Statement I is correct. A speculator aims to profit from price movements. By using futures contracts, a hedge fund can gain a large exposure to the market (e.g., the Hang Seng Index) with a relatively small initial margin payment. This use of a small capital outlay to control a large notional value is the definition of leverage. Statement II is correct. Hedging is the practice of using derivatives to reduce or offset the risk of adverse price movements in an underlying asset. An insurance company with a large equity portfolio faces the risk of a market decline. Selling stock index futures creates a short position that would profit if the market falls, thereby offsetting the losses on the physical stock portfolio. Statement III is incorrect. Arbitrage involves exploiting a price discrepancy between two or more markets or instruments to lock in a risk-free profit. The strategy described, buying a stock and a call option, is a speculative position taken to profit from an expected rise in the stock’s price and/or volatility, not an arbitrage trade. A true arbitrage would involve simultaneously buying an underpriced asset and selling an overpriced equivalent (e.g., buying the physical stock while selling an overpriced futures contract). Statement IV is correct. This is a precise description of a calendar spread (or time spread). The trader is taking a long position in the near-term contract and a short position in the longer-term contract, a strategy designed to profit if the price difference between the two contracts widens as expected (i.e., the front-month price rises relative to the back-month price). Therefore, statements I, II and IV are correct.

The explanation clarifies the fundamental differences between Over-the-Counter (OTC) and exchange-traded derivatives. The primary advantage of the OTC market is its flexibility, allowing two parties to negotiate and create a customized contract that precisely meets their specific risk management or investment requirements. This tailoring of terms, such as notional amount, maturity date, and underlying asset specifications, is a key feature that distinguishes it from the standardized nature of exchange-traded products. In contrast, exchange-traded derivatives have rigid, pre-defined contract terms, which can sometimes lead to a mismatch (basis risk) between the hedge and the actual risk exposure. The other statements describe features characteristic of exchange-traded markets, not the OTC market. Central clearing houses that mitigate counterparty risk are a hallmark of organized exchanges. Similarly, high liquidity and ease of closing positions are benefits of standardized, exchange-traded contracts, whereas bespoke OTC positions can be illiquid and difficult to unwind. Finally, price transparency is significantly greater on public exchanges with centralized order books, while the decentralized OTC market is generally considered more opaque.

The correct answer is that the agreement would be quoted as a 3×9 FRA. Forward Rate Agreements (FRAs) are quoted using a standard market convention that specifies two time periods from the transaction date. The first number indicates the number of months until the start of the notional loan period (the settlement date). The second number indicates the number of months until the end of the notional loan period (the maturity date). In this scenario, the borrowing commences in three months, so the first number is 3. The borrowing period itself is for six months. Therefore, the end of the period is nine months from today (3 months to start + 6 months duration). This makes the second number 9. A quote of ‘3×6 FRA’ is incorrect because it mistakenly uses the duration of the loan (6 months) as the end date, rather than calculating the total time from today to maturity. A ‘6×3 FRA’ incorrectly reverses the standard convention. A ‘6×9 FRA’ is also incorrect as it implies the borrowing period starts in six months, not three.

Hedging is a strategy designed to reduce or mitigate the risk of adverse price movements in an asset. A hedger already has an existing or anticipated exposure to an underlying asset and uses derivatives to offset that risk.

Statement I describes a ‘short hedge’. The fund manager has a long position in the physical stocks and is exposed to the risk of a market decline. By selling index futures, the manager creates a short position that will gain value if the market falls, thereby offsetting the losses on the stock portfolio.

Statement III describes a ‘long hedge’. The import company has a future liability in US dollars, which is effectively a short position in USD (it needs to buy them). By buying a USD/HKD forward contract, the company locks in a future purchase price, protecting itself against the risk of the USD strengthening against the HKD.

Statement II is an example of speculation. The trader has no underlying exposure to the tech company’s stock. The purchase of call options is a directional bet intended to profit from an anticipated price increase, not to reduce an existing risk.

Statement IV illustrates arbitrage. The desk is not hedging an existing risk but is exploiting a temporary price discrepancy between a warrant and its underlying stock to lock in a risk-free profit. This is a distinct activity from both hedging and speculation. Therefore, statements I and III are correct.

The correct answer is to engage in an interest rate swap to pay a fixed rate and receive a floating rate. A company with a floating-rate liability, such as a loan tied to HIBOR, faces the risk of rising interest rates increasing its borrowing costs. To convert this variable expense into a predictable, fixed expense, the company can enter into a ‘plain vanilla’ interest rate swap. In this arrangement, the company agrees to pay a predetermined fixed interest rate to a counterparty. In return, the counterparty agrees to pay the company a floating interest rate based on the same benchmark as the loan (3-month HIBOR). The incoming floating-rate payments from the swap are used to offset the outgoing floating-rate payments on the loan, effectively leaving the company with a net payment obligation at the fixed swap rate. Engaging in a swap to receive a fixed rate and pay a floating rate would be incorrect as it would double the company’s exposure to rising floating rates, compounding the original risk rather than hedging it. This is the position the swap counterparty would take. Purchasing an interest rate cap is a valid strategy for hedging against rising rates, but it does not convert the liability into a fixed obligation. A cap acts as an insurance policy, setting a maximum interest rate the company would pay. The company’s interest payments would still fluctuate below this cap, so the expense would not be stable or predictable, which was the stated goal. Entering into a single forward rate agreement (FRA) is unsuitable for this scenario. An FRA is designed to lock in an interest rate for a single future period, not for a series of payments over a multi-year term. A swap is the appropriate instrument for hedging a stream of cash flows over the life of a long-term loan.

The correct answer is that the OTC forward contract can be precisely customized to match the exact amount and settlement date of the underlying commercial transaction. This is a key advantage of the OTC market, as it allows hedgers to create a perfect hedge that aligns with their specific risk exposure. In contrast, exchange-traded futures are standardized in terms of contract size, maturity dates, and other specifications, which may lead to an imperfect hedge (basis risk) if the company’s needs do not align with the available contracts. One of the incorrect options suggests that OTC contracts have lower counterparty risk. This is generally false; exchange-traded derivatives involve a central clearing house that acts as the counterparty to every trade, significantly mitigating counterparty default risk. OTC trades are bilateral agreements, and the risk of one party defaulting is a primary concern, often managed through collateral agreements. Another incorrect option claims that OTC markets offer greater price transparency. This is the opposite of the truth. Exchange-traded markets provide high levels of price transparency, with real-time quotes publicly available. OTC market pricing is less transparent, as deals are negotiated privately between two parties. Finally, the suggestion that OTC contracts are generally more liquid and easier to close out is incorrect. The standardization of exchange-traded contracts fosters high liquidity, making it easy for participants to enter or exit positions. OTC contracts, being bespoke, are typically illiquid and can be difficult to unwind before maturity without the original counterparty’s agreement.

The primary motivations for participating in derivatives markets can be categorized into three main types: hedging, speculation, and arbitrage. Hedging is a strategy used to reduce or mitigate the risk of adverse price movements in an asset. A hedger typically has an existing exposure to an underlying asset and uses derivatives to protect its value. In this scenario, the portfolio manager holds a significant position in US technology equities and is concerned about a potential price decline. By purchasing index put options, he acquires the right to sell the index at a predetermined price, thereby establishing a floor for the value of his holdings and protecting the portfolio from a market downturn. This action is a clear example of hedging. The correct answer is that the manager’s primary motivation is to hedge the portfolio against a potential decrease in value. Speculation involves taking on risk by betting on the future direction of a market or asset’s price in the hope of making a profit, which is not the primary goal here as the manager is protecting an existing asset. Arbitrage involves exploiting price discrepancies between related instruments or markets to lock in a risk-free profit; the scenario provides no information about such an inefficiency. Generating income by selling covered call options is a valid derivatives strategy, but it is fundamentally different from the action described, which is purchasing put options for protection.

To determine the net financial outcome, one must calculate the impact on both the physical loan market and the futures market, then combine them. First, calculate the increase in interest expense on the loan. The initial quarterly interest was (HKD 60,000,000 × 3.5%) ÷ 4 = HKD 525,000. After the rate hike, the new quarterly interest is (HKD 60,000,000 × 5.0%) ÷ 4 = HKD 750,000. The increase in interest expense is HKD 750,000 – HKD 525,000 = HKD 225,000. This represents the ‘loss’ in the physical market. Second, calculate the profit from the short futures position. The treasurer sold at 96.50 and bought back at 95.00, realizing a gain of 1.50 points (150 basis points). For a 3-month HKD 1,000,000 contract, each basis point is worth HKD 25 (HKD 1,000,000 × 0.01% × 3/12). The profit per contract is 150 basis points × HKD 25 = HKD 3,750. With 62 contracts, the total futures profit is 62 × HKD 3,750 = HKD 232,500. Finally, the net outcome is the futures profit minus the increased interest expense: HKD 232,500 – HKD 225,000 = HKD 7,500. The correct answer is a net profit of HKD 7,500, which occurred because the position was slightly over-hedged. An answer of a net loss of HKD 225,000 incorrectly ignores the profit from the successful hedge. An answer of a net profit of HKD 232,500 is also incorrect as it fails to subtract the increased borrowing cost that the hedge was intended to offset. A net loss of HKD 7,500 would result from an incorrect calculation, reversing the profit and loss components.

The correct answer is that Alpha Capital makes a net payment of HKD 8 million. An equity swap involves exchanging two sets of cash flows. In this scenario, Alpha Capital has two obligations. First, it must pay the fixed leg, which is 3% of the HKD 100 million notional principal, amounting to a payment of HKD 3 million. Second, it receives the total return from the equity leg. Since the Hang Seng TECH Index had a total return of -5%, this ‘receipt’ is actually a negative amount, meaning Alpha Capital owes 5% of the notional principal, which is HKD 5 million. Both cash flows are payments from Alpha Capital. Therefore, the total net payment is the sum of these two obligations: HKD 3 million + HKD 5 million = HKD 8 million. The option suggesting a net payment of HKD 2 million is incorrect because it improperly nets the two amounts (5 million – 3 million) instead of adding them, failing to recognize that a negative return on the equity leg also constitutes a payment obligation. The option suggesting a net payment of HKD 5 million is incorrect as it completely disregards the fixed-rate payment leg of the swap. The option suggesting a net receipt of HKD 2 million incorrectly reverses the direction of the net cash flow and miscalculates the final amount.

The correct answer is a loss of HKD62,500. The price of a HIBOR futures contract is quoted as 100 minus the implied interest rate. Therefore, an increase in the futures price signifies a decrease in the underlying interest rate. The portfolio manager established a short position by selling futures, which profits from a decrease in price (an increase in interest rates). However, the market moved against this position as the price rose from 98.50 to 98.75, indicating that interest rates fell. The loss is calculated as follows: The price difference is the entry price minus the exit price (98.50 – 98.75), which equals -0.25 points. This difference is converted to basis points by multiplying by 100, resulting in -25 basis points. The loss per contract is -25 basis points multiplied by the value per basis point (HKD125), which equals -HKD3,125. For 20 contracts, the total loss is -HKD3,125 multiplied by 20, which is -HKD62,500. A profit of HKD62,500 would have been realized if the manager had taken a long position or if the price had fallen by 25 basis points. The other options representing a loss or profit of HKD625 are incorrect because they fail to properly convert the price difference of 0.25 points into 25 basis points before calculating the financial outcome.

Statement I is correct. HIBOR futures are cash-settled contracts, meaning that at expiry, profits or losses are exchanged in cash without any transfer of the underlying asset. In contrast, Three-year EFN futures are settled by physical delivery, where the seller must deliver qualifying Exchange Fund Notes to the buyer.

Statement II is correct. HIBOR futures, based on one-month and three-month HIBOR, are designed for managing risk at the short end of the Hong Kong dollar yield curve. Three-year EFN futures are used to hedge interest rate movements in the medium-term segment of the curve.

Statement III is correct. A key feature of futures contracts is their capital efficiency. Participants are required to post an initial margin, which is a fraction of the contract’s total notional value. This leverage allows for managing significant interest rate exposure with a relatively small capital outlay, a characteristic applicable to both HIBOR and EFN futures.

Statement IV is incorrect. While the Hong Kong Association of Banks (HKAB) owns the HIBOR benchmark, it does not guarantee the settlement of futures contracts. For all futures traded on the Hong Kong Futures Exchange (HKFE), settlement is guaranteed by the central counterparty, the HKFE Clearing Corporation Limited (HKCC), which mitigates counterparty risk for all participants. Therefore, statements I, II and III are correct.

The correct answer is a profit of HKD 91,000. When selling a call option, the writer receives a premium. The writer’s obligation is to sell the underlying asset at the strike price if the option is exercised. The option will be exercised by the buyer if the spot price at expiration is higher than the strike price. In this scenario, the spot rate (7.8500) is higher than the strike price (7.8200), so the option is exercised. First, calculate the premium received: USD 10,000,000 x 0.5% = USD 50,000. Converting this to HKD at the strike rate gives HKD 391,000 (USD 50,000 x 7.8200). Next, calculate the loss from the obligation to sell USD below the market rate: (Spot Rate – Strike Rate) x Notional Amount = (7.8500 – 7.8200) x 10,000,000 = HKD 300,000. The net profit or loss is the premium received minus the loss on the position: HKD 391,000 – HKD 300,000 = HKD 91,000 profit. A loss of HKD 300,000 is incorrect as it represents the loss on the underlying transaction without accounting for the premium income received by the seller. A profit of HKD 391,000 is incorrect because it only represents the premium received and ignores the loss incurred from the option being exercised. This would be the profit only if the option expired worthless. A loss of HKD 691,000 is an incorrect calculation, likely resulting from adding the loss to the premium instead of using the premium to offset the loss.

The correct answer is that Leo is acting as an arbitrageur, while Chloe is acting as a speculator. Leo’s strategy involves exploiting a temporary price discrepancy between the Hang Seng Index futures and the underlying spot index. By simultaneously buying the underpriced futures and selling the underlying stocks, he locks in a low-risk profit. This practice is known as arbitrage, and it contributes to market efficiency by helping to align the prices of related assets. Chloe, on the other hand, is not hedging an existing position or exploiting a current mispricing. She is taking a directional view on the market’s future movement based on economic forecasts. By purchasing call options, she is using leverage to speculate that the market will rise, hoping to profit from this price change. Her role is that of a speculator, who provides liquidity to the market by taking on risk. It is incorrect to classify Leo as a speculator, as his profit is derived from a current pricing inefficiency, not a forecast of future price direction. It is also incorrect to label Chloe as a hedger, as she is creating a new position to seek profit rather than reducing risk on an existing portfolio. Reversing the roles is also incorrect, as Chloe’s strategy is purely directional (speculation) and Leo’s is based on a price differential (arbitrage).

This question assesses the understanding of the profit and loss characteristics of a short strangle options strategy. A short strangle involves selling an out-of-the-money (OTM) call and an OTM put with the same expiration date.

The total premium collected is the sum of the premiums from the call and the put: HK$3 (from the call) + HK$2 (from the put) = HK$5.

Statement I: The maximum profit for a short strangle is the net premium received. This is achieved if the underlying asset’s price at expiration is between the two strike prices (HK$140 and HK$160). In this range, both options expire worthless, and the manager keeps the entire HK$5 premium. Thus, statement I is correct.

Statement II: The upside breakeven point is calculated as the call strike price plus the net premium received (HK$160 + HK$5 = HK$165). If the share price rises above HK$165 at expiration, the loss on the short call will be greater than the premium collected, resulting in a net loss for the position. Thus, statement II is correct.

Statement III: The downside breakeven point is the put strike price minus the net premium received (HK$140 – HK$5 = HK$135). The position is profitable if the share price at expiration is between the two breakeven points (HK$135 and HK$165). The statement that the position is profitable as long as the price remains above HK$140 is incorrect because it ignores the profitable range between HK$135 and HK$140. Thus, statement III is incorrect.

Statement IV: Selling uncovered options, as in a short strangle, carries theoretically unlimited risk. If the stock price rises significantly, the loss on the short call is unlimited. If the stock price falls to zero, the loss on the short put can be substantial (Put Strike – Premium – Stock Price). The maximum loss is not limited to the premium received. Therefore, statements I and II are correct.

To hedge a long equity portfolio against a potential market decline, the manager must create a short position in the market using index futures. Therefore, the manager should sell futures contracts. The number of contracts required is determined by the hedge ratio formula: Number of Contracts = (Portfolio Value × Portfolio Beta) / (Futures Index Level × Contract Multiplier). In this scenario: Portfolio Value = HKD 126,500,000; Portfolio Beta = 1.1; HSI Futures Index Level = 23,000; Contract Multiplier = HKD 50. First, calculate the value of one futures contract: 23,000 × HKD 50 = HKD 1,150,000. Next, calculate the number of contracts needed to hedge the portfolio: (HKD 126,500,000 × 1.1) / (HKD 1,150,000) = HKD 139,150,000 / HKD 1,150,000 = 121 contracts. Statement I correctly identifies the action (sell) and the calculated number of contracts. Statement II uses an incorrect calculation, likely omitting the beta. Statement III incorrectly suggests buying futures, which would increase market exposure rather than hedging it. Statement IV combines the incorrect action (buy) with the incorrect calculation. Therefore, statement I is correct.

The break-even point for an importer who buys a currency call option is the exchange rate at which the gain from exercising the option exactly covers the initial premium paid. To find this rate, the cost of the premium must be converted to a per-unit basis and added to the strike price. First, calculate the premium cost per unit of the foreign currency: Total Premium (HKD 75,000) divided by the Notional Amount (JPY 50,000,000) equals HKD 0.0015 per JPY. The break-even rate is then found by adding this per-unit premium cost to the option’s strike price. Therefore, the correct calculation is Strike Price (0.0660) + Per-Unit Premium (0.0015), which results in a break-even exchange rate of 0.0675 HKD/JPY. At this rate, the importer’s total cost equals what they would have paid in the spot market, resulting in neither a profit nor a loss from the hedging strategy. An exchange rate of 0.0660 is merely the strike price. At this rate, the option has no intrinsic value, and the importer would suffer a loss equal to the full premium paid. An exchange rate of 0.0645 is incorrect as it results from subtracting the premium from the strike price; this calculation is relevant for the break-even point of a put option buyer or a call option seller, not a call option buyer. The initial spot rate is historical data used to decide on a hedging strategy but is not a component in calculating the break-even point of the option itself.

In technical analysis, a support level is a price point or area on a chart where buying pressure is anticipated to be strong enough to overcome selling pressure, thereby halting a price decline and potentially reversing it. In the given scenario, the HK$50 level, where buying interest consistently emerges, correctly fits this definition. Conversely, a resistance level is a price point or area where selling pressure is expected to be strong enough to overcome buying pressure, stopping a price advance. The HK$60 level, where selling intensifies, is the resistance. Therefore, statements I and II are correct descriptions of these phenomena. Statement III is incorrect; a sustained price movement below a key support level like HK$50 would signal a bearish breakout and the potential start of a new downtrend, not an uptrend. Statement IV is also incorrect as it reverses the definitions; resistance levels are identified by connecting successive price peaks (highs), while support levels are identified by connecting price troughs (lows). Therefore, statements I and II are correct.

According to the Listing Rules of The Stock Exchange of Hong Kong Limited, an issuer of a derivative warrant is required to appoint a liquidity provider for each warrant series it lists. A key stipulation of this rule is that for each individual warrant issue, there can only be one designated liquidity provider. This ensures a clear and accountable party is responsible for providing continuous bid and ask quotes, thereby facilitating market liquidity. The requirement to appoint multiple providers to foster competition is incorrect; the rule specifies a single provider. The obligation to have a liquidity provider is a prerequisite for listing and is not conditional upon trading volume reaching a certain level. While an issuer may appoint an affiliated entity, there is no mandate that they must act as their own liquidity provider; the core obligation is the formal appointment of one.

The cost of carry represents the net cost of holding a physical asset, such as a commodity, over a period. This concept is fundamental to the pricing of futures contracts. The theoretical futures price is often calculated as the spot price plus the cost of carry. Statement I is correct because tangible costs associated with physically holding a commodity, such as warehousing fees and insurance premiums, are direct components of the cost of carry. Statement II is also correct; the financing cost, which is the interest or opportunity cost of the capital used to purchase and hold the commodity, is a significant part of the calculation. Statement III is incorrect because the cost of carry is about the costs of holding, not market expectations of future price changes. While expectations influence the overall futures price, they are not a component of the cost of carry itself. Statement IV is incorrect because the convenience yield is the benefit derived from holding the physical asset (e.g., avoiding production stoppages). As a benefit, it is subtracted from the other costs, thereby reducing the net cost of carry, not increasing it. Therefore, statements I and II are correct.

This question assesses the understanding of a currency call option’s pay-off structure, specifically the calculation of the break-even point and the logic for exercising the option.

Statement I is correct. The break-even exchange rate for the buyer of a call option is the point where the gain from exercising the option exactly offsets the premium paid. It is calculated as the Strike Price + Premium per unit. In this scenario, the break-even rate is HKD/EUR 8.5000 (strike) + HKD/EUR 0.1000 (premium) = HKD/EUR 8.6000. At this rate, the importer’s total cost matches the market, and any rate above this results in a net profit from the hedge.

Statement II is incorrect. For the buyer of an option (either call or put), the maximum potential loss is strictly limited to the premium paid. In this case, the total premium is EUR 5,000,000 HKD 0.1000/EUR = HKD 500,000. The loss is not unlimited; the premium is the price paid for the right, but not the obligation, to transact.

Statement III is correct. A call option should be exercised whenever the spot market price is higher than the strike price. Although the company only makes a net profit above the break-even rate of 8.6000, it is still financially advantageous to exercise at any rate above 8.5000. At 8.5500, exercising the option allows the company to buy EUR at 8.5000, which is cheaper than the market rate of 8.5500. This action reduces the overall loss on the position (the effective cost would be 8.5000 strike + 0.1000 premium = 8.6000, but buying at spot would cost 8.5500 + 0.1000 premium = 8.6500, so exercising saves money).

Statement IV is incorrect. An option strategy does not guarantee a lower cost compared to a forward contract. A forward contract provides certainty at a fixed rate (8.5200). The option provides flexibility. If the HKD were to strengthen significantly (e.g., the spot rate fell to 8.4000), the company would let the option expire and buy EUR at the cheaper spot rate, resulting in a better outcome than the forward. Conversely, if the spot rate ends between the forward rate and the option’s break-even rate, the forward would have been cheaper. Therefore, statements I and III are correct.

Statement I is incorrect. Exchange-traded warrants are issued by third parties, typically investment banks or listed companies, not by the exchange itself. The Hong Kong Exchanges and Clearing Limited (HKEX) provides the platform for trading and listing but does not act as the issuer. Statement II is correct. This is a fundamental distinction between warrants and exchange-traded options. Investors can buy (go long) warrants, but they cannot write or short-sell them. Statement III is correct. The pricing of a warrant is derived from its underlying asset and is sensitive to several factors, including the price of the underlying, the remaining time until expiry (time value), and the expected volatility of the underlying asset. Statement IV is correct. To ensure liquidity, the issuer of a warrant must appoint a market maker (also known as a liquidity provider) who is obligated to provide continuous bid and ask quotes on the exchange, allowing investors to buy and sell the warrant. Therefore, statements II, III and IV are correct.

The correct answer is that the investor’s maximum potential loss is limited to the premium paid, and they will break even if the HSI closes at 23,650 at expiration. This question assesses the understanding of a long put option’s pay-off profile. When an investor buys a put option, they pay a premium for the right, but not the obligation, to sell the underlying asset at the strike price. Their view is bearish, meaning they expect the underlying asset’s price to fall. The maximum loss for the buyer is the premium paid, which occurs if the option expires out-of-the-money (i.e., the HSI is at or above the strike price of 23,500). The profit potential is substantial but not unlimited, as the underlying index cannot fall below zero. The breakeven point is calculated by subtracting the premium from the strike price (Strike Price – Premium = 23,500 – 150 = 23,350). At this level, the gain from exercising the option exactly covers the initial cost of the premium. The statement that the investor’s maximum profit is limited to the premium received while their potential loss is unlimited describes a short put position, which is the opposite of the investor’s action. The statement that the investor will break even if the HSI closes at 23,650 incorrectly calculates the breakeven point by adding the premium to the strike price, which is the formula for a long call option. The statement that the investor profits if the HSI rises above the strike price describes the outcome for a call option buyer, which is inconsistent with purchasing a put option.

The correct answer is that the HIBOR futures contract is settled in cash based on a final settlement price, whereas the EFN futures contract requires the physical delivery of eligible Exchange Fund Notes. This highlights a fundamental difference in how these two types of interest rate futures contracts are concluded on the Hong Kong Futures Exchange. HIBOR futures are cash-settled instruments, meaning that at expiry, the parties exchange a cash payment representing the profit or loss, calculated against the final settlement price (the relevant HIBOR rate). This method is operationally simpler as it does not involve the transfer of any underlying physical asset. In contrast, Three-Year Exchange Fund Note (EFN) futures are physically settled. This means the seller of the contract has an obligation to deliver actual Exchange Fund Notes that meet specific criteria (e.g., a remaining maturity of 2.5 to 3.5 years) to the buyer. This requires more complex operational arrangements for sourcing and delivering the underlying securities. The other options are incorrect because they misrepresent these settlement mechanisms. Stating that EFN futures are cash-settled and HIBOR futures are physically settled is a direct reversal of the facts. The assertions that both are physically settled or that both are cash-settled are also incorrect, as they fail to recognize the key distinction between these two important hedging instruments.

This question assesses the understanding of the fundamental characteristics and risks of an equity swap, a common derivative instrument used by asset managers. Statement I is correct because equity swaps are typically over-the-counter (OTC) contracts, meaning they are not guaranteed by a central clearing house. This exposes each party to the credit risk of the other; if the counterparty defaults, the fund may not receive the equity returns it is owed. Statement II is also correct. The notional principal is a reference amount used solely for the calculation of the cash flows to be exchanged (e.g., the floating rate payment and the equity index return). This principal amount is not physically exchanged at the inception or maturity of the swap. Statement III is incorrect. Unlike options, swaps do not typically involve an upfront premium. The potential loss is not limited; if the equity index performance is significantly negative, the fund would owe a large payment to the counterparty, in addition to its floating rate payment obligations, potentially leading to losses far exceeding any initial cost. Statement IV is incorrect. Equity swaps are predominantly bespoke, privately negotiated contracts traded in the OTC market, not on a recognized exchange like the HKEX. Therefore, statements I and II are correct.

The correct answer is that the maximum profit is limited to the net premium received, while the potential loss is unlimited. This scenario describes a short straddle, an options strategy where an investor sells both a call option and a put option with the same underlying asset, strike price, and expiration date. This strategy is employed when the investor anticipates very low volatility in the underlying asset’s price, expecting it to trade near the strike price at expiration. The maximum profit is achieved if the underlying asset’s price is exactly at the strike price upon expiry, causing both options to expire worthless. In this case, the investor retains the full premium collected from selling both options. However, the risk is substantial. If the asset’s price moves significantly upwards, the loss on the short call is theoretically unlimited. If the price moves significantly downwards, the loss on the short put can be substantial (the strike price less the premium, as the stock price cannot fall below zero). Because of the unlimited upside risk, the overall strategy is considered to have unlimited potential loss. The profile of unlimited profit and limited loss describes the opposite strategy, a long straddle. A profile where both profit and loss are limited is characteristic of spread strategies, not a naked short straddle. A profile where the loss is limited to the strike price incorrectly ignores the unlimited risk associated with the short call position.

This question assesses the understanding of hedging strategies for both existing asset holdings and future transactions. Statement I is correct because to hedge a current long position (owning stocks) against a price fall, one must take an opposite position in the derivatives market, which is a short position in futures. Statement II is correct because to hedge a future purchase (a future long position) against a price rise, one must take the same position in the derivatives market now, which is a long position in futures to lock in a buying price. Statement III correctly describes the mechanics of the hedge for the existing portfolio: if the physical stocks lose value, the short futures position will gain value, offsetting the loss. Statement IV is incorrect. If the price of the underlying asset (technology stocks) falls, a long futures position will result in a loss, not a profit. This loss is the ‘cost’ of the hedge, which is offset by the benefit of being able to buy the physical shares at a lower price than originally anticipated. The statement incorrectly claims a profit would be realized on the futures position in a falling market. Therefore, statements I, II and III are correct.

Statement I is correct. Exchange-traded derivatives are standardized. This means their contract sizes, expiry dates (e.g., quarterly), and other specifications are fixed. A client with a unique requirement, such as a 13-month hedging period, may find that no listed contract perfectly matches their needs. This mismatch between the hedging instrument and the underlying exposure is known as basis risk. Statement II is correct. A key feature of bilateral OTC contracts is the absence of mandatory daily margining that is characteristic of exchange-traded products cleared through a central clearing house. While initial margin or collateral may be required, the lack of daily variation margin calls can free up a company’s working capital. Statement III is incorrect. Bespoke OTC contracts are, by their nature, illiquid. They are tailored agreements between two specific parties. Unlike a standardized, exchange-traded future which can be easily bought or sold to close a position, unwinding a custom OTC contract typically requires negotiation with the original counterparty and cannot be easily sold on a secondary market. Statement IV is correct. The fundamental advantage of the OTC market is its flexibility. It allows participants to create customized contracts that precisely match their specific risk management needs in terms of notional amount, settlement date, and underlying asset, which is not possible with standardized exchange-traded products. Therefore, statements I, II and IV are correct.

The correct answer is that the forward rate will be lower than the spot rate because the interest rate in Hong Kong is higher than in the Eurozone. The determination of currency forward rates is based on the principle of interest rate parity, which prevents arbitrage opportunities. The interest rate differential between two currencies dictates the difference between the spot and forward exchange rates. The currency with the higher interest rate will trade at a discount in the forward market, while the currency with the lower interest rate will trade at a premium. In this scenario, the Hong Kong Dollar (the quoted currency) has a higher interest rate (2.5%) than the Euro (the base currency) (1.5%). To offset the higher interest that could be earned by holding HKD, the HKD must be worth less in the forward market relative to the EUR. Therefore, the forward EUR/HKD rate will be lower than the spot rate. Stating that the forward rate will be higher inverts this principle. The idea that forward rates are based solely on market forecasts of future spot rates is incorrect; they are mathematically derived from interest rate differentials to establish an arbitrage-free price. Lastly, the forward rate will not be identical to the spot rate, as any difference in interest rates will be reflected in the forward points.

The swap spread is the difference between the fixed rate of an interest-rate swap and the yield on a sovereign government bond of the same maturity. In Hong Kong, the benchmark government security is the Exchange Fund Note. This spread is widely regarded as a key indicator of credit risk in the financial system. It represents the premium that market participants demand to take on the credit risk of a financial counterparty (typically a bank in the swap market) over the near-risk-free rate of a government issuer. Therefore, the correct answer is that a widening spread indicates a perceived increase in counterparty credit risk in the interbank market. This often signals a ‘credit crunch’ or a period of financial stress where banks become more hesitant to lend to one another. An anticipation of an interest rate cut by the monetary authority might affect the overall level of rates but does not directly explain the widening of the risk premium. A surge in liquidity and confidence would cause the spread to narrow, not widen, as perceived risk would decrease. A decrease in the issuance of government bonds might affect the bond’s yield due to supply factors, but the primary interpretation of a significant widening of the swap spread is related to systemic credit conditions.