This question assesses the understanding of how available contract months for Hang Seng Index (HSI) futures are determined. According to the rules of the Hong Kong Futures Exchange (HKEX), the available contract months for HSI futures consist of four specific categories: the spot (current) month, the next calendar month, and the next two calendar quarterly months. The designated quarterly months are March, June, September, and December. To solve the scenario, one must apply this rule to the given date. For a date in May, the spot month is May. The next calendar month is June. The next two quarterly months following May are September and December. Therefore, the complete list of available HSI futures contracts for trading would be the combination of these four months.

This question assesses the understanding of the risk-reward profile for a short call option strategy. When an investor sells or ‘writes’ a call option, they receive an upfront premium. This premium represents the maximum potential profit for the investor. The profit is achieved if the underlying asset’s price at expiration is at or below the strike price, causing the option to expire worthless. However, the writer of the call has an obligation to sell the underlying asset at the strike price if the option is exercised. The option will be exercised if the market price is above the strike price. The premium received provides a buffer against losses. The break-even point for the writer is the level at which the loss on the exercised option exactly equals the premium received. This point is calculated by adding the premium to the strike price (Break-Even Point = Strike Price + Premium). Any movement of the underlying asset’s price above this break-even point at expiration will result in a net loss for the writer. The potential loss is theoretically unlimited as the price of the underlying asset can rise indefinitely.

This question assesses the understanding of the fundamental differences between subscription warrants and derivative warrants, which are distinct products traded on the Stock Exchange of Hong Kong (SEHK). Subscription warrants are issued by a listed company on its own shares, primarily as a capital-raising tool. Upon exercise, the company issues new shares to the warrant holder, which increases the total number of shares in circulation and thus has a dilutive effect on the earnings per share and the ownership stake of existing shareholders. In contrast, derivative warrants are issued by a third party, typically an investment bank or financial institution, and not by the underlying company. The underlying asset can be a stock, an index, or a basket of stocks. When a physically settled derivative warrant on a stock is exercised, the issuer delivers existing shares to the holder; no new shares are created. Therefore, derivative warrants do not cause dilution of the underlying company’s share capital. Other typical distinctions include the tenor (subscription warrants are generally longer-term, 1-5 years, while derivative warrants are shorter-term, often 6-9 months) and the type (subscription warrants are call warrants, whereas derivative warrants can be either calls or puts).

The premium of an option is composed of intrinsic value and time value (also known as extrinsic value). Time value is influenced by several factors. As an option approaches its expiration date, its time value naturally erodes, a process known as time decay or theta decay. A decrease in implied volatility suggests that the market expects smaller future price swings in the underlying asset, which reduces the chance of the option finishing profitably, thereby lowering its time value. When an option moves deep in-the-money, its price becomes primarily composed of intrinsic value, and it behaves more like the underlying asset itself; the uncertainty component, which is what time value represents, diminishes. In contrast, the pricing of currency options, as described by models like Garman-Kohlhagen, is sensitive to the interest rate differential between the two currencies. For a call option on a foreign currency (e.g., a USD call priced in HKD), an increase in the domestic interest rate (HKD) relative to the foreign interest rate (USD) would typically increase the call option’s value. This is because the present value of the strike price to be paid in the domestic currency decreases, making the option more valuable.

In the Hong Kong derivatives market, both stock futures and stock options on the same underlying company share the same contract multiplier. This means that one contract of a stock future and one contract of a stock option represent the exact same quantity of the underlying shares. The contract value, however, is calculated differently. For a stock futures contract, the value is the futures price multiplied by the contract multiplier. For a stock options contract, the value (or cost of the contract) is the option premium multiplied by the same contract multiplier. It is also a key feature of the Hong Kong market that both individual stock futures and stock options are settled by physical delivery of the underlying shares, unlike index-based derivatives which are typically cash-settled.

Statement I is correct. A key feature of a Callable Range Accrual Note is that the coupon payment is contingent on all underlying assets in the basket remaining within their pre-defined ranges. If even one asset’s fixing value falls outside its range on an observation day, the investor typically receives a minimum, often zero, coupon for that period. Statement II is correct. For a Callable Bull Contract, a Mandatory Call Event (MCE) is triggered if the price of the underlying asset falls to or below the specified call price, leading to the immediate termination of the contract. Statement III is incorrect. It misattributes a key feature. Significant leverage is a primary characteristic of CBBCs, allowing investors to gain exposure with a smaller capital outlay. Callable Range Accrual Notes are not primarily designed as leveraged instruments. Statement IV is correct. The high potential coupon offered by a Callable Range Accrual Note is not a free lunch; it is the compensation provided to the investor for undertaking specific risks, including the risk of receiving a low coupon (if assets trade outside the range) and the reinvestment risk associated with an early call. Therefore, statements I, II and IV are correct.

This question assesses the ability to calculate the profit and loss from a hedging strategy involving interest rate futures and a physical bond portfolio.

First, calculate the profit from the short futures position. The fund manager sold at 98.00 and bought back at 97.20. For interest rate futures, a lower price implies a higher interest rate. The profit is based on the difference in basis points (bps). The price difference is 98.00 – 97.20 = 0.80, which is equivalent to 80 basis points.

Statement I: The profit on each futures contract is the number of basis points gained multiplied by the value per basis point. Calculation: 80 bps × HKD 125/bp = HKD 10,000. Therefore, statement I is correct.

Statement II: The total profit from the futures trade is the profit per contract multiplied by the number of contracts. Calculation: HKD 10,000/contract × 40 contracts = HKD 400,000. Therefore, statement II is correct.

Statement III: The overall net result is the profit from the futures position minus the loss on the physical portfolio. Calculation: HKD 400,000 (futures profit) – HKD 350,000 (portfolio loss) = HKD 50,000 net profit. The hedge was successful in more than offsetting the portfolio’s loss. Therefore, statement III is correct.

Statement IV: This statement is incorrect. The futures position was profitable because the manager correctly anticipated a rise in interest rates (fall in futures price) and took a short position. The hedge was effective as it resulted in an overall net profit for the combined position. Therefore, statements I, II and III are correct.

The provided diagram illustrates the profit and loss profile of a bull spread strategy. This strategy is constructed by an investor who is moderately bullish on the underlying asset. A call bull spread, for instance, involves buying a call option with a lower strike price and simultaneously selling a call option with a higher strike price on the same underlying asset with the same expiration date. The premium received from selling the higher-strike call partially offsets the cost of buying the lower-strike call, resulting in a lower net premium paid (a net debit) compared to simply buying a single call. This structure limits both the potential profit and the potential loss. The maximum profit is capped at the difference between the two strike prices minus the net premium paid, and it is achieved when the underlying price is at or above the higher strike price at expiration. The maximum loss is limited to the net premium paid for the spread, which occurs if the underlying price is at or below the lower strike price at expiration. Therefore, this strategy is suitable for an investor who anticipates a limited increase in the underlying asset’s price and wishes to reduce the upfront cost and risk of the position.

To determine Company ABC’s effective net borrowing cost, we must analyze all its interest-related cash flows. First, ABC has an underlying loan obligation where it pays a floating rate benchmark. Second, through the swap, ABC agrees to two further cash flows: it pays a fixed rate of 4% to Company XYZ, and it receives a floating rate of (benchmark + 5 basis points) from Company XYZ. The net effect is calculated by combining these three streams: (Payment on loan) + (Payment on swap) – (Receipt from swap). This translates to: (Floating Rate) + (4.00%) – (Floating Rate + 0.05%). The ‘Floating Rate’ payment and receipt cancel each other out, leaving a net cost of 4.00% – 0.05%, which equals 3.95%. The swap has successfully transformed Company ABC’s variable, floating-rate debt into a predictable, fixed-rate obligation of 3.95%. This demonstrates a fundamental risk management technique using derivatives, a concept central to the SFC’s regulatory expectations for licensed corporations dealing with or advising on such instruments.

Statement I is correct. The primary advantage of the Binomial model, which uses a discrete-time framework, is its ability to handle options with early exercise features, such as American-style options. At each node in the binomial tree, the model can check whether exercising the option is more valuable than holding it, something the standard Black-Scholes-Merton model cannot do as it is designed for European options exercisable only at maturity.

Statement II is incorrect. The direct inputs for the Binomial model concerning price movement are the up-factor (u), the down-factor (d), and the number of discrete time periods (n). While these inputs can be derived from the underlying asset’s volatility and the option’s time to expiration, volatility and time to expiration are the direct inputs for the Black-Scholes-Merton model, not the Binomial model.

Statement III is correct. This is the core assumption of the model, giving it its name. It assumes that in any single time step, the price of the underlying asset can only move to one of two possible future prices: an ‘up’ state or a ‘down’ state.

Statement IV is correct. The Binomial model is a numerical approximation of the continuous-time process assumed by the Black-Scholes-Merton model. As the number of time steps (n) in the binomial tree increases, the model’s result for a European-style option becomes a more refined approximation and will converge to the value calculated by the Black-Scholes-Merton formula. Therefore, statements I, III and IV are correct.

This question assesses the understanding of the margining process for exchange-traded derivatives in Hong Kong, specifically the concept of variation margin. The HKFE Clearing Corporation (HKCC) operates a mark-to-market system to manage counterparty risk. At the end of each trading day (and sometimes intra-day), all open futures positions are revalued at the current market price (the settlement price). The resulting profit or loss is settled daily. In this scenario, the client holds a short position in HSI futures. A short position profits when the underlying asset’s price falls. Conversely, when the Hang Seng Index rises, the short position incurs a loss. This unrealized loss is calculated through the mark-to-market process. To cover this loss and ensure the integrity of the clearing system, the HKCC requires the clearing participant to pay a ‘variation margin’ equal to the amount of the loss. The Exchange Participant, in turn, must collect this amount from the end client. This daily settlement prevents the accumulation of large losses. Initial margin, on the other hand, is the collateral deposited when a position is first opened to cover potential future losses. While margin levels can be adjusted by the exchange, a market move does not automatically double them. A position is typically closed out only if the client fails to meet a margin call, not as an automatic consequence of a market rally.

This question assesses the candidate’s understanding of the break-even calculation for a long call option strategy. The speculator is purchasing a call option, which gives them the right, but not the obligation, to buy the underlying silver futures contract at the strike price. The cost of acquiring this right is the premium. To break even, the speculator’s position must generate enough profit to cover this initial cost. The profit from exercising a call option is the difference between the underlying futures price at expiration and the strike price. Therefore, the break-even point is reached when this difference equals the premium paid. The formula is: Break-Even Point = Strike Price + Premium. In this scenario, the strike price is USD 15.75 and the premium is USD 2.85. Thus, the futures price must rise to USD 15.75 + USD 2.85 = USD 18.60 for the speculator to recover the initial investment and have a net profit/loss of zero. Any price above this level at expiration will result in a net profit.

To hedge a long position in an underlying asset, such as a portfolio of shares, an investor should take an opposite or short position in a related derivative instrument. In this case, the portfolio manager holds the shares (a long position) and is concerned about a price decrease. The appropriate hedging action is to sell stock futures. This creates a short position that will generate profits if the price of XY Airways stock falls, thereby offsetting the losses incurred on the physical stock portfolio.

The next step is to determine the correct number of futures contracts to sell to achieve a full hedge. This is calculated by dividing the total number of shares in the portfolio by the number of shares represented by a single futures contract (the contract multiplier).

Calculation:
– Total shares held: 500,000
– Shares per futures contract: 1,000
– Number of contracts required = Total shares held / Shares per contract
– Number of contracts = 500,000 / 1,000 = 500 contracts.

Therefore, the portfolio manager should sell 500 XY Airways stock futures contracts to fully hedge the equity position against a potential short-term decline in value. Buying futures contracts would double the exposure to the stock’s price movements, which is the opposite of hedging. Using an incorrect number of contracts would result in an imperfect hedge, either leaving the portfolio under-hedged or over-hedged.

This question assesses the understanding of option Greeks, which measure the sensitivity of an option’s price to various factors.
Statement I is correct. Delta measures the rate of change of the theoretical option value with respect to changes in the underlying asset’s price. It quantifies the sensitivity to day-to-day price movements.
Statement II is correct. Theta, often referred to as time decay, measures the rate of decline in the value of an option due to the passage of time. As an option approaches its expiration date, its time value erodes, and Theta quantifies this erosion.
Statement III is correct. Vega measures the rate of change in an option’s value with respect to a change in the implied volatility of the underlying asset. A spike in market uncertainty, such as around an earnings report, would directly impact implied volatility, and Vega is the tool to measure this risk.
Statement IV is incorrect. The risk associated with the rate of change of the portfolio’s Delta is measured by Gamma, not Rho. Rho is the Greek that measures sensitivity to changes in the risk-free interest rate. Therefore, statements I, II and III are correct.

This question tests the application of the put-call parity principle for options on futures to identify and execute an arbitrage strategy. According to this principle, a synthetic futures position can be created using a combination of call and put options. A synthetic long futures position is created by buying a call and selling a put with the same strike price and expiry. Conversely, a synthetic short futures position is created by selling a call and buying a put.

The arbitrage opportunity arises when the price of the actual futures contract differs from the price of the synthetic futures contract implied by the option premiums. The implied price of the synthetic future can be calculated. In this scenario, a synthetic long futures position is established by buying the 18,500 call for 300 points and selling the 18,500 put for 250 points. The net cost is 300 – 250 = 50 points. This combination replicates the payoff of a long futures contract entered at 18,500, but with an initial cost of 50 points. This implies a synthetic futures price of 18,500 (strike) + 50 (net premium) = 18,550.

The actual HSI futures contract is trading at 18,500. Since the synthetic futures price (18,550) is higher than the actual futures price (18,500), the actual future is underpriced relative to the synthetic one. The arbitrage strategy is to ‘buy low, sell high’: buy the underpriced actual futures contract and sell the overpriced synthetic futures contract.

To sell the synthetic long futures position, the trader must do the opposite of creating it: sell the call option and buy the put option. Therefore, the complete arbitrage strategy is to buy one HSI futures contract, sell one at-the-money (ATM) call option, and buy one ATM put option. This locks in a risk-free profit of 50 index points, as the combined payoff at expiration will be zero, while the initial position generates a net credit.

This question assesses the understanding of the fundamental characteristics and applications of different commodity derivatives. Statement I is incorrect because while many commodity futures involve physical settlement, cash-settled commodity futures are also common. The term ‘exclusively’ makes the statement inaccurate. Statement II is correct; commodity forwards are over-the-counter (OTC) instruments that are highly customizable in terms of quantity, quality, and settlement date, distinguishing them from standardized, exchange-traded futures. They are commonly used by producers to lock in prices. Statement III is incorrect because a key feature of a commodity swap is that it is financially settled without the physical exchange of the underlying commodity, similar to an interest-rate swap where payments are netted. Statement IV is correct as it accurately describes a common application of a commodity swap, where a consumer (like an energy user) enters into a fixed-for-floating swap to hedge against price volatility and achieve cost certainty. The floating leg is typically tied to a relevant commodity index. Therefore, statements II and IV are correct.

In technical analysis, identifying the prevailing trend is a fundamental skill for portfolio managers and analysts. A trend indicates the general direction of a market or an asset’s price. A downtrend is specifically characterized by a persistent downward movement in price over a period. The classic definition of a downtrend is a sequence where each successive peak (high) is lower than the previous one, and each successive trough (low) is also lower than the one before it. This pattern of ‘lower highs and lower lows’ signifies that sellers are more aggressive than buyers, consistently pushing the price to new lows and preventing rallies from reaching previous peak levels. Other patterns, such as ‘higher highs and higher lows’, define an uptrend. A mix, like ‘lower highs and higher lows’, typically signals a period of consolidation or a contracting price range (e.g., a symmetrical triangle), indicating market indecision rather than a clear directional trend. While a sharp price drop on high volume can be a feature within a downtrend, it is an event rather than the defining structural characteristic of the entire trend itself. Understanding these definitions is crucial for making informed decisions on timing entries and exits, which is part of the due diligence and risk management process expected of licensed persons under the Fund Manager Code of Conduct (FMCC).

To determine the break-even point for an importer who has purchased a currency call option, one must account for both the strike price and the premium paid for the option. The premium represents the initial cost of securing the right to buy the currency at a fixed rate. The break-even exchange rate is the level at which the holder of the option neither makes a profit nor incurs a loss from the position. This is calculated by adding the per-unit cost of the premium to the strike price. First, calculate the premium cost per unit of the foreign currency by dividing the total premium paid by the notional amount of the contract. In this scenario, the premium per Japanese Yen is HKD 100,000 divided by JPY 100,000,000, which equals 0.0010 HKD/JPY. Next, this per-unit premium cost is added to the option’s strike price. The strike price is 0.0650 HKD/JPY. Therefore, the break-even exchange rate is the strike price (0.0650) plus the per-unit premium (0.0010), resulting in 0.0660 HKD/JPY. At this specific exchange rate, the cost of exercising the option plus the premium paid is exactly equal to the cost of purchasing the currency in the spot market, meaning the overall position is flat.

To determine the financial result of the futures trade, one must first identify the direction of the profit. The manager sold futures to hedge against rising interest rates. When interest rates rise, the price of interest rate futures (quoted as 100 minus the implied interest rate) falls. The manager sold at a higher price (97.20) and bought back at a lower price (96.40), resulting in a profit. The calculation is as follows: First, find the difference in index points: 97.20 – 96.40 = 0.80 points. Second, convert this point difference into the number of minimum price fluctuations (ticks). Since one tick is 0.01 points, the gain is 80 ticks (0.80 / 0.01). Third, multiply the number of ticks by the official tick value for a Three-Month HIBOR futures contract, which is HKD 37.50. The profit per contract is 80 ticks × HKD 37.50/tick = HKD 3,000. Finally, multiply the per-contract profit by the number of contracts traded: HKD 3,000 × 20 contracts = HKD 60,000 profit.

This question assesses the understanding of option trading strategies, specifically those designed to profit from market volatility. The scenario describes a client who expects a large price swing in a stock but is uncertain about the direction. The most appropriate strategy for this market view is a long straddle. A long straddle involves simultaneously purchasing a call option and a put option on the same underlying asset, with the same strike price and expiration date. This strategy is profitable if the underlying stock price makes a significant move in either direction, sufficient to cover the total premium paid for both options. The maximum loss is limited to the net premium paid. In contrast, a covered call is an income-generating strategy for a neutral to slightly bullish outlook. A protective put is a hedging strategy to protect an existing long stock position from a price decline. A bull call spread is a strategy for a moderately bullish outlook with limited risk and limited reward. An advisor recommending such products must ensure they are suitable for the client’s risk tolerance and market view, in line with the principles of the SFC Code of Conduct.

This question assesses the understanding of swaptions, which are options to enter into an interest rate swap.

Statement I is correct. A call swaption (or receiver swaption) gives the holder the right, but not the obligation, to enter into a swap agreement where they receive a fixed rate and pay a floating rate. This is advantageous if the holder expects interest rates to fall.

Statement II is correct. A put swaption (or payer swaption) gives the holder the right to enter into a swap where they pay a fixed rate and receive a floating rate. A company that needs to borrow at a floating rate in the future can use a put swaption to hedge against rising rates. If rates rise, they can exercise the option to lock in a fixed borrowing cost.

Statement III is incorrect. Like any option, a swaption provides the holder (buyer) with a right, not an obligation. The writer (seller) of the swaption is the one who has the obligation to enter into the swap if the holder chooses to exercise their right.

Statement IV is incorrect. The description provided applies to a European-style option, which can only be exercised on its expiration date. A Bermudan-style swaption can be exercised on several pre-determined dates during the life of the option, offering more flexibility than a European option but less than an American option (which can be exercised at any time). Therefore, statements I and II are correct.

To determine the outcome of this bull put spread strategy, first calculate the net premium received per contract. This is found by subtracting the premium paid for the long put from the premium received for the short put. In this scenario, the net premium is 350 points (received) minus 210 points (paid), resulting in a net credit of 140 points per contract. Next, assess the position at expiration. The Hang Seng Index closed at 22,100, which is above both the 22,000 strike price of the short put and the 21,600 strike price of the long put. Consequently, both options expire worthless. The investor’s profit is therefore the initial net premium received. To find the total profit, multiply the net premium in points by the contract multiplier and the number of contracts traded: 140 points × HKD50 per point × 10 contracts. The break-even point for this strategy would be the higher strike price minus the net premium (22,000 – 140 = 21,860). Since the closing index level is above the break-even point, the position results in a profit.

A short straddle is an options strategy implemented when a trader expects low volatility in the underlying asset’s price. It involves simultaneously selling a call option and a put option of the same underlying asset, with the same strike price and expiration date. The trader’s maximum profit is the total net premium received from selling both options, which is achieved if the underlying asset’s price is exactly at the strike price at expiration. The strategy has two breakeven points: the strike price plus the total premium, and the strike price minus the total premium. In this scenario, the total premium received is HK$12 (from the call) + HK$10 (from the put) = HK$22. At an expiration price of HK$265, the sold put option expires worthless. However, the sold call option is in-the-money, resulting in a loss of HK$15 (HK$265 market price – HK$250 strike price). The net outcome is the premium received minus the loss on the call option: HK$22 – HK$15 = HK$7 profit per share.

Statement I is correct. Subscription warrants are issued by the underlying listed company, typically to raise capital. Upon exercise, the company issues new shares to the warrant holder, which increases the total number of shares outstanding and thus has a dilutive effect on the earnings per share and the ownership percentage of existing shareholders.

Statement II is correct. Derivative warrants are structured products issued by a third party, usually an investment bank, not the underlying company. Because the issuer is independent, the settlement of the warrant (whether through cash or physical delivery of existing shares bought from the market) does not involve the creation of new shares by the underlying company. Therefore, there is no dilution of shareholdings.

Statement III is correct. Subscription warrants are generally long-term instruments, with maturities typically ranging from one to five years, aligning with their capital-raising purpose. In contrast, derivative warrants are designed as shorter-term trading and hedging instruments, with typical maturities in Hong Kong ranging from six months to two years.

Statement IV is incorrect. This statement reverses the settlement methods. Subscription warrants are exercised for the physical delivery of new shares. For derivative warrants, while some can be physically settled, many are cash-settled. Furthermore, under Hong Kong listing rules, derivative warrants on indices, baskets of stocks, or overseas-listed stocks must be cash-settled. Therefore, statements I, II and III are correct.

The HKFE Clearing Corporation (HKCC) acts as a central counterparty (CCP) for derivatives trades, mitigating counterparty risk. A key component of its risk management framework is the Reserve Fund. Statement I is correct as the primary purpose of the Reserve Fund is to cover losses resulting from the default of a Clearing House Participant (CHP) when the defaulting CHP’s own margin and Reserve Fund contributions are insufficient. Statement II is also correct; the Reserve Fund is a mutualized fund, meaning all CHPs are required to contribute to it, sharing the risk of a member default. Statement III is incorrect because the Reserve Fund is specifically for default management and is not used for the day-to-day operational expenses of the clearing house, which are covered by other revenue sources like fees. Statement IV is incorrect as contributions to the Reserve Fund are not based on trading profits. Instead, they are calculated based on a CHP’s risk exposure, which considers factors like their open positions and margin requirements, reflecting the potential risk they bring to the clearing system. Therefore, statements I and II are correct.

This question assesses the understanding of a classic short hedge using interest rate futures, a common strategy for entities looking to borrow in the future. The corporate treasurer is concerned about rising interest rates, which would increase the cost of issuing commercial paper. To hedge this risk, they sell HIBOR futures.

Statement I is correct. If interest rates (HIBOR) rise, the price of the HIBOR futures contract will fall. Since the treasurer has a short position (sold futures), they can close the position by buying the contracts back at a lower price, thus realizing a gain. This gain is designed to compensate for the higher interest expense the company will have to pay on its commercial paper in the physical market.

Statement II is correct. If interest rates fall, the opposite occurs. The price of the HIBOR futures contract will rise. To close the short position, the treasurer must buy the contracts back at a higher price, resulting in a loss. However, this loss is offset by the fact that the company can now issue its commercial paper at a lower, more favourable interest rate. The hedge sacrifices the potential gain from falling rates to protect against the potential loss from rising rates.

Statement III is incorrect. In a falling rate environment, the firm benefits from lower borrowing costs, but it will incur a loss on its short futures position. It is not possible to profit from both sides in this hedging structure.

Statement IV is incorrect. The scenario explicitly describes an action taken to ‘mitigate the risk’ of rising rates. This is the definition of hedging, which aims to reduce or eliminate risk. Speculation, in contrast, involves taking on risk in the hope of generating a profit. The treasurer’s objective is risk management, not speculation. Therefore, statements I and II are correct.

This question assesses the understanding of option settlement procedures in Hong Kong and the calculation of intrinsic value. Hong Kong stock options are settled by physical delivery, meaning the actual underlying shares are exchanged upon exercise. In contrast, index options like HSI options are cash-settled. For a call option, being ‘in-the-money’ means the underlying asset’s market price is above the strike price. The intrinsic value is the difference between these two prices (Market Price – Strike Price). When an in-the-money call option with physical settlement is exercised, the holder pays the strike price to receive the underlying shares. The premium paid is a sunk cost and does not factor into the mechanics of the exercise transaction itself, although it is crucial for calculating the overall profit or loss.

To determine the net effective interest payment for Company ABC, one must analyze all its cash flows related to interest payments. First, identify the payment on its original loan, which is the floating rate benchmark. Second, consider the two legs of the swap. Company ABC pays a fixed rate of 4% to Company XYZ. Third, Company ABC receives a floating rate payment from Company XYZ, which is the floating rate benchmark plus 5 basis points (0.05%). The net effect is calculated by summing the outflows and subtracting the inflow: (Payment on loan) + (Payment on swap) – (Receipt from swap). This becomes (Floating Rate Benchmark) + (4.00%) – (Floating Rate Benchmark + 0.05%). The ‘Floating Rate Benchmark’ components cancel each other out, leaving a net payment of 4.00% – 0.05%, which equals 3.95%. This arrangement effectively converts Company ABC’s floating-rate liability into a fixed-rate liability.

This question tests the understanding of comparative advantage and the calculation of potential gains in an interest rate swap.

First, let’s analyze the comparative advantages. In the fixed-rate market, Company ABC can borrow at 4.10% (Benchmark + 10 bps), while Company XYZ borrows at 4.20% (Benchmark + 20 bps). Since ABC can borrow at a lower fixed rate, it has a comparative advantage in the fixed-rate market. Therefore, statement I is correct.

In the floating-rate market, Company ABC can borrow at Benchmark + 0 bps, while Company XYZ would have to borrow at Benchmark + 40 bps. Company ABC has a clear advantage here as well. Therefore, statement II, which claims XYZ has the advantage, is incorrect.

Next, we calculate the total potential gain, known as the Quality Spread Differential (QSD). This is the difference between the differentials in the two markets. The differential in the floating-rate market is 40 bps (40 bps – 0 bps). The differential in the fixed-rate market is 10 bps (20 bps – 10 bps). The QSD is the difference between these two differentials: 40 bps – 10 bps = 30 bps. This 30 basis point gain can be shared between the two parties and any intermediary. Therefore, statement III is correct.

Finally, let’s consider the structure of the swap. Company ABC wants to switch from floating to fixed payments, and Company XYZ wants to switch from fixed to floating payments. To achieve this, ABC must agree to pay a fixed rate to XYZ, and in return, XYZ must agree to pay a floating rate to ABC. This is the fundamental mechanism of a plain vanilla interest rate swap that meets both parties’ objectives. Therefore, statements I, III and IV are correct.

In technical analysis, a support level is a price point where buying pressure is historically strong enough to overcome selling pressure, causing the price to bounce back up. The significance of this level is amplified by the duration it holds and the volume of trades that occur there. When a price decisively breaks below a well-established support level, a key principle known as ‘role reversal’ comes into play. The former support level is now expected to act as a new resistance level. This occurs because market participants who bought at the previous support level are now holding a losing position. If the price attempts to rally back to that level, these participants may use the opportunity to sell and exit their positions at or near their break-even point, creating a wave of selling pressure that ‘resists’ further price increases.