CMFAS M9A practice questions, with answers and explanations

Why C: the bond part pays the interest and the par value. The investor has also sold a put option on the underlying stock, which is why, if the stock falls below the kick-in level, the investor must take a set number of shares instead of the par value (Ch 1 §3.15 to §3.16). Because the investor's upside is capped at the note's yield, with no protection if the stock falls, the note pays a higher yield than an ordinary bond to make up for the cap (§3.17).

Why each wrong option fails:

A. This is a bought call: the investor would pay a premium for it, not earn the higher yield.

B. This is a bought put: again the investor would pay a premium for it, and it would protect against a fall in the stock rather than take on that risk.

D. This is the tempting one, because a written call also caps the upside. But a written call would oblige the investor to deliver something if prices rise, whereas the risk in a reverse convertible is a fall in the stock.

Why A: a bonus certificate protects the investor only while the barrier holds. Once the barrier is crossed, the knock-out takes away the protection and the investor is paid the value of the underlying asset at maturity (Ch 1 §3.29 to §3.30). For a certificate that can be knocked out at any time, the protection stays gone for the rest of its life, even if the price climbs back above the barrier before expiry (§3.31).

Why each wrong option fails:

B. This is the tempting one: it would be right only if the barrier had never been crossed, or for a design that can be knocked out only at maturity.

C. The barrier is the trigger for the knock-out, not a payout floor.

D. The knock-out removes the protection, not the certificate: Ravi still holds it and is paid the value of the stock.

Why B:

Step 1: convert the US$10,000 back at the new rate. US$10,000 × 1.25 = S$12,500.

Step 2: compare it with what she put in. S$14,000 − S$12,500 = S$1,500 lost, even though her US-dollar principal came back in full.

Step 3: the US-dollar return needed to break even is the old rate divided by the new rate, less 1. S$1.40 ÷ S$1.25 = 1.12, so a 12% return is needed. Check: US$11,200 × 1.25 = S$14,000.

This is the method of the study text's US-dollar example (Ch 2 §4.2 to §4.3).

Why each wrong option fails:

A. This divides the S$1,500 loss by her original S$14,000. That gives the share of her money lost (10.71%), not the return needed to recover it.

C. This is the tempting one: the note protects her principal only in US dollars, not in Singapore dollars.

D. This divides the Singapore-dollar loss by the US-dollar principal, mixing the two currencies.

Why D:

Step 1: after day one the account holds S$3,000 − S$500 = S$2,500. That is above the maintenance margin of S$2,400, so there is no margin call yet.

Step 2: after day two it holds S$2,500 − S$400 = S$2,100, which is below S$2,400, so the broker makes a margin call.

Step 3: the variation margin brings the account back to the initial margin, not to the maintenance margin. S$3,000 − S$2,100 = S$900.

This is the method of the study text's gold futures example (Ch 3 §2.26 to §2.28).

Why each wrong option fails:

A. Whether a call is made depends on the maintenance margin, not on whether the losses have used up the whole initial margin.

B. This is the tempting one: the maintenance margin only decides when a call is made, and the top-up always goes back to the initial margin.

C. This counts only the second day's loss.

Why A:

Step 1: her total cost is the two premiums. (S$1.50 + S$1.50) × 100 shares = S$300.

Step 2: at S$24 the call is worth exercising and the put expires worthless. Call value = (S$24 − S$20) × 100 = S$400.

Step 3: profit = S$400 − S$300 = S$100.

Buying a call and a put at the same strike and expiry is the straddle in the study text's example: it gains from a big move either way, and loses most if the price stays near the strike (Ch 3 §3.41 to §3.42).

Why each wrong option fails:

B. This is the tempting one: it forgets that she paid S$300 in premiums.

C. This takes off only the call's premium, but she paid for the put too.

D. This would be her result only if the price ended at S$20, where both options expire worthless.

Why C: a plain vanilla interest rate swap exchanges fixed-rate interest for floating-rate interest in one currency, so payments falling on the same date are netted and only the difference changes hands. The principal is never exchanged; it is only a notional amount used to work out the interest (Ch 3 §4.6, §4.8 to §4.9). In a cross-currency swap the payments are in two different currencies, so they cannot be netted, and both the principal and the interest are exchanged (§4.10).

Why each wrong option fails:

A. An interest rate swap does not exchange the principal, and a cross-currency swap cannot net its payments, because they are in two currencies.

B. This reverses both swaps: it is the interest rate swap that exchanges only interest, netted, and the cross-currency swap that exchanges principal and interest without netting.

D. This is the tempting one: it is right about the interest rate swap but wrong about the cross-currency swap, which does exchange principal.

Why B: in a structured ILP, the structured products are tailor-made for the ILP sub-fund, and the issuer or another party stands ready to unwind them at prevailing market prices. The purpose is liquidity: the sub-fund must be able to pay out policy owners who redeem on any dealing day (Ch 4 §1.7).

Why each wrong option fails:

A. This is the tempting one, but unwinding happens at prevailing market prices, which can be below what was invested, so it cannot secure the return of the premium.

C. This describes how a participating fund is managed: an ILP has no smoothing, and the policy owner bears the full gains and losses (§1.4, §1.6).

D. A structured ILP remains exposed to counterparty risk (§1.7).

Why D: structured ILPs are more complex than stocks and bonds, and the more complex a product is, the harder it is to see how it behaves in different markets. The study text's guidance for someone who does not understand a structured ILP's features, including the most he could lose, is to stay out or keep the amount small (Ch 4 §4.1). It also warns that structured ILPs may not suit investors who do not fully understand the product's risk and return trade-off (§4.2).

Why each wrong option fails:

A. This is the tempting one, but in an ILP the policy owner bears the investment gains and losses, and may lose part or all of his principal (§1.6).

B. Choosing a regular premium policy does nothing to fix the real problem, which is that he does not understand what he is buying.

C. Investing the full amount is the opposite of the study text's advice, and switching sub-funds after a fall does not fix the real problem either.

Why A: despite the name, a portfolio bond is not a bond. It is an insurance wrapper around a portfolio of investments, and it falls within the definition of an ILP (Ch 5 §1.1). Regular income from it is paid by selling units of the investments (§4.4).

Why each wrong option fails:

B. This is the tempting one, because of the word "bond". But a portfolio bond's value moves with its underlying investments, not with interest rates, and the principal is not protected (§1.4).

C. This describes a participating policy.

D. This describes a promise of fixed income that a portfolio bond does not make.

Why B: in a plan like this, the yearly payout is the higher of the fixed 3% and the formula, so the most it can pay is the formula's full rate, here 18% a year when n equals N. The early-redemption level is only a trigger. In the study text's own case study, the trigger is 108% and the maximum return is 20% a year, and the text warns readers not to take the trigger to mean a maximum return of 8% (Ch 6 §1.2, §1.14). If redemption is triggered, she receives her premium plus the payout pro-rated for the time the policy ran.

Why each wrong option fails:

A. This is the tempting one: it is the exact mistake the study text warns about.

C. This confuses the fixed minimum with the maximum.

D. This describes the kick-in level of a reverse convertible bond (covered in Chapter 1), not an early-redemption trigger.