CMFAS Module 9A Key Notes 2

Legal risk refers to the potential loss arising from the uncertainty of legal proceedings, such as bankruptcy, and potential legal proceedings.

A derivative contract is a delayed delivery agreement in which its value is dependent upon or derived from other underlying assets. The holder of a derivative contract does not own the underlying assets.

The underlying assets (simply called “underlying” sometimes) of a derivative contract can be anything:

  • weather (such as the number of days in a month that temperature is above or below a certain level);
  • farm and agricultural outputs (such as soy bean, corn, pork belly);
  • metals (such as gold, aluminium, palladium);
  • energy (such as oil and gas); and
  • financials – both physical (such as equity, bond, currency) and intangible (such as equity index, bond index, interest rates).

Futures and forwards are contracts giving the obligation to buy (a “call” contract) or sell (a “put“ contract) the underlying assets:

  • in specified quantity;
  • at a specified price (the “delivery price” or “future price”);
  • on a specified future date (the “delivery date” or “settlement date”).

Futures

  • Standardised contracts traded on exchanges.
  • Subject to margin requirements
  • There are partial settlements of emerging gains / losses through daily mark-to-market1 process.

Forwards

  • Non-standardised contracts traded over the counter (OTC) between two parties.
  • Not subject to margin requirements.
  • Settlement of gains / losses only occurs on delivery date.

Depending on the underlying asset, the cost of carry takes into account payments and receipts for matters such as storage, insurance, transport costs, interest payments, dividend receipts, etc.

Options and warrants are similar. Both give the right to buy (“call” contract) or sell (“put” contract) the underlying security:

  • in specified quantity;
  • at a specified price (called the “exercise price”, or “strike price”); and
  • on or before a specified date (called the “expiry date”).

The value of option is based on a number of factors as follows:

  • current spot price of the underlying asset;
  • exercise price;
  • time until expiry;
  • interest rate;
  • volatility of the underlying; and
  • dividend rate on the underlying.

Barrier option: This is the option used in the barrier certificates. Under this option, the option to exercise depends on the underlying assets crossing or reaching a given barrier level.

There are four combinations
of this type of options as follows:
– Up-and-out: Spot price starts below the barrier level and has to move up and reaches the barrier level for the option to be knockedout (i.e., becomes null and void);
– Down-and-out: Spot price starts above the barrier level and has to move down and reaches the barrier level for the option to be knocked-out;
– Up-and-in: Spot price starts below the barrier level and has to move up and reaches the barrier level for the option to become activated; and
– Down-and-in: Spot price starts above the barrier level and has to move down and reaches the barrier level for the option to become activated.

The four basic bullish strategies as follows:

  • Long calls: Buying calls is a strategy that uses leverage with limited downside and unlimited upside potential,.
  • Covered calls: A covered call is a conservative strategy where one writes (i.e. sells) call options on stock already owned (note that we are not newly buying stock).
  • Protective puts: A protective put strategy calls for buying a put on stock that one has already owned.
  • Selling naked puts: Selling a naked put is a strategy that provides a discount relative to its current price

It is the exchange of the interest payments on a fixed rate loan to the payments on a floating rate loan. Since an interest rate swap operates in the same currency, cash flows occurring on same dates can be and are netted.

With a cross-currency swap, both the principal and interest payments are exchanged without any netting, because the cash flows are in different currencies, rendering netting impossible.

Currency swaps are often used by companies that have loans denominated in one currency, while revenues are denominated in another currency.

A commodity swap is an agreement in which one set of payments is set by the price of a commodity or by the price of a commodity index.

CFDs are similar to futures and options with one distinctive difference – CFDs do not have expiry dates. A CFD is effectively renewed at the close of each trading day and rolled forward if desired, providing that there is enough margin in the account to support the position. The investor in a CFD can close the contract at any time.

CFDs allow investors the flexibility to trade on both the long and the short sides of the market. By taking a long position, the investor receives dividends and pays interest; while by taking a short position, the investor pays dividends and receives interest.

The ways for payments to be made under a structured ILP to the policy owner include but not limited to:

  • Death benefits
  • Naturity/Survival Benefits

Single premium refers to the one-time upfront payment which the policy owner pays for the policy. It represents his principal sum of investment in the policy.

Regular premium refers to periodic premium payments (monthly, quarterly, half-yearly or yearly.

Difference between the bid and offer prices, usually in the range of 3% to 5%. This is the insurer’s fees for operating the sub-funds. This is separate from the investment management fees which are charged directly to the sub-funds monthly or quarterly, based on the assets under management (AUM) by the investment managers.

A pooled-investment vehicle such as ILP offers the average investors the advantages such as:

  • Professional Management
  • Portfolio Diversification
  • Access To Bulky Investments
  • Economies Of Scale (the larger the size of the transaction, the lower will be the per-unit cost)

Structured ILPs share some common drawbacks with conventional ILPs such as:

  • Several layers of fees and charges
  • The loss of investment control
  • Opportunity cost (investor loses the opportunity to invest it elsewhere)

An investor considering structured ILPs should also consider the risks of investing in structured products, in particular:

  • Counterparty Risk :A structured ILP would suffer significant losses should the counterparty be unable to fulfil the terms of the contracts, which could be payment of cash, or delivery of securities, or providing a guarantee.
  • Liquidity Risk: Derivative contracts are difficult to price and affix a market value to. Therefore, typically, structured ILP sub-funds are valued less frequently (such as weekly or monthly) as compared to other ILP sub-funds, which are valued daily. An investor in a structured ILP may not be able to immediately redeem his units, when he wishes to do so.

Structured ILPs are useful to investors who are seeking capital appreciation with a medium to high tolerance for loss of capital. They are also suitable for investors who are interested in specialty investment areas (such as hedge funds and private equity), but do not have sufficient experience, knowledge or resources, to invest in such niche areas on their own.

The decision to buy a structured ILP or a structured fund is often influenced by non-investment factors, such as the relationship with the sales representative, and the perceived difference in customer service.

An investor who does not understand the features of a structured ILP, including the maximum possible loss, should either not invest in it, or invest in a smaller amount to minimise his exposure. An investor with a low risk tolerance should consider carefully before investing in a structured ILP, as it often carry a higher degree of risk as compared to the traditional investments.

An investor should have sufficient information before he makes an investment decision, and be kept up to date on the performance of his investments. Communication with customers is continuous, separated in three stages of the product life cycle:

  • disclosure at the point of sale;
  • disclosure at policy inception; and
  • ongoing disclosure after policy inception.

The information that must be disclosed in the product summary for general information of the policy includes:

  • A general description, in non-technical terms, of the principal features of the ILP, including a description of the manner in which the benefits reflects the investment performance of each ILP sub-fund and factors affecting the policy benefits;
  • A list of the ILP sub-funds available for investment, their investment managers and sub-managers, and the funds’ auditors;
  • Information on the fund manager; and
  • The structure, investment objectives, focus and approach of each available ILP sub-fund. If the sub-fund is included under the CPF Investment Scheme, state so and indicate its risk classification.

There is a prescribed format of how the Product Highlights Sheet (PHS) should be prepared, giving answers and explanations to the following questions, at a minimum:

  • Who is the sub-fund suitable for?
  • What are you investing in?
  • Who are you investing with?
  • What are the key risks of this investment?
  • What are the fees and charges of this investment?
  • How often are valuations available?
  • How can you exit from this investment, and what are the risks and costs in doing so?
  • How do you contact the insurer?

The answers and explanations provided in the PHS should be clear and use simple language for ease of understanding. To this end, the insurer should observe the following requirements:

  • the use of diagrams (graphs, charts, flowcharts, tables) and numerical examples to explain structures and payoffs of the product aids investor’s understanding, and is encouraged;
  • technical jargons should be avoided. When technical terms are unavoidable, a glossary should be attached to the PHS to explain these technical terms;
  • the PHS should not be longer than four pages, not counting diagrams and glossary. The PHS, including diagrams and glossary, should not exceed eight pages;
  • text, including footnotes and references, should be in a font size of at least 10-point Times New Roman; and
  • an insurer shall refrain from including disclaimers in a PHS.

Investors who look to invest in a portfolio of different funds may find this product
attractive as it is convenient and flexible. Such a product may also be used for tax planning. Investors in high tax brackets may benefit from the favourable tax treatment for insurance products.