Investment Vehicle Characteristics (Units 12-17)

Question 1

What are S&P Bond Ratings and Moody Ratings?

Answer 1

Investment grade are first 3:
S&P:
AAA
AA
A
BBB
BB
B
Moody:
Aaa
Aa
A
Baa
Ba
B

Question 2

In order to qualify as a REIT …

Answer 2

A REIT must be invested in real estate. By law, at least 75% of a REIT’s assets must consist of real estate assets such as real property or loans secured by real property. That 75% can also include cash and U.S. government securities. If it is a mortgage REIT, there is no specific requirement regarding government-insured mortgages. A REIT must distribute at least 90% of its income to investors, not 75%.

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Question 3

How are bonds priced:
Corporate and Munis?
US Govt.?
What are these corporate/muni prices:
90 1/4
101 3/4
What are these US Govt prices:
90.8 (or 90.08)
101.24

Answer 3

Quoted as a percentage of par where 100% = $1000. Each point is $10. Fractions of a point are:

• –for corporate and munis in 1/8s of $10. Each 1/8 of $10 = $1.25
• –for US Govt. in 1/32nds of $10. Each 1/32 of $10 = $0.3125

90 1/4 = $902.50
101 3/4 = $1017.50

90. 8 = $902.50
91. 24 = $1017.50

Question 4

What is assessable and non-assessable stock?

Answer 4

Assessable stock is no longer sold in new issues, but its stock issued below par for which the issuer or creditors have the right to assess shareholders for the balance of unpaid par.
Because an assessable stock may require a payment made by the recipient, the gift is considered a sale. The gift of a nonassessable stock is not a sale because it is not a contract for value.

Question 5

What are alternative investments and what are their risks?

Answer 5

Hedge Funds; ETNs; Leveraged ETFs; inverse funds; structured products. The are highly complex but can provide diversification

• most leveraged or inverse ETFs reset daily meaning they are meant to achieve their objectives on a daily basis - they are suitable only for investors with a VERY short term horizon.
• liquidity, credit risk (know the strength of the issuer), a lack of efficient pricing (market price does not reflect real value) which can lead to abnormal returns - good and bad.

Question 6

What are warrants?

Answer 6

warrants have no relationship to stock ownership and usually have a strike price that is above current market price. Also a long expiration period - as much as 10 years. Usually attached to a new bond issue (to sweeten the deal) or a new stock offering. They can be detached and traded on the same exchange as the stock is traded.

Question 7

DERP Corporation has issued 5% convertible debentures maturing in 2040. The conversion price is $40 and the common is currently trading at $48 per share. One would expect the DERP debentures to be selling somewhat

A) below $1,000.
B) above $1,200.
C) above $1,000.
D) below $1,200.

Answer 7

B
The first step here is to compute the parity price. A conversion price of $40 means the debenture is convertible into 25 shares of the common stock (par of $1,000 divided by $40 = 25 shares). With a current market price of $48 per share, the parity price of the convertible would be $1,200 (25 x $48). Because convertible securities generally sell at a slight premium over their parity price, the debentures should have a current market value a bit higher than $1,200.

Question 8

What are Brady Bonds

Answer 8

Debt that’s issued by a developing country with an emerging market that is secured with pledged collateral, usually a US Treasury 0 coupon bond. No Brady bonds carry a guarantee by the US Govt

Question 9

What is Yield to Maturity formula?

Answer 9

Takes into account gain/loss at maturity in addition to interest.
For bonds bought at premium: (annual int - (premium/years to maturity))/Average price of bond which is ((price paid plus par)/2)
For bonds bought at discount: (annual int + (discount/years to maturity))/Average price of bond which is ((price paid plus par)/2)

Question 10

Explain Duration

Answer 10

Duration is used to measure sensitivity of a debt instrument to changes in interest rates. The longer the duration the more the price movement. 2 components are int. rate and maturity. If maturities are close bonds with HIGHEST INT RATE = SHORTEST DURATION.

Question 11

Several years ago, an investor purchased an investment-grade bond with a 6% coupon. Today that bond is priced to yield 4.6% to maturity in 5 years. If the bond is called at par in one year, the bond’s yield would be
A) 4.6%.
B) less than 4.6%.
C) the coupon rate of 6% because it is called at par value.
D) more than 4.6%.

Answer 11

Let’s take things in order. A bond with a 6% coupon is showing a YTM below 6%, the bond must be selling at a premium. When bonds selling at a premium are called in advance of the maturity date, the “loss” (the difference between the premium and the par value”) is recognized sooner than expected. This results in a yield to call (YTC) that is less than the YTM.

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Question 12

Employee ISO vs. NQSO?

Answer 12

NonQual SOs can be offered to board members and even suppliers. The difference between curr mkt price and strike price, called bargain element is treated as wages, thus ordinary income versus cap gains.
With ISO, if employee purchases stock and holds at least 2 years after grant date and 1 year after purchase date, they can treat as lt cap gains. If not, it’s treated like NSO for tax purposes. There is also a max 10 year limit for exercise of option. And the bargain element is a AMT item.

Question 13

What is a bonus annuity? And what is it’s disadvantage?

Answer 13

Index annuities and variable annuities sometimes offer a bonus on top the original investment. For example, if investing $60K with a 5% means they will begin with a $63K balance.
One of the characteristics of bonus annuities is that their surrender charges tend to be higher for a longer time than other insurance company products.

Question 14

Mr. Beale buys 10M RAN 6.6s of 32 at 67. What is his total purchase price?
A) $10,200
B) $10,000
C) $6,600
D) $6,700

Answer 14

D
For those of you not familiar with bond listings, this means that Beale bought $10,000 (10M) of the RAN Corporation bonds with a 6.6% coupon (interest rate stated on the face of the bond) that mature in 2032 (32). The price is 67, which represents 67% of $10,000, or $6,700.

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Question 15

What is whole life and universal life?

Answer 15

Whole Life Ins (WLI) provides protection for the whole of life. Begins the date of issue through date of death provided premiums are paid. The benefit is the face value or face amount and is constant throughout the policy’s life. There is a savings element which is represented by the “cash value.”
Universal Life is similar to Whole Life in that is has the same two elements (cash value and death protection). However, instead of being fixed and guaranteed amounts, the death protection resembles 1 year renewable term insurance and the cash value grows according to current interest rates. There is a minimum contract interest rate. And current annual rate which may be higher.

Question 16

A pooled investment fund buys all the shares of a publicly-traded company. The fund takes the company private, reorganizes the company, and replaces its management team. Three years later, the fund exits the investment through an initial public offering of the company’s shares. This pooled investment fund is best described as

A) a private equity fund.
B) a leveraged ETF.
C) a venture capital fund.
D) a hedge fund.

Answer 16

A
A private equity fund or buyout fund is one that acquires entire public companies, takes them private, and reorganizes the companies to increase their value. A hedge fund will rarely get involved with reorganizing an existing company. Venture capital funds invest in start-up companies. Leveraged ETFs do not take part in the management of their investments.

Question 17

A client has been contributing to a periodic payment annuity for 20 years. The M&E charge is 1.25% per year. What happens to that charge when the client annuitizes at attained age 68?
A) It increases because the client’s mortality risk is higher at the older age
B) It ceases
C) It continues
D) It continues but at a reduced rate

Answer 17

B
The M&E charge is for mortality and expenses. Once an annuity contract, fixed or variable, is annuitized, that charge no longer applies to the account. There may be an internally computed charge, but unlike the accumulation period, the charge is not broken out separately.

Question 18

What are viatical settlement and life settlement?

Answer 18

viatical - less than 24 mo life expectancy, no age restrictions. Life settlement is more than 2 years life expectancy and over 65.
Buyer pays a lump sum plus any premiums as long as the insured lives.

Question 19

Under the Investment Company Act of 1940, SEC Rule 12b-1 allows a fund to charge distribution and sales expenses to net assets as a percentage of the total assets. Normally, the cost of distribution of the shares is paid by the underwriter out of the sales load paid by the individual purchaser. For a fund to impose 12b-1 charges, which of the following conditions apply (applies)?

The board of directors has sole approval authority.
The majority of the outstanding shares has sole approval authority.
Both the board and the majority of outstanding shares must approve it.
A distribution plan must be written.

A) I only
B) I and III
C) III and IV
D) II and III

Answer 19

C
For the fund to impose 12b-1 charges, the distribution plan must be in writing and approved by a majority of the outstanding shares, as well as a majority of the board of directors, including a majority of directors classified as outside directors.

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Question 20

CLM - READ ANSWER:
A manufacturer of soybean oil is concerned that the price of soybeans will increase over the next 6 months. The best strategy to employ would probably be
A) a long hedge.
B) a trimmed hedge.
C) a neutral hedge.
D) a short hedge.

Answer 20

The concern is that the price will go up. Just as with options, when we are concerned that the price of something will go up, we go long that item. With options, it would be a long call; with futures it is simply hedging by going long (buying) the soybean futures. The soybean farmer who would be concerned about a decline in the price would go short soybean futures.

Question 21

What is Rule 144?

Answer 21

SEC rule requiring persons who hold control securities or restricted securities may sell them only in limited quantities.
Control stock is held by a control person.
A control person is director, officer, large stockholder or any immediate family members of the above, generally referred to as affiliates.
Purchases and sales of control stock must be reported to SEC. Form 144
For testing purposes assume that ownership of 10% or more of voting stock is considered control.

Question 22

What are prohibited activities for investment companies under the investment act of 1940

Answer 22

1. purchase on margin
2. sell short
3. no joint accounts with anyone else
4. acquire more than 3% of outstanding voting shares of another investment company

Question 23

Which of the following statements regarding ADRs are TRUE?
The securities are vehicles used to facilitate U.S. trading of foreign securities.
Dividends are received in the foreign currency.
Holders have foreign currency risk.
The receipts are issued by a foreign branch of a domestic bank.
A) I, II and III
B) II and IV
C) I and III
D) I, III and IV

Answer 23

D
ADRs are vehicles that facilitate U.S. trading of foreign securities. They are issued in English in the United States by domestic banks. Dividends are declared in the foreign currency but are payable to holders in U.S. dollars, which means that ADR holders are subject to foreign currency risk.
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Question 24

What is current yield calc?

Answer 24

Annual int. or dividends/current market price

Question 25

What is basis?

Answer 25

Yield to Maturity

Question 26

What is a preemptive right?

Answer 26

The preemptive right to maintain their proportionate share of stock in the company, Not usually available to preferred stock. Usually just available to common stock.
When additional shares of a company are going to be issued, current stock owners are given the right to come ahead or preempt new purchasers/general public. They are given to current stock holders at a price below current market, with a short life span like 45-60 days, they can be sold or left to expire.

Question 27

What are TIPS and STRIPS

Answer 27

TIPS are Treasury Inflation Protection Securities. Helps protect investors purchasing power risk. Principal amount is adjusted semi-annually by an amount equal to the change in CPE.
STRIPS have no interest. they are 0 coupon treasuries

Question 28

1 option contract = ___ shares

And, what is an options sales price called?

Answer 28

100 shares

premium

Question 29

When contrasting preemptive rights and warrants, it would be correct to state that, at issuance,

A) rights have time value while warrants have intrinsic and time value.
B) rights have intrinsic and time value while warrants only have intrinsic value.
C) rights have intrinsic value while warrants have intrinsic and time value.
D) rights have intrinsic and time value while warrants only have time value.

Answer 29

D
At the time of issuance, preemptive rights always offer the stock at a price below the current market thus creating intrinsic value. Although rights rarely are effective for longer than 45-60 days, that does represent time value. On the other hand, warrants are always issued with an exercise price above the current market (no intrinsic value) but do have time value.

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Question 30

What are these types of risk?
A) reinvestment risk.
B) default risk.
C) interest rate risk.
D) purchasing power risk.

Answer 30

A) there is reinvestment risk as to interest and as to principal. An investor may not be able to reinvest the income earned at the same rate the security itself is paying. Thus she would not be compounding at the same rate. 0 coupon bonds avoid this risk because there is nothing to reinvest along the way. There is risk also at maturity. If the investor was earning 10% but then at maturity rates are only 7%, she can only reinvest at the lower rate at maturity.
B) AKA Credit risk. The risk that the debtor may be unable to make the interest payments or re-pay the principal.
C) If interest rates go up the market price of all bonds will go down. The longer the term to maturity, the greater the price fluctuation when interest rates change.
D) Inflation reduces the buying power of a dollar. This is a systematic risk, meaning that diversifying your portfolio is of little help.

Question 31

Which of the following is not a type of life insurance policy?

A)
Universal life policy
B)
Term to 65 policy
C)
Endowment policy
D)
Variable annuity policy

Answer 31

D
Although a variable annuity may have a death benefit provision, it is not considered a life insurance policy. One key to that is, among other things, there is no health questionnaire when purchasing an annuity. Perhaps you have never heard of an endowment policy (it is not mentioned in the LEM). This type of situation may come up on the actual exam where one of the choices is something unfamiliar to you. Don’t let that cause you to lose your focus. Annuities are issued by life insurance companies, but they are not life insurance policies, so select the correct answer and move on.

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Question 32

In a scheduled premium variable life insurance policy, which of the following are guaranteed?

A)
A minimum cash value
B)
The ability to borrow a maximum of 75% of the cash value once the policy has been in force at least 3 years
C)
A minimum death benefit
D)
The right to exchange the policy for a permanent form of insurance with comparable benefits within the first 24 months of issue, as long as the insured passes a new physical examination

Answer 32

C
In a variable life insurance policy, a minimum death benefit is guaranteed, but no cash value is guaranteed. There is a contract exchange privilege during the first 24 months allowing the conversion of the variable policy to a comparable form of permanent insurance, but no physical is required. The 75% cash value loan is a minimum, not a maximum, and applies after the 3rd year of coverage.

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Question 33

One way in which universal life and variable life are similar is that both

A)
are considered securities
B)
have flexible premiums
C)
permit loans against the cash value
D)
have a fixed minimum cash value

Answer 33

C
As long as the policy has cash value, loans are permitted. Neither of these has a fixed minimum cash value, and only universal life has flexible premiums. Only variable life is considered a security.

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Question 34

Are variable annuities life insurance policies?

Answer 34

No. Variable annuities are not life insurance policies, even though they are issued by life insurance companies.

Question 35

Which of the following statements concerning universal life insurance are CORRECT?

Universal life has flexible premiums.
Universal life is based on the assumption that level annual premiums are to be paid throughout the insured's life.
The death benefit can fluctuate, but never below the guaranteed minimum face amount.
Cash values can fluctuate and may even fall to zero.
A)
I and IV
B)
III and IV
C)
II and III
D)
I and II

Answer 35

A
Universal life features flexible premiums that add to the cash value account, although there are no guarantees and the cash value can disappear if insufficient premiums are paid. There is no guaranteed minimum death benefit as there is with fixed (scheduled) premium variable life. The assumption that level annual premiums are to be paid throughout the insured’s life is associated only with ordinary whole life and scheduled premium variable life policies.

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Question 36

What are the key regulations for Investment Companies according to the investment company act with regard to :
the board of directors and 
Prohibited Activities,
Changes in investment policy, 
size of companies?

Answer 36

BOD must be 40% uninterested parties (no positions in the fund.
Prohibited activities:
–no purchase securities on margin
–no joint accounts
–no selling securities short
–no more than 3%voting shares in another investment co.
Changes in investment policy:
–any changes require majority vote of outstanding shares
Size:
–no offering may be made unless net worth of at least $100,000