The correct answer is that a widening swap spread indicates a perception of heightened counterparty credit risk in the banking system. The swap spread is defined as the difference between the fixed rate of an interest-rate swap and the yield of a government bond with the same maturity. It is widely regarded as a primary indicator of credit conditions in the financial markets. The government bond yield represents a nearly risk-free rate, while the swap rate incorporates a premium for the credit risk of financial institutions in the interbank market. Therefore, when this spread widens, it signifies that the market is demanding a higher premium for bearing the counterparty risk associated with banks, suggesting a deterioration in the perceived creditworthiness of the financial system. An expectation of a central bank rate hike would affect the entire yield curve, not just the credit spread component. A decrease in the government’s creditworthiness would likely cause government bond yields to rise, potentially narrowing the spread, which is the opposite effect. Finally, a widening spread is typically associated with periods of market stress and reduced liquidity, not an improvement in the liquidity of the government bond market.

The core concept being tested is asset switching using derivatives for tactical portfolio re-weighting. The portfolio manager, Ms. Chan, wants to decrease her portfolio’s exposure to Hong Kong equities and increase its exposure to US bonds based on her short-term market view. This can be achieved efficiently without transacting the physical assets.

Statement I is correct. To reduce exposure to a potential downturn in the Hong Kong equity market, establishing a short position in Hang Seng Index futures is an appropriate strategy. If the index falls as anticipated, the profit from the short futures position will offset the loss on her physical equity holdings.

Statement II is correct. To gain exposure to an expected rise in US bond prices, taking a long position in US Treasury bond futures is the correct approach. This allows the portfolio to benefit from the upward price movement of the bonds without the delay and cost of purchasing the physical securities.

Statement III is incorrect. This strategy is an example of tactical asset allocation or directional trading, not arbitrage. Ms. Chan is taking a view on the future direction of two different asset classes and positioning the portfolio to profit from that view. Arbitrage involves exploiting simultaneous price discrepancies in different markets for a risk-free profit, which is not the objective here.

Statement IV is incorrect. Using derivatives for asset switching does not eliminate market risk; it reallocates it according to the manager’s view. While the strategy hedges the existing physical positions, it introduces new risks, namely the directional risk that the manager’s forecast is wrong. If Hong Kong equities rally and US bonds fall, the derivative positions will incur significant losses. It also introduces basis risk. Therefore, statements I and II are correct.

The correct answer is a lookback option. This type of exotic option grants the holder the right to buy or sell the underlying asset at the most advantageous price it reached during a specified period. In this scenario, a lookback call option would allow the portfolio manager to purchase the stock at the lowest price observed over the six-month term, perfectly aligning with the objective of securing the best possible entry point amidst volatility. An average-rate option is incorrect because its payoff is based on the average price of the underlying asset over the period, not the single most favorable price. This would smooth out the price but would not capture the lowest point.
A chooser option is incorrect as it gives the holder the right to decide at a later date whether the option will be a call or a put. This is useful for hedging against uncertain market direction, not for optimizing the strike price based on past performance.
A barrier option is incorrect because its existence (either coming into effect or being extinguished) depends on the underlying asset’s price reaching a predetermined barrier level. It does not grant the right to transact at the best price observed during the option’s life.

The correct answer is that the terms, such as the settlement date and notional amount, can be specifically negotiated between the parties. Over-the-counter (OTC) derivatives like currency forwards are private agreements between two counterparties. This allows them to tailor the contract’s specifications—including the exact maturity date (to match the 4.5-month payment) and the precise notional value—to meet the specific hedging requirements of the corporate client. In contrast, exchange-traded currency futures are standardized contracts with fixed contract sizes, pre-determined contract months (e.g., March, June, September, December), and a set last trading day, which may not align perfectly with the company’s specific risk exposure, potentially creating a basis risk. The option suggesting a central clearing house is a primary feature of exchange-traded futures, designed to mitigate counterparty risk, whereas OTC forwards carry direct counterparty risk. The characteristic of high liquidity and transparent pricing is also more commonly associated with standardized, exchange-traded futures, not bespoke OTC instruments. Finally, the mandatory reporting of large open positions is a regulatory mechanism for supervised futures exchanges to monitor market concentration and stability, not a feature of OTC forwards that would make them more suitable for this specific hedging purpose.

A long butterfly spread is an options strategy suitable for a market environment with low expected volatility, where the trader anticipates the underlying asset’s price will remain within a narrow range. This aligns with the portfolio manager’s view, making Statement I correct. The strategy involves a net debit (cost) to establish, and the maximum potential loss is limited to this initial net premium paid. In this case, the cost is 80 points, so the maximum loss is 80 points. This makes Statement II correct. The maximum profit for a long butterfly spread is achieved when the underlying asset’s price at expiration is exactly at the strike price of the short options (the middle strike), which is 22,200 in this scenario, not at the outer strikes. Therefore, Statement III is incorrect. The breakeven points are calculated by adding the net premium to the lower strike price and subtracting the net premium from the higher strike price. The breakeven points are 22,080 (22,000 + 80) and 22,320 (22,400 – 80). Calculating the upper breakeven point by adding the premium to the higher strike is incorrect. Therefore, statements I and II are correct.

The correct answer is that the primary risk is grade basis risk. This risk arises when the asset being hedged is not identical to the asset underlying the derivative contract used for the hedge. In this scenario, the treasurer is hedging AA-rated corporate bonds using futures on Hong Kong Exchange Fund Notes (government debt). The difference in credit quality, issuer type, and yield spread between the corporate bonds and the government notes means their prices will not move in perfect correlation. This imperfect correlation is the essence of grade basis risk, which could lead to the hedge being ineffective and potentially resulting in unexpected losses or gains. The risk related to the costs of storage, insurance, and transport for physically settled contracts is known as delivery basis risk, which is not the primary concern described here. The credit risk of the corporate bond issuer is the inherent risk of holding the bonds themselves (i.e., the risk of default), not a risk created by the hedging strategy itself. Finally, since the scenario involves exchange-traded futures contracts, the risk of a counterparty failing to meet its obligations is significantly mitigated by the exchange’s clearing house, making it less of a primary concern compared to the basis risk from the asset mismatch.

Statement I is incorrect. An out-of-the-money (OTM) option, by definition, has no intrinsic value. For a call option, this occurs when the underlying asset’s price is below the strike price. Exercising it would result in a loss, so its intrinsic value is zero, not a positive amount. Statement II is correct. Hang Seng Index (HSI) options are cash-settled contracts. Upon exercise, the holder receives a cash payment equal to the intrinsic value (the difference between the final settlement price and the strike price), rather than taking delivery of the underlying index components. Statement III is correct. Unlike index options, single stock options in Hong Kong are settled by physical delivery. When a call option is exercised, the holder receives the actual shares of the underlying company from the writer. Statement IV is correct. The premium of an option is composed of intrinsic value and extrinsic (or time) value. For an at-the-money (ATM) option, the strike price is equal to the underlying asset’s price, meaning its intrinsic value is zero. Therefore, statements II, III and IV are correct.

This question assesses the understanding of different hedging instruments available to a commodity producer. Statement I is correct because swaps are over-the-counter (OTC) instruments that can be customized for long tenors, unlike standardized futures contracts which have fixed expiry dates and require periodic rolling for long-term hedges. Statement II is correct as exchange-traded futures are marked-to-market daily, and a short position (selling futures) would result in margin calls if the price of the underlying asset (gold) rises, creating a potential liquidity drain. Statement III is also correct; buying options requires paying a premium upfront, which is the cost of securing price protection. This premium is a sunk cost, regardless of whether the option is exercised. Statement IV is incorrect because standard forward contracts are bilateral OTC agreements and carry significant counterparty credit risk, similar to swaps. They are not centrally cleared like futures. Therefore, statements I, II and III are correct.

Statement I is correct. The profit or loss on a Hang Seng Index (HSI) futures contract is calculated by the number of index points moved multiplied by the contract multiplier, which is HKD 50 per point. If a client is short and the index falls by 100 points, they make a profit of 100 points × HKD 50 = HKD 5,000. Statement II is correct. An intra-market spread, also known as a calendar or time spread, involves taking opposite positions in two futures contracts on the same underlying asset but with different expiry dates. The objective is to profit from the change in the spread (the price difference) between the two contracts, not the absolute direction of the market. Statement III is incorrect. An inter-market spread involves two different but related underlying assets (e.g., HSI and S&P 500). This strategy is generally considered more risky than an intra-market spread due to basis risk, as the price relationship between the two different underlying assets can be less predictable than the relationship between two contracts on the same asset with different maturities. Statement IV is incorrect. This statement reverses the characteristics of futures and forwards. Forward contracts are traded over-the-counter (OTC) and are highly customizable, allowing parties to tailor the contract size, underlying asset, and settlement date. It is exchange-traded futures contracts that are standardized. Therefore, statements I and II are correct.

Statement I is correct. According to the rules governing futures brokers, if a client fails to meet two successive margin calls or demands for variation adjustments which in aggregate exceed a prescribed threshold, the broker is obliged to inform the Hong Kong Futures Exchange (HKFE) and provide the relevant client account details. Statement III is also correct. A broker has the right to liquidate a client’s collateral and close out open positions if the client fails to meet margin calls, provided this right is explicitly stated in the contract agreement signed between the broker and the client. Statement II is incorrect. Margins required by the HKFE must generally be cash-settled. Accepting non-cash collateral, such as a portfolio of stocks, requires prior approval from the HKFE Clearing Corporation Limited (HKCC). The firm cannot unilaterally accept it. Statement IV is incorrect. The authority to liquidate positions in the event of a margin default is typically granted by the client in the initial client agreement. A separate, specific authorization at the time of the default is not required for the broker to exercise this right. Therefore, statements I and III are correct.

Statement I is correct. The Hong Kong Futures Exchange (HKFE), a subsidiary of HKEX, is the primary exchange for trading a wide array of futures and options contracts, including benchmark products like Hang Seng Index (HSI) futures and options, and Hang Seng China Enterprises Index (HSCEI) futures and options.

Statement II is correct. A key feature of exchange-traded derivatives is the mitigation of counterparty risk. The HKFE Clearing Corporation Limited (HKCC) acts as the central counterparty (CCP) for all transactions on the HKFE. It registers, clears, and guarantees the performance of all contracts, effectively becoming the buyer to every seller and the seller to every buyer.

Statement III is correct. While index options are traded on the HKFE, options on individual stocks (stock options) are traded on The Stock Exchange of Hong Kong (SEHK). These contracts are cleared and guaranteed by a separate clearing house, The SEHK Options Clearing House Limited (SEOCH), which acts as the CCP for the stock options market.

Statement IV is incorrect. Structured products such as Derivative Warrants and Callable Bull/Bear Contracts (CBBCs) are traded on the SEHK, but they are not centrally cleared and guaranteed by a CCP like HKCC or SEOCH. They are instruments issued by third parties (typically investment banks), and the ultimate settlement obligation and counterparty risk lie with the issuer, not an exchange-affiliated clearing house. Their settlement is handled through the Central Clearing and Settlement System (CCASS), but this does not involve the performance guarantee provided by a CCP. Therefore, statements I, II and III are correct.

The correct answer is to sell HIBOR futures contracts. The portfolio manager’s risk is that rising interest rates will decrease the value of their fixed-income portfolio. HIBOR futures prices are inversely related to interest rates (priced as 100 minus the implied interest rate). Therefore, if interest rates rise, the price of HIBOR futures will fall. By selling (shorting) HIBOR futures, the manager establishes a position that will profit from a fall in the futures price. This profit would help offset the capital losses experienced in the fixed-income portfolio due to the same rise in interest rates, thus creating an effective hedge. Buying HIBOR futures contracts would be an incorrect strategy, as this position profits from falling interest rates (rising futures prices) and would exacerbate the portfolio’s losses if rates were to rise. Purchasing Exchange Fund Note (EFN) futures would be an inappropriate hedge; while EFNs are interest-rate sensitive, they are based on medium-term government debt yields, which may not move in perfect correlation with the short-term interbank rates (HIBOR) that are more likely to influence the broader fixed-income portfolio. This introduces significant basis risk. Entering into an interest rate swap to receive a fixed rate and pay a floating rate is a strategy to hedge against falling interest rates, not rising ones. To hedge against rising rates with a swap, one would need to pay fixed and receive floating.

This question tests the understanding of a long straddle options strategy, including the calculation of total cost, break-even points, and maximum loss. A long straddle involves buying a call and a put option with the same strike price and expiration date.

1. Calculate the Total Premium (Initial Cost): The investor pays a premium for both the call and the put option. Total Premium = Call Premium + Put Premium = HKD 5 + HKD 6 = HKD 11. Thus, statement I is correct.

2. Calculate the Break-Even Points: The strategy breaks even when the underlying stock price moves away from the strike price by an amount equal to the total premium paid.
Upside Break-Even: Strike Price + Total Premium = HKD 105 + HKD 11 = HKD 116.
Downside Break-Even: Strike Price – Total Premium = HKD 105 – HKD 11 = HKD 94.
The position breaks even if the stock price is either HKD 116 or HKD 94 at expiration. Thus, statement II is correct.

3. Determine the Maximum Loss: For any long option or combination of long options, the maximum potential loss is limited to the total premium paid. This occurs if the stock price at expiration is exactly at the strike price (HKD 105), causing both options to expire worthless. The loss would be the initial cost of HKD 11. Thus, statement III is correct.

4. Evaluate Profitability at a Specific Price: To be profitable, the stock price must be above the upside break-even point (HKD 116) or below the downside break-even point (HKD 94). If the stock price is HKD 95 at expiration, it is between the strike price and the downside break-even point. The put option would be in-the-money by HKD 10 (HKD 105 – HKD 95), and the call would expire worthless. The net result would be a loss of HKD 1 (HKD 10 gain from the put – HKD 11 total premium). Therefore, statements I, II and III are correct.

The correct answer is a loss of HK$10,000. When selling a put option, the seller (writer) receives a premium but takes on the obligation to buy the underlying asset at the strike price if the option is exercised. The break-even point for the seller is the strike price minus the premium received. In this case, the break-even point is 20,000 – 300 = 19,700. Since the Hang Seng Index (HSI) closes at 19,500, which is below the break-even point, the position results in a loss. The option is in-the-money, and the buyer will exercise their right to sell at 20,000. The seller’s loss from this obligation is the difference between the strike price and the market price, which is 20,000 – 19,500 = 500 points. However, the seller initially received a 300-point premium. Therefore, the net loss is 500 points – 300 points = 200 points. To find the monetary value, this is multiplied by the contract multiplier: 200 points HK$50/point = HK$10,000 loss. A profit of HK$15,000 incorrectly assumes the seller keeps the full premium without accounting for the loss on exercise. A loss of HK$25,000 correctly calculates the gross loss from the exercise (500 points HK$50) but fails to offset this loss with the premium that was initially collected. A profit of HK$10,000 miscalculates the final outcome; the position is unprofitable as the index settled below the break-even point.

The correct answer is a profit of HKD 400,000. The profit or loss from a futures trade is determined by the difference between the entry and exit prices, multiplied by the contract multiplier and the number of contracts. For a short position, a profit is made if the position is closed out (bought back) at a price lower than the initial selling price. The calculation is as follows: (Selling Price – Buying Price) x Contract Multiplier x Number of Contracts. The point difference is 21,500 – 21,100 = 400 points. The standard contract multiplier for a Hang Seng Index futures contract is HKD 50 per index point. Therefore, the profit per contract is 400 points × HKD 50/point = HKD 20,000. Since the investor traded 20 contracts, the total profit is HKD 20,000/contract × 20 contracts = HKD 400,000. A loss of HKD 400,000 would have occurred if the market had moved against the investor’s short position. A profit of HKD 8,000 incorrectly omits the HKD 50 contract multiplier. A profit of HKD 20,000 represents the gain on only a single contract, not the entire position of 20 contracts.

A synthetic long stock position is created by buying a call option and selling a put option with the same underlying asset, strike price, and expiration date. This strategy is designed to replicate the risk and reward profile of owning the underlying stock. The break-even point at expiration is the stock price at which the position results in zero profit or loss. To calculate this, one must first determine the net premium from the transaction. In this scenario, the investor receives a premium of HKD 8.00 for selling the put and pays a premium of HKD 4.50 for buying the call. This results in a net credit of HKD 3.50 (HKD 8.00 – HKD 4.50). The break-even price is then calculated by subtracting this net credit from the strike price. Therefore, the correct answer is HKD 90.00 (Strike Price) – HKD 3.50 (Net Credit) = HKD 86.50. At this price, the loss on the short put (HKD 90.00 – HKD 86.50 = HKD 3.50) is perfectly offset by the initial net credit received, and the long call expires worthless. An answer of HKD 93.50 incorrectly adds the net credit to the strike price, which would be the calculation for a synthetic short stock position. An answer of HKD 90.00 is incorrect as it represents the strike price but fails to account for the initial net premium received, which alters the position’s cost basis. An answer of HKD 82.00 is also incorrect because it only subtracts the put premium from the strike price, ignoring the offsetting cost of the call premium.

This question assesses the understanding of a basic long put option strategy.

Statement I is correct. The breakeven point for a long put option is calculated as the Strike Price minus the Premium paid. In this scenario, it is HKD 130.00 – HKD 2.80 = HKD 127.20. The investor will make a net profit only if the underlying stock price falls below this level at expiration.

Statement II is correct. When buying an option (either a call or a put), the maximum potential loss is always limited to the premium paid to acquire the option. In this case, the maximum loss is the HKD 2.80 premium per share, which occurs if the option expires worthless (i.e., the stock price is at or above the HKD 130.00 strike price at expiry).

Statement III is incorrect. The maximum potential profit is not limited to the strike price. The theoretical maximum profit is the strike price less the premium, which is HKD 130.00 – HKD 2.80 = HKD 127.20 per share. This would be achieved if the stock price fell to zero.

Statement IV is incorrect. For the strategy to be profitable, the share price must fall below the breakeven point of HKD 127.20. The required drop from the current price of HKD 134.65 is HKD 134.65 – HKD 127.20 = HKD 7.45. A fall of only HKD 4.65 would bring the price to HKD 130.00, at which point the option would expire at-the-money and the investor would lose the entire premium. Therefore, statements I and II are correct.

Statement I is correct. A core function of a clearing house acting as a Central Counterparty (CCP) is novation. Through novation, the original contract between the buyer and seller is replaced by two new contracts: one between the seller and the CCP, and another between the CCP and the buyer. This effectively makes the clearing house the counterparty to every trade, centralising and managing risk. Statement II is correct. To manage the counterparty credit risk it assumes, a clearing house implements a multi-layered risk management framework. This includes requiring clearing participants to deposit initial and variation margins to cover potential future exposure and current market fluctuations, as well as contributing to a default fund (or guarantee fund) to cover losses in the event of a participant’s default. Statement III is incorrect. While HKCC (HKFE Clearing Corporation Limited) clears futures and options traded on the Hong Kong Futures Exchange (HKFE), stock options traded on The Stock Exchange of Hong Kong (SEHK) are cleared by a different entity, the SEHK Options Clearing House Limited (SEOCH). Statement IV is incorrect. HKSCC is the clearing house for securities transactions on the SEHK. Over-the-counter (OTC) derivatives, such as interest rate swaps and non-deliverable forwards, are cleared by a separate entity, OTC Clearing Hong Kong Limited (OTC Clear). Therefore, statements I and II are correct.

The correct answer is HKD 6.7000 per 100 JPY. For an importer who buys a call option to hedge against a rising foreign currency, the break-even point is the exchange rate at which the profit from exercising the option exactly covers the initial premium paid. The calculation involves first determining the premium cost per unit of the foreign currency and then adding it to the strike price. In this scenario, the total premium is HKD 100,000 for a notional of JPY 50,000,000. The premium per JPY is HKD 100,000 / 50,000,000 = HKD 0.002. Since the exchange rate is quoted per 100 JPY, the premium per 100 JPY is HKD 0.002 100 = HKD 0.2000. The break-even rate is therefore the strike price plus this unit premium: HKD 6.5000 + HKD 0.2000 = HKD 6.7000 per 100 JPY. At this rate, the importer’s gain on the option exactly offsets its cost. An exchange rate of HKD 6.5000 per 100 JPY represents the strike price. At this rate, the option is at-the-money, but the importer would still realize a net loss equal to the full premium paid. An exchange rate of HKD 6.3000 per 100 JPY would be calculated by incorrectly subtracting the premium from the strike price, a calculation relevant for a different type of option position (e.g., a short call). An exchange rate of HKD 6.6000 per 100 JPY is incorrect as it would mean the importer has only recovered half of the premium cost through the option’s intrinsic value, still resulting in a net loss.

According to the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission, a licensed intermediary has several key responsibilities when onboarding a client for derivatives trading. Statement I is correct because providing a standardized Risk Disclosure Statement for futures and options is a mandatory step to ensure the client is formally aware of the specific and significant risks involved. Statement II is correct as a comprehensive Client Agreement is required. This agreement must authorize the firm to act for the client and must clearly outline critical terms, including the firm’s margin policies and procedures. Statement IV is correct because the suitability obligation is paramount. The firm must assess whether trading leveraged products like futures is suitable for the client’s risk tolerance, financial situation, and investment experience, especially since the client is new to this asset class. Statement III is incorrect; initial margin is a good faith deposit, representing a fraction of the contract’s notional value, not the full value. Requiring the full notional value would negate the leveraged nature of futures contracts. Therefore, statements I, II and IV are correct.

A swaption is a financial instrument that grants the holder the right, but not the obligation, to enter into an underlying interest rate swap. There are two primary types. A call swaption gives the holder the right to enter a swap where they will receive a fixed interest rate and pay a floating rate. This is advantageous if the holder expects interest rates to fall, as they can lock in a higher fixed receipt. A put swaption gives the holder the right to enter a swap where they will pay a fixed interest rate and receive a floating rate, which is beneficial if rates are expected to rise. In the given scenario, the portfolio manager anticipates a decrease in interest rates and wants the option to receive a fixed rate. Therefore, the correct instrument to purchase is a call swaption. A put swaption would be incorrect as it provides the right to pay a fixed rate, which is contrary to the manager’s strategy. An interest rate floor is used to protect against falling rates on a floating-rate asset by setting a minimum interest level, but it does not facilitate entering into a swap. A forward rate agreement (FRA) is an obligation, not an option, to lock in an interest rate for a single future period, which does not align with the manager’s need for an optional, multi-period swap.

The correct answer is a currency forward contract. This is because the treasurer requires a highly specific solution tailored to a non-standard amount (EUR 12,750,000) and a specific future date (105 days). Forward contracts are traded over-the-counter (OTC) and are designed to be fully customizable between two parties, allowing them to agree on the exact underlying amount, settlement date, and price. This directly addresses the treasurer’s need for a precise hedge. A standardized currency futures contract is unsuitable because futures are exchange-traded and have fixed contract sizes and predetermined settlement dates, which would not align with the treasurer’s specific requirements and could lead to an imperfect hedge (basis risk). A currency swap is also inappropriate for this scenario; swaps involve the exchange of a series of cash flows or interest payments over a period, which is more complex than what is needed to hedge a single, one-off receivable. A listed currency option, similar to a futures contract, is traded on an exchange and has standardized terms, making it less suitable for this highly specific requirement.

This question assesses the understanding of the fundamental differences between subscription warrants and derivative warrants. Statement I is correct because subscription warrants are issued by the underlying company itself to raise capital, and upon exercise, new shares are issued, which leads to a dilution of the existing share capital. Statement III is also correct; subscription warrants grant the right to subscribe to new shares, making them inherently call warrants. In contrast, derivative warrants, issued by third-party financial institutions, can be structured as either call or put warrants. Statement II is incorrect because while derivative warrants on single Hong Kong stocks can be physically settled, it is not a mandatory requirement. Many are cash-settled, and the term ‘must’ makes the statement inaccurate. Statement IV is incorrect as it reverses the typical expiry periods; subscription warrants generally have longer tenors (e.g., one to five years), whereas derivative warrants typically have shorter expiries (e.g., six to nine months). Therefore, statements I and III are correct.

This question tests the understanding of how a Forward Rate Agreement (FRA) functions as a hedge for a borrower against rising interest rates. In this scenario, Dragon Corp (the borrower) enters an FRA to lock in a borrowing rate of 4.0%. The reference rate at the fixing date turns out to be 4.5%, which is higher than the agreed FRA rate. The FRA is designed to compensate the borrower for this adverse movement.

Statement I is correct. Since the actual market rate (reference rate) of 4.5% is higher than the locked-in FRA rate of 4.0%, the seller of the FRA (Harbour Bank) must compensate the buyer (Dragon Corp) for the difference.

Statement II is correct. The settlement payment from the bank serves to offset the increased interest expense Dragon Corp will incur when borrowing at the higher market rate of 4.5%. This is the fundamental purpose of the hedge.

Statement III is correct. Although Dragon Corp will borrow from the market at 4.5%, it receives a cash settlement from Harbour Bank equivalent to the 0.5% difference (4.5% – 4.0%) on the notional principal. This effectively reduces its net borrowing cost back to the originally agreed 4.0%.

Statement IV is incorrect because it reverses the direction of the payment. Dragon Corp, as the buyer of the FRA hedging against a rate rise, is the party that receives payment when rates do rise. Therefore, statements I, II and III are correct.

The correct answer is that the LP’s action is justified if the situation is classified as a ‘fast market’. Under the Rules Governing the Listing of Securities on The Stock Exchange of Hong Kong Limited, Liquidity Providers (LPs) for derivative warrants have specific obligations to provide continuous quotes. However, the rules also recognize certain situations where it is impracticable for them to do so. A ‘fast market’ is one such recognized exemption. This term describes a market condition characterized by extremely high volatility, rapid price movements, and a surge in trading volume, which makes it technically difficult for the LP to maintain the required bid-offer spread and manage its hedging positions effectively. One incorrect option suggests the exemption applies because the first ten minutes of trading have passed; this is incorrect as the exemption period at the start of the day is only for the pre-market opening session and the first five minutes of trading. Another wrong answer mentions a minor technical glitch in an internal reporting system; this is not sufficient grounds for suspension, as the exemption for technical difficulties applies to problems that directly impede the LP’s normal quoting operations. The final incorrect option, concerning the warrant trading at a significant premium, is also invalid; market pricing, whether at a premium or discount, is a normal condition and does not relieve the LP of its liquidity-providing duties.

The correct answer is that the fund manager is acting as a hedger. A hedger is a market participant who uses derivatives to reduce or mitigate the risk associated with an existing or anticipated position in an underlying asset. In this scenario, the fund manager holds a substantial portfolio of technology stocks and is concerned about a potential market-wide downturn. By selling stock index futures, the manager establishes a short position that will generate profits if the overall market falls, thereby offsetting the potential losses on the physical stock portfolio. This action is a classic risk-management strategy, not one aimed at pure profit from market movements. A speculator, in contrast, would use derivatives to take on risk by betting on the future direction of an asset’s price without having an underlying exposure to protect. Their primary goal is to profit from price changes. An arbitrageur seeks to lock in a risk-free profit by simultaneously exploiting price discrepancies between the derivatives market and the underlying cash market, which is not what the manager is doing here. The concept of cost of carry is a fundamental component in pricing futures contracts, representing the net cost of holding the underlying asset until the futures contract’s delivery date, but it does not describe the role of the market participant in this context.

The correct answer is a loss of HK$402,500. The profit or loss on a futures trade is calculated by taking the difference between the selling price and the purchase price, and then multiplying by the number of contracts and the contract multiplier. Since the position was closed in two separate trades, the profit/loss for each trade must be calculated individually and then summed. For the first trade (closing 10 contracts):
Loss per contract = (Selling Price – Purchase Price) = (25,100 – 25,260) = -160 points.
Total loss for this trade = -160 points 10 contracts HK$50 per point = -HK$80,000. For the second trade (closing the remaining 15 contracts):
Loss per contract = (Selling Price – Purchase Price) = (24,830 – 25,260) = -430 points.
Total loss for this trade = -430 points 15 contracts HK$50 per point = -HK$322,500. Total result = Loss from first trade + Loss from second trade = (-HK$80,000) + (-HK$322,500) = -HK$402,500. A profit of HK$402,500 is incorrect as it reverses the calculation, which would only apply if the trader had initiated a short position. A loss of HK$537,500 is incorrect because it erroneously applies the final, lower closing price of 24,830 to all 25 contracts, ignoring the fact that 10 contracts were closed earlier at a higher price. A loss of HK$200,000 is also incorrect as it assumes all 25 contracts were closed at the first exit price of 25,100, failing to account for the larger loss on the remaining 15 contracts.

According to the rules of the Hong Kong Futures Exchange (HKFE), an exchange participant is generally prohibited from acting as the counterparty to its own client’s order. This rule is in place to prevent conflicts of interest. However, there are specific exceptions. The correct answer is that the client must have provided prior written consent for the firm to take the opposite side of their trade. This is one of the two primary conditions under which such a transaction is permissible. The other exception is when the open interest and/or turnover for the specific contract is lower than a level prescribed by the HKFE. The other choices describe actions that, while potentially relevant in other contexts, are not the specific prerequisite for this situation. Requiring a firm to first attempt execution on the open market relates to the general duty of best execution but is not the specific condition for acting as a counterparty. Reporting the transaction to the SFC after the fact is a separate regulatory obligation and does not provide the necessary pre-approval to conduct the trade. While obtaining internal approval from a Responsible Officer is a good governance practice, it does not substitute for the external regulatory requirement of obtaining client consent or meeting the low liquidity threshold.

The correct answer is that the arbitrageur should simultaneously buy the stock in the cash market, borrow funds at the risk-free rate, and sell the futures contract. This strategy is known as cash-and-carry arbitrage. First, one must determine the theoretical or ‘fair’ price of the futures contract using the cost-of-carry model. The fair price is calculated as the spot price plus the cost of financing the purchase of the underlying asset until the futures contract’s expiry. In this case, the fair price is HK$200 (1 + 4% 3/12) = HK$202. Since the futures contract is trading in the market at HK$208, it is overpriced by HK$6. To capture this risk-free profit, the arbitrageur sells the overpriced future at HK$208 and simultaneously buys the underlying stock at HK$200, financing the purchase by borrowing HK$200. At expiry, the cost of buying and holding the stock will be HK$202 (the initial HK$200 plus HK$2 in interest). The arbitrageur then delivers the stock to settle the futures contract, for which they receive HK$208. The resulting risk-free profit is HK$208 – HK$202 = HK$6. Selling the stock short and buying the futures contract is the incorrect strategy, known as reverse cash-and-carry arbitrage, which is only profitable when the futures contract is underpriced relative to its fair value. Conducting a fundamental analysis is an entirely different approach to investing that seeks to determine an asset’s intrinsic value based on economic and financial factors; it is not a method for exploiting short-term price discrepancies between related instruments. Buying the futures contract and selling the stock is the opposite of the correct arbitrage strategy for this scenario and would lead to a guaranteed loss if the prices converge at expiry.

Statement I is correct. An increase in the risk-free interest rate increases the cost of carry for the underlying asset. This benefits the holder of a call option (as they can invest the funds that would have been used to buy the asset) and disadvantages the holder of a put option (as the present value of the exercise price they would receive is lower). Therefore, a higher interest rate increases a call’s value and decreases a put’s value. Statement II is incorrect. This statement describes historical volatility. Implied volatility is the market’s forecast of future volatility, which is derived by inputting the current market price of an option into a pricing model (like the Black-Scholes-Merton model) and solving for the volatility variable. Statement III is incorrect. For two call options that are otherwise identical, the one with the lower exercise price gives the holder the right to buy the underlying asset at a cheaper price, making it more valuable. Therefore, the call option with the lower exercise price will have a higher premium. Statement IV is correct. Volatility represents the magnitude of an asset’s price movements. Higher volatility increases the probability that the option will finish deep in-the-money. This uncertainty benefits the holders of both call and put options, as their potential profit is unlimited while their loss is capped at the premium paid. Therefore, statements I and IV are correct.