HKSI Paper 9 Preview English Set Two Set Two

Statement I is correct because currency options provide the buyer with the right, but not the obligation, to buy or sell a specific amount of foreign currency at a predetermined exchange rate on or before a future date. This flexibility is a key characteristic of options contracts. Statement II is incorrect. While currency forwards do involve an agreement to buy or sell currency at a future date with a rate fixed at the agreement time, they are obligations, not options. There is no choice involved. Statement III is correct. Currency swaps involve two parties exchanging financial obligations related to liabilities denominated in different currencies. This exchange can help manage currency risk and optimize cash flows. Statement IV is incorrect. FX swaps involve buying or selling a currency on one date and reversing the transaction at a later date. This is a short-term exchange, not necessarily designed for long-term liability management like currency swaps. Therefore, the correct combination is I & III only. Understanding the nuances between these currency derivatives is crucial for managing risk and optimizing investment strategies in the foreign exchange market, as regulated under guidelines issued by the Hong Kong Monetary Authority (HKMA) concerning financial risk management.

Statement I is correct because Japanese candlestick charts visually represent the open, high, low, and close prices for a specific period, allowing traders to quickly assess the price movement and potential trend direction. The body of the candlestick indicates the range between the open and close prices, while the wicks (or shadows) represent the high and low prices. Statement II is correct because an up-trend is characterized by a series of successively higher peaks and troughs, indicating sustained buying pressure and positive market sentiment. Technical analysts identify up-trends to capitalize on potential long positions. Statement III is incorrect because a down-trend is characterized by successively lower peaks and troughs. Statement IV is incorrect because support levels are price levels where a downtrend is expected to pause due to a concentration of buyers. Resistance levels are price levels where an uptrend is expected to pause due to a concentration of sellers. Therefore, only statements I and II are correct. According to the Securities and Futures Ordinance (SFO) in Hong Kong, understanding market trends and using technical analysis tools like candlestick charts are essential for licensed individuals to provide informed investment advice and manage risks effectively. The SFO emphasizes the importance of competence and due diligence in analyzing market data to protect investors’ interests.

Statement I is correct. A lower exercise price for a call option means the holder has the right to purchase the underlying asset at a cheaper price, making it more valuable than a call option with a higher exercise price, all other factors being equal. This aligns with standard option pricing principles. Statement II is incorrect. Higher volatility in the underlying asset generally increases the price of both call and put options. This is because higher volatility implies a greater potential range of price movements for the underlying asset, increasing the probability that the option will end up in the money. Statement III is correct. An increase in interest rates typically leads to an increase in call option prices and a decrease in put option prices. This is because higher interest rates reduce the present value of the strike price, making the call option more attractive. Statement IV is incorrect. Delta measures the sensitivity of an option’s price to changes in the price of the underlying asset. It is a crucial measure for understanding and managing the risk associated with options trading, as it indicates how much the option price is expected to move for each dollar change in the underlying asset’s price. Therefore, the correct combination is I & III only.

The cost of carry is a crucial concept in commodity futures pricing. It represents the total expenses associated with holding a physical commodity over a specific period. These costs include storage fees, insurance premiums, and financing charges. A higher cost of carry generally leads to a higher futures price relative to the spot price, as market participants demand compensation for bearing these expenses. Statement I is correct because storage costs are a direct component of the cost of carry. Statement II is also correct; insurance is necessary to protect the commodity’s value during storage and is therefore included in the cost of carry. Statement III is incorrect because transportation costs, while relevant to the overall supply chain, are not considered part of the cost of carry. The cost of carry focuses on the expenses incurred while the commodity is held in storage. Statement IV is incorrect because the convenience yield represents the benefit of holding the physical commodity rather than a futures contract. It is a factor that *reduces* the futures price relative to the spot price, not a component of the cost of carry. Therefore, only statements I and II accurately describe components of the cost of carry.

The minimum net asset value requirement for issuers of derivative warrants in Hong Kong is stipulated to safeguard investors against the credit risk associated with these instruments. Derivative warrants, such as call or put warrants on stocks, expose investors to the financial stability of the issuing institution. If an issuer faces financial distress or insolvency, the value of the warrants could be significantly impacted, potentially leading to losses for investors. The HK$2 billion net asset value threshold serves as a benchmark to ensure that only financially robust entities are permitted to issue these complex financial products. This requirement aims to provide a reasonable level of assurance that the issuer has sufficient resources to meet its obligations under the warrants, reducing the likelihood of default. The Listing Rules of the Hong Kong Exchanges and Clearing Limited (HKEx) outline these criteria to maintain market integrity and protect investor interests. By setting a high bar for issuers, the regulatory framework seeks to foster confidence in the derivative warrant market and promote its sustainable development. This measure is part of a broader effort to regulate and supervise the financial industry, ensuring that participants adhere to stringent standards of financial soundness and operational competence. The net asset value requirement is a critical component of this regulatory oversight, contributing to the overall stability and reliability of the Hong Kong financial market.

This question assesses the understanding of how futures contracts, specifically HIBOR futures, can be used to speculate on interest rate movements and manage risk in anticipation of specific economic events. The scenario presented involves anticipating a currency attack and its potential impact on short-term and long-term interest rates. A speculator who believes a currency attack is imminent and that short-term rates will rise while long-term rates fall would strategically use futures contracts to profit from these anticipated movements. The correct strategy involves buying near-term futures and selling longer-term futures, effectively betting on the yield curve to flatten. Understanding the inverse relationship between futures prices and interest rates is crucial. When interest rates are expected to rise, futures prices fall, and vice versa. Therefore, to profit from rising short-term rates, the speculator should buy HIBOR futures, and to profit from falling long-term rates, the speculator should sell EFN futures. The incorrect options describe strategies that would be suitable for different expectations about interest rate movements or for hedging against different types of risks. The question requires careful consideration of the speculator’s beliefs and the expected market response to a currency attack.

Hedging, as exemplified in the scenario, is a risk management strategy used to mitigate potential losses from adverse price movements. In this context, the Hong Kong importer faces the risk of the Hong Kong dollar (HKD) depreciating against the US dollar (USD), which would increase the cost of purchasing USD 1,000,000 to pay for goods.

Statement I is correct because entering into a forward contract allows the importer to lock in a specific exchange rate for the future transaction, eliminating the uncertainty associated with fluctuating exchange rates. This is a common hedging strategy.

Statement II is correct because, by using a currency forward, the importer knows exactly how much HKD will be required to purchase the USD 1,000,000 in 12 months. This certainty aids in financial planning and budgeting.

Statement III is incorrect because hedging is not about eliminating all risk; it’s about reducing or mitigating specific risks. The importer still faces other business risks, such as changes in demand or supply chain disruptions.

Statement IV is incorrect because while hedging reduces the risk of adverse exchange rate movements, it also limits the potential benefit if the exchange rate moves in the importer’s favor. The importer forgoes the opportunity to purchase USD at a lower rate if the HKD strengthens. Therefore, the correct combination is I & II only.

A gold producer seeking to mitigate the risk of falling gold prices would strategically employ hedging instruments. Entering a gold forward contract allows the producer to lock in a future selling price, providing certainty but potentially missing out on price increases. Selling gold futures achieves a similar outcome, but requires active management due to margin calls and contract rollovers. A gold swap offers a longer-term solution, exchanging floating spot prices for a fixed price, reducing ongoing management needs and avoiding margin requirements. Purchasing gold put options provides downside protection, allowing the producer to sell gold at a predetermined price if the market price falls below it, while still benefiting from price increases. The choice depends on the producer’s risk appetite, time horizon, and operational considerations. Swaps are often favored for their long-term nature and reduced administrative burden, while options offer flexibility but come at a premium cost. Futures and forwards are suitable for shorter-term hedging needs. According to the Securities and Futures Ordinance (SFO) in Hong Kong, these hedging activities, if conducted by licensed corporations, must adhere to stringent risk management and disclosure requirements to protect investors and maintain market integrity. The SFO emphasizes the importance of understanding the risks associated with derivatives and ensuring that hedging strategies align with the firm’s overall risk management framework.

A put bull spread is an options strategy employed when an investor anticipates a moderate increase in the price of an underlying asset. It involves buying put options at a lower strike price and simultaneously selling put options at a higher strike price, both with the same expiration date. The strategy profits from the premium received from selling the higher strike puts, offsetting the cost of buying the lower strike puts. The maximum profit is limited to the difference between the strike prices, less the net premium paid. The breakeven point is calculated by subtracting the net premium paid from the higher strike price. This strategy is considered less risky than simply buying call options, as the premium received from selling the puts provides a cushion against potential losses. The investor’s view is bullish, but moderately so, as significant price increases beyond the higher strike price will not result in additional profit. The Securities and Futures Commission (SFC) emphasizes the importance of understanding the risk profile of such strategies, as outlined in their guidelines on complex financial products. Investors should carefully consider their risk tolerance and investment objectives before implementing a put bull spread. The SFC also requires intermediaries to ensure that clients understand the potential risks and rewards of options trading, as detailed in the Code of Conduct for Persons Licensed or Registered with the Securities and Futures Commission.

Hedging with futures contracts involves several key decisions, including whether to buy or sell, which contract to use, and the number of contracts required. The initial decision to buy or sell futures hinges on the desired outcome of the hedge. If the goal is to protect against a potential decrease in the value of an asset or portfolio, the appropriate strategy is to sell futures contracts. This is because a decline in the asset’s value should be offset by gains from the short futures position as the futures price decreases. Conversely, if the goal is to protect against a potential increase in the price of an asset, the appropriate strategy is to buy futures contracts. This is because an increase in the asset’s price should be offset by gains from the long futures position as the futures price increases. The choice of which contract to use depends on the time horizon of the hedge and the available contract months. The number of contracts needed is calculated by dividing the value of the position to be hedged by the value of one futures contract. This calculation ensures that the hedge is appropriately sized to offset potential losses or gains in the underlying asset. According to the Securities and Futures Ordinance (SFO) in Hong Kong, firms engaging in such hedging activities must ensure they have adequate risk management systems in place, and that their hedging strategies are aligned with their overall business objectives. This includes proper documentation of the hedging strategy, regular monitoring of its effectiveness, and appropriate disclosure to clients where relevant, as per the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission.

The short butterfly spread is a strategy implemented when an investor anticipates significant market volatility but is unsure of the direction. Statement I is correct because the strategy involves selling out-of-the-money calls, both above and below the current market price, to profit from a large price movement in either direction. Statement II is also correct; the investor buys twice the number of at-the-money (ATM) calls to create the ‘body’ of the butterfly, which will profit if the market moves substantially. Statement III is correct as this strategy is designed to profit from high volatility. Statement IV is also correct. The maximum profit is limited to the net premium received when initiating the position, minus any commissions. This is because the potential gains from the ATM calls are capped by the short calls at the higher and lower strike prices. The Securities and Futures Ordinance (SFO) requires licensed individuals to understand and manage the risks associated with complex trading strategies like the short butterfly spread, ensuring they can adequately advise clients on potential losses and gains. Therefore, all statements are correct.

I. Correct. A spread trade in commodity derivatives involves simultaneously buying and selling contracts on the same commodity but with different delivery dates. This strategy aims to profit from changes in the price differential between these contracts, reflecting expectations about future supply and demand dynamics. This is a common strategy used to capitalize on anticipated shifts in the forward curve.

II. Incorrect. While commodity derivatives can be used for hedging, a ‘naked’ position typically refers to an unhedged position. Taking a naked position in commodity derivatives means exposing oneself to the full price risk of the underlying commodity, without any offsetting hedge. This is generally considered a speculative strategy, not a hedging one.

III. Correct. A basis trade involves taking offsetting positions in the spot market and a related futures contract. The aim is to profit from changes in the ‘basis,’ which is the difference between the spot price and the futures price. This strategy is often used by commodity traders and processors to manage price risk and capitalize on perceived mispricings between the spot and futures markets.

IV. Incorrect. A calendar roll involves closing out a position in a near-term contract and simultaneously opening a similar position in a further-dated contract. While it can be part of a trading strategy, it is more accurately described as a maintenance activity to avoid taking delivery of the underlying commodity, rather than a specific directional trading strategy in itself. It is often used to extend the duration of a hedge or speculation.

The scenario illustrates a successful hedging strategy using put options to mitigate losses in a stock portfolio during a market downturn. Statement I is correct because the investor purchased put options on the Hang Seng Index with a strike price of 22,000 to protect their portfolio against a potential decline. This is a classic hedging strategy. Statement II is correct because the Hang Seng Index did indeed fall to 19,295, triggering the in-the-money status of the put options. The options became valuable because the index was below the strike price. Statement III is correct as the profit from the options trade partially offset the losses in the stock portfolio. The profit of HKD11,625,250 significantly compensated for the HKD15,000,000 loss in the portfolio, demonstrating the effectiveness of the hedge. Statement IV is incorrect. While the options strategy was successful in mitigating losses, it did not fully eliminate them. The portfolio still experienced a net loss, although the loss was substantially reduced due to the options hedge. Therefore, the correct combination is I, II & III only.

The underlying instrument in stock futures and stock options represents the specific asset that the contract is based upon. In the context of Hong Kong’s securities market, as highlighted in the provided text, this refers to a predetermined quantity of shares of a particular company. For instance, a stock future or option on HSBC Holdings might represent 400 shares, while a contract on China Mobile could represent 500 shares. Understanding the quantity of the underlying asset is crucial for calculating the contract’s total value. To determine the value, one must multiply the quoted price (for futures) or the option premium (for options) by the number of shares represented in the contract. This mechanism is essential for investors and traders as it directly impacts their potential profit or loss. The Hong Kong Securities and Futures Commission (SFC) oversees these contracts, ensuring transparency and fair trading practices. The specific quantities are defined by the exchange and are standardized to facilitate trading and reduce ambiguity. These standardized quantities are crucial for efficient trading and risk management in the derivatives market. The difference in contract specifications between different stocks reflects factors such as share price and trading volume, aiming to create contracts that are accessible and liquid.

A market order instructs the broker to execute a trade immediately at the best available price. This type of order prioritizes speed of execution over a specific price point. The broker’s primary duty is to fulfill the order as quickly as possible, securing the most favorable price currently offered in the market. While the broker aims for the best price, the final execution price can vary due to market volatility and order size. The client accepts this price uncertainty in exchange for the assurance that the order will be filled promptly. According to the SFC’s “Code of Conduct,” brokers must act in the best interests of their clients, which includes executing market orders efficiently and transparently. The broker should also disclose any potential conflicts of interest that may arise during the execution process. The client should be aware of the risks associated with market orders, such as the possibility of price slippage, especially in fast-moving markets. The broker should provide clear and concise information about the potential impact of market conditions on the execution price. This ensures that the client can make informed decisions about their trading strategy. The broker should also maintain records of all market orders executed, including the time of execution and the price achieved, in accordance with regulatory requirements.

The closing price represents the final price at which a security trades during a trading session. It is a crucial data point for investors and analysts as it reflects the market’s sentiment at the end of the trading day. In Hong Kong, the Stock Exchange of Hong Kong (SEHK) uses the closing price to calculate various indices and for settlement purposes. Understanding the closing price is essential for interpreting market trends and making informed investment decisions. The Securities and Futures Ordinance (SFO) mandates accurate reporting and transparency in price determination, including the closing price, to maintain market integrity and protect investors. Manipulating the closing price is a serious offense under the SFO, potentially leading to severe penalties. Investors often use the closing price in conjunction with other technical indicators to assess price movements and identify potential trading opportunities. The SEHK also publishes closing prices for various derivative products, such as futures and options, which are used for hedging and speculation. The closing price is a fundamental element in financial analysis and regulatory oversight, ensuring fair and efficient market operations in Hong Kong. Furthermore, the SFC actively monitors trading activities around the market close to prevent any abusive practices that could distort the closing price and mislead investors. Accurate determination and reporting of the closing price are therefore paramount for maintaining investor confidence and the overall stability of the Hong Kong securities market.

Statement I is correct because in an interest rate swap where a counterparty pays a fixed rate, they are essentially exchanging a predictable cash flow (the fixed rate) for a variable one. This is beneficial when the counterparty believes that interest rates will rise, as they are locked into paying a lower fixed rate than what the market rate might become. Statement II is correct because the counterparty receiving the fixed rate benefits when interest rates fall. They receive a higher fixed payment than the prevailing market rates. Statement III is incorrect because the notional principal is used to calculate the interest payments exchanged but is not itself exchanged. It serves as a reference amount. Statement IV is incorrect because interest rate swaps can be customized to fit specific needs and risk profiles, they are not limited to standardized terms. The Securities and Futures Commission (SFC) in Hong Kong oversees the regulation of over-the-counter (OTC) derivatives markets, including interest rate swaps, to ensure market integrity and investor protection, as outlined in the Securities and Futures Ordinance (SFO).

An equity swap is a contractual agreement where two parties exchange cash flows based on the performance of an equity or equity index. Understanding the mechanics and potential risks is crucial for financial professionals. The party receiving the equity return bears the risk of the underlying equity’s performance. If the equity performs poorly, they receive less than expected, and potentially pay out more to the counterparty. Conversely, if the equity performs well, they receive more. The party paying the equity return typically receives a fixed or floating rate, effectively hedging their exposure to interest rate risk. The notional principal is used to calculate the cash flows but is not exchanged.

Equity swaps are governed by standard ISDA (International Swaps and Derivatives Association) documentation, which provides a framework for defining the terms and conditions of the swap, including payment dates, calculation methods, and dispute resolution mechanisms. Regulatory oversight of equity swaps in Hong Kong is primarily through the Securities and Futures Commission (SFC), which monitors market activity and ensures compliance with relevant regulations to maintain market integrity and protect investors. Participants in equity swaps should carefully assess the creditworthiness of their counterparties, as default risk is a significant concern. Collateralization and netting agreements can help mitigate this risk. Furthermore, changes in tax laws can impact the economics of an equity swap, requiring ongoing monitoring and adjustments.

I is correct because hedging strategies, as demonstrated in the provided example, aim to offset potential losses in a portfolio by taking an opposing position in the futures market. The goal is to reduce the overall risk exposure of the portfolio. II is correct because the futures market allows investors to speculate on the future price movements of an index, such as the Hang Seng Index (HSI). By buying or selling futures contracts, investors can profit from anticipated market trends. III is correct because the example illustrates how a speculator can use HSI futures to profit from expected movements in the Hong Kong stock market, based on anticipated economic news and market sentiment. IV is correct because the example demonstrates how losses in the futures market can occur if the market moves against the speculator’s position. However, these losses can be offset by gains in the value of the underlying portfolio, as part of a hedging strategy. The Securities and Futures Ordinance (SFO) in Hong Kong regulates futures trading, ensuring market integrity and investor protection. Understanding hedging strategies and the use of futures contracts is crucial for managing risk and participating in the Hong Kong securities market, as outlined in the HKSI Paper 9 syllabus.

Statement I is correct because Japanese candlestick charts are indeed used to identify trends and critical price levels, such as support and resistance. They visually represent the open, high, low, and close prices for a given period, allowing analysts to quickly assess the direction and strength of price movements. Statement II is also correct. An uptrend is characterized by a series of successively higher peaks and troughs, indicating increasing buying pressure and positive market sentiment. Statement III is incorrect because a downtrend is characterized by successively lower peaks and troughs, reflecting increasing selling pressure and negative market sentiment. Statement IV is correct. Technical analysts use trend lines to identify potential support and resistance levels, which can act as areas where the price may find buying or selling interest. These lines are drawn connecting a series of highs (for resistance) or lows (for support) and can help traders anticipate potential price reversals or breakouts. Therefore, the correct combination is I, II & IV only.

A short strangle is a strategy employed when an investor anticipates low volatility in the underlying asset. It involves simultaneously selling an out-of-the-money call option and an out-of-the-money put option on the same asset with the same expiration date. The investor profits if the asset price remains within a defined range between the two strike prices, as both options will expire worthless. The maximum profit is the combined premium received from selling both options. The break-even points are calculated by adding the net premium received to the call option’s strike price and subtracting the net premium from the put option’s strike price. The risk is unlimited if the asset price moves significantly beyond either break-even point. In the given scenario, the investor receives a total premium of 80 points. The upper break-even point is the call strike price plus the total premium (22,400 + 80 = 22,480), and the lower break-even point is the put strike price minus the total premium (22,000 – 80 = 21,920). Therefore, the investor will start to incur losses if the Hang Seng Index rises above 22,480 or falls below 21,920. This strategy is governed by the Securities and Futures Ordinance (SFO) in Hong Kong, which mandates that intermediaries provide adequate risk disclosures to clients engaging in options trading, particularly concerning the unlimited potential losses associated with short positions. Furthermore, the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (SFC) requires intermediaries to assess the client’s understanding of options trading and their risk tolerance before executing such strategies.

Exchange-traded derivatives are traded on organized exchanges, offering benefits such as standardized contract specifications, a centralized marketplace, and novation. Standardized contract specifications ensure uniformity in terms of quantity, quality, delivery dates, and settlement procedures, reducing ambiguity and counterparty risk. A centralized marketplace provides a transparent and regulated environment for trading, facilitating price discovery and liquidity. Novation, facilitated by a central counterparty (CCP), replaces the original counterparties to a trade with the CCP, mitigating credit risk. These features enhance market efficiency and accessibility for a wide range of participants. The Securities and Futures Ordinance (SFO) in Hong Kong governs the regulation of exchange-traded derivatives, ensuring market integrity and investor protection. The Hong Kong Exchanges and Clearing Limited (HKEX) operates the primary exchange for derivatives trading in Hong Kong, providing a platform for trading futures, options, and other derivative products. Understanding the characteristics and regulatory framework of exchange-traded derivatives is crucial for participants in the Hong Kong derivatives market.

Submitting feedback on the HKSI Paper 9 Derivatives study manual is crucial for several reasons. Firstly, it directly contributes to the continuous improvement of the manual, ensuring that future candidates benefit from the insights and experiences of previous users. This aligns with the Hong Kong Securities and Futures Commission’s (SFC) emphasis on maintaining high standards of competence and professionalism within the securities industry, as outlined in the Licensing Handbook. Constructive feedback helps the HKSI refine the content, structure, and clarity of the manual, making it a more effective learning tool. Secondly, providing comments and recommendations allows candidates to voice any concerns or suggestions they may have regarding the material. This feedback loop is essential for identifying areas where the manual may be lacking or where additional clarification is needed. The HKSI’s commitment to incorporating feedback demonstrates its dedication to providing candidates with the best possible resources for exam preparation. Finally, the confidentiality of the feedback process encourages candidates to provide honest and candid assessments of the manual. This ensures that the HKSI receives accurate and unbiased information, which is essential for making informed decisions about future revisions. Therefore, submitting feedback is not only beneficial for future candidates but also reflects a commitment to upholding the standards of the securities industry in Hong Kong. Statements I, II, and III are correct.

Statement I is correct because HSI futures contracts are indeed cash-settled. This means that upon expiry, instead of physical delivery of the underlying assets, cash payments are made between the exchange clearing house and futures contract holders based on the difference between the contract price and the final settlement price. This is explicitly stated in the provided text. Statement II is correct because the last trading day for HSI futures contracts is the second-last business day of the contract month. This is a key feature of the contract specifications, allowing for a defined period before final settlement for price discovery and orderly liquidation. Statement III is incorrect. The final settlement price is the average of quotations of the Hang Seng Index taken at five-minute intervals from five minutes after the start of, and up to five minutes before the end of, the continuous trading session of the SEHK, and the close of trading on the SEHK on the last trading day. Statement IV is incorrect because the large open position for HSI futures contracts, requiring reporting to the Exchange, is 500 contracts in any one contract month, as specified by the Exchange. Therefore, the correct combination is I & II only.

The Black-Scholes-Merton (BSM) model, a cornerstone in options pricing, is designed for European-style options on assets that do not pay dividends. It assumes constant volatility, a risk-free interest rate, and that the underlying asset’s returns follow a log-normal distribution. The Garman-Kohlhagen model, an extension of the BSM model, specifically addresses currency options. It incorporates two risk-free interest rates: one for the domestic currency and one for the foreign currency. This adaptation accounts for the interest rate differential between the two currencies, which is a crucial factor in pricing currency options. The Garman-Kohlhagen model also assumes that the exchange rate follows a log-normal distribution. A key difference lies in the treatment of dividends or foreign interest. The BSM model can be adjusted for discrete dividends, but the Garman-Kohlhagen model inherently accounts for the continuous ‘dividend yield’ represented by the foreign risk-free interest rate. Furthermore, the Garman-Kohlhagen model is more sensitive to changes in interest rate differentials, making it particularly useful in volatile currency markets. Both models, however, share limitations such as the assumption of constant volatility, which is often not the case in real-world markets. Understanding these nuances is crucial for accurately pricing and managing currency options, as highlighted in guidelines from the Hong Kong Securities and Futures Commission (SFC) regarding risk management and valuation of derivative products.

Arbitrage opportunities arise when there are pricing discrepancies between related assets in different markets. In the context of cash and derivatives markets, this means exploiting differences in the price of an asset and its corresponding derivative (e.g., a stock and its futures contract).

Statement I is correct because a risk-free profit can indeed be made by simultaneously buying an undervalued asset in the cash market and selling an overvalued derivative contract on that asset. This locks in a profit when the price discrepancy converges.

Statement II is incorrect. Arbitrage is not inherently illegal or unethical. It is a legitimate trading strategy that helps to correct market inefficiencies. However, certain forms of arbitrage, such as those based on insider information, are illegal.

Statement III is incorrect. While transaction costs and market liquidity can reduce the profitability of arbitrage, they do not eliminate the possibility of arbitrage. Traders will still pursue arbitrage opportunities if the potential profit exceeds the costs.

Statement IV is correct because the Securities and Futures Ordinance (SFO) in Hong Kong does not explicitly prohibit arbitrage activities. However, it does prohibit market manipulation and other unfair trading practices, which could potentially be relevant if arbitrage is conducted in a way that distorts the market. According to the Securities and Futures Ordinance (SFO), any activities that involve market manipulation or create a false or misleading appearance of active trading are strictly prohibited. Arbitrage, in itself, is not illegal, but if it involves deceptive practices, it would violate the SFO.

A currency swap, as defined in the context of financial instruments, fundamentally involves the exchange of financial obligations denominated in different currencies. Statement I accurately reflects this core characteristic. The exchange of principal amounts at the beginning and end of the swap (Statement II) is a standard feature of currency swaps, distinguishing them from interest rate swaps where only interest payments are exchanged. Statement III correctly identifies the exchange of interest rate payments as a key component. These payments are typically not netted, unlike in some other types of swaps, and are paid in full in their respective currencies. Statement IV is incorrect because currency swaps do involve the exchange of principal amounts at both the start and the end of the swap’s term. The initial exchange sets up the swap, and the reversing exchange at the end unwinds the positions, returning each party to a state similar to their starting point, but having managed their currency exposures and potentially their interest rate risks over the swap’s life. Therefore, statements I, II, and III accurately describe the mechanics of a currency swap, while statement IV does not.

In an uptrend, a support level represents a price level where buying interest is strong enough to prevent the price from declining further. This occurs because as the price falls towards the support level, buyers are more inclined to purchase the asset, anticipating a price rebound. The increased demand at this level effectively halts the price decline and can initiate an upward movement. Conversely, in a downtrend, a resistance level is a price point where selling pressure is strong enough to prevent the price from increasing further. As the price rises towards the resistance level, sellers are more inclined to sell the asset, anticipating a price decline. This increased supply at the resistance level halts the price increase and can lead to a downward movement.

Understanding these levels is crucial for investors as they provide potential entry and exit points for trades. Support levels can be seen as areas to buy, expecting the price to bounce upwards, while resistance levels can be seen as areas to sell, expecting the price to fall downwards. However, it’s important to note that support and resistance levels are not absolute barriers. They can be broken, especially with significant news or market events. When a support level is broken, it can then act as a resistance level in the future, and vice versa. Identifying these levels often involves analyzing historical price data and looking for areas where the price has previously stalled or reversed direction. Technical analysts use various tools and techniques, such as trendlines and moving averages, to help identify potential support and resistance levels. The Securities and Futures Commission (SFC) emphasizes the importance of understanding market dynamics and risk management when trading securities, and recognizing support and resistance levels is a key aspect of this understanding.

The question explores the characteristics and significance of swap spreads, particularly in the context of credit risk and market conditions. Statement I is correct because the swap spread is indeed calculated as the difference between the swap rate and the yield of government bonds with the same maturity. This difference reflects the credit risk premium demanded by the market for the swap, as swaps are generally perceived as riskier than government bonds. Statement II is also correct. The swap spread serves as a crucial indicator of credit conditions. During periods of financial stress or credit crunches, the swap spread tends to widen significantly, reflecting increased risk aversion and higher perceived credit risk. This was evident during the 2008 financial crisis when swap spreads spiked. Statement III is incorrect because while the swap spread can be influenced by liquidity conditions, it primarily reflects credit risk. Liquidity issues can exacerbate the widening of swap spreads during crises, but the fundamental driver is credit risk. Statement IV is incorrect because while Long-Term Capital Management (LTCM) did experience significant losses related to convergence trading of swap spreads, the Asian financial crisis of 1997 also contributed to the volatility of swap spreads. The near-failure of LTCM further highlighted the risks associated with swap spread trading, but it was not the sole cause of increased awareness of swap spreads in financial markets. Therefore, only statements I and II are correct.

The scenario describes a situation where Bank 123 could have benefited from asset switching using derivatives. Statement I is correct because derivatives allow exposure to asset classes without immediately altering the physical asset mix, enabling Bank 123 to increase its equity exposure without selling existing assets. Statement II is correct because derivatives can lock in a selling price for interest-rate securities, protecting Bank 123 from potential losses if interest rates rise. Statement III is incorrect because the scenario focuses on asset switching to benefit from anticipated market movements, not hedging against potential losses. Statement IV is incorrect because while derivatives can be used to derive income, the primary focus in this scenario is on asset switching to capitalize on expected equity outperformance. Therefore, only statements I and II are correct. This aligns with the principles outlined in the HKSI exam syllabus regarding the use of derivatives for portfolio management and asset allocation, as detailed in materials concerning risk management and investment strategies under the Securities and Futures Ordinance.