Dec 1st

Question 1

Exempt reporting advisers (ERAs)

Answer 1

Exempt reporting advisers (ERAs) are advisers that are exempt from registration relying on either the venture capital fund adviser or private fund adviser ex¬emption. Although exempt from registration, an ERA is subject to certain reporting, recordkeeping, and other obligations.

Question 2

2 principals

Answer 2

There are 2 principals in every securities trade: the buyer and the seller. In this case, buying shares directly from clients who own those shares places the IA in the position of being one of the principals. This is an action that must be disclosed in writing to the client no later than completion of the transaction. In agency cross transaction, the firm is acting as an agent—that’s the reason for the term.

Question 3

FEES

Answer 3

Breakpoints for quantity purchases are available on shares that carry a front-end load. Those are Class A shares. Class B shares have a back-end load, Class C shares are considered level load, and when one purchases shares of a closed-end company, commissions are charged as would be on any stock purchase.

Question 4

Current yield

Answer 4

Current yield for any security is always computed on the basis of the current market value.
Current yield is determined by dividing annual interest payment by the current market price of the bond ($50 ÷ $900 = 5.56%). Years to maturity is not a factor in calculating current yield.

Question 5

Yield to Call (YTC)

Answer 5

The YTC computation involves knowing the amount of interest payments to be received, the length of time to the call, the current price and the call price. A bond with an 8% coupon will make $40 semi-annual interest payments.

Question 6

Tax-equivalent yield

Answer 6

Corporations receive the same tax break on municipal bonds as do individuals. Therefore, receiving a 5% return in the 39% tax bracket is equivalent to 8.20% before tax. A 4% bond to someone in the 35% bracket is equivalent to 6.15%; a 5.5% coupon to someone in the 28% bracket is equivalent to 7.64%; and a 6% bond to someone in a 25% bracket is equivalent to 8.0%.

Question 7

Beta

Answer 7

Beta is a measure of a stock’s volatility relative to the overall market, as measured by the S&P 500. A stock with a beta of 2.0 will move twice as fast as the overall market, while a stock with a beta of 0.5 will move half as fast as the overall market.
Beta is a measure of a portfolio’s volatility compared to the volatility of the overall market. Since systematic risk is risk associated with investing in the market, lowering the client’s volatility (beta) relative to that of the market should lower his exposure to market risk. Credit rating is used to measure default risk on debt securities, and earnings history would assist you in the measurement of business risk (unsystematic risk).
Beta tracks a stocks co-movement with the overall market. Because the “market” has a beta of 1.0, any stock with a lower beta will generally not have price movement equal to the market. Beta is a measurement of systematic risk, and low beta stocks have less than high beta ones. Beta has no relationship to unsystematic risk.

Question 8

Recommendations

Answer 8

If an adviser provides its clients with reports or recommendations prepared by a third party without disclosure of source, the adviser has acted unethically. There is, however, an exception to this rule which happens to apply here. If the adviser uses third-party reports as a basis for its own recommendation or as a support to its own recommendation to its client, it does not have to disclose this information.

Question 9

Zero-coupon

Answer 9

The only security that does not have reinvestment risk (the risk that periodic interest payments cannot be reinvested at the same yield as the bond providing the interest payments) is a zero-coupon bond such as Treasury STRIPS. With a zero-coupon bond, there are no periodic interest payments to reinvest, so a yield can be locked in. The interest rate that discounts the redemption price (par) to the discounted purchase price is the locked-in yield, which is the same as the internal rate of return, also referred to as the yield to maturity.

Question 10

Uniform Prudent Investor Act (UPIA)

Answer 10

Under the Uniform Prudent Investor Act, transaction costs are not a primary factor in a trustee’s determination of which investments to choose for the trust. They may be a factor in determining where to execute the transactions. The key for the prudent investor is to use skill and caution examining all of the factors involved to meet the stated objectives.

Question 11

Federal Reserve Board

Answer 11

The FRB attempts to slow down the economy and decrease the money supply with a corresponding increase in interest rates. When interest rates rise, the prime rate increases, bond yields rise, and bond prices drop. Higher interest rates have a tendency to slow down corporate growth, with a resulting slowdown in earnings; these events occur in this approximate sequence.

Question 12

An analytical tool used to predict the future price of a common stock using projected dividends is the:

Answer 12

There are two widely accepted forms of common stock price projection using dividends – the dividend discount model and the dividend growth model.

Question 13

Simple trust

Answer 13

A simple trust is one that is required to distribute all accounting income in the year earned, has no charitable beneficiaries, and does not distribute principal in the current year. A complex trust is one that is allowed to accumulate income, has a charitable beneficiary, or distributes principal. All trusts are complex in their final year because

Question 14

Dividend Growth Model

Answer 14

The classic definition of the Dividend Growth Model is “a stock valuation model that deals with dividends and their growth, discounted to today”. The market capitalization is the number of outstanding shares multiplied by the current market price per share and has nothing to do with the company’s dividend policies.

Question 15

Write a Call

Answer 15

A covered call option is one where the writer (seller) owns the stock on which the call is sold. There are two reasons to write covered calls. The primary one is that the sale generates income in the form of the premium received from the buyer. A secondary reason is that, at least to the extent of the premium received, there is some downside protection for the long stock. If the stock price rises as a result of company growth, the option will be exercised and the stock will be called away; this is something the writer generally does not want.

Question 16

A bond purchased at $900 with a 5% coupon and a 5-year maturity has a current yield of:

Answer 16

Current yield is determined by dividing annual interest payment by the current market price of the bond ($50 ÷ $900 = 5.56%). Years to maturity is not a factor in calculating current yield.

Question 17

Real rate of return

Answer 17

The real rate of return is another term for inflation-adjusted return. It is the total return, which is appreciation plus income adjusted for the inflation rate as expressed by the CPI. Tax bracket is necessary to compute after-tax return.

Question 18

Open-end or closed-end companies

Answer 18

All open-end investment companies sell at NAV plus sales charge (if any). Therefore, the asking price can never be less than the NAV. Closed-end company asking prices are determined by supply and demand, so their prices are independent of the fund’s NAV.

Question 19

Exempt from federal income tax

Answer 19

Municipal bonds are exempt from federal income tax. Treasury bonds are exempt from state tax but not federal tax. GNMAs are subject to federal, state, and local income tax.

Question 20

Sell stop order

Answer 20

This is really two orders. The first is to “stop” at 60. That is, once the stock trades at 60 or lower, enter my order. That second order is a sell, but with a limit of 60. So, the first time the stock hits 60 (or less), is the trade at 60. That triggers the sell limit. The next trade is a 59.95. Since the limit order is saying, “Get me 60 or higher, the 59.95 is not an acceptable price.” But, the next trade, 60.06 will meet the client’s goal of receiving no less than 60.

Question 21

Alpha

Answer 21

Alpha is the difference in the expected return of the portfolio, given the portfolio’s beta and the actual return the portfolio achieved. The higher the alpha, the better the portfolio has done in achieving excess or abnormal returns. The risk of the portfolio associated with the macroeconomic factors that affect all risky assets is systematic risk. The portfolio’s average return in excess of the risk-free rate divided by the standard deviation in returns of the portfolio is the Sharpe ratio or measure. The measure of the variance in returns of a portfolio around its average return is the standard deviation.

Question 22

An IAR is comparing an investment in two securities by computing the net present value of each. The available funds for investment are $20,000, and the present value of choice A is $21,223, while that of choice B is $18,946. Based on this information, it would be correct to state that

Answer 22

Anytime the present value is higher than the cost of the investment, the NPV is positive and you will have made a profitable investment. Therefore, purchasing choice A would result in an increase to the investor’s present wealth because buying something for $20,000 that has a present value of $21,223 gives the investor that added value.

Question 23

Current yield

Answer 23

Current yield is determined by dividing the annual dividend of $4 ($1 per quarter × 4 = $4) by the current stock price of $60 ($4 ÷ $60 = 6.7%).

Question 24

Statement of cash flows

Answer 24

The total of the cash from operations, investing, and financing, as reported on the statement of cash flows, is the net change in the cash position of the firm for the reporting period. The sum total, or the net change in cash, is not reported on either the balance sheet or the income statement. It is the sum total of the entries on the statement of cash flows which is a separate financial statement.

Question 25

Gross margin or Pre-tax margin

Cost of goods sold - Net revenues is a %

Answer 25

The gross margin, or margin of profit, is usually expressed as a percentage. It is the operating profit remaining after subtracting the cost of goods sold from the revenues (sales), divided by those revenues. In this question, the cost of goods sold is $14 million, and that number includes the depreciation. Subtracting $14 million from $20 million results in an operating profit of $6 million, which is 30% of the $20 million in revenues. You might also see this referred to as pre-tax margin. Please note that, as with so many questions on the exam, there are extra numbers that have no relevance to the question.

Question 26

Leverage

Answer 26

The debt to equity ratio is computed by dividing the issuer’s long-term debt by their total capitalization. The higher the ratio, the more leverage being used by the company. LONG TERM DEBT / TOTAL CAPITALIZATION

Question 27

What is the total return on a 1-year, newly issued (365 days to maturity) zero-coupon bond priced at 950?

Answer 27

To determine the total return on this zero-coupon bond, the $50 capital appreciation is divided by the cost of the bond (in this case, $50 divided by $950 equals a total return of 5.26%). Total return of a zero-coupon bond is made up entirely of the difference between the cost of the bond and the sale or maturity price of the bond.

Question 28

Federal funds rate

Answer 28

Rate charged on reserves traded among commercial banks for overnight use in amounts of $1 million or more.

Question 29

A commodities speculator purchases a 1,000 bushel wheat futures contract at 50 cents per bushel. At expiration, the settlement price is 45 cents per bushel. This individual

Answer 29

The simple math is as follows: the individual bought at 50 cents and sold at 45 cents, losing 5 cents per bushel. Multiply 5 cents ($.05) by 1,000 bushels and the loss is $50. It is the seller who is obligated to deliver; the buyer of the contract must accept delivery (unless there was an offsetting transaction prior to expiration). This individual was long the futures contact, not long (the owner of) the wheat.

Question 30

NPV

Answer 30

Any time an investment’s IRR is more than the required rate of return, the NPV is positive (and should probably be selected). The NPV is expressed as a dollar amount. It is the IRR which is expressed as a percentage.

Question 31

A client owns an investment grade bond that has a coupon of 7% and is priced to yield 5.4%. If similarly rated bonds are being issued today with coupons of 5%, it would be expected that the client’s bond

Answer 31

Answer: has a positive net present value. With a discount rate of 5% (the discount rate in a present value computation is the current market interest rate), a debt instrument with a 7% coupon rate will be selling at a premium (interest rates down, prices up). We are told that this bond is offering a yield of 5.4%, which is more than the current market rate. Because a present value computation using a 5.4% rate would reflect a lower value than a 5% rate (the higher the discount rate, the lower the value), the bond can be purchased at a price below its present value. Any time that occurs, the instrument has a positive net present value (the difference between the price and the present value).

Question 32

Closed-end investment company

Answer 32

Closed-end investment company shares are priced based on supply and demand. The ask is the price that investors will pay for purchasing shares and the bid is what investors receive when selling. Investors will also pay a commission as this is what the broker charges for executing the transaction. Shares of open-end investment companies are bought and redeemed based on NAV, but that is not so of closed-end companies.

Question 33

Index annuity

Answer 33

Although the participation rate is a component of the computation, it is not a method of computing the interest credit. In the annual reset index method, interest, if any, is determined each year by comparing the index value at the end of the contract year with the index value at the start of the contract year. Interest is added to the annuity each year during the term. Using the high-water mark the index-linked interest, if any, is decided by looking at the index value at various points during the term, usually the annual anniversaries of the date the annuity was purchased. The interest is based on the difference between the highest index value and the index value at the start of the term. Interest is added to the annuity at the end of the term. And finally, with the point-to-point method, the index-linked interest, if any, is based on the difference between the index value at the end of the term and the index value at the start of the term. Interest is added to the annuity at the end of the term. In each of these, the insurance company will specify the participation rate (what percentage of the increase will be credited) and a cap rate (the maximum amount to be credited).

Question 34

Conversion ratio

par value/conversion price

Answer 34

The conversion ratio is determined by dividing the par value of the bond, or $1,000, by its conversion price of $83.33 per common share. This results in a conversion ratio of 12 shares for each bond.

Question 35

S corporations

Answer 35

S corporations must not have more than 100 stockholders and each stockholder must be a citizen or resident of the United States. The corporation can only have one class of stock, and no more than 25% of the corporation’s income can come from passive activities. If you were not sure of this last fact, a useful test-taking technique is recognizing that all of the other choices are correct and there is no way to select them without this one.

Question 36

Duration

Answer 36

Duration measures a bond’s volatility with respect to a change in interest rates. The higher the duration, the greater the change in a bond’s price with respect to interest rate changes.

Question 37

Consumer Price Index (CPI)

Answer 37

The CPI does not measure the increase or decrease in the level of consumer prices with respect to the level of wholesales prices. The CPI only measures retail prices; not whether wholesale prices are passed through to the consumer.
The CPI measures the increase or decrease in the level of consumer prices with respect to the level of wholesale prices on which consumer prices depend.

The CPI measures the rate of increase or decrease in a broad range of prices, such as food, housing, medical care, and clothing.
D)
The CPI is computed monthly.

Question 38

Combined equity

Answer 38

There are two ways to compute the combined equity in a mixed (long and short) margin account. One is to add the “positives” and subtract the “negatives”. In this case, we are long (that is a “plus” for us) $21,000, and we have a credit balance (also a “plus” for us) of $22,000. That is a total of $43,000. Then, we owe (the debit balance) $8,000 against the long stock, and it will take us $18,000 to buy back the short stock. That is a total of $26,000. Subtracting that from the $43,000 gives us a +$17,000. The other way is to take each account separately. In the long account, what we own ($21,000), minus what we owe ($8,000), equals $13,000 of long equity. In the short account, what we “own” is the $22,000 credit balance, and what we owe is the $18,000 market value of the short. That comes out to $4,000. Now, add those two together, and you get the same $17,000.

Question 39

A bond is maturing in exactly 1 year. With a discount rate of 10%, which of the following purchase prices will result in an NPV of zero?

Answer 39

If the net present value of an investment is zero, then the price and the present value are the same. Using the PV formula, at a 10% discount rate, the PV of this bond would be $909.09. Because you are not given the proper calculator at the exam center, you have to “back into” the answer. When the price plus 10% interest over the year equals $1,000, the NPV is zero. So, simply take each of the 4 choices and multiply it by 110%. The correct choice comes out to $999.99. The closest wrong answer ($910) comes out to $1,001—this is close, but not as close as the correct choice.

Question 40

Section 13(d)

Answer 40

Section 13(d) of the Securities Exchange Act of 1934 requires filing of a Schedule 13D within 10 business days of the transaction once a person becomes an owner of more than 5% of the outstanding voting shares of a reporting company. Section 16 of the Act requires filing within 2 business days of any transaction by a control person, which is not the case here.

Question 41

Capital Asset Pricing Model. Analysts using CAPM

Answer 41

Under the CAPM, using the SML, we can determine the expected return of any given stock by taking the risk-free rate and adding to that the product of that stock’s beta coefficient and the difference between the expected return on the market and the risk-free rate. Standard deviation is not a factor in this computation.

Question 42

Monte Carlo

Answer 42

Monte Carlo analysis uses simulations to predict the probability of portfolio performance in light of multiple and uncertain variable conditions.

Question 43

Technical analysis

Answer 43

Technical analysis focuses on price patterns.

Question 44

Fundamental analysis

Answer 44

Fundamental analysis focuses on economic, industry, and business conditions.

Question 45

The efficient market hypothesis

Answer 45

The efficient market hypothesis argues that analysis itself has little, if any, value.

Question 46

Internal rate of return

Answer 46

The internal rate of return compounds returns and takes into consideration the time value of money.

Question 47

Real rate of return

Answer 47

Real rate of return considers the inflation rate and risk-adjusted return is another way of stating the Sharpe Ratio.

Question 48

The antifraud provisions of the Investment Advisers Act of 1940

Answer 48

The antifraud provisions of the Investment Advisers Act of 1940 apply to all conduct that concerns the integrity of the client relationship from an advisory standpoint. As far as actual securities transactions, those are covered under the antifraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934. The Advisers Act differed in that the activity did not have to be directly related to actual conduct in the offer or sale of securities, but extended to any deceitful conduct in the rendering of investment advice, the results of which constitute a fraud upon the client.

Question 49

Net Present Value (NPV)

Answer 49

NPV compares the value of a dollar today to the value of that same dollar in the future, taking inflation and returns into account. If the NPV of a proposed investment is positive, it should be accepted. However, if NPV is negative, the investment should probably be rejected because cash flows will also be negative.

Question 50

Covered Securities

Answer 50

Any security equal or senior to one listed on the NYSE is a covered security. Municipal bonds are a covered security except in their state of issuance. OTC Link and OTC Bulletin Board securities are not considered federal covered securities.

Question 51

A client’s mixed margin account has the following positions:

Long, 100 XYZ with a current market value of $5,000
Long, 300 ABC with a current market value of $16,000
Short, 200 DEF with a current market value of $10,000
Short, 100 GHI with a current market value of $8,000

The account has a debit balance of $8,000 and a credit balance of $22,000. What is the combined equity in the account?

Answer 51

There are two ways to compute the combined equity in a mixed (long and short) margin account. One is to add the “positives” and subtract the “negatives”. In this case, we are long (that is a “plus” for us) $21,000, and we have a credit balance (also a “plus” for us) of $22,000. That is a total of $43,000. Then, we owe (the debit balance) $8,000 against the long stock, and it will take us $18,000 to buy back the short stock. That is a total of $26,000. Subtracting that from the $43,000 gives us a +$17,000. The other way is to take each account separately. In the long account, what we own ($21,000), minus what we owe ($8,000), equals $13,000 of long equity. In the short account, what we “own” is the $22,000 credit balance, and what we owe is the $18,000 market value of the short. That comes out to $4,000. Now, add those two together, and you get the same $17,000.

Question 52

If you knew a given stock had a 40% chance of earning a 10% return, a 40% chance of earning 20%, and a 20% chance of earning -10%, the stock would have a(n):

Answer 52

The expected return is computed by taking the probability of each possible return outcome and multiplying it by the return outcome itself. In this example, if you knew a given stock had a 40% chance of earning a 10% return, a 40% chance of earning 20%, and a 20% chance of earning -10%, the expected return would be equal to 10%:
= (0.4 × 0.1) + (0.4 × 0.2) + (0.2 × -0.1),
= .04 + .08 = .12 − .02,
= 0.10,
= 10%.
You probably will not have to do this calculation on the exam, but you should know the concept.

Question 53

In May, an investor purchased a futures contract to purchase 5,000 bushels of wheat at $4.30 per bushel for December delivery. On settlement date, the spot price of wheat is $4.20 per bushel. For the investor, this

Answer 53

Unlike options, both parties to a futures contract are obligated to perform. That is, the buyer must accept delivery of the contract (in this case, 5,000 bushels of wheat). In practical matters, instead of having a truck show up at the door, the wheat would be sold at its spot price to a user. Therefore, the investor would lose 10 cents per bushel which, on 5,000 bushels, is $500. It was the seller of the contract who had a successful hedge because, instead of having to sell at the $4.20 spot price, the wheat is sold at the strike price of $4.30.

Question 54

Eurodollars

Answer 54

American dollars held in international banks, especially, but not exclusively, in Europe, are known as eurodollars.

Question 55

Multi-security portfolio returns

Answer 55

The expected return of a multi-security portfolio is computed by taking the probability of returns for each security. The computation then becomes: (25% of 12%) + (75% of 16%) or 3% + 12% = 15%.