Part 2 Flashcards

Question 1

Q

pass through certificate is best described as a:

corporation or trust through which investors pool their money in order to obtain diversification and professional management
security which is backed by the full faith, credit, and taxing power of the U.S. Government
security which is backed by real property and/or a lien on real estate
security which gives the holder an undivided interest in a pool of mortgages

Answer

A

A pass through certificate is a security which gives the holder an undivided interest in a pool of mortgages. The mortgage payments are “passed through” to the certificate holders.

Question 2

Q

Collateralized mortgage obligations may be backed by all of the following securities EXCEPT:

Real Estate Investment Trusts
Freddie Mac Pass Through Certificates
FNMA Pass Through Certificates
GMA Pass Through Certificates

Answer

A

CMO tranches are generally AAA rated (or have an implied AAA rating because the tranches are backed by GNMA, FNMA or Freddie Mac pass-through certificates). REITs are common stock companies that make direct investments in real estate.

Question 3

Q

Collateralized mortgage obligation issues have:

term structures
serial structures
series structures
combined serial and series structures

Answer

A

A CMO divides the cash flow from a pool of underlying mortgages into a number of tranches, each with a different maturity. All of the tranches are issued on the same date; but the maturities extend over a sequence of years. This is a serial structure.

Question 4

Q

Wide swings in market interest rates would affect which of the following for holders of collateralized mortgage obligations?

I Prepayment Rate
II Interest Rate
III Market Value
IV Credit Rating

l and lll
ll and IV
I, II, and III
I, II, III, and IV

Answer

A

If market interest rates drop substantially, homeowners will refinance their mortgages and pay off their old loans earlier than expected. Thus, the prepayment rate for CMO holders will increase. Furthermore, as interest rates drop, the value of the fixed income stream received from those mortgages increases, so the market value of the security will increase. Market interest rate movements have no effect on the stated interest rate paid by the security; and would not affect the credit rating of the issue.

Question 5

Q

“PSA’ stands for:

Prepayment Speed Assumption
Planned Securitization Algorithm
Predicted Standardized Amortization
Privatized Syndicated Asset

Answer

A

Mortgage backed pass-through certificates are “paid off’ in a shorter time frame than the full life of the underlying mortgages. For example, 30 year mortgages are now typically paid off in 10 ears - because people move. This “prepayment speed assumption” is used to “guesstimate” the expected life of a mortgage backed pass-through certificate. Note, however, that the “PSA* can change over time. If interest rates fall rapidly after the mortgage is issued, prepayment rates speed up; if they rise rapidly after issuance, prepayment rates fall.

Question 6

Q

CMO “Planned Amortization Classes” (PAC tranches):

reduce prepayment risk to holders of that tranche
increase prepayment risk to holders of that tranche
eliminate prepayment risk to holders of that tranche
have the same prepayment risk as companion classes

Answer

A

A newer version of a CMO has a more sophisticated scheme for allocating cash flows. Newer CMOs divide the tranches into PAC tranches and Companion tranches. The PAC tranche is a “Planned Amortization Class.” Surrounding this tranche are 1 or 2 Companion tranches. Interest payments are still made pro-rata to all tranches, but principal repayments made earlier than that required to retire the PAC at its maturity are applied to the Companion class; while principal repayments made later than expected are applied to the PAC maturity before payments are made to the Companion class. Thus, the PAC class is given a more certain maturity date; while the Companion class has a higher level of prepayment risk if interest rates fall, and a higher level of so-called “extension risk” - the risk that the maturity may be longer than expected, if interest rates rise.

Question 7

Q

Which CMO tranche will be offered at the highest yield?

Plain vanilla
Targeted amortization class
Planned amortization class
Companion

Answer

A

Companion tranches are the “shock absorber” tranches, that absorb prepayment risk out of a TAC (Targeted Amortization Class) tranche; or both prepayment risk and extension risk out of a PAC (Planned Amortization Class) tranche. Because the companion absorbs both of these risks, it has the greatest risk and trades at the highest yield. Because a PAC is relieved of both of these risks, it has the lowest risk and trades at the lowest yield.

Question 8

Q

The largest participants in the trading of U.S. Government debt include:

I Domestic money center banks
II Foreign money center banks
III Domestic Broker-Dealers
IV Foreign Broker-Dealers

I and II only
III and IV only
I and III only
I, II, III, IV

Answer

A

Trading of government and agency securities takes place in the over-the-counter market. The participants include large commercial banks, foreign banks, U.S. Government securities dealers, full service broker firms, and the Federal Reserve.

Question 9

Q

Which of the following statements are TRUE regarding GMA “Pass Through” Certificates?

I The certificates are quoted on a percentage of par basis
II The certificates are quoted on a yield basis
III Accrued interest on the certificates is computed on an actual day month / actual day year basis
IV Accrued interest on the certificates is computed on a 30 day month / 360 day year basis

l and III
I and IV
II and III
II and IV

Answer

A

GNMA certificates are quoted on a percentage of par basis in 32nds. Accrued interest on “agency” securities is computed on a 30 day month / 360 day year basis. (Do not confuse this with the accrued interest on U.S. Government obligations, which is computed on an actual day month / actual day year basis).

Question 10

Q

Which of the following trades settle in “clearing house” funds?

I General Obligation Bonds
II U.S. Government Bonds
III Agency Bonds
IV GMA Pass-Through Certificates

I only
l and II
ll and IV
III and IV

Answer

A

Corporate and municipal bond trades settle in clearing house funds. These are funds payable at a registered clearing house, which are usually not good funds for three business days. These trades are settled through NSCC - the National Securities Clearing Corporation.
U.S. Government and agency bond trades settle in Federal Funds, which are good funds the business day of the funds transfer (next business day for regular way settlement of government securities). Ginnie Mae Pass-Through certificates are U.S. Government guaranteed, so trades settle in Fed Funds. These trades are settled through GSCC - the Government Securities Clearing Corporation.

Question 11

Q

Mhich of the following trade “flat” ?

I Treasury Bills
II Treasury STRIPS
III Treasury Bonds
IV Treasury Receipts

I and Il only
III and IV only
I, II, IV
I, II, III, IV

Answer

A

Treasury Bills are short term original issue discount obligations, with the discount earned being the “interest.” Treasury Receipts and Treasury STRIPS are essentially zero-coupon obligations. Because all of these obligations do not make periodic interest payments, they trade “flat” - that is, without accrued interest. Treasury Bonds pay interest semi-annually, so they trade with accrued interest.

Question 12

Q

A 5 year 3 1/2% Treasury Note is quoted at 101-4 - 101-8. The note pays interest on Jan 1st and Jul 1st. All of the following statements are true regarding this trade of T-Notes EXCEPT:

interest accrues on an actual day month; actual day year basis
the yield to maturity will be higher than the current yield
•the trade will settle in Fed Funds
the trade will settle next business day if performed “regular way”

Answer

A

Because these T-Notes are trading at a premium, the yield to maturity will be lower than the current yield. The current yield does not factor in the loss of the premium over the life of the bond, whereas yield to maturity does. Government bond trades settle next business day; accrued interest is computed on an actual month/actual year basis, and trades settle through the Federal Reserve system in “Fed Funds.”

Question 13

Q

U.S. Treasury securities are generally considered to be immune to all of the following risks EXCEPT:

default risk
marketability risk
purchasing power risk
credit risk

Answer

A

Securities issued by the U.S. Government represent the largest securities market in the world. Therefore, very little marketability risk exists. Default risk and credit risk are the same - U.S.
Government securities are considered to have virtually no default risk. (The government can always tax its citizens to pay the debt or can print the money to do it). All debt obligations are susceptible to purchasing power risk - the risk that inflation raises interest rates, devaluing existing obligations.

Question 14

Q

A customer buys 5M of 4 ½% Treasury Bonds at 101-16. The current yield of the Treasury Bond is:

4.43%
4.50%
4.63%
4.70%

Answer

A

The customer buys the bonds at 101 and 16/32s = 101 ½2% of $1,000 = $1,015 (the fact that $5,000 face amount of bonds were purchased is irrelevant, since the formula is a percentage). The formula for current yield is:

Annual Income / Market Price = Current Yield

$45 (per $1,000 face amount) / $1,015 (per $1,000 face amount) = 4.43%

Question 15

Q

A wealthy retired investor is interested in buying Agency mortgage backed securities collateralized by 30-year mortgages as an investment that will give additional retirement income. When discussing this with the client, you should advise him that if market interest rates fall:

principal will be repaid earlier than anticipated and will need to be reinvested at lower rates, generating a lower level of income

there may be a loss of principal because homeowners are likely to default on their mortgage loans at higher rates

the maturity of the security is likely to extend and principal will be returned to the customer at a slower rate than anticipated

he will be able to sell the mortgage backed securities at a large profit because of their long maturity

Answer

A

If market interest rates fall, the homeowners will repay their mortgages faster because they will refinance and use the proceeds to pay off their old high rate mortgages that collateralize this mortgage-backed security. In effect, the maturity will shorten and the investor will be returned principal faster, which will have to be reinvested at lower current rates - another example of reinvestment risk.

Question 16

Q

Which statements are TRUE about the risks associated with federal agency securities?

I Agency securities have market risk
II Agency securities have virtually no market risk
III Agency securities have credit risk
IV Agency securities have virtually no credit risk

I and III
I and IV
II and Ill
II and IV

Answer

A

U.S. Government Agency Bonds (as with any fixed income security), have market risk. If interest rates rise, their prices will drop, with longer maturity and lower coupon issues dropping much faster than shorter maturity and higher coupon issues. Agencies also have virtually no credit risk since they are implicitly backed by the U.S. Government (with the exception of Ginnie Mae issues which are directly backed).

Question 17

Q

Yield quotes for collateralized mortgage obligations are based upon:

average life of the tranche
expected life of the tranche
15 year standard life
actual maturity of the underlying mortgages

Answer

A

Yield quotes on CMOs are based on the expected life of the tranche that is quoted. Do not confuse this with the “average life” of the mortgages in the pool that backs the CMO.
This pool, with say an average life of 12 years, is “chopped-up” into many different tranches, each with a given “expected life.” For example, there may be 10 tranches in the pool, with the first tranche having an expected life of 1-2 years, the second tranche having an expected life of 3-5 years, the third tranche having an expected life of 5-7 years, etc.

Question 18

Q

Which of the following statements are TRUE about Treasury Receipts?

I Interest is paid semi-annually
II Tax on interest earned is deferred until maturity
III Interest and principal are paid at maturity
IV Tax on interest earned is due annually

I and II
I and IV
II and IlI
Ill and IV

Answer

A

Treasury Receipts are U.S. Government bonds which have been stripped of coupons. In essence, they are original issue discount Government obligations. As with any OID, the discount must be accreted annually, and the accretion amount is taxable as interest earned for that year.
However, no monies are received from the issuer until maturity, when the security is redeemed at par. At this point, the owner receives the face amount but has no tax consequences (since the discount was taxed over the life of the bond).

Question 19

Q

Which statements are TRUE regarding the tax treatment of the annual adjustment to the principal amount of Treasury Inflation Protection Security?

I An annual upward adjustment due to inflation is taxable in that year.
II An annual upward adjustment due to inflation is not taxable in that year.
III An annual downward adjustment due to deflation is tax deductible in that year.
IV An annual downward adjustment due to deflation is not tax deductible in that year.

I and IlI
I and IV
II and III
II and IV

Answer

A

If the principal amount of a Treasury Inflation Protection Security is adjusted upwards due to inflation, the adjustment amount is taxable in that year as ordinary interest income. Conversely, if the principal amount of a Treasury Inflation Protection Security is adjusted downwards due to deflation, the adjustment is tax deductible in that year against ordinary interest income.
(TIPS are usually purchased in tax qualified retirement plans that are tax-deferred. This avoids having to pay tax each year on the upwards principal adjustment.)

Question 20

Q

A corporate bond which obligates the issuer to pay interest ONLY if the company meets a specified earnings test is a(n):

guaranteed bond
subordinated bond
income bond
collateral trust certificate

Question 21

Q

Which statements are TRUE about adjustment (income) bonds?

I Semi-annual payment of interest is assured
II Semi-annual payment of interest is not assured
III Repayment of principal at maturity is assured
IV Repayment of principal at maturity is not assured

l and III
l and IV
ll and III
II and IV

Answer

A

Income bonds only pay interest if the corporation earns enough “income” to make that interest payment. So payment of interest is not assured. In addition, if the issuer defaults (which could happen), then the principal will not be repaid either.

Question 22

Q

The conversion price of a convertible debenture is set at issuance at $25 per share. The common stock is now trading at $27.50 while the bond is trading at 110. If the bond falls 20% from its current market value, the new parity price of the common stock will be:

$22.00
$25.00
$27.50
$31.25

Answer

A

If the bond falls 20% from its current price of $1,100, the new price will be 80% x
$1,100 = $880 per bond. Since each bond is convertible based upon a conversion price of $25 per share,
the conversion ratio is $1,000 par / $25 conversion price = 40:1. The new parity price is $880 / 40 = $22
per share.

Question 23

Q

A corporation has issued 9%, $1,000 par convertible debentures, convertible at $50. The common stock is currently trading at $60. If the bond and the common are trading at parity, a customer purchasing 5M of the bonds will pay:

$1,000
$1.200
$5,000
$6,000

Answer

A

The bonds are convertible at $50, based on $1,000 par value. Therefore each bond converts into 20 shares ($1,000 par / $50 conversion price). If the common is trading at $60, the bond must be trading at 20 times this to be at parity. $60 × 20 = $1,200 parity price of one bond. The parity price of “5M” ($5,000 face amount, “M” is Latin for $1,000) is $1,200 x 5 = $6,000.

Question 24

Q

ABC Corporation has 10%, $1,000 par convertible bonds outstanding, convertible at a 40:1 ratio. The common stock is currently trading at $24.75. If the bond is currently trading at 101, at what market price of the common stock would an arbitrage possibility exist between the convertible bond and the stock into which it is convertible?

$24.00
$25.00
$25.25
$26.00

Answer

A

If the common stock were trading at $26, there would be an arbitrage opportunity. If the bond is bought and immediately converted into shares of common stock, the investor would: buy the bond for $1,010, convert the shares at a 40:1 ratio - or at $25.25 and then sell these shares in the market at $26, making $.75 per common share. If the common stock is trading at 25.25, there is a “wash” - buying the bond and selling the stock at the equivalent price - this is the current
parity price ($1,010 / 40 = $25.25 per share). When the stock trades below $25.25, if investor purchased
the bond, converted, and sold the stock at the current market price, there would be a loss.

Question 25

Q

Which statements are TRUE regarding a “step-down” certificate of deposit?

I The interest payment is fixed
II The interest payment may be reduced
III The principal payment is fixed
IV The principal payment may be reduced

l and III
I and IV
II and IlI
II and IV

Answer

A

A “step-down” CD is one that starts with a high introductory “teaser” interest rate. Then the rate “steps down” to the market rate of interest at specified intervals. Regardless, at maturity, the CD is redeemed at par.

Question 26

Q

Which statements are TRUE regarding Step-Down Certificates of Deposit?

I Initial payments are made at an interest rate that is above the market rate
II Initial payments are made at an interest rate that is below the market rate
III At a predetermined time, the interest rate is increased to a rate that is at, or above, the market
IV At a predetermined time, the interest rate is decreased to a rate that is at, or below, the market

I and IlI
I and IV
II and III
II and IV

Answer

A

This question boils down to the fact that you don’t get something for nothing. With a step-down CD, you start with a higher-than-market “teaser” rate. This is used as an incentive to the client to buy the CD. Then, at a predetermined date, the rate steps down to a lower rate, and this rate is usually a bit lower than the market rate at that time, so that, on average, the investor will still earn the market rate over the life of the CD.

Question 27

Q

A customer wants to know the principal difference between a market index linked CD and a regular CD. As the registered representative, you should inform the customer that:

Market index-linked CDs give a rate of return tied to the S&P 500 Index, whereas regular CDs give a rate of return tied to market interest rates
Market index-linked CDs can have a loss of principal if held to maturity whereas regular CDs cannot have a loss of principal
if held to maturity
Market index-linked CDs do not qualify for FDIC insurance whereas regular CDs do qualify for FDIC insurance subject to the $250.000 limit
Market index-linked CDs have a minimum life of 10 years, whereas there is no minimum life for regular CDs

Answer

A

Market Index Linked CDs are a type of “structured product” that consists of a “zero-coupon” synthetic bond component that grows based on the returns of an equity index; and that has a maturity established by an embedded option, typically 3 years from issuance.
Market Index Linked Certificates of Deposit tie their investment return to an equity index, usually the Standard and Poor’s 500 Index. This can give a potentially better rate of return than that of a traditional CD. If held to maturity, there is no penalty imposed on any CD. For an early withdrawal, traditional CDs may reduce the interest earned, but there is no loss of principal. In contrast, market index linked CDs typically impose a 3-5% principal penalty for early withdrawal. This “early withdrawal” penalty is imposed because the embedded option that established the maturity of the instrument was paid for and now is not being used.
Both regular and market index linked CDs qualify for FDIC insurance. Finally, the minimum life for market index linked CDs is typically 3 years;
whereas traditional bank CDs can have lives as short as 3 months.

Question 28

Q

An ET offers an investor all of the following benefits EXCEPT:

lack of liquidity risk
lack of credit risk
tax-efficiency
access to returns of foreign investments

Answer

A

An ET is an Exchange Traded Note. It is a type of structured product offered by banks that gives a return tied to a benchmark index. The note is a debt of the bank, and is backed by the faith and credit of the issuing bank. Thus, if the bank’s credit rating is lowered, the value of the ET will fall as well - so it has credit risk. ENs are listed on an exchange and trade, so they have minimal liquidity risk.
Their return can be based on “exotic” indexes, such as a Brazil or India index, so they can give investors access to the returns of foreign markets.
Finally, ETs make no interest or dividend payments. Their value grows as they are held based on the growth of the benchmark index, with any gain at sale or redemption currently taxed at capital gains rates. Thus, they are tax-advantaged as compared to conventional debt instruments.

Question 29

Q

All of the following statements are true about ETs EXCEPT:

ETs can be traded in the market like any other stock
ETNs offer an investment return tied to a benchmark index
ETNs are an equity security
ETNs are tax-advantaged

Answer

A

An ET is an Exchange Traded Note. It is a type of structured product offered by banks that gives a return tied to a benchmark index. The note is a debt of the bank, and is backed by the faith and credit of the issuing bank. They are not an equity security - they are a debt instrument. ETs are listed on an exchange and trade, so they have minimal liquidity risk. Finally, ETs make no interest or dividend payments. Their value grows as they are held based on the growth of the benchmark index, with any gain at sale or redemption currently taxed at capital gains rates. Thus, they are tax-advantaged as compared to conventional debt instruments.

Question 30

Q

Which statements are TRUE about ETNs?

I ETs are a structured product
II ETs are an investment company product
III ETNs are suitable for investors seeking income
IV ETs are suitable for investors seeking long-term capital gains

l and IlI
l and IV
Il and III
Il and IV

Answer

A

An ET is an Exchange Traded Note. It is a type of structured product offered by banks that gives a return tied to a benchmark index. The note is a debt of the bank, and is backed by the faith and credit of the issuing bank. ETs make no interest or dividend payments, so they are not suitable for an investor seeking income. Their value grows as they are held based on the growth of the benchmark index, with any gain at sale or redemption currently taxed at capital gains rates. Thus, they are tax-advantaged as compared to conventional debt instruments.

Question 31

Q

A bank issuer’s ET has been downgraded by Moody’s from Aaa to Aa. The price of the ET rose 2% after the downgrade was announced. What should the registered representative tell the client?

The bank downgrade does not matter because the price of the EN rose by 2%
The bank downgrade can affect the marketability of the ETN
The bank downgrade is not meaningful because the ET is still rated investment grade
The bank downgrade does not matter because the ET can be redeemed at par at maturity

Answer

A

ETs are “Exchange Traded Notes.” They are an equity index linked structured product, that is listed and trades on an exchange. Because they trade, the liquidity risk aspect of structured products is eliminated. What is not eliminated, however, is credit risk. These products are only as good as the guarantee of the issuing bank. These products typically have a 7 year maturity and a lot can go wrong in 7 years.

If the issuing bank is downgraded, then it would be expected that investor interest in the ET would fall. This should make the issue less marketable and also should cause the price to fall. In this question, the price rises, which can only be attributable to market interest rates falling. However, the ETN will still become less marketable after the downgrade.

Question 32

Q

The primary risk associated with investing in ENs is:

market risk
liquidity risk
credit risk
legislative risk

Answer

A

ETs are “Exchange Traded Notes.” They are an equity index linked structured product, that is listed and trades on an exchange. Because they trade, the liquidity risk aspect of structured products is eliminated. What is not eliminated, however, is credit risk. These products are only as good as the guarantee of the issuing bank. They typically have a 7 year life - and a lot can go wrong in 7 years (just ask anyone who purchased Lehman Brothers structured products or ETs).

Question 33

Q

An ETN does NOT have which risk?

Market risk
Credit risk
Marketability risk
Reinvestment risk

Answer

A

An ET is an Exchange Traded Note. It is a type of structured product offered by banks that gives a return tied to a benchmark index. The note is a debt of the bank, and is backed by the faith and credit of the issuing bank. Thus, if the bank’s credit rating is lowered, the value of the ET will fall as well - so it has credit risk. ETs are listed on an exchange and trade, so they have minimal marketability risk.
INs have market risk - if market prices fall, their value will fall in the market.

Question 34

Q

When comparing an ET to a structured product, which statement is TRUE?

ETs can be traded at any time while structured products cannot
ETNs offer current income while structured products do not
ETN income is taxable at higher rates than income from structured products
ETNs are equity securities that are exchange listed

Answer

A

An ET is an Exchange Traded Note. It is a type of structured product offered by banks that gives a return tied to a benchmark index. The note is a debt of the bank, and is backed by the faith and credit of the issuing bank. They are not an equity security - they a debt instrument. ETs are listed on an exchange and trade, so they have minimal liquidity risk. In comparison, a regular structured product is n negotiable and, if redeemed prior to maturity, imposes an early-redemption penalty. ETs make no interest or dividend payments. Their value gro as they are held based on the growth of the benchmark index, with any gain at sale or redemption currently taxed at capital gains rates. Thus, the are tax-advantaged as compared to other structured debt products.

Question 35

Q

A customer buys a $1,000 par reverse convertible note with a 1 year maturity and a 6% coupon rate. At the time of purchase, the reference stock is trading at $50 and the knock-in price is set at $40. If, at maturity, the reference stock is trading at $25, the customer will receive:

$1,000 par
20 shares of the reference stock
25 shares of the reference stock
40 shares of the reference stock

Answer

A

Reverse convertible notes were created for customers looking for enhanced yield in a low interest rate environment. Of course, any enhanced yield comes with higher risk. The note is linked to the price movements of an underlying stock (or very rarely, an underlying index). At maturity, the holder will receive par value, as long as the price of the reference stock is above the “knock-in” price (typically 70-80% of the initial reference price). On the other hand, if at maturity, the reference stock falls below the “knock-in” price, then the holder will receive the shares of stock. In this example, the share price has fallen from $50 to $25, which is below the “$40 knock-in” price. Thus, at maturity, the holder of the note will get the stock - not par value. The original conversion ratio was based on the reference price of $50. $1,000 par / $50 conversion reference
price = 20 shares per note. Thus, at maturity, the customer gets 20 shares, currently worth $25 each = $500 worth of stock. This customer has lost $500, partially offset by any interest income received.

Question 36

Q

An elderly customer that is currently invested in bonds for income is concerned about declining yields due to record low interest rates. He has contacted his registered representative and inquires about purchasing a reverse convertible note on a Blue Chip stock because it offers a higher yield. The customer should be informed that:

the note is safe because it is an obligation of a Blue Chip corporation
the note gives the customer the possibility of gains due to an equity price rise
he or she can potentially lose 100% of the principal amount due to a stock price decline
the “knock-in” price of the underlying security gives the customer the right to put the note back to the issuer at par at maturity

Answer

A

Reverse convertible notes were created for customers looking for enhanced yield in a low interest rate environment. Of course, any enhanced yield comes with higher risk. The note is linked to the price movements of an underlying stock (or very rarely, an underlying index). At maturity, the holder will receive par value, as long as the price of the reference stock is above the “knock-in” price (typically 70-80% of the initial reference price). On the other hand, if at maturity, the reference stock falls below the “knock-in” price, then the holder will receive the shares of stock. Thus, if the market price of the reference stock declines below the “knock-in” price, the customer receives the stock at maturity and not par value.
A reverse convertible note is a structured product that is an obligation of the issuing bank - not the corporation or the corporate securities on which the product is based. As such, the note only as good as the credit of the issuing bank. Furthermore, if the market price of the stock declines to, or through, the “knock-in” price, the customer receives stock at maturity and that stock could potentially be worthless. The customer should be made aware of all of these points.

Question 37

Q

Which of the following municipal issues is a short term note that is retired by a later permanent bond sale?

BAN
RAN
TAN
TRAN

Answer

A

Municipalities issue BANs (Bond Anticipation Notes) to “pull forward” funds that will be collected from a later permanent bond sale. For example, a municipality expects to float a 20 year bond issue in 6 months.
It can get the funds today by issuing 6 month BANs now. When the bond issue is floated, the proceeds are used to pay off the BANs.

Question 38

Q

Which statement BEST describes a bond which is trading “flat”? The bond is trading:

at par
with accrued interest
without accrued interest
at a fixed dollar price

Answer

A

A bond trades flat (without accrued interest) when the issuer has defaulted on the interest payments, or if the issue is an income bond or a zero coupon bond. Therefore, a current bondholder receives no interest on bonds that trade flat. When such a bond is traded, no accrued interest is paid from buyer to seller - so the trade is being done at a “flat” amount without any accrued interest added to the price.

Question 39

Q

A municipality would use general obligation bonds to finance all of the following EXCEPT the:

addition to an existing school building
construction of a new town hall
construction of an industrial park
addition of traffic lights to main intersections

Answer

A

The proceeds of general obligation bonds are used by municipalities to provide services to the general population - including the building and improvement of schools, police and fire department structures, and general municipal buildings. These bonds are serviced from general tax collections. Revenue bonds are used where there is a specific revenue source that can be pledged to bondholders to service the debt. Toll roads; toll bridges and tunnels; industrial parks where rents paid are the revenue source; water and sewer systems where separate water and sewer charges are imposed; are all typically built with revenue bond issues.

Question 40

Q

For bonds trading at a premium, rank the yield measures from lowest to highest?

Nominal; Current; Yield to Maturity; Yield to Call
Yield to Call; Yield to Maturity; Current, Nominal
Current; Nominal, Yield to Call, Vield to Maturity
Yield to Maturity; Current, Yield to Call; Nominal

Answer

A

When bonds are trading at a premium, the yield to call will be the lowest measure since the annual return is reduced by the annual amortized portion of the premium that will be “lost” over the life of the bond to the call date. The next highest yield will be the yield to maturity, since the premium will be lost over a longer “life” than if the bond is called early. Current yield will be higher than yield to maturity, since it does not include the annual premium loss. Stated yield will be the highest since it is the return based on par value.

Question 41

Q

Which statement is FALSE about CMBs?

CMBs are used to smooth out cash flow
CMBs are sold at a discount to par
CMBs are sold at a regular weekly auction
CMBs are direct obligations of the U.S. government

Answer

A

CMBs are Cash Management Bills. They are sold at auction by the Treasury on an
“as needed” basis to meet unexpected cash shortfalls, so they are not part of the regular auction cycle.
They are the shortest-term U.S. government security, often with maturities as short as 5 days. They are sold in $100 minimums at a discount to par value, just like Treasury Bills.

Question 42

Q

The physical securities which are the underlying collateral for Treasury Receipts can be which of the following?

I Treasury Bills
II Treasury Notes
III Treasury Bonds
IV Series EE Bonds

I and Il only
Ill and IV only
II and Ill only
I, II, III, IV

Answer

A

The physical securities which are held in trust against the issuance of Treasury Receipts are either Treasury Notes or Treasury Bonds. Series EE bonds cannot be used because they are non-marketable. T-Bills cannot be used because their maturity is too short.

Question 43

Q

The interest income earned on which of the following municipal bonds would be included in the alternative minimum tax computation?

School District Bond
Turnpike Revenue Bond
Industrial Revenue Bond
Water District Revenue Bond

Answer

A

The interest income derived from “non-essential use” private purpose revenue bonds is included in the alternative minimum tax computation. Industrial Revenue Bonds fall into this category. Public purpose bonds, such as G.O’s, and public facility revenue issues are not subject to the alternative minimum tax (AMT).

Question 44

Q

Which statements are TRUE regarding Treasury Inflation Protection securities?
I In periods of deflation, the amount of each interest payment will decline
II In periods of deflation, the amount of each interest payment is unchanged
III In periods of deflation, the principal amount received at maturity will decline below par
IV In periods of deflation, the principal amount received at maturity is unchanged at par

l and ill
l and IV
II and Ill
II and IV

Answer

A

Treasury “TIPS” are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal amount. In periods of deflation, the principal amount is adjusted downwards. Even though the interest rate is fixed, the holder receives a lower interest payment. due to the decreased principal amount. In this case, when the bond matures, the holder receives par - not the decreased principal amount.

Question 45

Q

An investor in the 31% tax bracket buys a 7% municipal bond quoted on a 6.25 basis. To calculate the equivalent taxable yield:

divide 6.25% by 69%
multiply 6.25% by 69%
divide 7% by 69%
multiply 7% by 69%

Answer

A

The formula for the equivalent taxable yield is:

Tax Free Yield / (100% - Tax Bracket) = Equivalent Taxable Yield

6.25% / (100% - 31%) = 6.25% / .69 = 9.06%

Question 46

Q

When a municipal issuer defeases its debt in accordance with the terms of the bond contract, it:

I terminates the lien that existing bondholders have on pledged revenues
II substitutes another source of revenue acceptable to the bondholders
III returns the principal amount to the bondholders at the time of the defeasance

l and II
I and III
II and Ill
I, II, III

Answer

A

When a municipality “defeases* its debt, it terminates the lien that the bondholders have on pledged revenues, and substitutes another acceptable form of collateral in the form of escrowed U.S. Government or Agency securities. The interest received from the escrowed government securities is the new revenue source for the issue. When the governments mature, the proceeds are used to pay off the bondholders.
Thus, the outstanding debt is not retired until maturity, or a call date.
(Also note that the tax law changes that took effect at the beginning of 2018 banned municipalities from doing any more advance refundings or pre-refundings. However, all the bonds that have been advance refunded remain outstanding until they reach their maturity date, while those that have been pre-refunded remain outstanding until their first call date.)

Question 47

Q

In a period of falling interest rates, a bond dealer would engage in all of the following activities EXCEPT:

raise prices in interdealer quote publications such as Bioomberg for municipal bonds
place “request for bids” in services such as Bloomberg on appreciated positions where the dealer has no current interest
bid for bonds to cover previously established short positions
buy put options on debt instruments to hedge existing short positions

Answer

A

In a period of falling interest rates, bond prices will be rising. Therefore, a dealer would raise his quoted prices in Bloomberg. If the dealer has appreciated bonds that he wishes to sell, he can place “Requests for Bids” for those bonds in Bloomberg. The dealer may bid (buy) bonds that he has previously sold short to limit losses due to rising prices. To hedge existing short positions against rising prices, the dealer would buy call options, not put options. Put options are used to hedge existing long positions from falling prices.

Question 48

Q

Which statements are TRUE about a Certificate of Participation (COP)?
I COPs are subject to statutory debt limits
II COPs are not subject to statutory debt limits
III COPs have a higher credit rating than G.O. bonds of the same issuer
IV COPs have a lower credit rating than G.O. bonds of the same issuer

I and III
I and IV
II and III
II and IV

Answer

A

As municipalities reached their debt limits with G.O bond issuance, they found it harder and harder to get voter approval to raise limits to sell additional G.O. bonds (think of Proposition 13 in California that capped property taxes to almost no increase unless the property was sold). To get around this, the COP - Certificate of Participation - was invented and COP issuance is now greater than
G.O. bond issuance in many states.

Question 49

Q

Which of the following statements are TRUE regarding Eurodollar bonds?

I Eurodollar bonds are issued by both domestic and foreign corporations
II Eurodollar bonds are denominated in U.S. dollars only
III Trading does not take place in the United States
IV The securities are not registered with the SEC

l and Ill only
II and IV only
II, III, IV
I, II, III, IV

Answer

A

Eurodollar bonds are issued by both domestic and foreign corporations outside of the U.S. markets to take advantage of lower interest rates. These bonds are denominated only in dollars and are payable only in dollars. Since trading does not take place in the U.S., these securities are not registered with the SEC.

Question 50

Q

A corporation has issued $1,000 par, 8% convertible bonds, callable at par. The bonds are convertible into 14 shares of common stock. Currently, the bond is trading at 102 while the common stock is trading at $75.50.
The corporation calls the bonds at par plus accrued interest of $20 per bond. A customer holds 100 bonds, purchased at par. The customer wishes to liquidate the position at the greatest profit. The BEST recommendation is to (ignoring commissions):

tender the bonds at the call price
sell the bonds at the current market price
sell short the common stock and convert the bonds for delivery to cover the short
continue to hold the bonds

Answer

A

If the bonds are tendered at the call price, the owner receives $1,000 per bond If the bonds are sold at the current market price, the owner receives $1,020 per bond. Since each bond is
convertible into 14 common shares, the short sale of 14 common shares will yield 14 x $75.50 = $1,057.
The bonds can then be converted to common to cover the short position. Thus, selling short the common is the best choice. Continuing to hold the bonds does not make sense since interest payments will cease.

Question 51

Q

A company that issued first mortgage bonds is in default. If mortgage bondholders’ claims are not satisfied from the sale of the property backing the bonds, then the bondholders:

have no recourse
can claim other property to satisfy the outstanding loans
can attempt to sell other assets to satisfy the outstanding loans
become general creditors for the balance due

Answer

A

Mortgage bondholders do not have claim to all property of the failed company (such as cash in bank accounts; accounts receivable; inventory; etc.); they only have claim to the real property pledged. If the bondholders’ claims are not satisfied from the sale of the real property, then they become general creditors for the balance due.

Question 52

Q

From an issuer’s standpoint, as the years progress, “level debt service” serial bond issues have:

I Decreasing interest payment amounts
II Increasing interest payment amounts
III Decreasing principal repayment amounts
IV Increasing principal repayment amounts

Iand III
I and IV
II and IlI
II and IV

Answer

A

Level debt service means that the issuer pays the same amount each year, with the funds being used to pay both interest and a portion of principal on the issue (similar to a mortgage amortization schedule). Since bonds are retired annually, the amount of the payment representing interest declines annually. The balance of the level payment is used to pay of bonds for that year. Thus, each year, the principal repayment amount increases

Question 53

Q

Which characteristics make a security least subject to liquidity risk?

I Short term maturity
II Long term maturity
III Low credit rating
IV High credit rating

I and III
I and IV
I and III
Il and IV

Answer

A

Liquidity risk is the risk that a security can only be sold by incurring large transaction costs. The easiest securities to sell (meaning the most readily marketable) are those with high credit ratings and short term maturities.

Question 54

Q

The regular way ex date, for a dividend paid to stockholders of record on Friday, June 15th, is:

Monday, June 11th
Tuesday, June 12th
Wednesday, June 13th
Thursday, June 14th

Answer

A

The regular way ex date is set at 1 business day prior to record date. The ex date is the very first date the stock trades without the value of the dividend. If the stock is bought on Wednesday, June 13th in a regular way trade, the trade settles in 2 business days on Friday, June 15th, so the holder is on record to receive the dividend (to receive the dividend, the trade must settle no later than the record date). If the stock is bought on Thursday, June 14th, the trade settles on Monday, June 18th. The stockholder would not have been on the record book as of the evening of June 15th (the record date) to receive the dividend. Thus, the first day that the stock trades without the purchaser receiving the dividend is Thursday, June 14th. This is the ex date.

Question 55

Q

What option position would be used to hedge a 2X leveraged ETF?

Purchase 1 put option on the ETF
Purchase 2 put options on the ETF
Sell 1 call option on the ETF
Sell 2 call options on the ETF

Answer

A

To hedge a stock position, a put must be purchased. The leverage of the ETF has no impact on the number of contracts that must be purchased to hedge. Because of the leverage, the ETF will be more volatile, and the option premium will be higher to reflect this.

Question 56

Q

A customer sells short 100 shares of ABC stock at $40 and buys 1 ABC Mar 40 Call @ $5. The maximum potential gain is:

$500
$3,500
$4,500
unlimited

Answer

A

If the stock falls, the customer gains on the short stock position. The customer sold the stock for $40. If it falls to “O,” the customer can buy the shares for “nothing” to replace the borrowed shares sold and make 40 points. The customer lets the call expire “out the money” losing 5 points, so the maximum potential gain is 35 points = $3,500.

Question 57

Q

A customer sells short 100 shares of ABC at $36 and buys 1 ABC Jul 35 Call @ $3. The stock falls to $30 and the customer closes the option contract at $1 and buys the stock at the current market price. The customer has a:

200 loss
$300 loss
$300 gain
$400 gain

Answer

A

The customer sold the stock for $36 and bought a call, paying a premium of $3 per share, for net proceeds of $33. The customer closes the positions by purchasing the stock at $30 and selling the call contract for $1, for a net payment of $29 per share. The net profit $33 - $29 = $4 or $400 on 100 shares.

Question 58

Q

On the same day, a customer buys 100 shares of ABC at $39 and sells short 100 shares of XYZ at $51. The customer then buys 1 ABC Jan 40 Put @ $4 and 1 XYZ Jan 50 Call @ $5. The breakeven points are:

ABC: $35 / XYZ: $46
ABC: $35 / XYZ: $55
ABC: $43 | XYZ: $46
ABC: $44 / XYZ: $55

Answer

A

The customer paid $4 for the ABC put and $39 for ABC stock, for a total of $43. This is the breakeven on ABC stock. The customer sold XYZ stock short for $51, but paid $5 for the XYZ call, for a net receipt of $46.

Question 59

Q

On the same day, a customer buys 100 shares of ABC at $25 and sells short 100 shares of XYZ at $35. The customer then buys 1 ABC Jan 25 Put @ $4 and 1 XYZ Jan 35 Call @ $6. XYZ rises to $42 and the customer exercises the call. ABC falls to $19 and the customer exercises the put. The net gain or loss on all transactions is:

$200 loss
$1,000 gain
$1,000 loss
breakeven

Answer

A

When XYZ rises, the customer exercises the long call to buy XYZ at $35. This stock is used to cover the short sale of XYZ stock at $35. There is no gain or loss on the stock but the premium paid of $600 for the call is lost. When ABC falls, the customer exercises the long put to sell ABC at $25. Since the customer bought the stock at $25, there is no gain or loss on the stock. However, the customer does lose the $400 paid in premiums for the put. The total loss is $1,000.

Question 60

Q

On the same day, a customer buys 100 shares of ABC at $25 and sells short 100 shares of XYZ at $35. The customer then buys 1 ABC Jan 25 Put @ $4 and 1 XYZ Jan 35 Call @ $6. XYZ rises to $42 and the customer exercises the call. ABC falls to $19 and the customer exercises the put. The net gain or loss on all transactions is:

$200 loss
$1,000 gain
$1,000 loss
breakeven

Answer

A

When XYZ rises, the customer exercises the long call to buy XYZ at $35. This stock is used to cover the short sale of XYZ stock at $35. There is no gain or loss on the stock but the premium paid of $600 for the call is lost. When ABC falls, the customer exercises the long put to sell ABC at $25. Since the customer bought the stock at $25, there is no gain or loss on the stock. However, the customer does lose the $400 paid in premiums for the put. The total loss is $1,000.

Question 61

Q

A corporation is attempting to sell additional shares to its existing shareholders through a rights distribution. A shareholder who wishes to subscribe must send the purchase amount with the rights certificate to the:

transfer agent
stand-by underwriter
rights agent
corporate controller

Answer

A

A rights agent is hired to handle the mechanics of a rights offering. To subscribe, the existing shareholders submit their rights with the subscription dollar amount to the rights agent.

Question 62

Q

A corporation issues $100 par convertible preferred stock, convertible at $8 per share when the market price of the common is $4. The preferred is issued under an “anti-dilutive covenant.” If the company declares a 2:1 stock split, which statements are TRUE?

I The conversion price is adjusted to $2
II The conversion price is adjusted to $4
III The conversion ratio is adjusted to 25:1
IV The conversion ratio is adiusted to 50:1

I and Ill
I and IV
II and Ill
II and IV

Answer

A

Under an “anti-dilutive” covenant, if there is a stock split or stock dividend resulting in the issuance of additional common shares, the conversion price and hence the conversion ratio are adjusted to reflect the fact that the market price of each common share will drop on the ex date. Prior to the stock dividend, the conversion price was $8 per share. If there is a 2 for 1 stock split, the new conversion price will be adjusted to $8/2 = $4 per share. Since each preferred share is
$100 par, the new conversion ratio will be $100/4 = 25:1.

Question 63

Q

During a period when the yield curve is flat:

short term rates are more volatile than long term rates
long term rates are more volatile than short term rates
short term and long term rates are equally volatile
no relationship exists between short term and long term rate volatility

Answer

A

Whether the yield curve is ascending (normal), flat or descending, the true statement always is that short term rates are more volatile than long term rates. Short term rates are susceptible to Federal Reserve influence, and move much faster than do long term rates. Long term rates respond more slowly; and reflect longer term expectations for inflation and economic growth, among other factors.

Question 64

Q

Which statement is FALSE regarding Treasury Inflation Protection securities?

In periods of inflation, the coupon rate remains unchanged
In periods of inflation, the amount of each interest payment will increase
In periods of inflation, the principal amount received at maturity will be par
In periods of inflation, the principal amount received at maturity is more than par

Answer

A

Treasury “TIPS” are Treasury Inflation Protection Securities - the principal amount of these securities is adjusted upwards with the rate of inflation. Even though the interest rate is fixed, the holder receives a higher interest payment, due to the increased principal amount. When the bond matures, the holder receives the higher principal
amount.

Answer 64

A

The rules on taxation of interest income received, generally, are:
Treasury/Agency Issues: Interest is subject to Federal Income tax, but is exempt from State and Local tax
Municipal Issues: Interest is exempt from Federal Income tax, and exempt from State and Local tax when purchased by a resident of that state Corporate Issues: Interest is subject to Federal Income tax, and to State and Local tax

Answer 65

A

Interest income derived from municipal bonds is currently exempt from federal income tax; however it is subject to state and local tax unless the state exempts the issue from taxation. Most states allow this only for issues that are purchased by residents of that state.

Answer 66

A

When evaluating debt securities, all of the risks listed must be considered - credit risk; purchasing power risk; legislative risk; and interest rate risk.

Answer 67

A

FINA states that a complex product is one where investment returns vary under differing scenarios. Examples include:
Asset-Backed Securities such as CMOs, where changing market interest rates affect the rate at which principal is repaid (prepayment and extension risk); Reverse Convertible Notes, which give a higher yield, but convert to equity if the stock falls below a pre-set level; Structured Notes, which offer a return tied to an equity index, subject to a floor and a cap;

Answer 68

A

Eurodollar bonds are issued by U.S. corporations, U.S. State and local municipalities, foreign corporations, and foreign governments. The bonds are issued in foreign countries but are payable in dollars. The U.S. Government does not issue Eurodollar Bonds.

Answer 69

A

A publicly traded fund has a 1 time stock issuance; closes its books to new investment and then lists its stock on an exchange or NASDAQ. The stock then trades like any other common stock, except the company is in the business of making investments; instead of say, making cars, beer, or computers. Thus, this type of fund is a “closed-end” fund - that is, closed to new investment.

Answer 70

A

The customer is purchasing enough ($30,000) to qualify for a 6 ½% sales charge. To compute the new lowered offering price, the formula is:

Ask Price = Bid (NAV). / (100% - Sales Charge %)

Answer 71

A

The reason why these funds are called “money” funds is that the securities held in the portfolios have very short maturities (less than 30 days) and turn over into cash quickly. Fund dividends are taxable, whether or not they are automatically reinvested in additional fund shares. Money market funds usually do not impose sales charges but all funds impose management fees.

Answer 72

A

REITs do not allow for flow through of loss - only net income flows through to shareholders under conduit tax treatment. On the other hand, Real Estate Limited Partnerships are a tax sheltered investment that allow both gain and loss to flow through to the partnership investors.

Answer 73

A

REITs do not invest in limited partnerships, which are tax shelter vehicles. This makes sense because REITs cannot pass losses to their shareholders. They invest primarily in real estate and mortgages (under the tax code, at least 75% of the REIT’s assets must be invested in real estate or mortgages). Any excess funds can be invested in securities, such as U.S. Governments, and can also be invested in the shares of other REITs.

Answer 74

A

If a Real Estate Investment Trust distributes at least 90% of its net investment income to shareholders, then it is regulated under Subchapter M of the Internal Revenue Code. The REIT pays no tax on the distributed income - the shareholder who receives the net income pays tax once. In addition, REITs must derive at least 75% of their income from real estate related activities to be “regulated” - however Choice A is not the best answer because these activities include investments in mortgages, as well as investments in real estate.

Answer 75

A

A stock breaks a “support” level as the market falls. If the stock breaks this level ($40), the investor feels that the price will plummet.
To profit, he wants to sell short if the market breaks $40 on the downside, so the order is to sell (short) @ $39 Stop. The order must be a sell stop because it is placed lower than the current market. If the market falls to $39, the order is triggered and becomes a market order to sell short. The order can then be executed on the next trade.
Once the short stock position is established, the customer believes that the price will plummet, and that the stock can be purchased later to cover the short sale at a much lower price for a profit.

Answer 76

A

The “after hours” trading sessions have much lower investor participation, so trading volumes are very small. Because of the lack of order flow, the market is less liquid; and as a result, few dealers participate in the market. Thus, one may not be able to get an execution; and each trade that is executed can result in a much greater than normal market price movement.

Answer 77

A

The NYSE does not set commission rates - these are set by brokers and dealers themselves. Odd lots are transactions for less than the normal trading unit of 100 shares. Odd lot orders are handled by the Specialist (now renamed the DMM - Designated Market Maker), by buying the odd lot into the Specialist’s (DMM’s) inventory account; or selling the odd lot out of the Specialist’s (DMM’s) inventory account.
Orders for odd lots have no priority on the NYSE trading floor - trading is in round lot units only.

Answer 78

A

Specialists (now renamed DMMs - Designated Market Makers)
cannot deal with the public, so they cannot act as underwriters. They are wholesale members of the NYSE who deal only with other member firms. DMMs act as market makers and broker’s brokers.
DMMs also act as the odd lot dealers for trades of NYSE listed stocks that are less than a round lot.

Answer 79

A

If a trade comes across the tape without the designation “s” (100 share units) or “s/s” (10 share units), then a round lot of 100 shares was traded.

Answer 80

A

A “When, As and If Issued” trade occurs without knowing the settlement date. When the securities are finally issued, a settlement date is set. If the settlement date is unknown, the amount of accrued interest due is unknown (interest accrues up to, but not including settlement). If the amount of accrued interest is unknown, the total transaction cost is unknown. The confirmation would state whether the trade was performed by the firm as agent or dealer.

Answer 81

A

The customer bought the stock at $55 and sells it at $58 for a $3
gain. However, he also sold the call at $3. The aggregate gain on both
transactions is +$3 + $3 = $600 gain.

Answer 82

A

If the stock moves to $41, the call goes “in the money” and will be exercised and the put expires “out the money.” When the call is exercised, the customer buys the stock at the strike price of $35, and sells it at the current market price of $41, for a 6 point gain. However, since 6 points was paid in combined premiums, the net result is no gain or loss. Thus, $41 is a breakeven point.

Answer 83

A

The customer has created a short put spread resulting in a $700
credit.

Answer 84

A

This is a hedging strategy. The customer paid $67 per share plus she paid $6 in premiums per share for the put contracts, for a total outlay of $73 per share. If the puts are exercised, the stock is sold for $70
per share, resulting in a 3 point loss per share. Since there are 200 shares involved, the total loss is $600.

Answer 85

A

A long stock position is not considered a “cover” for a short put since as the market goes down, the short put is exercised and the customer must buy another 100 shares of stock in addition to the shares already owned - so there is double downside risk. A short put is covered if the individual is short 100 shares of the security. As the market goes down, the short put is exercised and the customer is forced to buy back shares that have previously been sold “short.” The credit from the short sale is used to buy the shares, so there is no loss to the put writer.

Answer 86

A

A contract trades “at parity” when the premium equals intrinsic value. The BP Jul 160 Call has intrinsic value of 4 (since the market is 164). Since the premium is 4, the contract is at parity.

Answer 87

A

Under the “cheap stock rule,” if a customer wishes to short a stock under $5 a share, he or she must put up the greater of 100% or $2.50 per share. 100% of $2 per share × 1,000 shares = $2,000. $2.50 x
1,000 shares = $2,500. The greater amount is $2,500.

Answer 88

A

As the market drops, SMA locks. The amount available to borrow stays intact. A rising market (above 50% margin in the account) increases SMA. A purchase of securities uses SMA if the margin is not deposited. A sale of securities reduces the debit, increasing SMA.

Answer 89

A

Prior to making the new purchase, the margin account held 100 shares of ABC at $10, fully paid, for equity of $1,000 in the account. There is $500 of SMA from this position that cannot be used currently, since minimum margin to open an account is $2,000 of equity or the account being “fully paid,” whichever is less. Now the customer wishes to buy another $5,000 of stock, which would generate a Regulation T call of $2,500. Since there is $500 of SMA in the account, the customer need only deposit $2,000.

After all this, the account will show:

Long Market Value - Debit Balance = Equity

Answer 90

A

The initial margin to buy stock is 50%. 50% of $12,000 = $6,000. The initial margin to short stock is 50%. 50% of $10,000 = $5,000. The total initial margin requirement is $11,000.

Answer 91

A

The margin requirement to buy LEAP options with over 9 months to expiration is 75%. 75% of $600 premium per contract = $450 margin requirement per contract × 10 contracts = $4,500 deposit.

Answer 92

A

The “death benefit” of a variable annuity contract is not really much of one. If the contract holder dies prior to annuitization, the insurance company pays the greater of current NAV or the amount invested to a beneficiary. If the contract holder dies after annuitization, there is no more “death benefit.”

Answer 93

A

Contributions to tax qualified retirement plans are tax deductible.
They are made with “before-tax” dollars, hence those funds were never taxed. When distributions commence, since no tax was paid on the entire amount, the distribution is 100% taxable.

Answer 94

A

Distributions from qualified retirement plans, unless they are rolled over into an IRA, are taxable. To ensure that the tax will be paid, the tax code requires that 20% of the distribution amount be withheld as a credit against taxes due. No withholding tax is imposed if a trustee to trustee transfer is made - with the assets being transferred directly into another IRA or qualified retirement plan.

Answer 95

A

Health Savings Accounts (HSAs) were first authorized by Congress starting in the beginning of 2004. They are a tax advantaged medical savings account that is owned by the individual.

Answer 96

A

Syndicate members in the underwriting group share in both the selling responsibility for the issue and in liability for any unsold shares (or bonds).

Answer 97

A

Most general obligation issues are sold through competitive bid while revenue bond issues are typically sold through negotiated offerings.
Political subdivision issues are general obligation bonds of cities, counties, and townships. Enterprise activity issues are revenue bond issues where revenues from an enterprise pay for the debt service on the issue.

Answer 98

A

Whereas government securities are sold at auction conducted by the Federal Reserve, agency securities are sold to the public through a selling group of broker-dealers assembled by the agency. This is done on a negotiated basis, with the group consisting mainly of primary government dealers.

Answer 99

A

Primary offerings of agency securities to the public are made at par.
The selling concession is paid to the selling group members by the agency issuing the security. The concession is paid out of the proceeds of the offering.

Answer 100

A

SEC Rule 10b-18 sets ground rules for issuers or affiliated persons who wish to buy their shares in the open market. If an issuer aggressively buys its stock in the market, or bids for its stock, it can manipulate the market price upwards. Bids and purchases that are made in compliance with Rule 10b-18 will not be considered manipulative activities under Rule 10b-5 (“catch-all” fraud rule). Rule 10b-18 purchases, as they are known:
Must be effected through 1 broker/dealer on any given day;
Cannot be the opening transaction;
Cannot be executed within 10 minutes of market close if the security is “actively traded,” otherwise it cannot be executed within 30 minutes of market close;
Must be effected at prices no higher than the current market;
Cannot exceed 25% of the trading volume in the security that day (except for block purchases handled outside the normal flow of orders).

Answer 101

A

There is no prohibition on “insiders” holding or exercising call options on the related company’s stock - as long as the transactions are not effected using inside information.

Answer 102

A

The Securities and Exchange Commission was created by the Securities Exchange Act of 1934 (which was passed in the very beginning of 1934, while the 1933 Act was passed at the very end of
1933 - so these 2 Acts were really enacted “back-to-back”’).

Answer 103

A

FINRA sets minimum disclosure requirements when advertising a
CMO tranche. It requires disclosure of the:

Coupon
Anticipated Yield and Average Life
Specific Tranche ID - Number and Class
Final Maturity Date
Underlying Collateral
In addition, FINRA requires the following statement:

“The yield and average life shown above consider prepayment assumptions that may or may not be met. Changes in payments may significantly affect yield and average life.
Please contact your representative for information on CMOs and how they react to different market conditions.”

Then FINA states that the following disclosures are optional:
Minimum Denomination
Rating
Agency / Government Backing
Income Payment Structure
Generic Description of Tranche (e.g., PAC, Companion)
Yield to maturity of CMOs Offered at Par

Answer 104

A

Options communications that are distributed to more than 25 existing or prospective clients must be approved in writing prior to use by the designated Registered Options Principal (main office compliance
ROP). Retail communications include advertising, sales literature and independently prepared reprints distributed to more than 25 existing or prospective clients.
Options institutional sales literature and public appearances are the 2 public communications that do not require designated ROP approval.
However, they are subject to the firm’s policies and procedures.
Options correspondence is a communication to up to 25 existing or prospective clients. It is subject to “post use review and approval” by a branch manager or ROP.

Answer 105

A

The discount on all original issue discount bonds (corporate, government and municipal) must be accreted over the life of the bond. If the bond is held to maturity, the entire discount has been accreted and the adjusted cost basis is par. Since the bonds are redeemed at par, there is no capital gain or loss at maturity.

Answer 106

A

Since these discount bonds are purchased in the secondary market, the market discount that is earned over the life of the bonds is treated as taxable interest income. This is nothing more than a “tax grab” by the Federal government - the idea being that wealthy people buy municipal bonds, so if there is a way that they can be taxed without jeopardizing their basic Federal income tax-free status, why not? The holder has the option of either accreting the discount annually, and paying tax on the portion of the market discount earned; or of waiting until the bonds are sold or redeemed to pay the tax (the better option).
Since the bonds are valued at cost, there was no annual accretion of the discount. Thus, when the 10 year bonds are sold after 4 years, 4/10ths of the 10 point market discount has been “earned” and will be taxable as interest income at that point. The bonds were bought at
90; and sold for 95. Of the 5 point gain, 4 points (4% of $100,000 = $4,000) are taxed as interest income, with the remaining 1 point (1%
of $100,000 = $1,000) taxed as capital gain.

Answer 107

A

The final determination of the amount of discount that must be accreted on any (municipal, corporate, and Government) original issue discount bond is made by the Internal Revenue Service.

Answer 108

A

When a call option is exercised by the holder, the Options Clearing Corporation “assigns” the contract to any one of the individuals or firms that sold that option on a random basis. Once assignment occurs, the writer must deliver the stock to the holder for $50, 2 business days after exercise (the same as a regular way trade).

For tax purposes, the seller received $50 from selling the stock and also received $4 in premiums, so the “sales proceeds” are $54 per share. Any gain or loss depends on the price at which the shares were purchased (“the cost basis”).

Answer 109

A

When a put is purchased on a stock on the same day that the stock is bought, the put is said to be “married” to the stock position. The only reason the option was purchased was to protect the customer against loss if the market for the stock fell. It was not purchased to speculate in the market. The IRS treats a “married” put as part of the cost basis of the stock. Notice that, therefore, the put premium cannot be deducted as a capital loss if the put expires worthless; instead, it has increased the stock’s cost basis and will reduce any potential capital gain, when, and if, the stock is sold. As one would expect, this is the tax treatment that is most beneficial to the IRS and least beneficial to
the investor. The cost of the stock is $51 + $4 premium = $55 per
share. When the stock is sold at $59, the customer reports a 4 point capital gain.

Answer 110

A

Municipal bonds are not suitable for tax deferred accounts such as pension plans and IRAs. These accounts are already tax deferred, so putting taxable investments in them that generate a higher rate of return than municipals is appropriate. Furthermore, these higher returns will compound tax deferred as long as they are held in the pension account. Municipals give a lower rate of return than governments or corporates because of the federal tax exemption on their interest income. They are a bad choice for retirement accounts.
TIPS (Treasury Inflation Protection Securities) are great for retirement accounts. Their return is adjusted each year by that year’s inflation rate, and this builds tax deferred in a retirement account.
Finally, good quality equities have historically given a higher total return than bond investments, so they are good for long term investment in a retirement plan.

Answer 111

A

The market price averages are rising, but the strength of the market is weakening because the number of advancing issues is declining relative to falling issues. The market is reaching an “overbought” condition, and is approaching a peak.

Answer 112

A

In a reverse stock split, the number of common shares outstanding is decreased and the market price per share is increased proportionately on the “ex” date. Because the corporations’ earnings will be spread over fewer shares, earnings per share will increase. However, the company’s Price / Earnings ratio will remain constant because both the stock market price and the earnings per share will increase in the same proportion keeping the Price / Earnings ratio unchanged.

Answer 113

A

CMO planned amortization classes give a good yield that is 50 or so basis points higher than equivalent maturity Treasuries and are extremely safe. These meet the customer’s objective of additional income with low risk. Since this customer is only earning $35,000 per year, she is in a low tax bracket - making tax-deferred variable annuities unattractive. SPDRs - Standard and Poor’s 500 Depository Receipts are an exchange traded fund that consists of equities - which don’t provide much income. Income bonds only pay interest if the corporation has enough “income” - so these are not appropriate either.

Answer 114

A

A SEP IRA is a Simplified Employee Pension IRA, which is easier to set up and administrate than most other pension plans. It allows the employer to make a deductible contribution of a maximum of 25% of an employee’s income (20% effective rate), capped at $66,000 in2023. It also allows the employer to vary the contribution percentage each year - a key advantage of a SEP IRA.

Answer 115

A

Active portfolio management practitioners believe that they can outperform a benchmark portfolio (say an index fund) by finding undervalued securities in the marketplace. Passive portfolio managers, in contrast, believe that the market is “efficient” in pricing securities so that one cannot find “undervalued” securities. Passive portfolio managers simply buy index funds (which are managed to match the composition and performance of the chosen index).

Answer 116

A

A bond that is escrowed to maturity (ETM) is backed by escrowed U.S. Government securities - so it becomes the “safest” municipal bond because it becomes government backed. AAA rated general obligation bonds are extremely safe - they are backed by unlimited tax collections and have a top credit rating. But they are not as safe as bonds backed by escrowed U.S. Government securities.

Answer 117

A

Rule 101 of Regulation M covers syndicate members who are not market makers in that stock that are in an underwriting group for an “add on” stock offering. The intent is to make sure that they do not try and manipulate the price of the security upwards prior to the effective date, so that a higher POP could be set. They are subject to a restricted period for secondary offerings, of either 1 business day or 5 business days prior to the effective date, where they are prohibited from purchasing, making a bid for, or inducing the purchase of, the underwritten security. If the security is very actively traded, there is no restricted period. Note that they can accept unsolicited orders to buy the security. The rule states that:

Tier 1 Issue - if the security is actively traded (average daily trading volume of $1,000,000 or more and public float of at least
$150,000,000), there are no restrictions placed on market makers trading the issue prior to the distribution. The idea here is that this issue is too big for the price to be manipulated. This is called a “Tier 1” issue.

Tier 2 Issue - if the security has an average daily trading volume of $100,000 and a public float of at least $25,000,000 the restricted period is the business day prior to the effective date. This is called a “Tier 2” issue.

Tier 3 Issue - any other security not meeting these minimums is a “Tier 3” issue and is subject to a restricted period of 5 business days prior to the effective date.

Answer 118

A

Insurance company offerings are exempt from the 1933 Act with the exception of variable annuity and variable life contracts. Thus, a fixed annuity offered by an insurance company is exempt from the 1933 Act. Listed stocks, and stock options are non-exempt issues that must be registered with the SEC.

Answer 119

A

Issues that are exempt from registration under Federal laws are also exempt under state laws, so U.S. Governments do not have to be registered with the state. However, sales representatives, broker-dealers, and non-exempt issues (such as REITs) must be registered.

Answer 120

A

In competitive bid municipal underwritings, the offering price of each maturity must be disclosed, but there is not requirement to disclose the spread, which is typically very thin. There is no requirement to disclose the participation amounts of the underwriters (since this in no way affects the customer). However, the order priority provisions must be disclosed (the usual priority is Pre-Sale; Group Net; Designated; Member Takedown).

Answer 121

A

When performing a municipal bond tax swap, the investor is selling existing bonds at a loss and using the proceeds to buy similar, but not identical bonds so that the loss deduction is allowed under the “wash sale rule”.

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