CMFAS RES6A Quiz 90

The primary objective of SGX’s full corporate action adjustments for Extended Settlement (ES) contracts is to ensure that the contract’s value remains, as far as practicable, equivalent before and after the corporate event. This prevents undue advantage or disadvantage to contract holders solely due to the corporate action on the underlying security. The adjustments aim to maintain the economic position of the contract holder. The other options describe potential secondary effects, specific mechanisms, or unrelated aspects rather than the fundamental objective of the adjustments.

Mr. Tan’s position involves a spread, meaning he holds both a long and a short position in ES contracts of different contract months for the same underlying security. For spread positions, the Maintenance Margin (MM) is typically a lower percentage and is applied once for the entire spread. The Additional Margin (AM) accounts for mark-to-market gains or losses on each leg. 1. Calculate Maintenance Margin (MM): The MM for spread positions is 2.5% of the underlying price. Using the initial buy price of the long leg as the reference for the underlying price, as per the syllabus example: MM = $5.20 (initial buy price) 500 units 2.5% = $65.00. 2. Calculate Additional Margin (AM) for the Long July ES position: The investor bought at $5.20 and the valuation price is $5.00. This represents a gain of $0.20 per unit ($5.20 – $5.00). AM (Long) = ($5.20 – $5.00) 500 units = $100.00. A gain reduces the overall margin requirement, so this is treated as a negative component in the total margin calculation, i.e., -$100.00. 3. Calculate Additional Margin (AM) for the Short September ES position: The investor sold short at $5.35 and the valuation price is $5.60. This represents a loss of $0.25 per unit ($5.35 – $5.60). AM (Short) = ($5.35 – $5.60) 500 units = -$125.00. A loss increases the overall margin requirement, so this is treated as a positive component in the total margin calculation, i.e., +$125.00. 4. Calculate Total Required Margin: Total Required Margin = MM + Net Additional Margin Total Required Margin = $65.00 + (-$100.00) + (+$125.00) Total Required Margin = $65.00 + $25.00 = $90.00.

A Constant Proportion Portfolio Insurance (CPPI) strategy aims to provide capital protection while allowing participation in the upside potential of a risky asset. It achieves this by dynamically adjusting the allocation between a risky asset and a risk-free asset. As the value of the risky asset appreciates, more is allocated to it, and vice-versa. However, the strategy has specific vulnerabilities. The provided text highlights that there is a higher chance for the portfolio value to drop to its floor value, forcing the manager to allocate the entire fund into the risk-free asset, under certain market conditions. These conditions include a prolonged period of range-bound prices, after a major deleveraging event, or when there has been a sharp drop in asset prices. When the fund is fully allocated to the risk-free asset, it loses all participation in any subsequent appreciation of the underlying risky asset. Therefore, a market characterized by prolonged range-bound prices or a sudden, significant drop in asset values is the most likely scenario to trigger this specific negative outcome for a CPPI strategy. Conditions like consistent upward trends, low volatility, or strong appreciation are generally favorable for CPPI strategies, allowing them to perform as intended.

According to CMFAS Module 6A guidelines, specifically section 13.7.8, if a customer fails to obtain the necessary margins by the close of the market on T+2 after a margin call, the Member and Trading Representative (TR) shall not accept orders for new trades for the customer. However, an important exception is made for orders which would result in the customer’s Required Margins being reduced (i.e., risk-reducing trades). Furthermore, the Member and TR may take actions they deem appropriate, without giving notice to the customer, to reduce their exposure. Such actions can include liquidating all or part of the customer’s collateral or offsetting positions. There is no requirement for a formal written warning before liquidation, nor is SGX approval explicitly required for the Member to take action to reduce its own exposure, although SGX may also order such action. Risk-neutral trades are generally not permitted after the T+2 deadline if the margin call is unmet.

Structured funds fundamentally differ from traditional mutual funds in their investment methodology. Traditional mutual funds typically involve direct investment in underlying assets and rely on the fund manager’s active discretion for allocation. In contrast, structured funds are designed to replicate the performance of an underlying asset or provide a synthetic return by incorporating derivatives. Their allocation strategy is often static or rule-based, rather than purely discretionary. This use of derivatives in structured funds introduces a wider variety of risks, including counterparty risk, which is generally more prevalent compared to traditional mutual funds.

The question assesses understanding of the specific settlement procedures for the 3-month Singapore Dollar Interest Rate Futures contract, as outlined in the CMFAS Module 6A syllabus. According to the contract specifications, the Final Settlement Price for this particular futures contract is determined based on the Association of Banks in Singapore’s USD/SGD Swap Offered Rates. Crucially, this determination occurs at a precise time: 11:00 am, Singapore time, and specifically on the contract’s last trading day. Other options present incorrect timings or days, which do not align with the established settlement protocols for this instrument.

The hedge ratio is a critical component in constructing a delta-neutral hedge. A delta-neutral hedge aims to create a position where the overall value of the hedged asset (the liability in this case) combined with the hedging instrument (futures contracts) remains constant, or as close to constant as possible, despite movements in the underlying market variable (interest rates). The formula for a hedged position is V = S + h x F, where V is the value of the hedged position, S is the security price (or liability value), h is the hedge ratio, and F is the futures price. For a complete or delta-neutral hedge, the change in the value of the hedged position (ΔV) should be zero. Therefore, the fundamental objective of calculating the hedge ratio is to determine the precise number of futures contracts needed to offset the sensitivity of the liability’s value to interest rate changes, thereby stabilizing the combined position’s value. The other options relate to different aspects of futures trading and hedging, such as liquidity considerations (identifying the most liquid contract), basis risk management (projecting target rates or rolling over contracts), but they do not describe the core purpose of the hedge ratio itself in achieving a delta-neutral outcome.

When a mandatory call event is triggered for a Bull Knock-Out contract, the residual value is determined by the difference between the underlying asset’s settlement price at the time of the call and the strike price, divided by the conversion ratio. In this specific scenario, the underlying XYZ Corp share price at the mandatory call event is $20.50, which serves as the settlement price. The strike price is $20.00, and the conversion ratio is 5:1. Therefore, the calculation for the residual value is ($20.50 – $20.00) ÷ 5, which equals $0.50 ÷ 5, resulting in a residual value of $0.10 per contract.

When an Exchange Traded Fund (ETF) tracks an index composed of illiquid or infrequently traded securities, the efficiency of the creation and redemption mechanism can be compromised. Authorized Participants (APs) find it more challenging and costly to acquire or dispose of the underlying securities to create or redeem ETF units. This difficulty leads to wider bid-ask spreads for the underlying assets, which in turn typically results in wider bid-ask spreads for the ETF units themselves on the secondary market. Furthermore, the inability of APs to effectively arbitrage away price discrepancies means the ETF’s market price is more likely to deviate significantly from its Net Asset Value (NAV), trading at either a premium or a discount. This divergence between market price and NAV, along with increased transaction costs for the underlying, contributes to a higher tracking error, which is the deviation of the ETF’s performance from its underlying index.

The question describes the key characteristics of a condor spread. A condor spread is a neutral trading strategy that combines a bull spread and a bear spread, similar to a butterfly spread. The crucial distinction, as highlighted in the scenario, is that a condor spread involves four contracts with equally distributed delivery months and does not have a common middle month that is sold twice, unlike a butterfly spread. This structure allows for a wider range of profitability around the central price point. A calendar spread involves only two contracts with different delivery months for the same underlying asset. A basis trade is an arbitrage strategy focused on the convergence of values between two related securities. The TED spread is an indicator of credit risk, representing the difference between U.S. Treasury and Eurodollar futures prices, not a trading strategy for an investor to implement in this manner.

A zero-cost collar is an option strategy designed to provide protection against adverse price movements without incurring an upfront net premium cost. For an exporter expecting foreign currency (USD) receipts and concerned about the foreign currency weakening (depreciating) against their home currency (JPY), they would typically buy a put option on the foreign currency (USD put/JPY call) to protect against depreciation. To offset the premium paid for this put, they simultaneously sell a call option on the foreign currency (USD call/JPY put). The strike prices of these options are adjusted so that the premium received from selling the call equals the premium paid for buying the put, resulting in a zero net premium outlay. This strategy limits both the downside risk (due to the purchased put) and the upside potential (due to the sold call) within a defined range, making it suitable for an investor with a stable or range-bound market outlook who wants cost-effective protection. The other options either involve an upfront premium cost (buying a protective put), have a different primary objective (covered call for income generation against existing long positions), or are not an option strategy (futures contract).

Tracking error measures the deviation of an ETF’s performance from its underlying index. The daily computation and public disclosure of an ETF’s Net Asset Value (NAV) is a standard valuation and reporting procedure. While an ETF’s market price can trade at a premium or discount to its NAV, and tracking error can contribute to this, the act of calculating the NAV itself is not a direct cause of the ETF’s performance deviating from its benchmark. Instead, NAV reflects the value of the ETF’s underlying assets. In contrast, transaction costs from rebalancing, cash holdings leading to cash drag, and challenges in replicating an index due to illiquid securities (resulting in differences in portfolio holdings) are all explicitly identified as direct contributors to tracking error in the CMFAS Module 6A syllabus.

The investor in this structured product is effectively the seller of an interest rate call swaption. When market interest rates decrease below the strike price, the call swaption becomes in-the-money for the option buyer. This means the investor (as the seller) will have to make payouts to the option buyer, representing a market risk exposure. Furthermore, structured products are exposed to the credit risk of their issuer. If the product is issued by a Special Purpose Vehicle (SPV) and its credit standing deteriorates, there is a risk that the SPV may default on its obligations to the investor, especially if the SPV is not guaranteed by its parent entity. Therefore, the investor faces both the market risk from the swaption’s performance and the credit risk of the SPV.

The premium of a warrant is defined as the difference between the warrant price and its intrinsic value. This premium largely represents the time value of the warrant. Time value reflects the market’s expectation of the underlying asset’s future price movements and the remaining duration until the warrant’s expiry. Warrants with more time until expiry or higher expected volatility in the underlying asset typically have a higher time value component in their premium. It is not the immediate profit, a maximum potential loss, or an administrative fee.

The premium of a call option is influenced by several factors. An increase in the underlying share price directly increases the call option’s intrinsic value and thus its premium. Higher implied volatility suggests a greater likelihood of significant price movements, which benefits option buyers (both calls and puts) by increasing the chance of the option ending in-the-money, thereby increasing the time value component of the premium. A reduction in expected future dividends for the underlying stock is also beneficial for call options, as dividends typically cause the share price to drop on the ex-dividend date, which would otherwise negatively impact a call option’s value. Therefore, a combination of these three factors—a rising underlying share price, increasing volatility, and reduced expected dividends—would most significantly contribute to an increase in the call option’s premium. Other options contain factors that would either decrease the call option’s premium (e.g., decreasing underlying share price, falling volatility, increasing dividends, decreasing interest rates, or shortening time to expiration) or have mixed effects that would not lead to the most significant increase.

For an investment firm structuring an equity-linked note, the ideal market conditions at issuance are high interest rates and low volatility in the underlying asset. High interest rates lead to a lower present value for the zero-coupon bond component, which means a larger ‘discount sum’ is available from the capital allocated to the bond. This larger discount sum can then be used to purchase the embedded call option, potentially allowing for a higher participation rate for investors. Concurrently, low volatility in the underlying asset makes the cost of equity options cheaper. This combination of more available funds for the option and a lower option cost allows the issuer to create a more appealing product with better upside potential for investors while managing their own costs effectively. Other combinations of interest rates and volatility would either reduce the funds available for the option or increase the option’s cost, making the structured product less attractive or more expensive to issue.

An accumulator is an equity-linked structured product that allows an investor to purchase a pre-determined quantity of a reference stock at regular intervals at a fixed, often discounted, strike price. A key feature of most accumulators is the knock-out barrier. If the daily closing price of the underlying shares reaches or exceeds this barrier, the derivative agreement is terminated. This means the investor will no longer accumulate shares at the discounted price, effectively capping their potential gains from the agreement. The strike price remains fixed throughout the agreement unless terminated, and there is no mechanism for automatic adjustment upwards. While early termination by the investor typically incurs ‘break’ costs, the termination due to the knock-out barrier being hit is a pre-defined feature of the product, not a penalty imposed on the investor for favorable market conditions.

An Equity-Linked Structured Note (ELSN) typically comprises two main components: a zero-coupon bond for capital preservation and an equity call option for potential upside returns. The zero-coupon bond is purchased at a discount to its face value, and its present value is inversely related to the prevailing interest rates. When interest rates increase, the present value of the zero-coupon bond decreases (PV = Face Value / (1+r)^T). The ‘discount sum’ is the difference between the bond’s face value and its present value. A lower present value of the bond, resulting from higher interest rates, leads to a larger discount sum. This larger discount sum is then available to purchase the equity call option. Assuming the premium of the equity call option remains constant, a larger discount sum allows the issuer to purchase more option contracts, thereby increasing the investor’s potential equity participation rate in the underlying asset.

A call option grants its buyer the right, but not the obligation, to purchase a specified underlying asset at a predetermined strike price within a set timeframe. Correspondingly, the seller of that call option assumes a contractual obligation to sell and deliver the underlying asset at the strike price if the buyer decides to exercise their right. This means the buyer holds the choice, while the seller must fulfill the contract if exercised. This is distinct from a put option, where the buyer has the right to sell and the seller has the obligation to buy.

Exchange-Traded Notes (ETNs) are debt instruments issued by financial institutions. This means that an ETN’s performance is not only linked to the underlying market benchmark or strategy it tracks but also carries the credit risk of the issuing institution. If the issuer defaults, investors could lose their principal. Conversely, Exchange-Traded Funds (ETFs) are investment funds that hold a diversified portfolio of actual underlying assets (e.g., stocks, bonds, commodities). When an investor buys an ETF, they are purchasing shares in a fund that owns these assets, thereby gaining an ownership stake in the underlying portfolio. This fundamental difference in structure means ETFs generally do not carry the same level of issuer credit risk as ETNs, as the assets are typically held separately by the fund.

The scenario describes a fund that seeks exposure to an underlying asset without directly holding it, instead utilizing derivative transactions and potentially a hedging asset. This mechanism is the defining characteristic of an Indirect Investment Policy Fund, also known as a Swap-based Fund, as outlined in the syllabus. These funds gain synthetic exposure to the underlying asset’s performance through derivatives. A Capitalized Fund, in contrast, is characterized by the automatic reinvestment of dividends and income back into the fund, focusing on accumulation rather than the method of asset exposure. A Formula Fund’s payout is determined by a pre-defined, rule-based calculation, which is a different structural feature. Lastly, a Capital Preservation Fund is designed with the primary objective of protecting a significant portion of the initial capital, which describes the fund’s goal rather than its method of gaining asset exposure.

The index-linked note is structured to provide 100% principal preservation at maturity. In addition to the principal, the investor receives a return on the principal. The terms specify that this return will be the greater of two conditions: a 24% minimum total return or 100% participation in the underlying index’s average performance. In the given scenario, the average performance of the index is 18%. When comparing the two conditions, 24% (minimum total return) is greater than 18% (index participation). Therefore, the investor will receive a 24% total return on their initial principal, in addition to the original principal amount.

Extended Settlement (ES) contracts are considered a superior hedging tool for achieving a near-perfect hedge compared to warrants primarily because of their delta. ES contracts have a delta of approximately 1.0, meaning their price movement is nearly one-to-one with the underlying asset. This characteristic provides an immediate and almost complete offset to the price fluctuations of the physical shares being hedged. In contrast, warrants have a delta that is typically less than 1.0 (e.g., 0.5 for at-the-money warrants), and their hedging effectiveness depends on factors like the strike price and time to expiry, making them less direct for achieving a full hedge. While other features of ES contracts, such as not requiring a strike price, simpler breakeven calculations, and margin-based costs not subject to time decay, contribute to their overall attractiveness as a hedging instrument, the near 100% delta is the key factor for their effectiveness in achieving a near-perfect hedge.

When a financial institution aims to isolate the credit risk of a structured note issuance from its main operations and keep the associated debt off its primary balance sheet, it typically establishes a Special Purpose Vehicle (SPV). The SPV is a separate legal entity that issues the notes directly to investors. From the bank’s perspective, the SPV’s assets and liabilities are not reflected on its balance sheet, making it an ‘off-balance sheet’ arrangement. In the event of a default, noteholders can only make a claim on the SPV’s assets and have no recourse to the bank that set up the SPV. Direct issuance, conversely, places the debt directly on the bank’s balance sheet, and noteholders bear the bank’s credit risk. Debentures are a legal form (wrapper) for structured notes, but they represent a direct obligation of the issuer and are typically on-balance sheet. Structured deposits are a different product type, also a debt obligation of the bank and thus on-balance sheet, and while they offer principal protection in Singapore, they do not serve the purpose of off-balance sheet issuance for structured notes.

A structured note is fundamentally a debt instrument, or debenture, issued by an entity. This means that investors are exposed to the credit risk of the issuer for the repayment of principal and any promised coupons. The key feature of a structured note is that it integrates one or more derivatives. These derivatives link the note’s return characteristics, such as coupon amounts or market value, and often the principal repayment, to the performance of underlying instruments like equities, indices, interest rates, or commodities. Therefore, the note’s performance is not solely dependent on the issuer’s credit but also on the performance of these underlying assets. Unlike direct investments in the underlying assets, the note holder typically does not have a direct claim or ownership over the underlying instruments. While some structured notes may offer capital protection, principal repayment is often not guaranteed and can be contingent on the underlying asset’s performance. Structured notes are regulated under the Securities and Futures Act (SFA) in Singapore and are subject to prospectus requirements unless offered to accredited investors, meaning they are not unregulated products. The value is determined by the performance of the underlying assets and the issuer’s creditworthiness, not solely by the issuer’s discretion.

To construct a synthetic short put, an investor needs to combine a long position in the underlying asset with a short call option. This combination replicates the payoff structure of a short put, where the investor benefits if the underlying asset’s price rises above the strike price of the short call, and faces potential losses if the price falls significantly. The other options represent different synthetic positions: short underlying and long call creates a synthetic long put; long underlying and long put creates a synthetic long call; and short underlying and short put creates a synthetic short call.

To determine the number of futures contracts required for a delta-neutral hedge, we first calculate the hedge ratio (h). The hedge ratio for an interest rate hedge, assuming a 1:1 correlation between the loan interest rate and the Eurodollar rate, is given by the formula: h = – [ (Loan Tenor / 360) / (Futures Tenor / 360 (1 + Current Loan Rate Loan Tenor / 360)) ] Given: Loan Value = USD 80,000,000 Loan Tenor = 150 days Current Loan Rate = 3.00% p.a. (0.03) Futures Contract Tenor (for Eurodollar futures) = 90 days (which is 0.25 when expressed as a fraction of 360 days) Futures Contract Size = USD 1,000,000 First, calculate the Loan Tenor / 360: 150 / 360 = 0.41666667 Next, calculate the term (1 + Current Loan Rate Loan Tenor / 360): 1 + (0.03 0.41666667) = 1 + 0.0125 = 1.0125 Now, substitute these values into the hedge ratio formula: h = – [ 0.41666667 / (0.25 1.0125) ] h = – [ 0.41666667 / 0.253125 ] h = – 1.646802 The number of contracts is then calculated as: Number of contracts = – Hedge Ratio Loan Value / Contract Size Number of contracts = – (-1.646802) 80,000,000 / 1,000,000 Number of contracts = 1.646802 80 Number of contracts = 131.74416 Rounding to the nearest whole contract, the company should use 132 futures contracts.

The question pertains to the evaluation of a hedging strategy and the common sources of error when a hedge does not perfectly offset the underlying risk. According to the CMFAS Module 6A syllabus, specifically in the section on ‘Managing the Hedge’, it is stated that ‘Normally the main sources of error are due to the projected value of the basis at the lift date and the parameters estimated for cross hedges.’ Therefore, fluctuations in the estimated basis value at the time the hedge is closed out (or ‘lifted’) are a primary and common source of hedging error. The other options describe broader market risks, counterparty risks, or strategic misalignment, which are distinct from the specific operational errors in hedge effectiveness as described in the context.

The scenario describes a market mechanism that intervenes during high volatility by slowing down trading without imposing a full halt. According to the CMFAS Module 6A syllabus, ‘Shock Absorbers’ are precisely designed for this purpose: they are systems in the trading infrastructure that slow down trading when markets experience significant volatility but do not halt trading completely. ‘Circuit Breakers’, while also a market disruption mitigation tool, trigger complete trading halts. ‘Daily Price Limits’ are used to limit price volatility without slowing or halting trading activity. ‘Capital Controls’ are government actions related to country risk, such as restricting the flow of foreign capital, and are not a market disruption mechanism implemented by an exchange to manage trading speed.

The scenario describes a fund manager protecting an existing bond portfolio over a precisely defined investment period, with the goal of minimizing the variance in the expected total return by calibrating its interest rate sensitivity. This strategy is explicitly defined as a strong form cash hedge, also known as immunization. Immunization involves creating and maintaining a cash and futures portfolio with the same interest rate sensitivity as a zero-coupon bond with a maturity equal to the investment period. A weak form cash hedge (inventory hedge) aims to minimize the price variance of an existing asset portfolio held for an indefinite period. Anticipated hedges (both weak and strong form) are designed for future cash flows or anticipated positions, not for protecting an already held portfolio over a known investment horizon.