Chapter 23 Structured Products RQ Flashcards
What do principal-protected notes (PPNs) guarantee?
A. Payment of interest.
B. Repurchase of securities.
C. Return of principal.
D. Payment of principal and interest.
C. Return of principal.
While the issuer agrees to repay investors the amount originally invested (the principal) plus interest, only the return of principal is actually guaranteed. Although PPNs are issued by chartered banks, they are not protected by Canada Deposit Insurance Corporation (CDIC).
What provides the potential for return in a zero-coupon bond plus option structured PPN?
A. Zero coupon bond.
B. Underlying fund.
C. Performance of underlying index.
D. Options.
D. Options.
In the zero-coupon bond plus option structure, the PPN issuer invests most of the proceeds in a zero-coupon bond that has the same maturity as the PPN. The zero-coupon bond guarantees the return of principal on maturity. The remainder of the proceeds is invested in an option on the underlying asset. The option portion of the PPN provides the potential return.
An investor purchases a 5-year PPN linked to the average return on a basket of 10 common shares, with a maximum return of 40% attributable to any one common share. The actual return of each stock at the end of 5 years is as follows:
ABC 10% KLM 10% CDE 37% MNO -45% EFG 49% OPQ 29% GHI -12% QRS 30% IJK -3% STU -5% Calculate the effective average return.
A. 9.1%.
B. 9.6%.
C. 10.0%.
D. 21.6%.
Since the maximum return attributable to any one common share is 40%, the effective average return would be (10% + 37% + 40% - 12% - 3% + 10% - 45% + 29% + 30% - 5%)/10 = 9.1%. Even though stock EFG had an actual return of 49%, the maximum return would be reduced to 40% for the effective average calculation. Stock MNO had a return of -45%. There is no limitation on how low the stock can drop. The only limitation when calculating the effective average is that no individual stock can exceed a return of 40%.
Identify the investor who would be the most suitable candidate to invest in a PPN.
A. Jillian, age 25, with a high regular income and significant consumer debt.
B. John, age 25, with high regular income and low expenses.
C. Lily, age 35, investing with a goal of purchasing a home in three months.
D. Kamini, age 65, newly retired on a small fixed pension.
B. John, age 25, with high regular income and low expenses.
John would be the most suitable investor as he has no need of income, and has low expenses. He can afford to take the risk that the return might be low. PPNs are not appropriate for investors such as Kamini who rely on a regular and predicable investment income to fund their lifestyle. Investors such as Lily who need instant liquidity should not purchase a PPN as liquidity is not guaranteed with these products. Also, although the issuer may offer to facilitate a secondary market, it is under no obligation to do so. Jillian’s high level of consumer debt also indicates that she may not have the lengthy investment horizon appropriate for PPNs.
Identify the correct risk and return characteristics of an MBS.
Yields are lower than those of government bonds with similar terms.
MBS are much riskier than T-bills.
MBS are typically more liquid than other structured products.
Yields are higher than the yields on T-bills.
A. 1 and 3.
B. 2 and 3.
C. 2 and 4.
D. 3 and 4.
D. 3 and 4.
An MBS earns a return that is comparable to a typical GIC and typically higher than that of Treasury bills or other Government of Canada bonds with similar terms. Because the Government of Canada stands behind the CMHC guarantee, MBSs are roughly equal in security to Government of Canada T-bills and bonds. As such, one would expect the yields to be virtually the same as those of government bonds. In fact, there is a clear yield premium on the MBS.
MBSs are fully liquid investments and can be sold at market value at any time. While split shares can be sold at market value on an exchange, other structured products such as PPNs and market-linked GICs are not nearly as liquid as MBS. PPNs, for example, may not have a secondary market at all, while market-linked GICs are usually non-redeemable until maturity.
A PPN is issued with a NAV of $10.00, and is redeemed at maturity at $15.00 five years later. Calculate the amount of tax per unit that an investor in a 40% marginal tax bracket will owe at maturity.
A. $0.00.
B. $0.40.
C. $1.00.
D. $2.00.
D. $2.00.
It is generally accepted that any return from a PPN will be taxed as interest income. In this example, the ($15-$10) = $5 gain will be treated as interest income and subject to $5 x 40% = $2.00 in tax.
Calculate the overall return on XYZ Index-linked GIC at maturity if the initial index level was 14,000, the ending index level was 20,000, and the maximum cap on returns is 30%?
A. 12.86%.
B. 18.00%.
C. 30.00%.
D. 42.86%.
C. 30.00%.
The overall return on an index-linked GIC is calculated as:
Step One: Index Growth = (Ending Index Level – Initial Index Level) / Initial Index Level x 100.
In this question, (20,000-14,000)/14,000 x 100 = 42.86%
Step Two: Overall Return cannot exceed the maximum cap on returns.
In this question, 42.86% exceeds the maximum cap on returns of 30%. The total return on the investment is capped at a maximum of 30%.
An investor with a high risk tolerance, high risk capacity, and a high return expectation is interested in purchasing an Asset Backed Security. Recommend a suitable tranche to this client.
A. Junior.
B. Senior.
C. Mezzanine.
D. Securitized.
A. Junior.
The standard securitization scheme for an ABS generally has a 3-tier tranche hierarchy: Senior, Mezzanine and Junior. The senior tranche has the least amount of credit loss risk associated with it and attracts the most credit-sensitive type of investor. The junior tranche, normally the smallest of the three tranches, has the greatest amount of credit risk and attracts a somewhat smaller group of investors who are more comfortable in assessing and taking more risk in the ABS. This tranche, however, anticipates a higher rate of return than investors in the other ABS tranches.
Identify the organization that guarantees the interest, principal and payment of the underlying assets of mortgage-backed securities (MBS)?
A. NHA.
B. CDIC.
C. OSFI.
D. CMHC.
D. CMHC.
The security backing MBS mortgages are residential properties (single-family, multi-family and social housing) fully insured as to interest, principal and timely payment by CMHC.
Identify the risk that the prepayment option on an MBS exposes a Canadian investor to?
A. Currency.
B. Reinvestment.
C. Liquidity.
D. Interest Rate.
B. Reinvestment.
The prepayment possibility introduces reinvestment risk. If rates decline, it may not be possible to find the same yield as the investor initially received on his/her investment.
XYZ Investment Corporation creates a new ABC Corporation Split Share investment vehicle, selling the ABC Split preferred share for $20.00 for each ABC common share in the trust. Calculate the maximum percentage amount investors who bought the ABC Split Capital shares can lose.
A. 0%.
B. 20%.
C. 80%.
D. 100%.
D. 100%.
Investors in capital shares can lose the entire value of their investment if the underlying portfolio of common shares declines sufficiently. Capital shares are ranked after preferred shares in priority in the event that the split-share corporation is wound up and they are not paid until after obligations to preferred holders and other liabilities are paid.
DEF Corporation’s common shares increase sharply in price from the time of original issue to the time of wind-up of a split-share arrangement. Other than investors in the common shares themselves, which stakeholders will benefit?
A. DEF split share capital shareholders.
B. DEF Corporation.
C. DEF split share preferred shareholders.
D. DEF split share preferred and split share capital shareholders.
A. DEF split share capital shareholders.
Split shares are issued for a specific term stated in the prospectus; at the end of the term, the split-share company will redeem the shares. At that point, once the owners of the preferred shares have received back their principal investment and once other obligations have been paid, the capital shares receive the remaining value. In this example, the capital shares will benefit from receiving the increase in value from the initial price of the common share. DEF Corporation will not benefit, as there is no additional flow of funds to the Corporation resulting from the windup.
An investor owns a 5-year Market-Linked GIC. The GIC has a 65% participation rate. The market index grew from 9,000 to 14,000 over the 5 years. Calculate the investor’s return.
A. 35.71%.
B. 36.11%.
C. 55.56%.
D. 65.00%.
B. 36.11%.
The index growth was ((14,000 - 9000)/9000) = 55.56%.
The investor is entitled to 65% of any growth in the index, so the investor’s return is 55.56% x 65% = 36.11%.
The shares of XYZ Ltd. trade at $60 with an annual dividend of $1.80. The trust issued one XYZ split preferred share at a price of $30 for each XYZ common share the trust holds. Calculate the dividend yield on the split preferred share.
A. 0.0%.
B. 1.5%.
C. 3.0%.
D. 6.0%.
D. 6.0%.
In this example, the holders of the preferred shares receive the entire $1.80 dividend from the XYZ Ltd. common share. This gives the preferred share a dividend yield of 6%, which is twice the yield on the common shares because only half as much money is required to receive the full common share dividend.
The dividend on the common shares of a split share corporation is reduced by 40%. Assuming the split preferred share has a guaranteed dividend, what action will be taken within the corporation?
A. Sell capital shares to pay the dividends.
B. Sell additional Split Capital shares to pay the dividends.
C. Sell portfolio shares to pay the dividends.
D. Sell additional Split Preferred shares to pay the dividends.
C. Sell portfolio shares to pay the dividends.
If a dividend is cut, portfolio shares have to be sold to pay the dividends, which results in less value for holders of capital shares.
