Cleint Investment Recommendations and Strategies (Units 18-24)

Question 1

What is bid price? What is offer/ask price?

Answer 1

The current bid is the highest price at which the dealer will buy and the current offer is the lowest price at which the dealer will sell. The difference between the bid and ask is call the spread.
The more active the stock, the narrower the spread.

Question 2

What is Reg T call?

Answer 2

In margin accounts, customers may borrow part of a securities purchase price from BD under terms set by Fed Rsv Board Regulation T. Says which securities are eligible and stipulates 50% of security value may be borrowed from BD.

Question 3

What is the risk measure associated with the capital market line (CML)?
A) Alpha
B) Beta
C) Systematic risk
D) Standard deviation

Answer 3

D
In the context of the CML, the measure of risk is total risk, or standard deviation. Beta (systematic risk) is used to measure risk for the security market line (SML).

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Question 4

What are 3 techniques for minimizing interest risk for bond holders?

Answer 4

1. Barbell: s.t. bonds (1-2yrs) on one end with equal amount of l.t. bonds (10+yrs) on the other ened.
2. Bullet: bonds purchased at different times all with same maturity or target date. Like for college education.
3. Laddering: Bonds all purchased at same time but maturing at different times.

Question 5

What is market capitalization and the various levels?

Answer 5

The number of outstanding shares times the current market price.
Small cap is $300M to $2Billion
Mid cap is $2-10Billion
Large cap is greater than $10Billion

Question 6

what is a limit order?

Answer 6

Limits the amount paid or received for securities. A customer limits the acceptable purchase or selling price. A limit order can only be executed at the specified price or better (lower for a buy and higher for a sell)

Question 7

Which of the following characteristics best exemplifies a value stock?

A) High earnings-per-share growth, high profitability
B) Low earnings-per-share growth, high profitability
C) Low price-to-book, high price-to-earnings ratio
D) Low price-to-book, low price-to-earnings ratio

Answer 7

D
A value investor focuses on share price in anticipation of a market correction and improving company fundamentals. Therefore, such an investor tends to select a stock featuring lower price-to-earnings and price-to-book value ratios. A growth investor focuses on high earnings-per-share, growth, and high profitability.

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Question 8

What is hypothecation?

Answer 8

Permission by client to use margin securities as collateral for loan and permission to re-hypothecate / pledge securities held in margin account to lending institution. A mandatory part of the margin agreement.

Question 9

Which of the following offers the opportunity to realize a capital gain rather than ordinary income?
A) Deferred annuities
B) Stock dividends
C) Cash dividends
D) Section 529 plans

Answer 9

Stock dividends, unlike cash dividends, are not taxable in the year of receipt. Instead, they reduce the owner’s cost basis and, when sold at a price above that cost basis, are treated as capital gain rather than ordinary income. Deferred annuities never generate anything but ordinary income, and qualified withdrawals from Section 529 plans result in no taxation on the earnings. If they are not qualified, there is ordinary income tax plus a penalty.

Question 10

Which of the following has the power to close a stock exchange for up to 90 days?

A) The SEC
B) The Administrator in the state where that stock exchange is located
C) The president of the United States
D) The president of that stock exchange

Answer 10

A
The Securities Exchange Act of 1934 granted the SEC the power to close any registered stock exchange for up to 90 days. All that is required is notice to the president of the United States.

Question 11

Two years after their wedding, Pam and Jim became the proud parents of child. Both grandparents want to help ensure educational funds for their new grandchild by using the Coverdell ESA. Assuming they are within the earnings limitations, which of the following would be permitted?

A) $1,000 from Pam’s parents and $1,000 from Jim’s parents into separate ESAs
B) $2,000 from Pam’s mother, $2,000 from Pam’s father, $2,000 from Jim’s mother, and $2,000 from Jim’s father
C) $2,000 from Pam’s parents and $2,000 from Jim’s parents into separate ESAs
D) $2,000 from Pam’s parents and $2,000 from Jim’s parents into a single ESA

Answer 11

A
Any individual whose modified adjusted gross income is under the limit set for a given tax year can make contributions. There’s no limit to the number of accounts that can be established for a particular beneficiary; however, the total contribution to all accounts on behalf of a beneficiary in any year can’t exceed $2,000.

Question 12

What is a stop order?

Answer 12

Becomes a market order if the stock reaches or goes through the trigger price.

Question 13

Which of the following phrases best describes a prudent investor?
A) A person in a fiduciary capacity who invests in a prudent manner
B) An investment adviser representative handling a discretionary account
C) A trustee who invests with reasonable care, skill, and caution
D) The custodian for a minor under the Uniform Transfers to Minors Act

Answer 13

C
Although all of these may have a fiduciary responsibility; the definition, as expressed in the Uniform Prudent Investor Act of 1994, requires reasonable care, skill, and caution.

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Question 14

What is LIBOR

Answer 14

It is the world’s most widely used benchmark for short term interest rates.
Eurodollars are US dollars placed in banks outside the US. The deposits remain denominated in US dollars. (EuroYen are Yen placed in banks outside Japan). European banks lend Eurodollars to other banks outside US much like US banks lend federal funds to one another. Interest rate is usually based on London Interbank Offered Rate (LIBOR).

Question 15

What is systematic risk

Answer 15

Undiversifiable. Market risk. Risk for the stock market as a whole.

Question 16

What is Capital Market Line CML?

Answer 16

An offshoot of CAPM (Capital Asset Pricing Model).
The CML is generally used to evaluate diversified portfolios.
The CML provides an expected return based on level of risk. It uses:
–expected return of portfolios
–risk free rate
–return on the market
–standard deviation of the market
–standard deviation of the portfolio

Question 17

What kind of accounts can be TOD?

Answer 17

Individual, JTWROS, tenants in entirety

Question 18

Samantha Wells, a British citizen temporarily working in the United States, wants to form a business venture with other investors. She is looking for favorable tax treatment of earnings and losses. She also wants to limit the number of investors, but is willing to share control of the enterprise with others to attract them. What business form do you advise to her?
A) S Corporation
B) Limited Partnership
C) C Corporation
D) General Partnership

Answer 18

Limited partnerships would not work because the other investors have limited say in how the enterprise is run. C corporations do not provide favorable tax treatment of gains or losses. While an S corporation appears to be the right answer, only U.S. citizens or resident aliens can own one.

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Question 19

An agent making a sales presentation to a client about a mutual fund’s historical returns is required to explain to the client the difference between the fund’s

A) total return and risk-adjusted return.
B) current yield and real return.
C) current yield and holding period return.
D) current yield and total return.

Answer 19

D
When comparing to a benchmark, it is common to show various return computations. In connection with the solicitation of investment company shares, it is considered an unfair business practice to discuss returns without fully explaining the difference between current yield and total return.

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Question 20

Under which of the following circumstances would a premature distribution from a traditional IRA be exempt from the premature distribution penalty?
A) When the account is fully funded with nondeductible contributions
B) A distribution taken to satisfy the terms of a court-ordered property settlement
C) When the distribution is paid in equal annual amounts over the owner’s life
D) A distribution taken at age 55 if the owner is retired

Answer 20

C
A distribution from an IRA taken in equal annual amounts over the owner’s life is not subject to the 10% premature distribution penalty even if started before age 59½. This is one of the exceptions that apply to IRAs. The exception for qualified domestic relations orders (QDROs) and for retirement at age 55 apply to employer-sponsored plans but not to IRAs.

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Question 21

What does a market maker’s quote like this mean (45 - 45.2)(8 x 10)?

Answer 21

Means dealer is offering 1000 shares for sale at 45.2 and is ready to buy 800 shares for sale at 45. If not stated the quote is good for a single round lot (100 shares)

Question 22

A grandparent wishes to contribute funds to an account for the benefit of the college education of a grandchild. In which of the following does the donor have the greatest amount of control over the assets in the account?

A) An UGMA account
B) A Coverdell ESA
C) An UTMA account
D) A Section 529 plan

Answer 22

D
It is the Section 529 plan that offers the greatest amount of control to the donor. In the case of the ESA, on the IRS form used to open the account, it states: “The ‘responsible individual”’ named by the depositor shall be a parent or guardian of the designated beneficiary.” Unless we are told that the grandparent has been appointed as legal guardian, there is a lack of control. And, even then, one thing the “responsible individual” cannot do that the donor to a 529 plan can is take the money back. Although the grandparent could be named the custodian of the UGMA or UTMA account, the only authority there is to make the investment decisions and disbursements until the termination age of the account.
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Question 23

What are some common uses for derivatives?

Answer 23

Derivatives are generally not appropriate for highly risk-adverse investors due to the risk and sophistication involved. Some of the common uses of derivatives are for:

Hedging to reduce the impact of adverse price movements (e.g., by buying put options or selling futures contracts).
Anticipating future cash flows.
Asset allocation changes.
Income (selling options).

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Question 24

What are Eurodollars?

Answer 24

Eurodollars are US dollars placed in banks outside the US. The deposits remain denominated in US dollars. (EuroYen are Yen placed in banks outside Japan). European banks lend Eurodollars to other banks outside US much like US banks lend federal funds to one another. Interest rate is usually based on London Interbank Offered Rate (LIBOR).

Question 25

What is process and requirements for opening an options account?

Answer 25

One question asked on a new options account form that is not required on a normal brokerage account opening is investment experience and knowledge (e.g., number of years, size, frequency, and type of transactions) for options, stocks and bonds, commodities, and other financial instruments.
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A designated supervisory person must approve or disapprove opening account in writing. And client must receive ODD prior to account approval.
Within 15 days of account approval, BD must obtain from customer a written agreement that they will be bound by FINRA rules for trading options and that they have received ODD and bound to rules of Options Clearing Corporation

Question 26

When saving money for a child’s college education, one consideration is the impact that those savings will have on the child’s eligibility for financial aid. Funds saved in which of the following vehicles has the most detrimental effect on financial aid?

A) Coverdell ESA
B) UTMA
C) Prepaid tuition plan
D) Section 529

Answer 26

B
Assets held in custodial accounts (UTMA or UGMA) are counted at 20% of their value, which compares unfavorably with the 5.64% valuation of Section 529 or Coverdell ESA assets. Please note: It is highly unlikely that you will need to know the percentages – but you will need to know that custodial accounts do not receive as beneficial treatment when applying for financial aid.

Question 27

What does this mean - WXYZ is quoted at 43.25 to .50

Answer 27

It means that the bid price the customer would receive for her shares is 42.25, and the ask price that the customer would pay for her shares is 43.50. The difference is the dealers spread.

Question 28

Compare and Contrast UGMA and UTMAs

Answer 28

Both are for 1 minor (and SS# for minor is used to set up account) with 1 custodian to manage.
No limits on amt of cash or securities given (though gift tax could be triggered to donor)
Assets are managed by custodian until age of majority for UGMA or age set by state for UTMA.
Fiduciary responsibility by custodian: no margin, no securities for collateral. Covered call writing is normally allowed.
Securities are registered in the name of the custodian for the benefit of the minor.
DIFFERENCES:
UTMAs have greater investment choices. Real estate, partnership interests allowed for UTMA not UGMA
For UTMAs in many states custodian can delay transfering assets to bene until age 21 or 25

Question 29

What is Security Market Line SML?

Answer 29

The SML is derived from the CML (Capital Market Line) (which is an off shoot of the CAPM (Capital Asset Pricing Model).
The SML allows us to evaluate specific securities for use in a diversified portfolio. It uses:
–expected return for the specific asset
–the risk free rate
–the return of the market
–the beta of the asset
The SML determines the expected return for a security on the basis of its beta and the expectations about the market and the risk-free rate. We want to determine how much over the risk free rate we should earn for taking the investment risk.

Question 30

What is a stop limit?

Answer 30

Entered as a stop order and changed to a limit order Ia specified price or better (lower for a buy and higher for a sell) if the stock hits or goes through the trigger price

Question 31

When does a customer have to receive the OCC Options Disclosure Document?
A)Within 15 days of account approval
B)At or prior to the time the account is approved for options trading
C)With the confirmation of his first options transaction
D)Within 5 business days of the first options trade

Answer 31

Before opening an account to trade options, the owner must be told about the risks involved with trading options. By providing the owner with an options disclosure document titled Understanding the Risks and Uses of Options at or prior to the time of account approval, the broker-dealer satisfies the risk disclosure requirements.

Question 32

What does it mean to distribute per stirpes?

Answer 32

When a will calls for a per stirpes distribution of assets, it provides that if any named beneficiary predeceases the testator (the maker of the will), surviving children of that individual share in the share that the individual would have received. For example, if the testator had 3 children and 1 of them died first, any children of the deceased would share in their parent’s portion (they would split one-third of the estate between them).

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Question 33

What investment constraint applies to private foundations?

Answer 33

IRS requires them to distribute 5% of it’s net investment assets each year as qualifying distributions.

Question 34

What are Money Market Instruments?

Answer 34

Short term debt (money) with maturity less than 1 year - usually less than 6 months - sold at discount rather than paying interest.
Treasury bills, Negotiable CDs (sometimes called Jumbo CDs), Commercial paper with maturities less than 1 year, Eurodollars and foreign currency markets.
CDs are the only MM instrument that pays interest (usually semi-annually).
Eurodollars are US dollars placed in banks outside the US. The deposits remain denominated in US dollars. (EuroYen are Yen placed in banks outside Japan). European banks lend Eurodollars to other banks outside US much like US banks lend federal funds to one another. Interest rate is usually based on London Interbank Offered Rate (LIBOR).

Question 35

What is modern portfolio theory?

Answer 35

A theory under the Capital Asset Pricing Model
An approach that attempts to quantify and control risk. It differs from traditional security analysis in that emphasizes determining the relationship between risk and reward in the OVERALL PORTFOLIO rather than in analyzing SPECIFIC SECURITIES.
This theory holds that specific risk can be diversified away by building portfolios whose assets are not correlated.
The goal is to build an OPTIMAL PORTFOLIO.

Question 36

What is the Sharpe ratio?

Answer 36

Risk Adjusted return. The overall return less risk free rate divided by standard deviation of the portfolio. Measures the amount of return per unit of risk. The higher the ratio, the better or more return per unit of risk.

Question 37

Which securities can and cannot be purchased on margin/used as collateral according to reg T

Answer 37

Yes: Exchange listed stocks and bonds, stocks on nasdaq, warrants of either of those.
No: options, rights, insurance contracts
Maybe: Mutual funds and new issues cannot be purchased on margin but can be used as collateral once they have been owned for 30 days

Question 38

Which accounts are only allowed to be opened as cash accounts - no margin allowed?

Answer 38

personal and corporate retirement accounts; custodial accounts like UTMAs; coverdell ESAs

Question 39

What is
A) Anchoring effect
B) Herd theory
C) Confirmation bias

Answer 39

A) The anchoring effect is when you base your decisions on initial information received and find it difficult to move away from that decision.
B) Herd theory, or “following the herd”, is when an investor jumps on the bandwagon following the lead of others.
C) This scenario is an example of the confirmation bias which states that investors tend to look for information that supports their previously-established decisions and beliefs.

Question 40

ERISA, a federal retirement law, was created to protect which of the following?

A) Employees in the private sector
B) Banks and insurance companies
C) Employees in the public sector
D) Individual retirement accounts (IRAs)

Answer 40

A
The Employees Retirement Income Security Act of 1974 (ERISA) is designed to cover employees in the private sector. In this context, private sector means corporate employees; public sector means government employees.

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Question 41

What are ineligible investments and ineligible investment practices for IRAs?

Answer 41

Ineligible investments:
Collectibles
Life Insurance contracts (like whole or term)

Ineligible Practices:
no Short sales
No margin accounts
no speculative options trading

NOTE: Covered calls are allowed

Question 42

The general rules dealing with a broker-dealer extending credit for a customer to purchase securities are found in Regulation T of the Federal Reserve Board. However, Regulation T does NOT address

A)
mixed margin accounts
B)
maintenance margin
C)
initial margin requirements
D)
loan value of securities

Answer 42

B
Maintenance margin levels are set by the SROs, such as FINRA. They are currently 25% for long accounts and 30% for short accounts (you will not have to calculate these).

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