The scenario describes a need to hedge a foreign exchange risk for a specific, non-standard amount and a non-standard time horizon (seven months). This requires a highly customized solution. Currency futures are traded on an exchange and have standardized contract sizes and settlement dates (e.g., quarterly), making them unsuitable for hedging such a specific obligation without creating basis risk. An interest rate swap is used to manage interest rate risk, not currency transaction risk. An equity index option relates to the stock market and is irrelevant to this scenario. A currency forward contract is an over-the-counter (OTC) agreement between two parties (e.g., the company and a bank) that can be tailored to the exact amount, currency pair, and settlement date required by the client. This makes it the ideal instrument for this specific hedging situation.

The scenario describes a foreign exchange (FX) swap. This instrument involves two transactions: a spot transaction and a forward transaction in the opposite direction. In this case, the institution sells USD for HKD (the spot leg) and simultaneously agrees to buy USD back with HKD at a future date (the forward leg). The primary purpose of such a transaction is for liquidity management. The institution is effectively borrowing HKD for a short period by using its surplus USD as collateral. This is a common treasury management technique used by financial institutions to manage their short-term funding requirements in different currencies. Speculation is not the main driver, as the forward rate is locked in, mitigating exchange rate risk. Hedging a single future payment would typically be accomplished with a simple currency forward contract, not a swap involving an immediate spot transaction. While the Hong Kong Monetary Authority (HKMA) uses FX swaps to manage liquidity in the banking system under the Linked Exchange Rate System, a single institution’s transaction is for its own treasury management, not a direct execution of monetary policy.

To determine the outcome of the trade, one must first understand the relationship between interest rates and the price of Three-Year Exchange Fund Note (EFN) futures. The price of an EFN future is quoted as 100 minus the implied yield. Therefore, an expectation of rising interest rates (and thus rising yields) translates to an expectation that the EFN futures price will fall. To profit from a falling price, a trader must establish a short position, which involves selling the futures contracts initially and buying them back later at a lower price. In this scenario, the manager correctly sells the contracts first. The financial result is calculated by finding the difference between the entry (selling) price and the exit (buying) price, and then multiplying this by the number of contracts and the contract’s tick value. The price difference is 98.50 (sell) – 97.80 (buy) = 0.70. Since the minimum price fluctuation (tick size) is 0.01, this price difference represents 70 ticks (0.70 / 0.01). The profit per contract is the number of ticks gained multiplied by the tick value: 70 ticks × HK$50/tick = HK$3,500. As the position involved 10 contracts, the total result is HK$3,500 per contract × 10 contracts.

An accumulator contract obligates an investor to purchase a specified quantity of an underlying asset at a pre-agreed strike price on certain dates. Statement I is correct as this obligation persists even if the market price falls below the strike price, which is the primary source of risk for the investor. Statement II is also correct; the ‘knock-out’ or trigger price feature is a key characteristic that terminates the contract and caps the investor’s potential profit. Statement III accurately describes the risk of a leveraged accumulator, where a significant drop in the underlying asset’s price can trigger a clause that doubles the quantity of shares the investor must purchase, thereby magnifying potential losses. Statement IV is incorrect. The investor in an accumulator is effectively shorting a put option, not buying an option. Their maximum loss is not limited to a premium paid; rather, it could be substantial, potentially amounting to the entire value of the shares they are forced to purchase (strike price multiplied by quantity) if the underlying asset’s value drops to zero. Therefore, statements I, II and III are correct.

A bear put spread is an options strategy employed when an investor has a moderately bearish outlook on an underlying asset. It involves buying a put option with a higher strike price and simultaneously selling a put option with a lower strike price, with both options having the same expiration date. This strategy limits both the potential profit and the potential loss. The maximum loss is capped at the net premium paid to establish the position (the debit). The maximum profit is calculated by taking the difference between the two strike prices and subtracting the net premium paid. In this scenario, the net premium paid is the premium for the long put (HK$8) minus the premium received for the short put (HK$3), which equals HK$5. This is the maximum potential loss. The difference between the strike prices is HK$160 – HK$150 = HK$10. Therefore, the maximum profit is the difference in strikes (HK$10) minus the net premium paid (HK$5), resulting in HK$5 per share. This maximum profit is realized if the underlying share price is at or below the lower strike price (HK$150) at expiration.

Statement I is correct. According to the HKEX contract specifications for Hang Seng China Enterprises Index Options, new long-dated options with a term of approximately 2.5 years are introduced twice a year, following the expiry of the June and December contracts. Statement II is incorrect. The contract multiplier for a standard Hang Seng China Enterprises Index Option contract is HK$50 per index point, not HK$10. Statement III is correct. As with other index options, these contracts are cash-settled. This means that upon exercise or expiry, the difference between the strike price and the final settlement price is paid in cash, and there is no physical delivery of the underlying shares that constitute the index. Statement IV is incorrect. The Final Settlement Day is the business day immediately preceding the last business day of the contract month. The last trading day is the same day. Therefore, statements I and III are correct.

Statement I is incorrect. Implied volatility is a forward-looking measure that reflects the market’s consensus on future price movements. While historical volatility can be a reference point, implied volatility is primarily determined by the current supply and demand for the option and overall market sentiment. It is not calculated solely from past data. Statement II is correct. The interest-rate differential between the two currencies is a fundamental component of the Garman-Kohlhagen model, which is an extension of the Black-Scholes-Merton model for foreign exchange options. This differential represents the ‘holding cost’ or ‘cost of carry’ of the underlying currency pair. Statement III is correct. A significant aspect of options trading is taking a view on volatility. By buying or selling an option, a trader is implicitly agreeing or disagreeing with the level of implied volatility priced into the option premium. If the subsequent realised volatility differs from the implied volatility, it creates a profit or loss opportunity. Statement IV is incorrect. The key innovation of the Garman-Kohlhagen model over the original Black-Scholes-Merton model is its ability to incorporate two distinct risk-free interest rates—one for the domestic currency and one for the foreign currency. It does not use a single, blended, or averaged rate. Therefore, statements II and III are correct.

This question assesses the ability to calculate the profit or loss of a short strangle options strategy. A short strangle involves selling an out-of-the-money call option and an out-of-the-money put option with the same expiration date on the same underlying asset. The strategy is profitable if the underlying asset’s price at expiration remains between the two breakeven points. The maximum profit is limited to the total net premium received. The first step is to calculate the total premium collected, which is 120 points from the call and 100 points from the put, for a total of 220 points. Next, determine the outcome of each option leg at the settlement price of 19,350. The 20,500 call option is out-of-the-money (since 19,350 < 20,500) and expires worthless, so the investor keeps the full 120 point premium. The 19,500 put option is in-the-money (since 19,350 < 19,500), resulting in a loss on this leg. The loss is calculated as the difference between the strike price and the settlement price: 19,500 – 19,350 = 150 points. The final net profit or loss is the total premium received minus the loss on the exercised option: 220 points – 150 points = 70 points profit.

A Forward Rate Agreement (FRA) is a contract that locks in an interest rate for a future period. The settlement amount compensates one party for the difference between the agreed FRA rate and the actual market reference rate on the settlement date. The calculation involves two key steps. First, the interest differential is calculated for the notional principal over the contract period. This is the difference between the interest calculated using the agreed FRA rate and the interest calculated using the prevailing reference rate. Second, because this settlement payment is made at the beginning of the interest period (not at the end), the calculated interest differential must be discounted to its present value. The standard market convention, as outlined in regulations concerning derivatives and risk management, is to use the current market reference rate as the discount rate for this calculation, as it reflects the time value of money for the period being hedged.

This question assesses the understanding of various types of exotic options commonly used in structured products.
Statement I is correct. A rainbow option is an option whose payoff depends on two or more underlying assets. A common type is an option on the best or worst performer of a basket of assets, which matches the client’s requirement to gain exposure to the best-performing stock among several.
Statement II is correct. A barrier option’s existence depends on the underlying asset’s price reaching a predetermined barrier level. A ‘knock-in’ option is a type of barrier option that only comes into existence (becomes active) if the underlying price hits the barrier.
Statement III is incorrect. The description provided refers to a lookback option, which allows the holder to ‘look back’ over the option’s life and exercise it at the most advantageous price (e.g., the lowest price for a call or the highest price for a put). An average-rate (or Asian) option, by contrast, has a payoff determined by the average price of the underlying asset over a specified period.
Statement IV is correct. A chooser option provides the holder with the flexibility to decide at a specified future date whether the option will be a standard European call or put option. This is valuable when the holder is uncertain about the future direction of the underlying asset’s price. Therefore, statements I, II and IV are correct.

The Black-Scholes-Merton (BSM) model is a fundamental tool for pricing European-style options. It identifies five key variables that influence an option’s premium. For a call option, the relationships are as follows: 1) Price of the underlying asset: A higher asset price increases the call premium. 2) Exercise price: A higher exercise price decreases the call premium. 3) Time to expiration: A longer time to expiration increases the call premium, as there is more time for the asset price to move favorably. 4) Volatility of the underlying asset: Higher volatility increases the call premium because it raises the probability of the option finishing deep in-the-money. 5) Risk-free interest rate: A higher risk-free rate increases the call premium. This is because the present value of the exercise price (which the call buyer pays in the future) is lower when interest rates are higher, making the right to buy more valuable today.

This question tests the understanding of the specific roles of different clearing houses within the Hong Kong Exchanges and Clearing Limited (HKEx) group. Statement I is correct; Hong Kong Securities Clearing Company Limited (HKSCC) is the central clearing house for securities transactions (e.g., stocks) traded on The Stock Exchange of Hong Kong Limited (SEHK), operating the Central Clearing and Settlement System (CCASS). Statement II is incorrect; it confuses the role of the exchange with the clearing house. The Hong Kong Futures Exchange Limited (HKFE) is the exchange where futures contracts are traded, but the clearing and settlement function is performed by its designated clearing house, HKCC. Statement III is correct; HKFE Clearing Corporation Limited (HKCC) is the central counterparty responsible for clearing trades executed on the HKFE. Statement IV is correct; The SEHK Options Clearing House Limited (SEOCH) is the specific entity responsible for clearing stock option contracts traded on the SEHK. Therefore, statements I, III and IV are correct.

A swaption is an option granting the holder the right, but not the obligation, to enter into an underlying interest rate swap at a future date. Statement I correctly defines a payer swaption, which gives the holder the right to pay a fixed rate and receive a floating rate. This is the appropriate instrument for a borrower seeking to hedge against rising interest rates. Statement II correctly defines a receiver swaption, which gives the holder the right to receive a fixed rate and pay a floating rate. Statement III is incorrect; to hedge against rising interest rates on a liability, the company needs to lock in a fixed payment. Therefore, it should purchase a payer swaption, not a receiver swaption. Statement IV is correct. For the buyer of any option, including a swaption, the maximum potential loss is the non-refundable premium paid to purchase the option. The buyer has the right to walk away if exercising the option is not favorable, limiting their downside to the initial cost. Therefore, statements I, II and IV are correct.

A collar strategy is an investment approach used to protect a long stock position from potential declines in value. It involves three components: holding the underlying shares, purchasing a protective put option, and selling a covered call option. The premium income generated from selling the call option is used to offset, either partially or fully, the cost of buying the put option. The maximum potential profit from this combined position is capped. It occurs when the stock price at expiration is at or above the strike price of the sold call option. The profit is calculated as the difference between the call’s strike price and the initial stock purchase price, plus any net credit (or minus any net debit) from the options premiums. Conversely, the maximum potential loss is floored by the protective put. It occurs when the stock price at expiration is at or below the strike price of the purchased put option. The loss is calculated as the difference between the initial stock purchase price and the put’s strike price, adjusted for the net premium from the options.

This question assesses the understanding of two key inputs in the Garman-Kohlhagen currency option pricing model: the interest-rate differential and implied volatility. For a call option on a foreign currency (e.g., JPY, priced in USD), an increase in the domestic interest rate (USD) reduces the present value of the strike price, which is paid in the domestic currency. A lower present value for the strike price makes the call option more valuable, all else being equal. Separately, an increase in implied volatility reflects greater market expectation of future price swings in the underlying asset. This increased uncertainty raises the chance of the option finishing significantly in-the-money, thereby increasing the time value and the overall premium for both call and put options. When both events occur simultaneously—a wider interest-rate differential (due to a higher domestic rate) and a surge in implied volatility—both factors work in the same direction to increase the price of the foreign currency call option.

An interest-rate swap is an over-the-counter derivative contract in which two parties agree to exchange interest rate cash flows, based on a specified notional principal amount, from one party to the other, and vice-versa, for a specified period. In a ‘plain vanilla’ swap, one party pays a fixed interest rate while the other pays a floating interest rate. A company with a floating-rate liability, such as a loan tied to HIBOR, is exposed to the risk of rising interest rates, which would increase its borrowing costs. To hedge this risk, the company can enter into an interest-rate swap where it agrees to pay a fixed rate. In return, it will receive floating-rate payments from its counterparty, typically based on the same benchmark as its loan (HIBOR). The floating-rate payments received from the swap can then be used to service the floating-rate interest on the loan. This effectively converts the company’s floating-rate debt into a synthetic fixed-rate debt, thereby protecting it from adverse movements in interest rates.

Statement I is correct. In technical analysis, the closing price is widely regarded as the most critical price of a trading period. It represents the final valuation agreed upon by market participants for that day and is used as the primary input for many widely-used technical indicators, such as moving averages and the Relative Strength Index (RSI).

Statement II is also correct. The lowest price of the day marks the point where selling pressure was met and overcome by buying pressure, effectively halting the price decline for that period. This level is often interpreted by technical analysts as an intraday support level.

Statement III is incorrect. It is logically impossible for a closing price to be below the day’s lowest price, as the lowest price is, by definition, the minimum price reached during the trading session. Furthermore, a closing price near the day’s low would indicate bearish sentiment, not bullish momentum.

Statement IV is incorrect. The standard calculation for the Relative Strength Index (RSI) is based on the average gains and losses derived from the changes in closing prices over a specified period, not the lowest price. The closing price is therefore a crucial component of the RSI calculation. Therefore, statements I and II are correct.

A short strangle is an options strategy implemented when an investor anticipates low volatility in the underlying asset. It involves simultaneously selling an out-of-the-money (OTM) call option and an OTM put option on the same underlying asset with the same expiration date. The investor’s maximum profit is limited to the total net premium received from selling both options. This maximum profit is realized if the underlying asset’s price at expiration is between the two strike prices. The strategy has two breakeven points, beyond which it starts to incur losses. The risk is theoretically unlimited on the upside (due to the short call) and substantial on the downside (due to the short put). To calculate the breakeven points, first determine the total premium received. In this scenario, the total premium is 120 points (from the call) + 100 points (from the put) = 220 points. The upside breakeven point is calculated by adding the total premium to the call option’s strike price (18,600 + 220 = 18,820). The downside breakeven point is calculated by subtracting the total premium from the put option’s strike price (17,800 – 220 = 17,580). Therefore, the strategy will be unprofitable if the Hang Seng Index is above 18,820 or below 17,580 at expiration. Due to the unlimited risk profile, licensed corporations must ensure such a strategy is suitable for the client’s risk tolerance and experience, in accordance with the Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission.

This question tests the understanding of interest rate parity and its application in calculating forward exchange rates and implementing a currency hedge.

First, calculate the theoretical 1-year forward rate (F) using the interest rate parity formula: F = S [(1 + interest rate_quote) / (1 + interest rate_base)]. In a USD/HKD quote, HKD is the quote currency and USD is the base currency.
F = 7.8200 [(1 + 0.030) / (1 + 0.045)]
F = 7.8200 [1.030 / 1.045]
F = 7.8200 0.9856459
F ≈ 7.7078
Therefore, statement I is correct.

Second, compare the forward rate to the spot rate. The spot rate is 7.8200 and the calculated forward rate is 7.7078. Since the forward rate is lower than the spot rate, the base currency (USD) is trading at a forward discount against the quote currency (HKD). Therefore, statement II is correct.

Third, calculate the forward margin (forward points). This is the difference between the forward rate and the spot rate, typically expressed in points (1 point = 0.0001).
Forward Points = (Forward Rate – Spot Rate) 10,000
Forward Points = (7.7078 – 7.8200) 10,000
Forward Points = -0.1122 10,000 = -1122 points.
Therefore, statement III is correct.

Fourth, determine the correct hedging action. The manager holds USD assets and is concerned about the USD depreciating against the HKD. To hedge this risk, the manager needs to lock in a future exchange rate to convert USD into HKD. This is achieved by selling USD forward and buying HKD forward. Therefore, statement IV is correct.

Since all four statements are correct, the correct option is ‘All of the above’. Therefore, all of the above statements are correct.

Statement I correctly describes a hedger, whose primary goal is to use derivatives to mitigate or eliminate price risk associated with an existing or anticipated position in an underlying asset. In this case, the treasurer is hedging against adverse movements in the USD/HKD exchange rate. Statement II accurately portrays a speculator. Speculators use derivatives to profit from anticipated price movements. The use of futures contracts allows them to gain significant market exposure (leverage) with a smaller capital outlay (initial margin) than buying the underlying assets directly. Statement III correctly defines the role of an arbitrageur, who seeks to profit from temporary mispricing between a derivative and its underlying asset. By simultaneously buying the underpriced future and selling the overpriced underlying assets, they lock in a risk-free profit, which in turn helps align the prices in the two markets. Statement IV is incorrect; it confuses the role of a speculator with that of a hedger. The primary aim of a speculator is to profit from taking on risk, not to reduce the volatility of an existing portfolio. Reducing portfolio volatility is the objective of a hedger. Therefore, statements I, II and III are correct.

According to the Listing Rules of the Hong Kong Exchanges and Clearing Limited (HKEX), the issuer of a derivative warrant must appoint a liquidity provider. The primary obligation of this liquidity provider is to facilitate a fair and orderly market for the warrant by providing continuous liquidity. This is achieved by quoting both a bid price (the price at which they are willing to buy) and an ask price (the price at which they are willing to sell) throughout the trading day. The rules specify requirements for this activity, including the minimum duration the quotes must be present, the maximum allowable spread between the bid and ask prices, and the minimum size of the order that must be serviced at those prices. This ensures that investors can enter or exit their positions even when natural market demand is low. The role is not to stabilize or guarantee the warrant’s price, which is determined by market forces, nor is it related to the initial issuance process or the provision of investment advice.

To determine the effective selling price, one must calculate the outcome of both the physical stock transaction and the futures hedge. First, calculate the number of futures contracts required for the hedge by dividing the total number of shares by the contract multiplier (shares per contract). Next, calculate the profit or loss from the futures position by taking the difference between the entry (selling) price and the exit (buying) price, then multiplying by the contract multiplier and the number of contracts. Then, calculate the total proceeds from selling the physical shares at the market price when the hedge is closed. Finally, combine the proceeds from the stock sale with the profit from the futures trade to find the total cash inflow. Dividing this total amount by the original number of shares gives the effective selling price per share.

Statement I is correct because the fundamental purpose of a Credit Default Swap (CDS) is to transfer the credit risk associated with a reference entity from the protection buyer to the protection seller. The buyer pays a premium in exchange for a payout if a specified credit event, such as a default, occurs. Statement II is incorrect. A key feature of the CDS market is that the protection buyer does not need to own the underlying reference obligation (the bond). This allows CDS to be used for both hedging actual exposure and for speculation. The firm is not required to sell its bond holdings. Statement III is correct. Upon a credit event, a CDS can be settled in two primary ways: physical settlement, where the buyer delivers the defaulted bonds to the seller in exchange for their par value, or cash settlement, where the seller pays the buyer the difference between the bond’s par value and its post-default market price. Statement IV is incorrect. While a CDS transaction involves various risks, the primary risk mitigated by using a central clearing house is counterparty risk, which is the risk that the seller of the protection will be unable to meet its payment obligations in the event of a default. Market risk refers to the risk of losses due to factors that affect the overall performance of financial markets, which is not the main risk addressed by a central clearing counterparty. Therefore, statements I and III are correct.

This question assesses the understanding of the profit and loss profile for a short call option strategy. When an investor sells (or writes) a call option, they receive an upfront premium. Their view is typically neutral to bearish on the underlying asset, meaning they expect the price to stay below the strike price. The maximum profit is limited to the premium received, which occurs if the underlying asset’s price is at or below the strike price at expiration, causing the option to expire worthless. The break-even point for the seller is calculated by adding the premium received to the strike price. If the underlying asset’s price rises above this break-even point, the seller begins to incur a loss. The potential loss is theoretically unlimited because the price of the underlying asset can rise indefinitely. To calculate the final profit or loss, one must compare the premium received against the option’s intrinsic value at expiry. The intrinsic value for a call option is the amount by which the settlement price exceeds the strike price (Settlement Price – Strike Price). The net profit/loss is therefore: Premium Received – Intrinsic Value.

This question assesses a candidate’s understanding of their responsibilities regarding the official study materials for HKSI examinations. The HKSI explicitly states that the financial industry is dynamic, and regulations and market practices may change. Consequently, study manuals are updated periodically. The examination questions are based on the material in the manual that is current at the time of the exam. The official and prescribed method for candidates to ensure they have the most up-to-date information is to regularly check the HKSI Online Registration and Enrolment System. Through this portal, candidates can download the latest version of the E-Study Manual and review any summaries of recent updates. Relying solely on an older, printed or downloaded version of the manual is inadvisable, as it may not reflect recent, examinable changes. While learning outcomes define the scope of knowledge required, they must be studied using the most current content. Sourcing information from external news or industry websites, while useful for general knowledge, is not a reliable strategy for exam preparation, as the exam is specifically based on the content provided by the HKSI.

The Hong Kong Exchanges and Clearing Limited (HKEX) offers various tenors for Hang Seng Index (HSI) options to cater to different trading and hedging strategies. Among these are long-dated options. Statement I is correct because new long-dated HSI options are indeed introduced twice a year, specifically after the contract expiry in June and December. Statement II is also correct as these newly listed long-dated options have a term of 3.5 years (42 months) at introduction. Statement III is incorrect; the introduction of new long-dated options is based on a pre-set calendar cycle (June and December expiry) and is not conditional upon market performance metrics like the index reaching an all-time high. Statement IV is incorrect because standard HSI options are settled based on the Final Settlement Price of the corresponding Hang Seng Index futures contract, not the Mini-HSI futures contract. Mini-HSI options are settled against Mini-HSI futures. Therefore, statements I and II are correct.

This question assesses the understanding of a long hedge using futures contracts to manage price risk for a commodity consumer. A long hedge involves buying futures contracts to lock in a purchase price and protect against rising prices.

First, let’s establish the hedge details:
– Commodity: Copper
– Exposure: 500 tonnes
– Hedge instrument: Copper futures
– Contract size: 25 tonnes per contract
– Number of contracts to buy (go long) = 500 tonnes / 25 tonnes/contract = 20 contracts.
– Hedge price (futures entry price) = USD 8,000 per tonne.

The goal of this hedge is to fix the effective purchase price of copper at approximately USD 8,000 per tonne, regardless of market fluctuations.

Let’s evaluate each statement:

Statement I: If the copper price rises to USD 8,500 per tonne, the long futures position will generate a profit. The profit is calculated as (Settlement Price – Entry Price) × Quantity = (USD 8,500 – USD 8,000) × 500 tonnes = USD 250,000. This statement is correct.

Statement II: If the copper price rises to USD 8,500 per tonne, the effective net cost will be USD 8,000 per tonne. The physical cost of buying copper is USD 8,500 × 500 = USD 4,250,000. The profit from the futures hedge is USD 250,000 (as calculated for statement I). The net cost is Physical Cost – Futures Profit = USD 4,250,000 – USD 250,000 = USD 4,000,000. The effective cost per tonne is USD 4,000,000 / 500 tonnes = USD 8,000. This statement is correct.

Statement III: If the copper price falls to USD 7,700 per tonne, the long futures position will generate a profit. The outcome is calculated as (Settlement Price – Entry Price) × Quantity = (USD 7,700 – USD 8,000) × 500 tonnes = -USD 150,000. This is a loss, not a profit. This statement is incorrect.

Statement IV: If the copper price falls to USD 7,700 per tonne, the effective net cost will be USD 7,700 per tonne. The physical cost of buying copper is USD 7,700 × 500 = USD 3,850,000. The loss from the futures hedge is USD 150,000 (as calculated for statement III). The net cost is Physical Cost + Futures Loss = USD 3,850,000 + USD 150,000 = USD 4,000,000. The effective cost per tonne is USD 4,000,000 / 500 tonnes = USD 8,000. The effective cost is locked in at USD 8,000, not the lower market price of USD 7,700. This statement is incorrect. Therefore, statements I and II are correct.

This question assesses the ability to calculate the profit or loss from a synthetic long stock options strategy. A synthetic long stock position is created by buying a call option and selling a put option with the same strike price and expiration date. The payoff profile of this strategy mimics that of holding the underlying stock.

First, determine the initial net cost or credit of establishing the position. The representative buys a call for a HKD 2.50 premium and sells a put for a HKD 3.50 premium. This results in a net credit of HKD 1.00 per share (HKD 3.50 received – HKD 2.50 paid).

Next, calculate the profit or loss from closing each leg of the position:
1. Long Call Option: The call was bought at HKD 2.50 and sold at HKD 6.50. The profit on this leg is HKD 6.50 – HKD 2.50 = HKD 4.00 per share.
2. Short Put Option: The put was sold (written) at HKD 3.50 and bought back at HKD 0.50. The profit on this leg is HKD 3.50 – HKD 0.50 = HKD 3.00 per share.

Finally, combine the results from both legs to find the total profit per share: HKD 4.00 (from call) + HKD 3.00 (from put) = HKD 7.00 per share.

Since one option contract represents 100 shares, the total profit per contract is HKD 7.00 per share 100 shares/contract = HKD 700.

This scenario is relevant to the SFC Code of Conduct, which requires licensed persons to have a thorough understanding of the financial products they recommend or trade, including their risk-reward profiles and how profits and losses are realized.

This question assesses the understanding of foreign exchange (FX) settlement risk, also known as Herstatt risk, a critical operational and counterparty risk concept for asset managers.

Statement I is correct. Herstatt risk is the specific risk that one party in an FX transaction pays out the currency it sold but does not receive the currency it bought. This is a form of principal risk and arises due to the time lags between the settlement of the two legs of the transaction, often across different time zones. In this scenario, Prosperity AM pays JPY in the Tokyo time zone and waits for the USD payment in the New York time zone, exposing it to the default of Global FX Bank during this interval.

Statement II is correct. A payment-versus-payment (PvP) system is the primary mechanism to mitigate Herstatt risk. The Continuous Linked Settlement (CLS) Bank is the most prominent example. It acts as a central clearinghouse, ensuring that the final transfer of one currency occurs only if the final transfer of the other currency also takes place, thus eliminating the principal risk during settlement.

Statement III is incorrect. While bilateral netting agreements (often under an ISDA Master Agreement) are crucial for managing overall counterparty credit exposure, they primarily reduce pre-settlement risk by netting the value of multiple transactions. They do not eliminate the principal risk of a single transaction during the actual settlement process. The full principal of the JPY leg is still at risk at the point of payment unless a PvP system is used.

Statement IV is incorrect. The primary risk described in the scenario is settlement risk, which is a form of credit or counterparty risk—the risk of losing the entire principal amount. Market risk refers to the risk of loss due to adverse movements in the exchange rate. While market risk exists for any open FX position, the specific risk highlighted by the settlement time lag is the potential default of the counterparty, not currency fluctuation. Therefore, statements I and II are correct.

Statement I is correct because an equity swap allows an investor to gain the economic exposure of an underlying asset, in this case the Hang Seng Index, without physically purchasing the constituent stocks. This is referred to as achieving synthetic long exposure. Statement II is correct because Apex Asset Management relies on the prime broker to make payments based on the index’s performance. If the prime broker were to default on its obligations, Apex would suffer a financial loss, which constitutes counterparty credit risk. Statement III is incorrect. In most equity swaps, the notional principal is a reference amount used solely for calculating the periodic payments. It is not physically exchanged between the two parties at the initiation or termination of the contract. Statement IV is incorrect because the swap is specified as a ‘total return swap’. A total return swap, by definition, includes all components of return: both capital appreciation/depreciation and income, such as dividends paid by the underlying stocks. Therefore, statements I and II are correct.