CMFAS RES6A Quiz 88

The Constant Proportion Portfolio Insurance (CPPI) strategy aims to maintain a minimum ‘floor’ value for the portfolio while participating in the upside potential of a risky asset. However, it faces specific risks. According to the principles of CPPI, if the market experiences a prolonged period of range-bound prices, a major deleveraging event, or a sharp drop in asset prices, the portfolio value has a higher chance of falling to its floor. When this occurs, the strategy dictates that the entire fund must be allocated to the risk-free asset to protect the capital. Once fully allocated to the risk-free asset, the portfolio loses its exposure to the risky asset and, consequently, cannot participate in any subsequent appreciation of that asset. Therefore, a prolonged period of range-bound price movements is a key scenario that leads to this outcome. Steadily increasing asset values, sudden significant appreciation, or consistent moderate growth with minor drawdowns are generally favorable or manageable conditions for a CPPI strategy, as they would typically lead to increased allocation to the risky asset or allow the strategy to perform as intended without hitting the floor.

For an R-Category Bear Callable Bull/Bear Contract (CBBC), a Mandatory Call Event (MCE) is triggered when the underlying asset’s spot price rises and touches or exceeds the specified call price. In this scenario, the call price is $50, and the spot price has risen to $50.05, thus exceeding the call price. When an MCE occurs, the CBBC expires early, and its trading terminates immediately. As it is an R-Category CBBC, the holder may receive a small cash payment, known as a residual value, because for R-CBBCs, the call price is different from the strike price, allowing for this possibility.

The question tests the candidate’s attention to detail regarding the specific market conventions for determining the last trading day of different futures contracts, as outlined in the CMFAS Module 6A syllabus. For the 3-month Eurodollar Futures, the last trading day is explicitly defined as ‘2 London business day immediately preceding the 3rd Wednesday of the expiring contract month’. In contrast, the 3-month Singapore Dollar Interest Rate Futures specifies ‘2 business days preceding the 3rd Wednesday of the expiring contract month’. The crucial distinction lies in the explicit reference to ‘London business days’ for the Eurodollar contract, which implies that non-London holidays would not count, versus the more general ‘business days’ for the Singapore Dollar contract, which would typically refer to Singapore business days. The other options present incorrect comparisons or details regarding the timing or reference markets.

A Credit Linked Note (CLN) is a structured note that exposes investors to credit markets, essentially by having the investor provide credit insurance via an embedded Credit Default Swap (CDS). As outlined in the CMFAS Module 6A syllabus, investors in a CLN are primarily exposed to two distinct credit risks. The first is the credit risk of the note issuer itself, or the entity holding the collateral for the CDS if an SPV is involved. The second is the credit risk of the ‘reference entity’ to which the embedded CDS is linked. If either the issuer or the reference entity defaults, the investor’s principal or coupon payments could be adversely affected. The other options describe different types of risks, such as market volatility, interest rate risk, operational risk, or general market fluctuations, which are not the primary credit risks inherent to the structure of a Credit Linked Note as defined in the syllabus.

To determine the number of futures contracts needed to hedge an equity portfolio, the formula N = (VP / Value_of_one_futures_contract) β is used. Here, N represents the number of contracts, VP is the current value of the portfolio, Value_of_one_futures_contract is the notional value of a single futures contract, and β (beta) is the portfolio’s volatility relative to the market index. In this scenario, the portfolio value (VP) is SGD 12,000,000, the beta (β) is 1.2, and the notional value of each futures contract is SGD 200,000. Plugging these values into the formula: N = (12,000,000 / 200,000) 1.2. First, calculate the ratio of the portfolio value to the futures contract value: 12,000,000 / 200,000 = 60. Then, multiply this by the portfolio’s beta: 60 1.2 = 72. Therefore, Sarah should sell 72 futures contracts to achieve the desired reduction in market risk.

A guaranteed stop-loss order is a premium service offered by some CFD providers. Unlike a standard stop-loss order, which may be subject to slippage in volatile markets (meaning it could be executed at a price worse than the specified stop price if the market gaps), a guaranteed stop-loss ensures that the position will be closed out precisely at the price set by the investor. This provides absolute certainty regarding the maximum potential loss, even if the market experiences significant price jumps or gaps. Therefore, in the scenario described, the position would be closed at the $75.00 stop-loss price, irrespective of the market opening lower at $72.00. The other options describe outcomes inconsistent with the nature of a guaranteed stop-loss: closing at the gapped price ($72.00) would be typical for a standard stop-loss, converting to a limit order is not how it functions, and requiring manual confirmation contradicts the automatic execution feature.

The question describes a scenario where a portfolio manager anticipates a rise in interest rates and wants to profit from this while limiting their maximum potential loss to the initial outlay. Buying an interest rate call option aligns perfectly with these objectives. An interest rate call option gives the buyer the right to receive a known interest rate payment if the prevailing interest rate at expiration is above the strike price. If the rates rise as anticipated, the option will be in-the-money, allowing the manager to profit. The maximum loss for the option buyer is always limited to the premium paid for the option, fulfilling the requirement of strictly limiting potential losses. Selling an interest rate put option, while generating premium income, exposes the seller to potentially unlimited losses if interest rates move significantly against their position. Buying a bond call option would be beneficial if interest rates were expected to fall (causing bond prices to rise), which is contrary to the scenario. An interest rate swap is a different derivative instrument used for managing interest rate exposure, but it does not inherently limit losses to an initial premium in the same way an option purchase does for the buyer.

To determine the required rebalancing action in a Constant Proportion Portfolio Insurance (CPPI) strategy, follow these steps: 1. Calculate the Floor Value: The floor is 85% of the initial portfolio value of $100. So, Floor = 0.85 $100 = $85. 2. Calculate the Cushion: The cushion is the difference between the current total portfolio value and the floor. Current Portfolio Value = $95. Cushion = $95 – $85 = $10. 3. Calculate the Target Risky Asset Allocation: This is determined by multiplying the cushion by the multiplier. Multiplier = 5. Target Risky Asset Allocation = Multiplier Cushion = 5 $10 = $50. 4. Determine the Rebalancing Action: Compare the target risky asset allocation with the current risky asset allocation. Current Risky Asset Allocation = $40. Since the target allocation ($50) is higher than the current allocation ($40), the manager needs to increase the allocation to the risky asset. The amount to increase is $50 – $40 = $10. 5. Identify the Source of Funds: To increase the risky asset allocation, funds must be moved from the risk-free asset. Therefore, the manager must sell $10 of the risk-free asset and use those proceeds to buy $10 of the risky asset.

Ms. Chen anticipates a substantial increase in the market price of shares and wants to profit without obligation. A call option buyer has the right, but not the obligation, to buy the underlying asset at a contracted strike price, which is beneficial if the market price rises above the strike price. Therefore, buying a call option aligns with Ms. Chen’s objective. Mr. Lee foresees a significant drop in share price and aims to gain from this decline, also without obligation. A put option buyer has the right, but not the obligation, to sell the underlying asset at a contracted strike price, which is beneficial if the market price falls below the strike price. Thus, buying a put option aligns with Mr. Lee’s objective. Selling either a call or a put option would impose an obligation on the seller, which contradicts the stated goal of both investors to operate ‘without being obligated’.

The CMFAS Module 6A syllabus highlights that while Reverse Convertibles and Discount Certificates can achieve similar risk-return profiles, their underlying compositions are distinct, a concept often illustrated by put-call parity. A Reverse Convertible is typically constructed from a bond (or note) combined with a short put option. This structure provides income from the bond and the premium from the short put, but exposes the investor to the full downside risk if the underlying asset falls below the put’s strike price. In contrast, a Discount Certificate is composed of a long zero-strike call option and a short call option. The premium received from selling the short call is greater than the cost of the long zero-strike call, and this net premium is passed to the investor as a discount at the time of investment. Both products cap upside potential and expose the investor to significant downside risk, but achieve this through different combinations of derivatives and fixed income instruments. Therefore, the statement that accurately describes the Discount Certificate’s components as a long zero-strike call option and a short call option, in contrast to a Reverse Convertible’s bond and short put option, is correct. The other options misrepresent the fundamental building blocks of one or both of these structured products.

The scenario describes a financial entity identifying a temporary price discrepancy between a futures contract and its underlying assets, then executing simultaneous trades to profit from this imbalance without taking on significant directional market risk. This activity is the defining characteristic of an arbitrageur. Arbitrageurs seek to make riskless profits by exploiting price differences between related markets or instruments that have a fixed relationship. They do not take directional bets on the market but rather capitalize on temporary market inefficiencies. Hedgers use futures to reduce or limit risk associated with an adverse price change in an existing position. Speculators take directional bets on the market, aiming to profit from anticipated price movements. Market makers provide liquidity to the markets by continuously quoting both bid and offer prices.

A Range Accrual Note (RAN) is designed such that the investor receives a specified coupon only when a reference index, such as SORA, remains within a predefined range during the observation period. If the index moves outside this range, the coupon accrual is reduced or becomes zero. The question explicitly states that the principal is fully protected at maturity and assumes the issuer’s creditworthiness. Therefore, the primary risk unique to the RAN structure, under these conditions, is the variability or potential loss of the expected coupon income due to the reference index’s movement outside the stipulated range. Options suggesting principal loss are incorrect because the note specifies principal protection. Option 3 is incorrect as SORA is a benchmark rate, not an entity with credit risk. Option 4, while a general risk for any note, is mitigated by the question’s premise of assuming issuer creditworthiness, directing focus to the specific features of the RAN’s coupon mechanism.

Structured warrants listed on SGX-ST are predominantly settled in cash, especially upon expiration if they are in-the-money. This settlement is typically automatic. For a call warrant, the cash settlement amount is calculated as the difference between the underlying share price (S) and the exercise price (X), divided by the conversion ratio (n), i.e., (S – X) / n. The warrant holder receives this cash payment directly. Physical settlement, where the underlying shares are delivered, is less common for structured warrants on SGX-ST. Therefore, the investor would receive a cash payment, and there is no requirement for the investor to submit an exercise notice or for the issuer to deliver physical shares under these typical circumstances.

Rho is the option Greek that specifically measures the sensitivity of an option’s price to changes in the risk-free interest rate. When an investor is concerned about how fluctuations in interest rates might affect their option positions, monitoring Rho provides direct insight into this particular risk factor. Delta, on the other hand, quantifies the option price’s sensitivity to movements in the underlying asset’s price. Vega assesses the option price’s responsiveness to changes in the implied volatility of the underlying asset. Theta measures the rate at which an option’s value decays as time passes towards its expiration date. Therefore, for concerns related to interest rate fluctuations, Rho is the appropriate metric to observe.

The scenario describes a trading firm experiencing issues with futures contracts that have distant expiry dates, specifically noting higher volatility and difficulty in liquidation during adverse market conditions. This challenge directly relates to the concept of liquidity risk associated with contract maturity. A maturity limit is specifically designed to address this by restricting exposure to contracts beyond a certain expiry timeframe. This is because liquidity typically decreases for further-month contracts, making them more volatile and harder to unwind. While maximum loss limits control overall losses, open contracts limits manage total position size, and stress test limits assess portfolio resilience under extreme conditions, only a maturity limit directly targets the risks stemming from the reduced liquidity and increased volatility of longer-dated futures contracts.

Structured funds in Singapore are regulated under the Code on Collective Investment Schemes (CIS) as part of the Securities & Futures Act (SFA). A significant operational distinction highlighted in the syllabus is that structured funds are mandated to provide regular Net Asset Values (NAVs). This requirement ensures transparency and consistent valuation for investors, a practice not typically required for structured notes or structured deposits. Conversely, structured funds usually have separate fees (e.g., fund management and administration fees), unlike structured notes and deposits where fees are often embedded in the product’s pricing. While some structured funds may offer principal protection, it is not an exclusive or universal feature for all structured funds to guarantee full principal protection. Lastly, structured funds are managed by asset management companies holding a Capital Markets Services (CMS) license, not exclusively by institutions with a universal banking license.

The question describes an options strategy constructed using contracts on the same underlying asset, but with both different strike prices and different expiration dates. According to the CMFAS Module 6A syllabus, a diagonal spread is explicitly defined as being created using options of the same underlying security but with different strike prices and different expiration dates. It is considered a combination of vertical and calendar (horizontal) spreads. A vertical spread involves options with the same expiration date but different strike prices. A horizontal (or calendar) spread involves options with the same strike price but different expiration dates. A condor spread is a variation of a butterfly spread, typically involving four options with four different strike prices, but it doesn’t inherently specify different expiration dates as its primary distinguishing feature in the same way a diagonal spread does for both strike and expiration differences.

A bear put spread is a strategy implemented by buying a higher striking in-the-money put option and selling a lower striking out-of-the-money put option of the same underlying security with the same expiration date. This strategy results in a net debit, meaning a cash outlay is required to enter the trade. The maximum potential loss for a bear put spread occurs if the underlying asset’s price rises above the strike price of the long put option at expiration. In this scenario, both put options expire worthless, and the investor loses the initial net debit paid to establish the position. The net debit is calculated as the premium paid for the long put minus the premium received from selling the short put. Here, the premium paid is $4.00 and the premium received is $1.50, so the net debit, and thus the maximum loss, is $4.00 – $1.50 = $2.50.

To determine the total expenses incurred by the investor, we need to calculate the commission for both the buy and sell transactions, the Goods and Services Tax (GST) on these commissions, and the financing interest for the holding period. 1. Calculate Buy Commission: Value of purchase = Quantity × Opening Price = 5,000 units × $1.50 = $7,500 Buy Commission = Value of purchase × Commission Rate = $7,500 × 0.3% = $22.50 2. Calculate GST on Buy Commission: GST (9%) = Buy Commission × 9% = $22.50 × 0.09 = $2.025 3. Calculate Total Buy Transaction Cost: Total Buy Cost = Buy Commission + GST on Buy Commission = $22.50 + $2.025 = $24.525 4. Calculate Sell Commission: Value of sale = Quantity × Closing Price = 5,000 units × $1.60 = $8,000 Sell Commission = Value of sale × Commission Rate = $8,000 × 0.3% = $24.00 5. Calculate GST on Sell Commission: GST (9%) = Sell Commission × 9% = $24.00 × 0.09 = $2.16 6. Calculate Total Sell Transaction Cost: Total Sell Cost = Sell Commission + GST on Sell Commission = $24.00 + $2.16 = $26.16 7. Calculate Financing Interest: The financing interest is calculated on the opening value of the position. Annual Interest = Opening Value × Annual Financing Rate = $7,500 × 4.5% = $337.50 Daily Interest = Annual Interest / 360 days = $337.50 / 360 = $0.9375 per day Total Interest for 15 days = Daily Interest × Number of Days = $0.9375 × 15 = $14.0625 8. Calculate Total Expenses Incurred: Total Expenses = Total Buy Transaction Cost + Total Sell Transaction Cost + Total Financing Interest Total Expenses = $24.525 + $26.16 + $14.0625 = $64.7475 Rounding to two decimal places, the total expenses incurred are $64.75.

Basis risk is the primary risk introduced in a hedging strategy when there are imperfections between the asset being hedged and the futures contract used. The scenario describes three common causes of basis risk: the underlying asset in the futures contract is not completely identical to the asset being hedged (e.g., different grades of a commodity), the hedger is uncertain about the exact date of the physical transaction, and the hedge may require the futures contract to be closed before its delivery month. These factors mean that the spot price of the asset being hedged and the futures price of the contract used may not move in perfect tandem, or converge as expected at the desired closing date, leading to an uncertain hedging outcome. Liquidity risk refers to the difficulty of executing a trade without impacting the price due to insufficient market depth. Credit risk is the risk of financial loss due to a counterparty’s failure to meet its obligations. Operational risk relates to losses resulting from inadequate or failed internal processes, people, and systems, or from external events. While these are all types of financial risks, the specific issues outlined in the scenario directly correspond to the definition and causes of basis risk.

Arbitrage between Forward Rate Agreements (FRAs) and interest rate futures contracts aims to exploit temporary pricing inefficiencies. While aligning the value dates of both instruments is crucial for a risk-free arbitrage, the provided syllabus material highlights that even with corresponding value dates, ‘residual basis risks or fixing risks’ can persist. A paramount factor in minimizing these specific risks is to ensure that no significant calendar events or releases of important economic data (such as unemployment figures or consumer price index) are scheduled to occur between the fixing dates of the two instruments. Such events can cause the underlying interest rates to move in an unpredictable manner, leading to a divergence in the final settlement values of the FRA and the futures contract, thereby eroding the intended risk-free profit. Verifying identical underlying reference rates is a prerequisite for considering the instruments ‘corresponding,’ rather than an additional risk mitigation step for residual basis risk. Differences in liquidity between OTC FRAs and exchange-traded futures, or managing margin calls for futures, relate more to operational and liquidity management rather than the specific basis risk arising from timing discrepancies of market-moving events between fixing dates.

Extended Settlement (ES) Contracts are specifically designed to allow investors to take short positions, enabling them to profit from anticipated price declines in underlying securities. A key benefit highlighted in the CMFAS Module 6A syllabus is that ES contracts allow for taking a short position without immediately incurring borrowing costs or facing the possibility of a buy-in, which are common challenges with shorting in the ready market. While contra trading allows for intra-day short selling, it does not offer the same extended tenure or avoidance of borrowing costs for positions held longer. Margin financing, as per the syllabus, generally does not facilitate short selling. Ready market spot trading, when used for short selling, inherently involves borrowing the shares and thus incurring borrowing costs and the risk of a buy-in if shares are not returned.

An Extended Settlement (ES) long hedge is a strategy employed when an investor anticipates purchasing shares in the future but is concerned about a potential increase in the share price before their funds become available. By entering into an ES long contract, the investor effectively locks in a purchase price for the underlying shares. This action protects them from the adverse impact of a rising market price, ensuring they can acquire the shares at a predetermined cost. While ES contracts do involve an initial margin outlay, they allow the investor to secure a future purchase price with a smaller initial capital commitment compared to buying the shares outright immediately. The primary goal is price certainty and risk mitigation against upward price movements, not speculation or avoiding margin requirements.

The Capital Protected Portfolio Insurance (CPPI) strategy is designed to protect principal while offering upside potential. Its rebalancing mechanism dictates that the allocation to the risky asset is determined by a multiplier times the cushion value (Total portfolio value – Floor value). In a prolonged range-bound market, even if the underlying asset does not experience a significant crash, its fluctuations within a narrow band, combined with any minor losses or fees, can gradually erode the total portfolio value relative to the floor. As the total portfolio value decreases or stagnates, the cushion value shrinks. A smaller cushion value, by the CPPI formula (Allocation to Risky Asset = Multiplier x Cushion Value), directly leads to a reduced allocation to the risky asset. This forced reduction in risky asset exposure during periods of market stagnation can lead to the undesirable outcome of ‘selling low’ and missing out on potential future upside if the market eventually recovers, as the portfolio may be entirely shifted to the risk-free asset.

To determine the number of futures contracts required to hedge an equity portfolio, the formula for hedging equity risks is applied. The formula is: Number of Contracts (N) = (Portfolio Value (VP) / (Futures Price (F) Contract Multiplier (T))) Portfolio Beta (β). Given the following values: Portfolio Value (VP) = S$15,000,000 Portfolio Beta (β) = 1.2 Current Futures Quote (F) = 3,000 points Contract Multiplier (T) = S$50 per point First, calculate the total value represented by one futures contract: Value of one futures contract = Futures Price (F) × Contract Multiplier (T) = 3,000 points × S$50/point = S$150,000. Next, substitute these values into the hedging formula: N = (S$15,000,000 / S$150,000) × 1.2 N = 100 × 1.2 N = 120 contracts. Therefore, 120 futures contracts should be utilized to establish the desired hedge.

The question pertains to the daily price limit rules for futures contracts as specified in the CMFAS Module 6A syllabus. According to the provided specifications, whenever the price of a futures contract moves by 15% in either direction from the previous day’s settlement price, trading at or within a price limit of 15% is allowed for the next 10 minutes. After this 10-minute cooling-off period has elapsed, there are no further price limits for the remainder of that trading day. This rule applies unless it is the last trading day of the expiring contract month, in which case there are no price limits at all. The scenario describes a 16% movement on a day that is not the last trading day, triggering the 15% limit rule and subsequent cooling-off period.

The question requires the application of the adjustment formula for dividends on warrants, as specified in the CMFAS Module 6A syllabus under ‘Adjustment for Dividends’. The formula for the Adjustment Factor is (P – SD – ND) / (P – ND), where P is the last cum-date closing price of the underlying, SD is the Special Dividend per Share, and ND is the Normal Dividend per Share. The New Exercise Price is then calculated by multiplying the Old Exercise Price by this Adjustment Factor. In the given scenario: Old Exercise Price = $25.00 P (last cum-date closing price) = $100.00 SD (Special Dividend per Share) = $5.00 ND (Normal Dividend per Share) = $2.00 First, calculate the Adjustment Factor: Adjustment Factor = (100 – 5 – 2) / (100 – 2) Adjustment Factor = 93 / 98 ≈ 0.94897959 Next, calculate the New Exercise Price: New Exercise Price = Old Exercise Price × Adjustment Factor New Exercise Price = $25.00 × (93 / 98) New Exercise Price ≈ $23.72448979 Rounding to two decimal places, the new adjusted exercise price is $23.72. Option 2 ($24.23) would result from incorrectly omitting the Normal Dividend (ND) from the numerator of the adjustment factor, calculating (P – SD) / (P – ND) = (100 – 5) / (100 – 2) = 95 / 98, then $25.00 × (95 / 98) ≈ $24.23. Option 3 ($23.25) would result from incorrectly omitting the Normal Dividend (ND) from the denominator, using P instead of (P – ND), calculating (P – SD – ND) / P = (100 – 5 – 2) / 100 = 93 / 100, then $25.00 × (93 / 100) = $23.25. Option 4 ($25.79) results from an incorrect inversion of terms in the adjustment factor, such as (P – ND) / (P – SD) = (100 – 2) / (100 – 5) = 98 / 95, then $25.00 × (98 / 95) ≈ $25.79.

A Range Accrual Note (RAN) is a structured product where the coupon payment is contingent on a reference index (such as the 3-month SGD SOR) remaining within a predefined range during the observation period. If the reference index consistently closes outside this range, the investor will receive less or no interest for those specific days. However, a fundamental characteristic of RANs, as a type of yield enhancement structure, is that the principal sum is generally preserved and returned at maturity, subject to the issuer’s credit risk. Therefore, the primary implication of the index staying outside the range is a reduction or cessation of coupon accrual, not a loss of principal or a guaranteed minimum coupon. The note does not typically have an automatic early redemption feature based solely on the index moving out of range.

The yield to note holders for a First-to-Default Credit Linked Note (CLN) is influenced by the correlation among the underlying reference entities. As per the syllabus, lower correlation among the companies in the basket implies more independent risk factors, which increases the overall probability of a first default occurring within the basket. This higher risk necessitates a higher yield to compensate the note holders. Conversely, if the correlation among the entities increases, their default events become more interdependent. In the extreme case of perfect correlation, the basket effectively behaves as if it contains only a single risk factor, meaning the probability of a first default is equivalent to the default probability of any single entity. This reduced effective risk for the note holder (compared to an uncorrelated basket) means a lower yield is required to compensate them. Therefore, an increase in correlation generally leads to a lower required yield.

Yield Enhanced Securities, also known as Discount Certificates, are designed to offer investors an attractive yield by allowing them to purchase exposure to an underlying asset at a discount to its market price. In return for this discount, the investor’s potential upside exposure is capped. Specifically, at maturity, if the underlying asset’s closing price on the expiration or valuation date(s) is at or above the exercise price, the holder receives a cash settlement equal to the exercise price. If the closing price is below the exercise price, the holder receives a cash settlement equal to the value of the underlying on the expiration or valuation date(s). This payoff structure aligns with the scenario of seeking a discount while accepting capped upside. The other options describe the characteristics of different types of exotic warrants: currency translated warrants involve different settlement and underlying currencies; basket warrants have a collection of shares as their underlying; and index warrants are cash-settled based on an index level difference, typically without further adjustments for corporate actions.