A Canadian investment fund manager is launching a new ETF that will track a custom-built global equity index. The manager decides to use a 'total return swap' for synthetic replication rather than holding the underlying securities directly. Which of the following is a primary reason for choosing this ETF structure, particularly for a global index with potentially illiquid international components, and a key risk associated with it? A. Reason: Lower transaction costs for frequent rebalancing; Risk: Increased liquidity risk of the swap counterparty. B. Reason: Enhanced dividend tax credit for Canadian investors; Risk: Higher management fees from the swap agreement. C. Reason: Ability to track hard-to-access markets efficiently; Risk: Exposure to counterparty credit risk. D. Reason: Reduced currency hedging costs for foreign components; Risk: Potential for higher tracking error due to swap pricing.

Question: A Canadian investment fund manager is launching a new ETF that will track a custom-built global equity index. The manager decides to use a 'total return swap' for synthetic replication rather than holding the underlying securities directly. Which of the following is a primary reason for choosing this ETF structure, particularly for a global index with potentially illiquid international components, and a key risk associated with it?

A. Reason: Lower transaction costs for frequent rebalancing; Risk: Increased liquidity risk of the swap counterparty. B. Reason: Enhanced dividend tax credit for Canadian investors; Risk: Higher management fees from the swap agreement. C. Reason: Ability to track hard-to-access markets efficiently; Risk: Exposure to counterparty credit risk. D. Reason: Reduced currency hedging costs for foreign components; Risk: Potential for higher tracking error due to swap pricing.

Answer options:

• A. Reason: Lower transaction costs for frequent rebalancing; Risk: Increased liquidity risk of the swap counterparty.
• B. Reason: Enhanced dividend tax credit for Canadian investors; Risk: Higher management fees from the swap agreement. ✅ C. Reason: Ability to track hard-to-access markets efficiently; Risk: Exposure to counterparty credit risk.
• D. Reason: Reduced currency hedging costs for foreign components; Risk: Potential for higher tracking error due to swap pricing.

Correct answer: C. Reason: Ability to track hard-to-access markets efficiently; Risk: Exposure to counterparty credit risk.

Explanation: Synthetic replication using total return swaps allows ETFs to track indices efficiently, especially those with illiquid or hard-to-access components, by gaining economic exposure without owning the securities. The primary risk of this structure is counterparty credit risk, as the ETF's performance depends on the swap counterparty fulfilling its obligations.