Pension Transfers and Planning Advice (Level 6)

Correct: In a renounceable rights issue on the SGX, the rights are ‘renounceable’ because the holder can choose to give up their right to subscribe and instead sell that right to someone else. These are known as nil-paid rights, which are traded on the SGX for a specific period, allowing shareholders to capture the value of the rights without committing further capital.

Incorrect: The assumption that the Central Depository will automatically exercise rights is incorrect as rights typically lapse and become worthless if the shareholder fails to provide instructions or payment. Claiming that the subscription price must be at a premium is a misunderstanding of market practice, as rights are almost always offered at a discount to the market price to encourage participation. Stating that nil-paid rights are non-transferable describes a non-renounceable rights issue, which does not allow for the trading of entitlements on the secondary market.

Takeaway: Renounceable rights issues allow Singapore investors to trade their nil-paid entitlements on the SGX if they do not wish to subscribe.

Correct: Commercial paper is a money market instrument that takes the form of an unsecured promissory note. In Singapore, it is issued by large, creditworthy corporations or financial institutions to raise short-term funds. It does not pay a coupon but is instead issued at a discount to its face value, with the return to the investor being the difference between the purchase price and the redemption value at maturity.

Incorrect: Describing the instrument as a secured debt obligation with regular interest payments is incorrect because commercial paper is fundamentally unsecured and operates on a discount basis rather than a coupon basis. The suggestion that it requires a full prospectus for every issuance ignores the common exemptions under the Securities and Futures Act for offerings made to institutional or accredited investors in the wholesale market. Characterizing it as a government-guaranteed tool for monetary policy confuses corporate debt with MAS-issued instruments like Treasury bills or MAS bills.

Takeaway: Commercial paper is an unsecured, short-term discount security used by creditworthy corporations for flexible working capital management in the wholesale market.

Correct: A sub-custodian is a local provider, typically a bank, appointed by a global custodian to perform custody and settlement functions in a specific domestic market where the global custodian does not have a direct presence. This arrangement allows the global custodian to offer its clients a single point of contact for a multi-market portfolio while ensuring that local regulatory requirements and settlement procedures are handled by an entity with direct access to the local infrastructure.

Incorrect: Confusing the role with a central depository is incorrect because a depository is the central infrastructure of a market rather than an agent appointed by a global custodian to represent a specific client’s interests. Suggesting a prime broker is inaccurate as their primary function involves providing leverage, securities lending, and consolidated reporting for hedge funds rather than acting as a local safekeeping agent for a global custodian. Identifying the entity as a regional custodian is incorrect because a regional custodian manages a cluster of markets in a specific geographic area, whereas the specific entity performing tasks within a single domestic market on behalf of a global provider is defined as a sub-custodian.

Takeaway: Sub-custodians are local agents appointed by global custodians to provide specialized safekeeping and settlement services within specific domestic jurisdictions.

Correct: In the Singapore context, rights issues are corporate actions intended to raise capital quickly from existing shareholders, usually featuring a short subscription period of approximately two to three weeks. Warrants, however, are long-term leverage instruments that grant the holder the right to subscribe for new shares at a fixed price over a much longer duration, often ranging from two to five years.

Incorrect: The assertion that warrants are always issued at a discount is incorrect as they are often issued out-of-the-money, whereas rights are typically offered at a discount to encourage shareholder participation. Claiming that rights are only for institutional investors is false because rights issues are specifically designed to allow all existing shareholders, including retail investors, to maintain their proportional stake. Stating that warrants involve treasury shares while rights are cash-settled is inaccurate because both instruments generally result in the issuance of new ordinary shares, leading to equity dilution.

Takeaway: Rights issues are short-term capital-raising tools for existing shareholders, while warrants are long-term instruments providing future equity subscription rights.

Correct: Credit ratings are opinions on the relative credit risk of an issuer or specific debt obligation. A significant limitation is that they are often lagging indicators; rating agencies typically perform periodic reviews, and a rating may not reflect sudden financial distress or market shifts until after the event has occurred. This delay means the market price of a bond often adjusts to new risks well before a formal rating downgrade is announced.

Incorrect: The strategy of treating ratings as a comprehensive guarantee is incorrect because ratings are merely professional opinions on default probability, not insurance against insolvency. Suggesting that the Singapore Exchange standardizes ratings for liquidity is a misconception, as credit ratings focus on credit risk rather than the ease of trading a security. Relying on ratings as a definitive valuation that replaces independent due diligence is a failure of risk management, as institutional investors are expected to conduct their own analysis to supplement agency opinions.

Takeaway: Credit ratings are lagging opinions on default risk that require independent verification and do not guarantee issuer solvency or market liquidity.

Correct: Continuous Linked Settlement (CLS) utilizes a Payment-versus-Payment (PvP) mechanism. This ensures that the settlement of one currency leg in a foreign exchange trade occurs if, and only if, the settlement of the other currency leg also occurs. This eliminates Herstatt risk, which is the risk that one party pays out the currency it sold but does not receive the currency it bought due to time zone disparities or counterparty failure.

Incorrect: Focusing on capital adequacy ratios addresses the general financial health of a bank but does not solve the specific timing risk inherent in cross-border currency settlement. Suggesting that the Singapore government provides a sovereign guarantee for private FX trades is incorrect as no such blanket indemnity exists for institutional market participants. Relying on MEPS+ alone is insufficient because while MEPS+ provides real-time gross settlement for SGD within Singapore, it does not inherently link to foreign payment systems to provide the cross-currency synchronization that CLS offers.

Takeaway: CLS eliminates Herstatt risk by using a Payment-versus-Payment mechanism to settle both sides of an FX trade simultaneously across time zones.

Correct: In a standard securities lending arrangement, the lender transfers legal title of the securities to the borrower. This means the borrower appears on the share register and is entitled to exercise voting rights. If the lender wishes to vote on a specific corporate matter, they must recall the securities from the borrower prior to the record date of the meeting.

Incorrect: The belief that legal title remains with the lender is incorrect because stock lending involves an absolute transfer of title rather than a pledge or lien. Expecting to receive dividends directly from the issuer is a common misconception; the borrower receives the actual dividend and is contractually obligated to pay a manufactured dividend or equivalent payment to the lender. Suggesting that every individual trade requires specific regulatory approval from the Monetary Authority of Singapore is inaccurate, as firms operate under broad regulatory frameworks and master agreements rather than trade-by-trade permissions.

Takeaway: Stock lending involves the transfer of legal title, meaning the lender loses voting rights unless the securities are recalled before the record date.

Correct: Stripping a bond involves the separation of the periodic coupon payments and the final principal repayment into individual tradable entities. In the Singapore Government Securities market, each of these components becomes a zero-coupon security, meaning they are sold at a discount to their face value and do not pay interim interest.

Incorrect: The strategy of converting the bond into a floating-rate instrument linked to SORA describes a derivative overlay or a different asset class rather than the mechanical process of stripping. Simply suggesting that the principal is liquidated while coupons are turned into an annuity misinterprets how the components are traded as independent discount securities. Focusing on isolating risks to achieve a higher credit rating is incorrect because the credit risk remains tied to the Singapore Government as the issuer, regardless of how the cash flows are packaged.

Takeaway: Bond stripping creates individual zero-coupon securities from the original coupon and principal components of a fixed-income instrument.

Correct: Structured products like ELNs are typically unsecured debt obligations of the issuing institution. This means that the investor is a creditor of the issuer. If the issuer faces insolvency or default, the investor may lose their entire investment, regardless of how well the underlying basket of SGX stocks has performed. This credit risk is a fundamental characteristic that distinguishes structured notes from the underlying equities themselves.

Incorrect: The belief that these products are covered by the Singapore Deposit Insurance Corporation is incorrect because structured notes are classified as investment products rather than traditional bank deposits. Suggesting that MAS requires physical collateral for all retail structured products is inaccurate, as many are synthetic or unsecured obligations. Claiming that issuers must provide daily liquidity at par value is false, as structured products often suffer from limited secondary market liquidity and exit prices are subject to market fluctuations and significant costs.

Takeaway: Structured products carry significant issuer credit risk, as they are generally unsecured debt obligations not covered by deposit insurance schemes.

Correct: To exchange a Depositary Receipt for the underlying shares, the holder must go through the cancellation process. This involves surrendering the GDRs to the depositary bank that issued them. Once the GDRs are cancelled, the depositary bank instructs its custodian in the issuer’s home market to deliver the actual ordinary shares to the investor’s designated local account in that jurisdiction.

Incorrect: The strategy of selling on one exchange and buying on another is a market-based transition rather than the formal exercise of the exchange rights inherent in the GDR structure. Relying on the Central Depository (CDP) to re-register the shares is incorrect because the CDP only handles the settlement of the GDRs on the SGX, not the underlying shares held in a foreign jurisdiction by a custodian. Opting for a formal request to the Monetary Authority of Singapore is unnecessary as the MAS does not provide individual permits for the mechanical cancellation and exchange of depositary instruments by private investors.

Takeaway: Exchanging GDRs for underlying shares requires surrendering the receipts to the depositary bank to trigger the release of shares by the custodian.

Correct: In the Singapore corporate framework, ordinary shares represent equity ownership where holders typically exercise control through voting rights at General Meetings. However, they occupy the lowest priority in the capital structure, meaning they are residual claimants who only receive a distribution of assets during liquidation after all creditors and preference shareholders have been fully satisfied.

Incorrect: The strategy of suggesting dividends are a fixed obligation ignores the discretionary nature of equity distributions and the legal requirement to prioritize debt interest. Claiming that equity holders rank above secured creditors contradicts the fundamental principle of the hierarchy of claims in corporate insolvency. Opting for the view that ordinary shares are redeemable at the holder’s demand confuses the characteristics of perpetual equity with those of debt instruments or specific classes of redeemable preference shares.

Takeaway: Ordinary shares offer voting rights and growth potential but carry the highest risk as residual claimants in a liquidation scenario.

Correct: Indicative prices are non-binding and serve as a reference for where a security might trade. They allow market participants to perform portfolio valuations and gauge market sentiment without requiring the dealer to commit to a trade at that specific price. This is common in the OTC bond market, especially for less liquid issues where dealers are unwilling to provide firm, executable quotes at all times.

Incorrect: Believing these are legally binding quotes confuses indicative pricing with firm two-way quotes, which require the dealer to execute at the stated bid or offer for a specified size. Suggesting the Monetary Authority of Singapore sets daily settlement prices for corporate bonds is incorrect as the regulator does not act as a commercial pricing source for private debt instruments. Claiming the clearing house guarantees execution prices misinterprets the role of clearing houses, which manage post-trade risk and settlement rather than setting pre-trade execution prices or providing liquidity guarantees.

Takeaway: Indicative prices are non-binding valuation guides, whereas firm quotes represent a dealer’s commitment to trade at specific prices and sizes.

Correct: Index-linked bonds are specifically designed to protect investors from inflation by adjusting both the principal (capital) and the interest (coupon) payments in line with a recognized inflation index, such as the Consumer Price Index (CPI). This dual adjustment ensures that the purchasing power of the income stream and the final capital repayment remains stable in real terms.

Incorrect: The strategy of only adjusting the final redemption value is insufficient because it leaves the investor’s periodic income vulnerable to purchasing power erosion over the life of the bond. Relying on a fixed annual percentage increase is incorrect as it does not reflect actual inflation measurements, which is the defining characteristic of an index-linked security. Suggesting that the Monetary Authority of Singapore pegs market prices to the CPI is a misconception; while the cash flows are adjusted, the market price of the bond still fluctuates based on secondary market supply, demand, and real interest rate changes.

Takeaway: Index-linked bonds protect purchasing power by adjusting both principal and interest payments based on a specific inflation index like the CPI.

Correct: The SGX serves as a centralized platform where the interaction of supply and demand leads to transparent price discovery. By establishing standardized rules and a robust regulatory framework under the Securities and Futures Act, it fosters a liquid secondary market, allowing investors to enter and exit positions efficiently while providing issuers with access to a broad capital base.

Incorrect: The idea that an exchange guarantees price stability or prevents losses is a common misconception as market forces and company performance determine prices. Expecting the exchange to take legal liability for issuer disclosures is incorrect because the primary responsibility for prospectus accuracy lies with the directors and the issue manager. Requiring voice-broking is contrary to modern exchange operations in Singapore, which rely on electronic order-driven systems to maximize efficiency and transparency.

Takeaway: Stock exchanges provide a regulated, centralized marketplace that ensures transparent price discovery and secondary market liquidity for all participants.

Correct: A floating charge is a form of security created over a class of assets that may change in the ordinary course of business, such as inventory or receivables. In Singapore, the key feature of a floating charge is that it allows the chargor (the company) to deal with those assets freely until a ‘crystallising event’ (such as a default or the appointment of a receiver) happens, at which point the charge ‘fixes’ onto the assets then held.

Incorrect: The strategy of requiring prior written consent for every asset disposal describes a fixed charge, which is typically used for non-circulating assets like land or heavy machinery. Opting for a structure where bondholders take immediate legal title describes a legal mortgage rather than a floating charge. Focusing on the priority of claims is misleading because, under Singapore insolvency law, floating charge holders generally rank behind certain preferential creditors, such as employees’ wages and CPF contributions, in a winding-up scenario.

Takeaway: A floating charge allows a company to trade its circulating assets until a default triggers crystallisation into a fixed charge.

Correct: In Singapore, collective investment schemes (CIS) offered to the retail public must be authorized or recognized by MAS and must comply with the Code on Collective Investment Schemes. This Code imposes strict requirements on investment parameters, diversification, and borrowing to protect retail investors. Restricted schemes, which are offered only to accredited or institutional investors, are exempt from these specific retail-focused investment guidelines, allowing for more complex or concentrated strategies.

Incorrect: The assumption that restricted schemes are exempt from AML/CFT requirements is incorrect because all financial institutions in Singapore must maintain robust compliance standards regardless of the investor’s status. Claiming that only retail schemes require disclosure documents is a misconception; while restricted schemes do not require a MAS-registered prospectus, they typically provide an information memorandum to meet disclosure obligations. The idea that retail schemes cannot use derivatives is false, as they are permitted to use them for efficient portfolio management and hedging, subject to the limits in the CIS Code.

Takeaway: Retail funds in Singapore require MAS authorization and strict adherence to the CIS Code, unlike restricted schemes for accredited investors.

Correct: Underwriting serves as a financial guarantee for the issuer. By entering into an underwriting agreement, the financial institution (underwriter) assumes the risk of undersubscription. This ensures the company receives the total funds needed for its expansion regardless of whether the public fully subscribes to the offering, providing certainty of funding.

Incorrect: The strategy of price stabilization is a separate activity governed by specific regulations that occurs after the offering to manage volatility, rather than guaranteeing the initial capital raise. Simply conducting an underwritten offer does not provide an exemption from the Securities and Futures Act (SFA) requirements regarding the lodgement and registration of a prospectus with the Monetary Authority of Singapore. Choosing to use an underwriter does not transfer the statutory legal liability for the accuracy of the prospectus, as the directors of the issuer remain responsible for the disclosures made to the public.

Takeaway: Underwriting provides issuers with financial certainty by transferring the risk of undersubscription to the financial institution at a predetermined price.

Correct: The Delivery versus Payment (DVP) mechanism is a settlement procedure that links the transfer of securities and the transfer of funds. By ensuring that the delivery of the asset happens only when the payment is confirmed, it effectively eliminates principal risk, which is the risk that one party fulfills their obligation while the other defaults.

Incorrect: Focusing on price stability during the settlement cycle confuses settlement risk mitigation with market risk management. The strategy of transferring title before payment is received describes a ‘free delivery’ system, which actually increases principal risk rather than mitigating it. Suggesting that DVP is an insurance pool mischaracterizes a structural settlement process as a capital-based compensation scheme like the Fidelity Fund.

Takeaway: DVP is a settlement mechanism that eliminates principal risk by ensuring securities delivery and payment occur simultaneously and conditionally.

Correct: Proprietary trading firms are the primary entities that pursue high-frequency algorithmic trading as a core business model. They use their own capital rather than client funds, allowing them to take on the significant technology costs and operational risks associated with low-latency arbitrage and market-making strategies on the SGX.

Incorrect: Focusing on retail brokerage firms is incorrect because their business model is centered on earning commissions and fees from client transactions rather than high-speed proprietary arbitrage. The strategy of sovereign wealth funds is typically focused on long-term capital preservation and growth, which is inconsistent with the millisecond-level turnover of HFT. Opting for corporate treasury departments is also misplaced as these entities use financial markets primarily to mitigate commercial risks like currency volatility rather than seeking speculative profits through algorithmic execution speed.

Takeaway: Proprietary trading firms are the dominant users of high-frequency algorithmic trading strategies, leveraging low-latency infrastructure to profit from market inefficiencies.

Correct: Emerging markets typically exhibit lower liquidity and market depth compared to developed markets like Singapore. For institutional investors, this lack of depth means that large buy or sell orders are more likely to cause significant price movements, known as price impact, which increases the total cost of execution and slippage.

Incorrect: The strategy of assuming uniform corporate governance is flawed because emerging markets often have less stringent disclosure requirements and weaker regulatory oversight than the MAS-regulated environment. Expecting a total absence of capital controls is unrealistic as emerging jurisdictions are more prone to imposing sudden restrictions on currency movements during economic volatility. Presuming that settlement infrastructure is identical to the SGX ignores the reality that many emerging markets have less mature clearing systems, leading to higher counterparty and operational risks.

Takeaway: Emerging markets are characterized by lower liquidity and higher price impact compared to the sophisticated trading infrastructure of developed markets like Singapore.

Correct: Structured products are defined by their payoff being linked to an underlying benchmark or asset. Unlike standard corporate bonds that pay a fixed or floating coupon regardless of market fluctuations (provided the issuer is solvent), a structured note’s return is dependent on specific market conditions or the performance of an underlying index, introducing significant payoff structure risk.

Incorrect: Believing that the Singapore Deposit Insurance Corporation provides a safety net for investment products is a common misconception as SDIC coverage is generally limited to specific bank deposits and insurance policies rather than investment notes. Assuming that the Monetary Authority of Singapore acts as a liquidity provider for private financial instruments misinterprets the regulator’s role in market oversight versus market making. The strategy of assuming credit risk is eliminated through mandatory collateralization ignores the reality that many structured products are unsecured obligations of the issuer and remain subject to the issuer’s creditworthiness.

Takeaway: Structured products carry unique payoff risks because their returns are dependent on the performance of underlying market variables rather than fixed interest payments.

Correct: In the context of Equity-Linked Notes (ELNs) common in Singapore, the payout structure often involves physical settlement. If the underlying asset price falls below the strike or barrier price (a knock-in event), the investor is obligated to take delivery of the shares. This results in the investor holding an asset worth less than their initial cash investment, effectively losing a portion of their principal.

Incorrect: The strategy of relying on the SGX clearing house for protection is incorrect because structured notes are typically unsecured debt obligations of the issuing financial institution, not the exchange. Claiming the product is a risk-free deposit is a significant misconception, as structured notes are investment products and are explicitly excluded from the Singapore Deposit Insurance Corporation (SDIC) coverage. Describing the note as a standard convertible bond is inaccurate because ELNs are ‘reverse convertibles’ where the conversion is triggered by market conditions rather than being an optional right exercised by the investor.

Takeaway: Structured products like ELNs expose investors to both issuer credit risk and the potential for physical delivery of depreciated underlying assets.

Correct: The greenshoe, or over-allotment option, is a price stabilization tool used in Singapore IPOs. It allows the stabilizing manager to sell more shares than the base deal size (usually up to 15%). If the share price falls below the offer price after listing, the manager buys shares in the open market to support the price. If the price rises, the manager exercises the option to buy shares from the issuer or a lending shareholder at the original offer price to cover the short position created by the over-allocation.

Incorrect: The idea that this is a mandatory regulatory requirement for institutional discovery is incorrect, as the greenshoe is a commercial choice used for stabilization rather than a fixed MAS quota. Describing it as a legal obligation for the issuer to buy back shares mischaracterizes the role of the stabilizing manager and the optional nature of the mechanism. Suggesting the greenshoe is a mechanism to cancel the offering based on subscription levels confuses stabilization with minimum subscription conditions or ‘all-or-nothing’ clauses.

Takeaway: The greenshoe option enables price stabilization by allowing underwriters to over-allocate shares and manage post-listing supply and demand dynamics.

Correct: Credit ratings represent an agency’s opinion on the likelihood of default at a specific point in time. They are subject to ‘rating lag’ because agencies typically review ratings periodically rather than continuously. This means the rating might not immediately reflect sudden credit events, deteriorating cash flows, or shifts in the macroeconomic environment that occur between review cycles.

Incorrect: The belief that ratings encompass all risks is a common error; ratings specifically measure credit risk and do not account for price volatility or the ease of selling the bond in the secondary market. Treating a rating as a guarantee of payment is a fundamental misunderstanding of credit risk, as even highly-rated issuers can face insolvency and default. The idea that ratings are static is incorrect because agencies actively monitor issuers and can upgrade, downgrade, or place ratings on credit watch as new information becomes available.

Takeaway: Credit ratings are time-specific opinions on default risk and should not be viewed as real-time indicators or comprehensive risk measures under Singapore’s investment frameworks.

Correct: An unweighted (or equal-weighted) index assigns the same weight to every constituent regardless of its market capitalization. In the Singapore market, where a few large entities like major banks significantly impact market-cap weighted indices, an unweighted index allows analysts to see how the typical or average company is performing. This prevents the index from being skewed by the performance of the largest companies, providing a clearer view of the broader market’s breadth.

Incorrect: The strategy of reflecting the total market value is the defining characteristic of market-capitalization weighted indices, not unweighted ones. Opting for an unweighted index actually increases rebalancing requirements because the weights must be adjusted periodically to return them to equality after price movements. Focusing on free-float and liquidity adjustments is a technique used to refine market-cap weighted indices to ensure they are investable, rather than a feature of equal weighting.

Takeaway: Unweighted indices provide a view of the average stock’s performance by removing the bias toward large-cap companies found in market-cap indices.

Correct: The Request for Quote (RFQ) model is a quote-driven electronic trading method where a customer (the institutional client) initiates the process by asking one or more dealers for a price. This allows for price discovery and negotiation in the decentralized over-the-counter (OTC) bond market, which is the standard for institutional debt instruments in Singapore.

Incorrect: Providing continuous streaming prices on a central limit order book describes an order-driven or automated market-making system rather than the inquiry-based RFQ protocol. Utilizing an inter-dealer broker for anonymous inventory management is a wholesale dealer-to-dealer activity that does not involve the direct customer-to-dealer interaction found in RFQ. Relying on a centralized exchange matching engine with price-time priority is characteristic of exchange-traded equities or retail bonds rather than the institutional OTC quote-driven environment.

Takeaway: The RFQ model is the primary electronic method for customer-to-dealer bond trading, allowing clients to solicit specific quotes from liquidity providers.

Correct: In the securitisation process, the Special Purpose Vehicle (SPV) is designed to be bankruptcy-remote. This means that the assets transferred to the SPV are legally isolated from the originator. If the originator faces insolvency, the investors in the asset-backed securities still have a claim on the underlying mortgage pool, as those assets are no longer part of the originator’s estate.

Incorrect: The strategy of providing a full corporate guarantee for all tranches is generally not the role of the SPV, as its capacity to pay is strictly limited to the cash flows generated by the underlying assets. Simply conducting the daily collection of interest describes the role of the servicer, which is a distinct functional role often retained by the originator rather than the SPV itself. Opting to view the SPV as a regulatory authority is incorrect because credit ratings are provided by independent Credit Rating Agencies, and regulatory oversight in Singapore is conducted by the Monetary Authority of Singapore (MAS).

Takeaway: The Special Purpose Vehicle provides bankruptcy remoteness by legally isolating securitised assets from the originator’s credit risk.

Correct: A firm two-way quote represents a committed bid and offer at which a dealer is willing to trade immediately for a specific transaction size. This provides the investor with certainty of execution. In contrast, an indicative price is merely an estimate of where the market is currently trading and does not legally or professionally bind the dealer to execute at those levels without further negotiation.

Incorrect: The strategy of suggesting that indicative prices are mandatory for government securities is incorrect because Primary Dealers in the Singapore Government Securities market are actually required to provide firm, actionable quotes to maintain liquidity. Focusing only on the inclusion of regulatory levies misidentifies the nature of the quote, as both types usually refer to the clean price of the bond rather than the settlement costs. Choosing to believe that indicative prices are for retail investors is a misconception of market practice, as indicative pricing is a standard tool used in wholesale and institutional markets for price discovery in illiquid instruments. Opting for the view that firm quotes are only for corporate bonds on the SGX ignores the fact that firm quotes are the standard for liquid OTC trading across various debt instruments.

Takeaway: Firm quotes are binding commitments for immediate execution, whereas indicative prices are non-binding estimates used for market discovery and valuation purposes.

Correct: Stratified sampling is a passive methodology where the manager divides the index into various sections or ‘cells’ based on characteristics like industry sector or market capitalization. By selecting a representative sample of securities from each cell, the manager can closely track the index’s performance without the need to trade every illiquid or expensive constituent, thereby reducing transaction costs and managing liquidity risk effectively.

Incorrect: The strategy of purchasing every single constituent regardless of cost or liquidity describes full replication, which often results in higher tracking errors due to the impact of trading illiquid small-cap stocks. Choosing to overweight specific stocks to outperform the benchmark is a form of active or enhanced management that deviates from the core objective of a passive tracking mandate. Opting for tactical shifts into cash or bonds based on market timing is an active management technique that introduces human judgment and market-timing risk, which is inconsistent with passive index tracking.

Takeaway: Stratified sampling allows passive managers to track an index efficiently by holding a representative subset of securities when full replication is impractical.

Correct: Commercial paper is a short-term, unsecured debt instrument issued by corporations to meet immediate financial obligations. It is typically issued as a discount security, meaning it does not pay a periodic coupon; instead, it is sold at a price below its face value, and the investor’s return is the difference between the purchase price and the par value at maturity.

Incorrect: The strategy of treating commercial paper as a secured instrument is incorrect because CP is fundamentally an unsecured obligation relying on the issuer’s credit rating. Describing the instrument as a long-term security with coupon payments is inaccurate as CP is a money market instrument with a maturity usually under one year and is issued at a discount. Suggesting that it is a government-guaranteed facility for small businesses misrepresents its nature as a private-sector wholesale market tool used primarily by large, creditworthy entities.

Takeaway: Commercial paper is an unsecured, short-term discount security used by large corporations to manage working capital and liquidity needs efficiently.