Chapter 8 Suitability and Prohibited Activities Flashcards
What do you need to create a customer profile?
- Adequate information is necessary
- Know your prospect prior to making a recommendation
- Look for suitability, not profit
- Suitability is unique
What is disposable income?
Income after taxes
What is discretionary Income?
Income after taxes, personal necessities, and debt
[after you made all required payments]
Where does money come from for investment?
Discretionary Income
What are Time Horizon?
Time frame for investment
What would you recommend against inflation?
Stocks are protection against inflation
What is systematic risk?
P.R.I.M.E
Purchase power risk
Reinvestment Risk
Interest Rate Risk
Market Risk
Exchange Rate Risk
What is nonsystematic Risks?
lessened or eliminated through diversification
- Captial Risk
- Business Risk
- Liquidity
- Credit Risk
- Call Risk
- Taxation risk
- Regulatory Risk
- Legislative risk
- Social or political risk
- Prepayment Risk
What are some risk management Strategies?
Risk vs Reward- Risk is higher than reward
Diversification
Asset Allocation -
Portfolio Rebalancing
Hedging
Defensive vs aggressive
What is total risk?
Considers interest, dividends, and capital appreciation
What is risk adjusted return?
Measures return based ipon the amount of risk
What is annualized Return?
Measures earning per year
What is Inflation Adjusted Return?
Subtracts inflation from return based on CPI
What is after tax return?
Removes taxes rom return
Which return is the broadest index?
Wilshire Index - considered the total market index
Whats the narrowest index?
Value line
What does the FINRA Rule 2111 do?
3 suitability Measures
1) Reasonable basis Suitability
2) Customer Specific Suitability -
3) Quantitative Suitability
What does the FINRA Rule 2111 do?
3 suitability Measures
1) Reasonable basis Suitability
2) Customer Specific Suitability -
3) Quantitative Suitability
What must you do when you borrow money.
Must notify the firm and get written approval
What is commingling?
Customer funds and securities must always be segregated from the RR or firm accounts
Wash Trade
Matched Sales
Painting the Tape
makes an attempt to make it look like theres activity
What is spoofing?
Putting an order and pulling out just before.
What is excessive trading (CHurning/twisting)
Buying a lot of stock just to make commision
What is Freeriding?
Trying to make a profit before paying
What is backing away?
when the market maker backs away
What is front running?
Placing an order before the customer. Trying to purchase
What is pump and dump?
Buy a lot of stock and spread rummors to increase the value and then sell it for profit
What is regulation M?
Regards the follow on offering.
Syndicate cannot aggressively trade the subject prior to effective date
What must an RR do when creating a customer profile?
The RR should make a reasonable effort to obtain the customers financial information, prior investment experience, attitudes towards risk, and investment objectives
What does the FINRA KNOW YOUR CUSTOMER rule state?
RR and member firms must use DUE DILLIGENCE to obtain essential information to open and service the customers account, follow the customers instructions, and to comply with all laws and regulations
How does the RR verify if the information is correct?
The RR must send a copy of the customers profile or account record to the customer within 30 days of opening the account w/ next statement
When does an RR have to verify that all information is correct for a customers profile?
Every 36 months
Prior to making any suitable customer recommendations, a registered representative should?
A) Be well schooled in selling techniques
B) Find out the college or university they graduated from
C) Complete all required continuing educations
D) Know their customer
D) Know their customer
What information do you need when Opening a new customer account?
- Age
- Marital Status
- Dependents
- Employment Status
- Income
- Expenses
- Disposable Income (After income tax money)
What is Discretionary Income?
Is the amount an individual income that is left for spending, investing or saving after taxes and personal necessities and debts have been paid
What happens when economic out put is strong in relation with Discretionary Income?
Discretionary income tend to be high
What happens when inflation hits during a strong economic output?
Discretionary Income will fall
What is the formula for Discretionary Income?
Total Income - expenses = Discretionary Income
All the following are relevant personal and financial information necessary for a registered representative to make a suitable recommendation, EXCEPT?
A) Age
B) College degree earned
C) Dependents
D) Employee Status
B) College Degree earned
What are assets?
Assets are a resource with economic value that the client owns or controls with the expectation that they will provide a benefit
What are liabilities?
Represents a clients debt or obligations and refer to any money or service that is currently owed to another party
What are liquid assets?
Things that can be converted to cash quickly and easily
How do you calculate Net Worth
Assets - Liabilities = Net Worth
What is the marginal rate of taxation?
Its the amount paid on the last dollar earned
If an older investor wants to invest for future generations, it is recommended that they:
A) Liquidate all assets even if penalites apply
B) Spend down all their assets while alive
C) Make investment decisions based on the beneficiary’s profile
D) Cancel any life insurance policies to save money
C) Make investment decisions based on the beneficiary’s profile
What is a beta?
Describes the likely movement of a security compared to the market
Who should a security with high volatility be recommended to?
Should only be recommended to an investor with a suitable risk tolerance level
Who are hit the hardest during inflation?
Fixed-income investors are the hardest hit by inflation
In the long term, which of the following investments is most likely to protect an investors portfolio against the effects of inflation?
A) Stocks
B) Corporate Bonds
C) Government Stocks
D) Emerging market debt securities
A) Stocks
Rank the following securities from most to least aggressive based on their beta
- ABC Investment Grade Corporate Bond Funds with a beta of .9
- ABC Index Fund with a beta of 1.0
- ABC Growth Fund with a beta of 1.7
1) ABC Growth Fund with a beta of 1.7
2) ABC Index Fund with a beta of 1.0
3) ABC Investment Grade Corporate Bond Fund with a beta of .9
- HIGHER BETA means that the price of the security is MORE LIKELY to RISE or FALL dramatically over a SHORT TIME PERIOD
- LOWER BETA means that a security value DOES NOT FLUCTUATE as dramatically or as frequently
What is the investors 2 main objective when determining Risk Tolerance?
The two main objectives are growth and income
What is Systematic Risks?
Risks that cannot be avoided or reduced through diversification
how many kinds of systematic risks are there?
There are 7 kinds of systematic risks
- Market Risk
- Interest Rate Risk
- Reinvestment Risk
- Inflation
- Currency (Exchange Risk)
What are Nonsystematic Risk>
Risks associated witha a specific security, company, or industry, not the return of the overall market. These risks can be lessened by diversification
What kinds of nonsytematic risks are there?
Prepayment (Loans being paid off early)
Capital Risk (Risk of loosing all capital )
Business Risk (Business fails)
Liquidity Risk (When the value of something falls)
Credit Risk (Pay back the interest to its creditors)
Taxation Risk (When tax law changes that affects the security negatively)
Legislative Risk (Law change that affects a business negatively)
Social or Political Risk (Political changes, social events, or instability affects investments returns)
Call Risk (Company offer new security at a lower Yield)
An investor purchases 1,000 shares of XYZ stock. What risk does this investor face?
A) Regulatory risk
B) Call Risk
C) Political Risk
D) Business Risk
D) Business Risk
The possibility that an issuer will be unable to pay back the interest and/or principal due to its creditors is known as what type of risk?
A) Interest Rate
B) Inflation
C) Reinvestment
D) Credit
D) Credit Risk
What investment has Currency, politcal, and social risks?
ADR
What risks does municipal bonds have?
Taxability, interest rate, purchasing power, reinvestment, and liquidity
What type of investment has Reinvestment and interest Rate, no purchasing power risk?
TIPS
What kind of risks are associated with T-bonds?
Purchasing power, reinvestment, and interest rate risk, no default risk
What risks are involved with STRIPS?
Interest rate and purchasing power risks, no reinvestment risk
What are large Cap stocks?
Market capitilization of $10 billion and higher
What are mid Cap stocks?
Market capitalization of 2 billion and 10 billion
What are small cap stocks?
Market capitalization of 2 billion or lower
What is a growth Stock?
Its a fast growing stock
Whats a value stock?
A value stock is one that is purchased below its potential value
Which of the following statements about diversification is true?
A) It prevents portfolio losess
B) It cannot guarantee a profit or prevent loss
C)It guarantees portfolio profits
D) It addresses systematic Risks
B) It cannot guarantee a profit or prevent a loss
What is Portfolio Rebalancing?
Its to make sure it stays in line with the inventors risk profile and investment objectives
What is sector rotation?
The advisor moves from different asset classes based on the business cycle
What is Hedging>
Is a method used to reduce systematic risk. It is to protect investors from market decline
What is defensive Investment Strategy?
Portfolio allocation aimed at minimizing loss of principal for investors seeking capital preservation
What is an aggressive Investment Strategy?
Attempts to achieve maximum return primarily through capital appreciation
What type security would you recommend for an Income Strategy?
CMOs, REITs, Preferred stock, Bonds
What type of security would you recommend for a Capital Appreciation strategy?
ADRs, Common Stock, ETFs
What type of securities would you recommend for Capital Preservation?
Commercial paper, Bankers acceptance, T-notes and bonds
What is the total return equation?
Divide the total gains by the initial outlay of funds
What is the holding period return?
Is the return on investment or portfolio over the period the investment is held
What is annualized return?
Demonstrates how much money a security earned each year for a specific period
What is risk Adjusted Return?
The risk adjusted return measures the security’s return based on the amount of risk
What is the Inflation Adjusted Return?
Subtracts the inflation rate from the return
What is the Risk- Free Rate
A return where you assume there are no losses and is extremely safe
What is active return?
The amount above average return
What are the three main suitability obligations?
- Reasonable basis Suitability
- Customer Specific Suitability
- Quantitative Suitability
Under FINRA Rule 2111, which of the following is not one of the 3 suitability obligations?
A) Qualitative
B) Quantitative
C) Reasonable basis
D) Customer Specific
A) Qualitative
All the following are considered fraudulent activity, except:
A) Fictious accounts
B) Misuse of cutomers funds or securities
C) Unauthorized transactions
D) Unsolicited trading
D) Unsolicited trading
What does FINRA Rule 2165 do?
It was created to protect senior citizens from abusive and manipulative actions of investment professionals.
What is a Wash Trade?
Simultaneous purchase and sale of the same security. Gives the appearance of active trading.
What is painting the tape?
Manipulative trading involving a series of purchases, or sales, rather than paired buys and sells with the intent to give the false appearance of a trend in a stock price and lure other investors into the same trading activity
What is freeriding?
When a customer attempts to profit on and then sell those same securities before paying for them
What is Front Running?
Occurs when a broker dealer or registered representative trades ahead of a large customer order that may affect the price of the security
What is Regulation M Rules 100-105 for?
prohibits the syndicate members in a follow on offering from aggressively trading the subject security in the secondary market and has placed time restrictions on thinly traded securities to only allow trading after the effective date
How are market makers compensated.
They are only compensated through the spread
What is Pump and Dump?
Purchase a bunch of stocks and then spread market rumors to raise the value of the stock. Once value has gone up the investor will try to sell the stock for profit
Which of the following activities by an agent does not constitute market manipulation?
A) Providing false market quotations
B) Creating the impression that a security is actively trading
C) Recommending an investment without considering the clients risk tolerance
D) Front Running
C) Recommending an investment without considering the clients risk tolerance
What are the civil penalties for insider trading?
The greater of 300% of the profit gained or the loss avoided
