order is designed for immediate execution at the best available price in the market at the time the order is processed. For a buy order, it will match against the lowest ask price currently available. This means that even if the market price moves upwards after the order is placed, the entire order will still be filled at the new, higher best available price, ensuring complete execution without any portion remaining open. In contrast, a Limit Order set at $75.03 would only execute at $75.03 or lower; if the lowest offer price rises to $75.08, the order would not be filled. A Market-to-Limit Order placed at $75.03 would attempt to execute at that price, but if only partially filled, any remaining quantity would stay open at $75.03, which would not be the current best available price of $75.08. A Buy-Stop Entry Order is a contingent order that triggers a market entry when a specific price is reached, typically used for breakout strategies, and is not primarily for immediate execution at the current best available price in a volatile market.

The structured fund is call-protected for the initial one-year period. After this, early redemption observation dates occur every six months. The first observation date is 15 March 2015 (one year after the initial date). The second observation date is 15 September 2015 (six months later). The third observation date is 15 March 2016 (another six months later). If the mandatory call event is triggered on this third observation date, it means three observation periods have passed successfully. The payout price is calculated as the periodic yield multiplied by the number of observations. Given a periodic yield of 4.25%, the payout price would be 4.25% multiplied by 3, which equals 12.75%. The terminal value, which represents the total percentage of the initial investment returned, is the redemption value (100% of initial investment) plus the calculated payout price. Therefore, the investor receives 100% + 12.75% = 112.75% of their initial investment.

Arbitrage is a strategy that exploits temporary price discrepancies between the same or extremely similar assets traded in different markets. The fundamental action involves simultaneously buying the asset in the market where it is relatively cheaper and selling it in the market where it is relatively more expensive. This simultaneous execution locks in a risk-free profit from the price difference. The other options describe actions that either involve different, unrelated assets, introduce basis risk by not using identical instruments, or represent a market exit strategy rather than an arbitrage trade.

Reverse Convertibles are constructed using a long zero-coupon bond and a short put option. The short put option is a key derivative component that defines the investor’s downside exposure. Discount Certificates, on the other hand, are constructed using a long zero-strike call option and a short call option. The short call option in a Discount Certificate is crucial for capping the upside performance and generating premium income. Therefore, the primary derivative components that distinguish their construction are the short put in a Reverse Convertible and the short call in a Discount Certificate. The other options describe incorrect derivative components or misattribute them to the wrong product, or incorrectly suggest reliance on a long put for downside exposure in both products.

This question assesses understanding of the payout conditions for the 3-year Auto-Redeemable Structured Fund, specifically when it reaches maturity without an early redemption. According to the product description, if the product does not terminate early during its life, the final payout is based on a formula. If the performance of the Nikkei 225 index is greater than or equal to the performance of the S&P 500, the payout is 125.5%. However, if the Nikkei 225’s performance is less than the S&P 500’s performance, the payout is 100%, which means a payback of the principal without any additional income. The options referring to 125.5% apply to the opposite performance condition, while the periodic yield of 4.25% is relevant for calculating the payout price during an early redemption event, not for the final payout at maturity if no early call occurred under these specific performance conditions.

The question tests the candidate’s understanding of the specific final settlement price determination mechanisms for different futures contracts as outlined in the CMFAS Module 6A syllabus, Appendix C. For the 3-month Singapore Dollar Interest Rate Futures, the final settlement price 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 incorrect options refer to the settlement mechanisms of other contracts (such as 3-month Eurodollar Futures or Full-sized 10-year Japanese Government Bond Futures) or present a plausible but factually inaccurate description, ensuring that the candidate must have a precise understanding of each contract’s specifications.

The question tests the application of the formula for hedging equity risks using futures contracts, as covered in the CMFAS Module 6A syllabus, specifically Appendix D. The objective is to achieve a delta-neutral hedge, which requires calculating the appropriate number of futures contracts. The standard formula for determining the number of futures contracts (N) needed to hedge an equity portfolio is: N = (Portfolio Value (VP) Portfolio Beta (β)) / (Futures Price (F) Contract Multiplier (T)) Given the values: Portfolio Value (VP) = $12,500,000 Portfolio Beta (β) = 1.15 Futures Price (F) = 4,200 points Contract Multiplier (T) = $25 per point Substitute these values into the formula: N = (12,500,000 1.15) / (4,200 25) N = 14,375,000 / 105,000 N = 136.9047… Rounding to the nearest whole number, the number of contracts required is 137. It is important to note that the formula provided in the Appendix D document, N = VP / F x T x β, if interpreted literally as N = (VP T β) / F, would yield a different result (85,565 contracts in this scenario). However, adhering to the principle of deferring to the latest accurate market practices, the standard and widely accepted formula for hedging equity risks, which places the contract multiplier (T) in the denominator to represent the total value of one futures contract (F T), is used for the correct answer. This ensures the calculation aligns with practical financial applications and the underlying concept of hedging.

The auto-redeemable feature of the structured fund specifies that the product will be terminated early if the closing level of any of the underlying indices falls below 75% of its initial level on a specified early redemption observation date. In the provided scenario, the iBoxx 5-7 Euro Eurozone index is observed at 70% of its initial level. Since 70% is below the 75% threshold, the condition for early redemption is met. According to the product terms, if this condition is met, the product is redeemed at 100% of the principal value, ensuring capital preservation for the investor. The performance of the other indices or the mechanism for calculating future coupon payments does not override this specific auto-redemption trigger.

The question describes a neutral trading strategy that combines bull and bear spreads, uses four distinct futures contracts, has no common middle expiration month, and features equally distributed delivery months. This precisely matches the definition of a Condor spread. A Butterfly spread, while also a neutral strategy combining bull and bear spreads with four legs, is characterized by having a common middle expiration month, where the middle month is sold twice. A Calendar spread involves only two contracts with different delivery months for the same underlying asset. A Basis trade is an arbitrage strategy involving opposing long and short positions in two related securities to profit from convergence, not a multi-leg spread with distinct expiration characteristics as described.

The question addresses a key risk for writers of American options. Unlike European options, which can only be exercised at expiration, American options grant the holder the right to exercise at any time up to and including the expiration date. Therefore, if the underlying asset’s price moves significantly in a direction unfavorable to the option writer (e.g., a sharp increase for a call option writer), the holder can choose to exercise early. This forces the writer to fulfill their obligation (e.g., deliver the shares for a call option) immediately, potentially leading to substantial and premature losses, regardless of the writer’s original strategy to manage the position until expiration. The other options describe incorrect characteristics or risks not specific to the early exercise feature of American options for a writer.

Gamma measures the rate of change of an option’s delta with respect to the underlying asset’s price. Managing gamma risk is crucial for options portfolios, especially for large or complex positions. According to established risk management practices, one primary method to restrict gamma exposure is by setting a limit on the absolute change in the portfolio’s delta. This directly controls the second-order sensitivity of the portfolio to price movements. The other recognized method is to apply risk tolerance amounts expressed as a maximum potential loss. Setting a strict upper limit on the total number of open options contracts is a general position limit, not specific to gamma risk. Implementing a cap on the sensitivity of option prices to changes in market volatility relates to managing Vega risk, which measures sensitivity to volatility changes. Executing interest rate swap transactions is a method used to reduce Rho risk, which measures the impact of interest rate changes on option prices, and time decay is related to Theta risk.