Part 3

Question 1

A client has 100 shares of GHI when the company
declares a 20% stock dividend. After the payment of
the dividend, the client has
A. a proportionately decreased interest in the
company
B. a proportionately increased interest in the company
C. no effective change in the value of the position
D. a 20% return on the investment

Answer 1

C

No new money into the company, just more shares.

Question 2

Preferred stock

1. Characteristics
   a. Equity security with a _ (_) dividend
   b. Purchased for _ purposes, behaves like _

Board still has to approve dividends, but must be paid _ common stock dividends.

Answer 2

Preferred stock

1. Characteristics
   a. Equity security with a fixed (stated) dividend
   b. Purchased for income purposes, behaves like debt

Board still has to approve dividends, but must be paid before common stock dividends.

Question 3

Types of Preferred Stock

1. _- missed dividends are not paid later.
2. _ Preferred - accrues payments due its shareholders in the event dividends are reduced or suspended.
3. _ Preferred - a company can buy back from investors at a stated price after a specified date. Having the call price at a _ over par is one way to compensate for this additional risk (and inconvenience). Another is that the dividend rate on callable preferred stock is generally a bit _ than other preferred stock issued by the corporation.
4. _ Preferred - owner can exchange the shares for a fixed number of shares of common stock of the issuing corporation. Issued with a _ stated dividend rate than nonconvertible preferred of the same quality because the investor may have the opportunity to convert to common shares and enjoy greater capital gain potential.
5. _-Rate Preferred - dividends are usually tied to the rates of other interest rate benchmarks, such as Treasury bills and money market rates, and can be adjusted as often as _. Because the payment adjusts to current interest rates, the price of the stock remains relatively _.

For investors looking for fixed income through preferred stocks, _ would be their least appropriate choice.

Answer 3

Types of Preferred Stock

1. Straight - missed dividends are not paid later.
2. Cumulative Preferred - accrues payments due its shareholders in the event dividends are reduced or suspended.
3. Callable Preferred - a company can buy back from investors at a stated price after a specified date. Having the call price at a premium over par is one way to compensate for this additional risk (and inconvenience). Another is that the dividend rate on callable preferred stock is generally a bit higher than other preferred stock issued by the corporation.
4. Convertible Preferred - owner can exchange the shares for a fixed number of shares of common stock of the issuing corporation. Issued with a lower stated dividend rate than nonconvertible preferred of the same quality because the investor may have the opportunity to convert to common shares and enjoy greater capital gain potential.
5. Adjustable-Rate Preferred - dividends are usually tied to the rates of other interest rate benchmarks, such as Treasury bills and money market rates, and can be adjusted as often as quarterly. Because the payment adjusts to current interest rates, the price of the stock remains relatively stable.

For investors looking for fixed income through preferred stocks, adjustable-rate would be their least appropriate choice.

Question 4

Benefits of preferred stock ownership

a. Preference over common
1) Dividends
2) _ order

Risks of preferred stock

a. Because dividend is _, there is _ risk and _ risk.
b. Dividends are not _.

Answer 4

Benefits of preferred stock ownership

a. Preference over common
1) Dividends
2) Liquidation order

Risks of preferred stock

a. Because dividend is fixed, there is inflation risk and interest rate risk.
b. Dividends are not guaranteed.

Question 5

American Depositary Receipts (ADRs)

1. Facilitate the trading of foreign securities in the U.S. securities markets (domestically)
   a. Foreign company _ stock
   b. _ purchases the stock
   c. Domestic bank then _ the ADR
   d. Trades in _ and _ in U.S. markets. Dividends are in _.
   e. No _ or _ rights for investor

• _ Rights - give a shareholder the opportunity to buy additional shares in any future issue of a company’s common stock before the shares are made available to the general public.
  f. Investor subject to _ risk

Answer 5

American Depositary Receipts (ADRs)

1. Facilitate the trading of foreign securities in the U.S. securities markets (domestically)
   a. Foreign company issues stock
   b. Domestic (U.S.) bank purchases the stock
   c. Domestic bank then issues the ADR
   d. Trades in dollars and English in U.S. markets. Dividends are in dollars.
   e. No voting or preemptive rights for investor

• Preemptive Rights - give a shareholder the opportunity to buy additional shares in any future issue of a company’s common stock before the shares are made available to the general public.
  f. Investor subject to currency risk

Question 6

Valuation methods
1. Technical analysis

• a. Analyst charts a stock’s market price and volume over a period of time
  
  • 1) Determine trends
  • 2) Support and resistance
    
    • A support level is the price range at which a technical analyst would expect the demand for a stock to _ substantially.
    • The resistance level signifies the price at which a stock’s supply would be expected to _ substantially.
  • 3) Moving averages
• b. Used to minimize timing risk
• c. Major technical theories include the following:
  
  • 1) Short interest—high is bullish
  • 2) Odd-lot—do the opposite
  • 3) Advance/decline—_ of the market. If number of delclines are higher, even if market close higher, this still means _.

A technical analyst looking to smooth out the dailyvolatility of a stock’s performance would probably use
A. support and resistance
B. the odd-lot theory
C. moving averages
D. the advance/decline line

Answer 6

Valuation methods
1. Technical analysis

• a. Analyst charts a stock’s market price and volume over a period of time
  
  • 1) Determine trends
  • 2) Support and resistance
    
    • A support level is the price range at which a technical analyst would expect the demand for a stock to increase substantially.
    • The resistance level signifies the price at which a stock’s supply would be expected to increase substantially.
  • 3) Moving averages
• b. Used to minimize timing risk
• c. Major technical theories include the following:
  
  • 1) Short interest—high is bullish
  • 2) Odd-lot—do the opposite
  • 3) Advance/decline—breadth of the market. If number of delclines are higher, even if market close higher, this still means bearish.

A technical analyst looking to smooth out the dailyvolatility of a stock’s performance would probably use

C. moving averages

Question 7

Fundamental analysis

a. Looks at the company’s financial statements (Unit 9)
b. Stock’s price should reflect earnings or dividend growth or decline
c. Used to minimize _ risk

Answer 7

Fundamental analysis

a. Looks at the company’s financial statements (Unit 9)
b. Stock’s price should reflect earnings or dividend growth or decline
c. Used to minimize business risk

Question 8

Valuing Equity Securities
Dividend models

Dividend discount model (DDM)

• 1) _ value of future dividends using discounted cash flow (DCF) computation (Unit 13)
• r = D/P

If you have a $100 par, 6% preferred stock and the required rate of return is 8%, what shou Id the current market price of the stock be? You might encounter a question similar to this on the exam and you solve it by?

Dividend growth model (DGM)

• 1) Assumes _ of dividends
• (r=D/P + g)

An analyst is attempting to determine a reasonable value for a particular common stock. When comparing the result used by the two dividend models, it would be true to state that

• A. using the dividend discount model will result in a higher valuation than using the dividend growth model
• B. using the dividend growth model will result in a higher valuation than using the dividend discount model
• C. the valuation will be approximately the same, whichever model is used
• D. the dividend models can only be used with preferred stock

Answer 8

Valuing Equity Securities
Dividend models

Dividend discount model (DDM)

• 1) present value of future dividends using discounted cash flow (DCF) computation (Unit 13)
• r = D/P

If you have a $100 par, 6% preferred stock and the required rate of return is 8%, what shou Id the current market price of the stock be? You might encounter a question similar to this on the exam and you solve it by dividing the $6 dividend
(6% of the $100 par) by the 8% required rate of return: $6.00 / 0.08 = $75. In other words, if this preferred stock is selling for $75 per share, the $6 annual dividend will produce an 8% return on your investment.

Dividend growth model (DGM)

• 1) Assumes growth of dividends

An analyst is attempting to determine a reasonable value for a particular common stock. When comparing the result used by the two dividend models, it would be true to state that

• B. using the dividend growth model will result in a higher valuation than using the dividend discount model

Question 9

Bond pricing

1. Par (face) value—$_ each bond
2. Par value × stated interest rate = annual interest

• a. _-annual interest payments
• b. 6% bond pays $30 each _ months

3. Compute price

• a. Quoted as percentage of par
  
  • 1) _ point = 1% of par = $10.00 (Both Gov. and Corp.)
  • 2) Corporate/_ bonds: _ = $1.25. Fraction of $10, they are in 1/8, 90 1/4, 100 1/8, etc.
  • 3) _ bonds: 32nds where _ = $.3125 (_=1/32 of $10). 0.16 = ½ = $5.00.
• b. Par, premium, or discount

Answer 9

Bond pricing

1. Par (face) value—$1,000 each bond
2. Par value × stated interest rate = annual interest

• a. Semi-annual interest payments
• b. 6% bond pays $30 each 6 months

3. Compute price

• a. Quoted as percentage of par
  
  • 1) 1 point = 1% of par = $10.00 (Both Gov. and Corp.)
  • 2) Corporate/municipal bonds: 1/8 = $1.25. Fraction of $10, they are in 1/8, 90 1/4, 100 1/8, etc.
  • 3) Government: 32nds where .01 = $.3125 (.01=1/32 of $10). 0.16 = ½ = $5.00.
• b. Par, premium, or discount

Question 10

Corporates and Municipal

• Corporate and municipal bonds are quoted as a percentage of par where 100% = $1,000
• Each bond point represents $10, and the fractions are in eighths: each 1/8 = $_
  
  • A bond quoted at 90¼ = _
  • A bond quoted at 101¾ = _

Governments

■ Government bonds are quoted as a percentage of par.
■ Each point is $10, and each .1 represents _ of $10 ($0.3125).

• A government bond quoted at 90.8 (or 90.08) = _
• A government bond quoted at 101.24 = _

Answer 10

Corporates and Municipal

• Corporate and municipal bonds are quoted as a percentage of par where 100% = $1,000
• Each bond point represents $10, and the fractions are in eighths: each 1/8 = $1.25
  
  • A bond quoted at 90¼ = 902.50
  • A bond quoted at 101¾ = 1017.50

Governments

■ Government bonds are quoted as a percentage of par.
■ Each point is $10, and each .1 represents 1/32 of $10 ($0.3125).

• A government bond quoted at 90.8 (or 90.08) = 902.50
• A government bond quoted at 101.24 = 1017.5

Question 11

Compute Bond Prices
• ABC 8s of 30 at 125 (or ABC 8s30 @ 125)
• Stated, nominal,coupon = _%
• Maturity date: _
• Current price:$_;

• Current Yield: _%

Answer 11

Compute Bond Prices
• ABC 8s of 30 at 125
• Stated, nominal,coupon = 8%
• Maturity date: 2030
• Current price:$1,250;

• Current Yield: 6.40%

Question 12

Relationship of yields

1. Coupon, nominal, stated
   * a. Fixed at issuance
2. Current yield

• a. Annual interest ÷ current market price
• b. Above coupon if at a discount
• c. Below coupon if at a premium

3. Yield to maturity

• a. Yield if held to maturity
  
  • 1) Includes gain if bought at discount
  • 2) Includes loss if bought at premium

4. Yield to call

• a. Realized yield if bond is called
  
  • 1) Loss of premium more quickly lowers return

Question 13

What’s investment grade vs speculative grade(junk bonds) for S&Ps vs Moody’s?

Answer 13

Standard & Poor’s

Investment Grade: AAA, AA, A, BBB

Speculative: BB and below

––––––––––––––––––––––––––––––––––––––––

Moody’s

Investment Grade: Aaa, Aa, A, Baa

Speculative: Ba and below

Question 14

Parity price of convertible bonds

1. Bond is convertible into _ number of common shares
2. Price when bond and stock are at _ value

Example:

$1000 par value bond with conversion price of $40.

Calculate conversion to common: $_/$_= _shares

What is the bond parity price if common stock is trading at $50/share?

Parity price = _ of common x Coversion shares = $_ x _= $_.

Answer 14

Parity price of convertible bonds

1. Bond is convertible into fixed number of common shares
2. Price when bond and stock are at equal value

Example

$1000 par value bond with conversion price of $40.

Calculate conversion to common: $1000/$40 = 25 shares

What is the bond parity price if common stock is trading at $50/share?

Parity price = CMV of common x Coversion shares = $50 x 25 = $1250.

Question 15

Duration

1. Measures volatility of bond prices by weighting the time the bond interest takes to pay for the bond
2. Longer duration means _ bond volatility

• a. Interest rates up, bond price down; interest rates down, price up based on duration
• b. Zero coupon bond’s duration is its _ — most _

3. If maturities are about the same, lowest coupon has _ duration and highest coupon has _ duration (_ sensitive)
4. If coupons are about the same, latest maturity has _ duration and soonest maturity has _ duration (_ sensitive)
5. Convexity is a more sophisticated measurement of sensitivity to interest rate changes

Answer 15

Duration

1. Measures volatility of bond prices by weighting the time the bond interest takes to pay for the bond
2. Longer duration means higher bond volatility

• a. Interest rates up, bond price down; interest rates down, price up based on duration
• b. Zero coupon bond’s duration is maturity—most volatile

3. If maturities are about the same, lowest coupon has longest duration and highest coupon has shortest duration (least sensitive)
4. If coupons are about the same, latest maturity has longest duration and soonest maturity has shortest duration (least sensitive)
5. Convexity is a more sophisticated measurement of sensitivity to interest rate changes

Question 16

Rules for using Duration to Manage Bond Portfolios

Interest goes up or down, what kind of bonds to buy?

Answer 16

If interest rates are expected to rise, shorten duration (Interest rates up, shorten Duration)

Remember: UPS: UP for “up” and S for “shorten”)

If interest rates are expected to fall, lengthen duration. Buy low coupon bonds with long maturities.

Interest rates fall → lengthen duration.

Remember: FALLEN - FAL for “fall” and LEN for “Lengthen.”

Question 17

Discounted Cash Flow (DCF)

1. It is commonly used to value _ securities
2. Bond’s price will always reflect a yield equal to current market interest rates for comparable risk.

• a. Take the income payments scheduled to be received over a given future period and adjust that for the time value of money
  
  • 1) Discount rate is _ to the current market interest rates
• b. Take the future principal repayment—use the discount rate to compute the present value

1. A client interested in fixed income is viewing different bonds with the same rating and a coupon of 6%. Using the DCF method, which bond should have the highest market value?
   A. 5-year maturity when the discount rate is 4%
   B. 5-year maturity when the discount rate is 8%
   C. 10-year maturity when the discount rate is 4%
   D. 10-year maturity when the discount rate is 8%
2. The value of the bond is the present value of its cash flow stream.

• a. The higher the discounted cash flow, (the sum of present value of the income and principal) the _ the value of the bond.
• b. Cash flow analysis on mortgage-backed debt uses _ maturities.
• c. When used with equities, it is the dividend discount model.
  
  • 1) Only dividends, no _ value

Answer 17

Discounted Cash Flow (DCF)

1. It is commonly used to value debt securities
2. Bond’s price will always reflect a yield equal to current market interest rates for comparable risk

• a. Take the income payments scheduled to be received over a given future period and adjust that for the time value of money
  
  • 1) Discount rate is equal to the current market interest rates
• b. Take the future principal repayment—use the discount rate to compute the present value

1. A client interested in fixed income is viewing different bonds with the same rating and a coupon of 6%. Using the DCF method, which bond should have the highest market value?
   C. 10-year maturity when the discount rate is 4%
   when the current interest rate in the market place (that is what the discount rate represents) is less than the coupon, the bond price is higher (as interest rates go down, bond prices go up). And, if the current market interest rate is higher than the coupon rate, the bond’s price will be lower (when interest rates increase, bond prices fall). That would narrow the choices to the two 4% bonds. That is, a bond with a 6% coupon should sell at premium when current interest rates are at4% and when interest rates are at 8%, the 6% bond should be selling at a discount. Then, as we’ve just learned with duration, when interest rates change, the longer the time to maturity, the greater the effect on the market price of a bond.
2. The value of the bond is the present value of its cash flow stream.

• a. The higher the discounted cash flow, (the sum of present value of the income and principal) the higher the value of the bond.
• b. Cash flow analysis on mortgage-backed debt uses average maturities.
• c. When used with equities, it is the dividend discount model.
  
  • 1) Only dividends, no maturity value

Question 18

U.S. government securities: the safest issuer of debt in terms of default risk in the United States— interest tax-exempt at the state and local level

1. Active secondary trading (negotiable)
   a. T-bills ( no _)
   b. T-notes
   c. T-bonds
   d. Treasury Inflation Protection Securities (TIPS)—offer _ protection

• 1) Semiannual adjustment to principal based on _
  2. Benefits of government issues include the following:
• a. Safety
• b. Liquidity
• c. Best place to be when recession and _ are predicted

3. Risks of government issues include the following:

• a. Lower yields
• b. Interest rate risk
  
  • 1) Inverse relationship between interest rates and bond prices
• c. Inflation risk (except TIPS)

Answer 18

U.S. government securities: the safest issuer of debt in terms of default risk in the United States— interest tax-exempt at the state and local level

1. Active secondary trading (negotiable)
   a. T-bills ( no coupon interest)
   b. T-notes
   c. T-bonds
   d. Treasury Inflation Protection Securities (TIPS)—offer inflation protection

• 1) Semiannual adjustment to principal based on CPI
  2. Benefits of government issues include the following:
• a. Safety
• b. Liquidity
• c. Best place to be when recession and deflation are predicted

3. Risks of government issues include the following:

• a. Lower yields
• b. Interest rate risk
  
  • 1) Inverse relationship between interest rates and bond prices
• c. Inflation risk (except TIPS)

Question 19

Government agency issues

older ones have _ attached, new ones are _ entry

1. Government National Mortgage Association (GNMA or Ginnie Mae)

• Only agency issue _ by the full faith and credit of the U.S. government
• _-through certificate - homeowner pay mortgage, payments collected in pool, then pass through proportionally to investors.
• _ income

2. Federal National Mortgage Corporation (FNMA or Fannie Mae)
   * a. Pass-through certificate, _ income

Answer 19

Government agency issues

older ones have coupons attached, new ones are book entry

1. Government National Mortgage Association (GNMA or Ginnie Mae)

• Only agency issue backed by the full faith and credit of the U.S. government
• Pass-through certificate - homeowner pay mortgage, payments collected in pool, then pass through proportionally to investors.
• monthly income

2. Federal National Mortgage Corporation (FNMA or Fannie Mae)
   * a. Pass-through certificate, semi-annual income

Question 20

A client has a TIPS with a coupon rate of 4.5%. The inflation rate has been 7% for the last year. What is the inflation-adjusted return?
A. -2.5%
B. 4.5%
C. 7.0%
D. 11.5%

Answer 20

Answer: B. TIPS adjust the principal value every 6 months to account for the inflation rate. Therefore, the real rate of return will always be the coupon.

Question 21

TIPS

• These notes are issued with a fixed interest rate, but the _ amount is adjusted semiannually by an amount equal to the change in the Consumer Price Index,
• The interest payment the investor receives every six months is equal to the fixed interest rate times the _ principal. During times of inflation, the interest payments _, while during times of deflation, the _ payments fall.
• These notes are sold at _ interest rates than conventional fixed-rate Treasury notes because of their adjustable nature.
• In any year when the principal is adjusted for inflation, that increase is considered _ income for that year even though the increase will not be received until the note _.

EXAMPLE
If you have a TIPS bond with a 3% coupon and the annual inflation rate is 4% for the next two years, here is what happens:

Each six months, you will receive 1.5% (half of the annual 3% coupon) of the principal value as adjusted for the inflation rate. If the inflation rate is 4% per year, that is 2% each six months. So, after the first semiannual period, the principal value of the bond is now $1,020 (102% x $1,000). Therefore, the first interest check will be 1.5% x $1,020, or $15.30. Six months later, the adjusted principal value is $1,040.40 (102% x $1,020), so that interest check will be for $15.61 ($1,040.40 x 1.5%). As we continue into the next year, the principal will increase to $1,061.21 ($1,040.40 x 102%) and the interest check will be for $15.92. Because we’re only looking at two years, the ending principal value will be $1,082.43 with the final interest check of $16.24. As you can see, both the income from the TIPS and its principal value are increasing at a compounded rate based upon inflation.

Answer 21

TIPS

• These notes are issued with a fixed interest rate, but the principal amount is adjusted semiannually by an amount equal to the change in the Consumer Price Index,
• The interest payment the investor receives every six months is equal to the fixed interest rate times the newly adjusted principal. During times of inflation, the interest payments increase, while during times of deflation, the interest payments fall.
• These notes are sold at lower interest rates than conventional fixed-rate Treasury notes because of their adjustable nature.
• In any year when the principal is adjusted for inflation, that increase is considered reportable income for that year even though the increase will not be received until the note matures.

EXAMPLE
If you have a TIPS bond with a 3% coupon and the annual inflation rate is 4% for the next two years, here is what happens:

Each six months, you will receive 1.5% (half of the annual 3% coupon) of the principal value as adjusted for the inflation rate. If the inflation rate is 4% per year, that is 2% each six months. So, after the first semiannual period, the principal value of the bond is now $1,020 (102% x $1,000). Therefore, the first interest check will be 1.5% x $1,020, or $15.30. Six months later, the adjusted principal value is $1,040.40 (102% x $1,020), so that interest check will be for $15.61 ($1,040.40 x 1.5%). As we continue into the next year, the principal will increase to $1,061.21 ($1,040.40 x 102%) and the interest check will be for $15.92. Because we’re only looking at two years, the ending principal value will be $1,082.43 with the final interest check of $16.24. As you can see, both the income from the TIPS and its principal value are increasing at a compounded rate based upon inflation.

Question 22

Name these investments

1. dollar-denominated bonds issued in the U.S. by foreign banks and corporations. The bonds are issued in the U.S. when market conditions are more favorable than on the Eurobond market or in domestic markets overseas.
2. deposit/debt in any foreign bank that is denominated in dollars.
3. This instrument is used to finance imports and export transactions. Before a foreign exporter will ship goods to the U.S., the exporter wants assurance of payment when the goods arrive.
4. short-term, unsecured promissory note issued by large, well- known, and financially strong companies, normally sold at a discount .
5. Sovereign debt securities, denominated in U.S. dollars (USD), issued by developing countries and backed by U.S. Treasury bonds, but does not carry US government guarantee. Partners were US, IMF, and World Bank.

Answer 22

1. Yankee Bonds
2. Eurodollars/Eurobond
3. Banker’s acceptance
4. Commercial paper
5. Brady Bonds

Question 23

Types of corporate bonds

1. Secured
2. Unsecured, e.g., debentures

• a. _ debt
  3. High-yield bonds
  4. Zero-coupon bonds
• a. Issued at a _
• b. Appropriate for target investments
• c. No _ risk
• d. High _
• e. Generates _ income - should be held in _ accounts
• f. investors may still have to pay _ on the _ interest that accrues each year.

Answer 23

Types of corporate bonds

1. Secured
2. Unsecured, e.g., debentures

• a. Subordinated debt
  3. High-yield bonds
  4. Zero-coupon bonds
• a. Issued at a deep discount
• b. Appropriate for target investments
• c. No reinvestment risk
• d. High volatility
• e. Generates phantom income - should be held in nontaxable accounts
• f. investors may still have to pay taxes on the imputed or phantom interest that accrues each year.

Question 24

Corporate Debt
Benefits
1. A predictable stream of income (interest payments made _)
2. Repayment of principal at specified maturity date (bonds held to maturity have no _ risk as to principal)
3. Prior claim on issuer’s assets

• a. _ bonds have pledged assets
• b. Debentures have _ over any equity

Risks - DRIP
Default risk

• a. Creditworthiness of issuer
  
  • 1) High-quality versus low-quality debt

Reinvestment risk

• a. Interest payments and return of principal

Interest rate risk

• a. Common to all fixed-income investments

Purchasing power risk

• a. Fixed payments lose buying power

Call risk

• a. Call protection

Prepayment risk is only found with _ securities

Answer 24

Corporate Debt
Benefits
1. A predictable stream of income (interest payments made semiannually)
2. Repayment of principal at specified maturity date (bonds held to maturity have no interest rate risk as to principal)
3. Prior claim on issuer’s assets

• a. Secured bonds have pledged assets
• b. Debentures have priority over any equity

Risks - DRIP
Default risk

• a. Creditworthiness of issuer
  
  • 1) High-quality versus low-quality debt

Reinvestment risk

• a. Interest payments and return of principal

Interest rate risk

• a. Common to all fixed-income investments

Purchasing power risk

• a. Fixed payments lose buying power

Call risk

• a. Call protection

Prepayment risk is only found with mortgage-backed securities

Question 25

Municipal bonds
1. Issued by a form of government other than the federal government or agency of the federal government

• a. Interest exempt from federal taxes
• b. Exemption may also apply at state and local level
• c. _ subject to taxation

Types of municipal issues
1. General _ (GO) bonds

• a. _ by full faith and credit (taxes)
  
  • 1) Issuer’s authority to _

2. _ bonds
   * a. Backed by specific revenue source, tolls, or user fees
3. Benefits of municipal bonds

• a. Low default risk
• b. Tax-free income
  
  • 1) Attractive to those in high federal tax brackets

4. Risks of municipal bonds

• RIP
• Reinvestment
• Interest rate risk
• Purchasing power risk

Possible exposure to the alternative minimum tax (AMT)- _ activity municipal bonds

Answer 25

Municipal bonds
1. Issued by a form of government other than the federal government or agency of the federal government

• a. Interest exempt from federal taxes
• b. Exemption may also apply at state and local level
• c. Capital gains subject to taxation

Types of municipal issues
1. General obligation (GO) bonds

• a. Backed by full faith and credit (taxes)
  
  • 1) Issuer’s authority to tax

2. Revenue bonds
   * a. Backed by specific revenue source, tolls, or user fees
3. Benefits of municipal bonds

• a. Low default risk
• b. Tax-free income
  
  • 1) Attractive to those in high federal tax brackets

4. Risks of municipal bonds

• RIP
• Reinvestment
• Interest rate risk
• Purchasing power risk

Possible exposure to the alternative minimum tax (AMT)- Private activity municipal bonds

Question 26

Taxable Equivalent Yield (TEY)

Muni paying 5% and marginal tax rate of 20%, what’s the TEY?

What tax does out of state Munis have to pay?

Answer 26

To make the returns on municipal bonds comparable to those of taxable bonds, the TEY can be calculated.

TEY = Tax Exempt Yield / (1-Marginal Tax Rate): 0.05/(1-.02) = 0.0625

OR

TEY x (1-Marginal Tax Rate) = Tax Exempt Yield

*Interest on the out‐of‐state municipals are subject to state income tax.

Question 27

Money market instruments (cash equivalents)

1. Used to finance short-term cash requirements
2. Characteristics

• a. High-quality debt
• b. Short-term (_ or less to maturity)
• c. Issued at a discount, except CDs

3. Issuers

• a. Corporations—_ paper / _notes
• b. Banks—negotiable (jumbo, $_ minimum) CDs
  
  • 1) No _ penalty
  • 2) Insured by FDIC (to $_)
  • 3) Not issued at _
  • Can be _ in secondary markets
• c. U.S. government—all _, as well as bonds and notes inthe secondary market with one year or less remaining to maturity

4. Rates
   * a. London Interbank Offered Rate (_)—bank to bank shortterm lending rate - will disappear by 2021
5. Benefits of money market securities

• a. Safety
• b. Liquidity

6. Risks of money market securities

• a. Low yields
• b. Not suitable for long-term investors

Answer 27

Money market instruments (cash equivalents)

1. Used to finance short-term cash requirements
2. Characteristics

• a. High-quality debt
• b. Short-term (one year or less to maturity)
• c. Issued at a discount, except CDs

3. Issuers

• a. Corporations—commercial paper / pomissory notes
• b. Banks—negotiable (jumbo, $100,000 minimum) CDs
  
  • 1) No prepayment penalty
  • 2) Insured by FDIC (to $250,000)
  • 3) Not issued at discount
  • Can be traded in secondary markets
• c. U.S. government—all T-bills, as well as bonds and notes inthe secondary market with one year or less remaining to maturity

4. Rates
   * a. London Interbank Offered Rate (LIBOR)—bank to bank shortterm lending rate
5. Benefits of money market securities

• a. Safety
• b. Liquidity

6. Risks of money market securities

• a. Low yields
• b. Not suitable for long-term investors

Question 28

Deposit Accounts
A. Cash
1. Insured bank deposits

• a. _ deposit accounts (DDA) - _ accounts
• b. Insured bank CDs—time _ accounts(TDA)
  
  • 1) First choice for capital preservation
  • 2) No _ risk - because there’s no market for these

Answer 28

Deposit Accounts
A. Cash
1. Insured bank deposits

• a. Demand deposit accounts (DDA) - Checking accounts
• b. Insured bank CDs—time deposits accounts(TDA)
  
  • 1) First choice for capital preservation
  • 2) No interest rate risk - because there’s no market for these

Question 29

Investment Company Act
A. Investment company registration—Investment Company Act of 1940

1. Three categories of investment companies

• a. _-amount certificate company - issuer guarantees stated payment to investor at a date in the _.
• b. _ trust - registered investment companies with a _ portfolio. That is, at the time of organization, the portfolio is purchased and, because there is no ongoing management company, there are _ being made. Shares are redeemed at _ at the end.
• c. _ companies
  
  • 1) _-end (mutual funds) and _-end

2. Requirements for investment company registration with SEC

• a. _ capitalization of $_
• b. _ investment objective
• c. _ financial reports to _
  
  • 1) _ to shareholders

Answer 29

Investment Company Act
A. Investment company registration—Investment Company Act of 1940

1. Three categories of investment companies

• a. Face-amount certificate company - issuer guarantees stated payment to investor at a date in the future.
• b. Unit investment trust- registered investment companies with a fixed portfolio. That is, at the time of organization, the portfolio is purchased and, because there is no ongoing management company, there are basically no changes made. Shares are redeemed at NAV at the end.
• c. Management companies
  
  • 1) Open-end and closed-end

2. Requirements for investment company registration with SEC

• a. Private capitalization of $100,000
• b. Clearly defined investment objective
• c. Annual financial reports to SEC
  
  • 1) Semiannual to shareholders

Question 30

Investment Company Act
B. Shareholders’ right to vote
1. Changing nature of business

• a. From _-end to _-end
  2. Changing investment _or policies

3. Cease to do business
4. Changing investment _

C. Structure of investment companies
1. Board of directors

• a. No _ or _-related misdemeanors
• b. Minimum _% _-interested (outside directors)

Answer 30

Investment Company Act
B. Shareholders’ right to vote
1. Changing nature of business

• a. From open-end to closed-end
  2. Changing investment objective or policies

3. Cease to do business
4. Changing investment adviser

C. Structure of investment companies
1. Board of directors

• a. No felonies or securities-related misdemeanors
• b. Minimum 40% non-interested (outside directors)

Question 31

Investment Company Act
Investment adviser to manage portfolio for a fee
a. _-year initial contract, renewable _
b. Maximum _-day termination notice
c. Must be in _

1. The investment adviser’s contract must be initially approved by a majority vote of the _ and a majority of the _ members of the board of directors.
2. It is renewed annually by either a majority of the _ or a majority of the_.
3. In addition, as with all contracts, initial and renewal, it requires a majority of the _.

Answer 31

Investment Company Act
Investment adviser to manage portfolio for a fee
a. Two-year initial contract, renewable annually
b. Maximum 60-day termination
c. Must be in writing

1. The investment adviser’s contract must be initially approved by a majority vote of the outstanding shares and a majority of the noninterested members of the board of directors.
2. It is renewed annually by either a majority of the board or a majority of the outstanding shares.
3. In addition, as with all contracts, initial and renewal, it requires a majority of the noninterested board members.

Question 32

Investment Company Act - General rules, could be exceptions
D. It is unlawful for any registered investment company to:
1. purchase any security on _;
2. effect a _ sale of any security;
3. participate in any _ trading account in securities; or
4. _ greater than _% of the voting shares of another investment company.

The Investment Company Act of 1940 requires that investment companies employ the services of a commercial _ as _ to hold and safeguard the physical assets (cash and investment portfolio) of the fund.

Answer 32

Investment Company Act
D. It is unlawful for any registered investment company to:
1. purchase any security on margin;
2. effect a short sale of any security;
3. participate in any joint trading account in securities; or
4. Acquire greater than 3 % of the voting shares of another investment company.

The Investment Company Act of 1940 requires that investment companies employ the services of a commercial bank as custodian to hold and safeguard the physical assets (cash and investment portfolio) of the fund.

Question 33

Capitalization of Management Companies
Open-end Company

• _ primary offering, number of shares not _
• _ required for investors to review
• Limited to _ class of capital (common)
• Must _ shares on request, within _ days.
• No _ trading

Closed-end Company

• Number of shares _
• No _ after IPO
• Issues common stock, _ and/or _
• No _ of shares, just Secondary trading (_/OTC)

Only the closed-end company is legally permitted to issue senior securities (preferred stock and bonds).

Answer 33

Capitalization of Management Companies
Open-end Company

• Continuous primary offering
• Prospectus required
• Limited to one class of capital (common)
• Must redeem shares on request, within 7 days.
• No secondary trading

Closed-end Company

• Number of shares fixed
• No prospectus after IPO
• Issues common stock, preferred and/or bonds
• No redemption of shares
• Secondary (exchange/OTC)

Question 34

Pricing of Funds
A. Pricing
1. Closed-end priced via supply and demand

• a. Can be at a _ to or _ over NAV
  2. Open-end priced via a formula: NAV per share = (assets – liabilities) ÷ _ of shares
• Sales charges _ part of a mutual fund’s NAV. The NAV is computed by subtracting all liabilities (it is the _ who pays the sales charge, not the fund) from the fund’s assets)
• a. _ pricing - price determined by value the next end-of-market(4PM ET) pricing.
• Open-end can have sales charge, so it could be said to be purchased at _ of NAV. But can never be sold at a _ to NAV

Answer 34

Pricing of Funds
A. Pricing
1. Closed-end priced via supply and demand

• a. Can be at a discount to or premium over NAV
  2. Open-end priced via a formula: NAV per share = (assets – liabilities) ÷number of shares
• Sales charges are not part of a mutual fund’s NAV. The NAV is computed by subtracting all liabilities (it is the investor who pays the sales charge, not the fund) from the fund’s assets.
• a. Forward pricing - price determined by value the next end-of-market(4PM ET) pricing.
• Open-end can have sales charge, so it could be said to be purchased at premium of NAV. But can never be sold at a discount to NAV

Question 35

Mutual Fund Fees and Share
Classes
A. 12b-1 fees
1. Used for _ and _/distribution
2. _ expense charged against fund’s NAV

• a. How often is it paid?
• b. Not a CDSC/back-end load

3. The maximum 12b-1 fee for marketing and promotion is _%
   * a. No load funds are limited to _%

POP - Public Offering Price = NAV/share + applicable sales charges

Answer 35

Mutual Fund Fees and Share
Classes
A. 12b-1 fees
1. Used for marketing and promotion
2. Annual expense charged against fund’s NAV

• a. Paid on a quarterly basis
• b. Not a CDSC/back-end load

3. The maximum 12b-1 fee for marketing and promotion is .75%
   * a. No load funds are limited to .25%

Question 36

Mutual Fund Fees and Share Classes
1. Class A shares (_-end load)

• a. Investors pay sales charge on each purchase
• Sales charge goes to the _, not the mutual fund.
• Sales load is % of _ not % of _
• b. No front-end load on _ funds

2. Class B shares (_-end load [_SC])

• a. Investors pay _ charge at redemption
  
  • 1) Based on _ (not _) at redemption
• b. Higher _ fee than Class A shares

3. Class C shares (_ load)

• a. Purchase at NAV with 1% CDSC for 1 year
• b. Higher _ fee than Class A

4. Class I shares

• a. Institutional only including employer plans
• b. No _-end load; no _

Answer 36

Mutual Fund Fees and Share Classes
1. Class A shares (front-end load)

• a. Investors pay sales charge on each purchase
• Sales charge goes to the underwriter, not the mutual fund.
• Sales load is % of POP not % of NAV
• b. No front-end load on no-load funds

2. Class B shares (back-end load [CDSC])

• a. Investors pay declining charge at redemption
  
  • 1) Based on NAV (not POP) at redemption
• b. Higher 12b-1 fee than Class A shares

3. Class C shares (level load)

• a. Purchase at NAV with 1% CDSC for 1 year
• b. Higher 12b-1 fee than Class A

4. Class I shares

• a. Institutional only including employer plans
• b. No front-end load; no CDSC

Question 37

Reductions in Sales Charges
There are two ways that an investor can take advantage of reduced sales charges available on Class _ shares for larger purchases.

■ Breakpoints-a scale of declining sales charges based on the amount invested
■ Rights of _-permits an investor to aggregate shares owned in _ accounts in some or all funds in the fund _ to reach a breakpoint discount with no time limit.

Answer 37

Reductions in Sales Charges
There are two ways that an investor can take advantage of reduced sales charges available on Class A shares for larger purchases.

■ Breakpoints-a scale of declining sales charges based on the amount invested
■ Rights of accumulation-permits an investor to aggregate shares owned in related accounts in some or all funds in the fund family to reach a breakpoint discount with no time limit.

Question 38

Reduction in sales charges (A shares)
1. Breakpoints - could be combined

• a. Individuals and spouses
• b. _ and _ children
• c. _ formed for a business purpose
• d. Not an _ club
• Discounts may also be made to directors, officers, partners, employees, or sales representatives of the _, its investment _, or its principal _.

2. Breakpoint sale (violation under FINRA and _)
   * a. Selling _ the breakpoint

Letter of _ (_months max) - investor states he will invest additional funds to reach breakpoint.

_ LOI (max of _ days) - sign the LOI as late as _ days after initial purchase.

_ months is the combination of LOI and backdating.

The provisions of the LOI hold regardless of the price _. The investor is not legally obligated to comply with the terms of the letter, so some shares purchased at the reduced sales charge are held in _. These shares are _ to repay the reduction in sales charge if the contract is not completed.

Answer 38

Reduction in sales charges (A shares)
1. Breakpoints

• a. Individuals and spouses
• b. Parents and dependent children
• c. Entity formed for a business purpose
• d. Not an investment club
• Discounts may also be made to directors, officers, partners, employees, or sales representatives of the fund, its investment adviser, or its principal underwriter.

2. Breakpoint sale (violation under FINRA and NASAA)
   * a. Selling beneath the breakpoint

Letter of Intent (13 months max) - investor states he will invest additional funds to reach breakpoint.

Backdating LOI (max of 90 days) - sign the LOI as late as 90 days after initial purchase.

13 months is the combination of LOI and backdating.

The provisions of the LOI hold regardless of the price appreciation. The investor is not legally obligated to comply with the terms of the letter, so some shares purchased at the reduced sales charge are held in escrow. These shares are liquidated to repay the reduction in sales charge if the contract is not completed.

Question 39

Private Funds
A. Not registered with SEC or states

• 1. Fund manager registered if securities not _
• 2. High risk—low liquidity
• 3. High compensation to managers

B. Private funds look for going _
C. Venture cap funds look for _stages

Answer 39

Private Funds
A. Not registered with SEC or states

• 1. Fund manager registered if securities not exempt
• 2. High risk—low liquidity
• 3. High compensation to managers

B. Private funds look for going concerns
C. Venture cap funds look for earliest stages

Question 40

Hedge Funds - A type of _ fund
A. Pooled investment vehicles that use _ strategies

• 1. Leveraging through margin and derivatives
• 2. Short selling
• 3. Arbitrage
• By hedging, the portfolio manager attempts to produce returns in both up and down markets: producing “_” returns.

B. Not Required to _ with SEC

• 1. _ to the fund generally are registered
• 2. Limited _ compared to mutual funds

C. _ liquidity

• 1. Usually issued as _ partnership interests
     * a. Lock-up period

D. High expenses

• 1. Management generally receives a base performance fee (2% + 20%)
• Two refers to the standard management fee of 2% of assets annually, while 20 means the incentive fee of 20% of profits above a certain threshold known as the hurdle rate.
• 2. Management generally has a partnership interest (“skin in the game”)

E. Accredited (or qualified) investors only

Answer 40

Hedge Funds - A type of private fund
A. Pooled investment vehicles that use sophisticated strategies

• 1. Leveraging through margin and derivatives
• 2. Short selling
• 3. Arbitrage
• By hedging, the portfolio manager attempts to produce returns in both up and down markets: producing “absolute” returns.

B. Not Required to register with the SEC

• 1. Advisers to the fund generally are registered
• 2. Limited transparency compared to mutual funds

C. Limited liquidity

• 1. Usually issued as limited partnership interests
     * a. Lock-up period

D. High expenses

• 1. Management generally receives a base performance fee (2% + 20%)
• Two refers to the standard management fee of 2% of assets annually, while 20 means the incentive fee of 20% of profits above a certain threshold known as the hurdle rate.
• 2. Management generally has a partnership interest (“skin in the game”)

E. Accredited (or qualified) investors only

Question 41

Exchange-traded funds (ETFs)
1. Traded on exchanges or Nasdaq

• a. Intra-day price _
• b. can be bought on margin and sold short?

2. Typically tracks an index

• a. Possibly lower expense ratio than index fund
• b. Possibly more tax _ than mutual fund
• c. _ to buy and sell

Answer 41

Exchange-traded funds (ETFs)
1. Traded on exchanges or Nasdaq

• a. Intra-day price fluctuations
• b. Can be bought on margin and sold short

2. Typically tracks an index

• a. Possibly lower expense ratio than index fund
• b. Possibly more tax efficient than mutual fund
• c. Commissions to buy and sell

Question 42

Real estate investment trusts (REITs)
1. Tradable units in portfolio of real estate or mortgages

• a. Equity trusts—invest in portfolio of operating real estate
• b. Mortgage (debt) trusts—loan money for mortgages to owners of real estate or invest in (purchase) existing mortgages
  
  • 1) Revenues generated primarily by the interest that they earn on the mortgage loan

■ An owner of REITs holds an _ interest in a pool of real estate investments.
■ REITs are _ because they _ on exchanges and OTC.
■ REITs are not _ companies (mutual funds).
■ REITs offer dividends and gains to investors but do not _ losses like limited partnerships, and therefore are not considered _ programs (DPPs).
■ The key numbers are: (1) at least _% of a REIT’s assets must be represented by real estate assets such as real property or loans secured by real property, cash, and U.S. government securities; (2) at least _% of the REIT’s annual gross income must be from real estate-related income, such as rents from real property and interest on obligations secured by mortgages on real property; and (3) in order to qualify as a REIT, the REIT must distribute at least _% of its taxable income.

• d. Historically exchange listed
  
  • 1) Non-traded REITs require extra _.

Answer 42

Real estate investment trusts (REITs)
1. Tradable units in portfolio of real estate or mortgages

• a. Equity trusts—invest in portfolio of operating real estate
• b. Mortgage (debt) trusts—loan money for mortgages to owners of real estate or invest in (purchase) existing mortgages
  
  • 1) Revenues generated primarily by the interest that they earn on the mortgage loan

■ An owner of REITs holds an undivided interest in a pool of real estate investments.
■ REITs are liquid because they trade on exchanges and OTC.
■ REITs are not investment companies (mutual funds).
■ REI Ts offer dividends and gains to investors but do not flow through
losses like limited partnerships, and therefore are not considered direct participation programs (DPPs-Unit 17).
■ The key numbers are: (1) at least 75% of a REIT’s assets must be represented by real estate assets such as real property or loans secured by real property, cash, and U.S. government securities; (2) at least 75% of the REIT’s annual gross income must be from real estate-related income, such as rents from real property and interest on obligations secured by mortgages on real property; and (3) in order to qualify as a REIT, the REIT must distribute at least 90% of its taxable income.

• d. Historically exchange listed
  
  • 1) Non-traded REITs require extra suitability.

Question 43

Benefits and Risks

A. Benefits of investment company securities

1. Diversification
2. Professional management
3. Liquidity
4. Low minimum initial investment

B. Risks of investment company securities

1. Market risk for equity funds
2. Interest rate risk for bond funds
3. Fees and expenses
4. No control over manager’s timing of purchases or sales

Question 44

Annuities
1. Fixed annuity

• a. Insurance company guarantees both the rate of return (the interest rate) and the payout to the investor.
• b. Interest rate can change—contract explains conditions.
• c. Not a securities product

2. Variable annuity

• a. Insurance product
  
  • 1) Mortality guarantee (lifetime income)
• b. Securities product
  
  • 1) Separate account with sub-accounts
• a) Specifically for variable annuities
• b) Wide range of objectives available
  
  • 2) Possible hedge against inflation

Assumed _ Rate (AIR)
The AIR is a basis for determining distributions from a variable annuity. The rate, usually estimated conservatively, provides an earnings target for the separate account. Simply, if the actual earnings exceed the AIR, the annuity payments _ ; if they fall short of the AIR, the payments decrease.

Annuity units vs _ units:

The number of annuity units is _ when an annuitant starts the _ process, and the monthly payment will _ with the market value of the securities in the separate account portfolio. The value of _ units varies with the value of the portfolio, and the growth portion of the monthly payments is subject to income tax.

The investment return of a variable annuity comes from
A. the performance of the selected sub-accounts
B. the rate stated in the policy contract
C. computing the excess of the premiums
received over the mortality experience
D. the insurance company’s general account

Answer 44

Assumed Interest Rate (AIR)
The AIR is a basis for determining distributions from a variable annuity. The rate, usually estimated conservatively, provides an earnings target for the separate account. Simply, if the actual earnings exceed the AIR, the annuity payments increase; if they fall short of the AIR, the payments decrease.

Annuity units vs Accumulation units:

The number of annuity units is fixed when an annuitant starts the payout process, and the monthly payment will vary with the market value of the securities in the separate account portfolio. The value of accumulation units varies with the value of the portfolio, and the growth portion of the monthly payments is subject to income tax.

The investment return of a variable annuity comes from
A. the performance of the selected sub-accounts

Question 45

Variable annuity separate account versus mutual fund

• Purchase _ rather than _
• Tax _ versus current taxation
  
  • a. All growth within annuity is tax deferred
  • b. Participate in the equities market with expenses generally higher than mutual fund with the same objective
• Tax-free transfer between _ : Unlike mutual funds where the exchange between funds is a taxable event, the investor can transfer from one subaccount to another without any current tax liability.
• No _ : Because the annuity calls for direct designation of a beneficiary, upon death, the asset passes directly without the time and expense of probate.

Answer 45

Variable annuity separate account versus mutual fund

• Purchase units rather than shares
• Tax deferral versus current taxation
  
  • a. All growth within annuity is tax deferred
  • b. Participate in the equities market with expenses generally higher than mutual fund with the same objective
• Tax-free transfer between subaccounts: Unlike mutual funds where the exchange between funds is a taxable event, the investor can transfer from one subaccount to another without any current tax liability.
• No probate: Because the annuity calls for direct designation of a beneficiary, upon death, the asset passes directly without the time and expense of probate.

Question 46

Return on FIA
A. Index annuities (equity index annuity)
1. Cash values tied to the performance of an index

• a. Participate (generally with a _ ) in the gains but not the _
  2. Designed to reduce the _ risk of fixed annuities without the _ risk of a variable annuity
  3. Is it a security?
• a. Registered personnel selling these must comply with suitability and disclosure requirements.

purchaser can be offered the following choices as to how growth in the underlying index will be credited in the form of interest to the account:

1. _ reset. In this method, the interest to be credited to the account is computed by comparing the index value at the end of the year to the value at the beginning of the year (hence the term annual).Annual reset generally has a lower participation rate than point to point.
2. _ mark. In this method, the highest value reached by the index between anniversary dates of the annuity is compared to the value at the beginning of the year. This option can provide the highest gains.
3. _. In this method, the interest is computed based on the value of the index at the end of the contract compared to the beginning. A variation is annual point-to-point.
4. _. The most common is a monthly average and this can be the best options when markets are expected to be highly volatile.

Answer 46

Return on FIA
A. Index annuities
1. Cash values tied to the performance of an index

• a. Participate (generally with a cap) in the gains but not the losses
  2. Designed to reduce the purchasing power risk of fixed annuities without the market risk of a variable annuity
• a. Monthly averaging generally best in volatile market
• b. Annual reset generally lowest participation rate

3. Not regulated as a security
   * a. Registered personnel selling these must comply with suitability and disclosure requirements.

purchaser can be offered the following choices as to how growth in the underlying index will be credited in the form of interest to the account:

1. Annual reset. In this method, the interest to be credited to the account is computed by comparing the index value at the end of the year to the value at the beginning of the year (hence the term annual).Annual reset generally has a lower participation rate than point to point.
2. High-water mark. In this method, the highest value reached by the index between anniversary dates of the annuity is compared to the value at the beginning of the year. This option can provide the highest gains.
3. Point-to-point. In this method, the interest is computed based on the value of the index at the end of the contract compared to the beginning. A variation is annual point-to-point.
4. Averaging. The most common is a monthly average and this can be the best options when markets are expected to be highly volatile.

Question 47

Purchase and Settlement Options
A. Funding
1. Single premium deferred annuity (accumulation units)
2. Periodic payment deferred annuity (accumulation units)
3. Single premium immediate annuity (annuity units)
4. Bonus annuity

B. Distribution

1. Random withdrawals
2. Annuitize

• a. Straight life
• b. Life with period certain
• c. Joint life with last survivor

Question 48

Tax on Withdrawals
A. Taxation of annuities
1. Contributions not through employer-sponsored retirement plans are made with after-tax dollars (nonqualified).

• a. Deposits are cost basis.
• b. Growth (earnings) are tax _.
• c. Everything above cost basis is taxed as _ upon distribution.
  
  • 1) _% penalty tax < age_
• d. Withdrawals are taxed _, meaning _ first and the return of basis only when the _ are exhausted.
• e. Annuitize
  
  • 1) _ ratio

An investor purchased a periodic payment variable annuity 5 years ago at the age of 56. The annual premium payments were $10,000 and the current value is $62,000. If the investor is in the 25% income tax bracket and needs to withdraw $18,000 for an emergency, the amount of tax due would be
A. $3,000
B. $3,300
C. $4,500
D. $4,950

Answer 48

Tax on Withdrawals
A. Taxation of annuities
1. Contributions not through employer-sponsored retirement plans are made with after-tax dollars (nonqualified).

• a. Deposits are cost basis.
• b. Growth (earnings) are tax deferred.
• c. Everything above cost basis is taxed as ordinary income upon distribution.
  
  • 1) 10% penalty tax < 59½
• d. Withdrawals are taxed LIFO, meaning earnings first and the return of basis only when the earnings are exhausted.
• e. Annuitize
  
  • 1) Exclusion ratio

An investor purchased a periodic payment variable annuity 5 years ago at the age of 56. The annual premium payments were $10,000 and the current value is $62,000. If the investor is in the 25% income tax bracket and needs to withdraw $18,000 for an emergency, the amount of tax due would be
A. $3,000

It’s not annuitized, so pay tax on all the earnings.

Question 49

Life insurance
1. Types of life insurance

• a. Term life (TL) for a fixed term (e.g., 1, 5, 10, or 20 years)
  
  • 1) No _ value
  • 2) Renews with same face but higher premium
• b. Whole life (WL)
  
  • 1) _ premium
  • 2) Guaranteed _ benefit and _
• c. Universal life (UL)
  
  • 1) _ premiums and _ amount (option _)
  • 2) _ not guaranteed
  • 3) May be _
• d. Variable life (VL)
  
  • 1) _ premium
  • 2) Guaranteed minimum _
  • 3) _ not guaranteed
    
    • a) Based on performance of _ account

Answer 49

Life insurance
1. Types of life insurance

• a. Term life (TL) for a fixed term (e.g., 1, 5, 10, or 20 years)
  
  • 1) No cash value
  • 2) Renews with same face but higher premium
• b. Whole life (WL)
  
  • 1) Fixed premium
  • 2) Guaranteed death benefit and cash value
• c. Universal life (UL)
  
  • 1) Flexible premiums and face amount (option B)
  • 2) Cash value not guaranteed
  • 3) May be overfunded
• d. Variable life (VL)
  
  • 1) Scheduled (fixed) premium
  • 2) Guaranteed minimum death benefit
  • 3) Cash value not guaranteed
    
    • a) Based on performance of separate account

Question 50

Variable Life Insurance Loans and Contract exchange
A. Policy loans

• _ of _% of cash value availabe for loans after _ year

B. Policy exchange

1. _-month right to exchange to any form of _ policy
2. No _required(no _ underwriting)
3. based on _ age

Answer 50

Variable Life Insurance Loans and Contract exchange
A. Policy loans

• Minimum of 75% of cash value availabe for loans after third year

B. Policy exchange

1. 24-month right to exchange to any form of permanent policy
2. No physical required(no medical underwriting)
3. based on original age

Question 51

Derivative Characteristics
The common characteristic of all derivatives is that their value is derived from the value of some underlying asset. The primary derivative on the exam will be the listed option contract with equity securities as the underlying asset.

Definition of an Options contract
“A contract through which a seller gives a buyer the right, but not the obligation, to buy or sell a specified number of shares at a predetermined price within a set time period.”

• *Participants**
  1. Buyer
  a. Rights
  2. Seller
  a. Obligations

Buy 1 ABC Nov 40 Call @4

What does this mean?

Answer 51

Buy 1 call contract(100 shares) of ABC, expires November, at strike(exercise) price $40. Premium of $4.

Question 52

Derivative Characteristics
D. Standardized terms
1. Underlying asset
2. Expiration month

• a. LEAPS may be written for up to _ months, all others a maximum of _ months.
  3. Exercise (_) price

A standardized option contract will always specify
A. the first day the option may be exercised
B. the last day the option may be exercised
C. the potential profit that may be realized upon exercise
D. the price at which the option may be exercised

Answer 52

Derivative Characteristics
D. Standardized terms
1. Underlying asset
2. Expiration month

• a. LEAPS may be written for up to 39 months, all others a maximum of nine months.
  3. Exercise (strike) price

A standardized option contract will always specify
D. the price at which the option may be exercised

Last month of exercise is specified, not the last date.

Question 53

Types of options
1. Calls

• a. Owner has right to buy stock.
• b. Seller has obligation to sell.

2. Puts
   * a. Owner has right to _ stock.

Strategies
1. Buying call options (long, holder)

• a. _ strategy—profit if the underlying stock’s price rises
  2. Buying put options (long, holder)
• a. _ strategy—profit if the underlying stock’s price falls
  3. Selling call options (_, writer)
• a. Neutral to bearish strategy—if stock price falls, option expires
• b. Income strategy—writer keeps premium

4. Selling put options (_, writer)

• a. Neutral to bullish strategy—if stock price rises, option expires
• b. Income strategy—writer keeps premium

Answer 53

Types of options
1. Calls

• a. Owner has right to buy stock.
• b. Seller has obligation to sell.

2. Puts
   * a. Owner has right to sell stock.

Strategies
1. Buying call options (long, holder)

• a. Bullish strategy—profit if the underlying stock’s price rises
  2. Buying put options (long, holder)
• a. Bearish strategy—profit if the underlying stock’s price falls
  3. Selling call options (short, writer)
• a. Neutral to bearish strategy—if stock price falls, option expires
• b. Income strategy—writer keeps premium

4. Selling put options (short, writer)

• a. Neutral to bullish strategy—if stock price rises, option expires
• b. Income strategy—writer keeps premium

Question 54

Benefits and Risks Using Options

A. Cost of using options
1. Commissions to buy and sell

B. Benefits of using options
1. Long position

• a. Leverage increases return percentage
• b. Less capital at risk
• c. Long put has less risk than short stock sale
• d. “Insurance” (hedging—Unit 20)

2. Short position

• a. Income from the premium
• b. Partial hedge
  
  • 1) Call hedges long stock position to extent of premium
  • 2) Put hedges short stock position to extent of premium

C. Risks of using options
1. Long

• a. Guess wrong—lose most or entire premium paid
• b. Time decay—option expires
• c. Inability to exercise
  
  • 1) European style—exercise only at _ date (EE)
  • 2) American style—exercise at _ (AA)

2. Short

• a. Profit generally limited to premium received
• b. Gains are invariably short-term (highest tax)
• c. _ call has unlimited risk

Answer 54

Benefits and Risks Using Options

A. Cost of using options
1. Commissions to buy and sell

B. Benefits of using options
1. Long position

• a. Leverage increases return percentage
• b. Less capital at risk
• c. Long put has less risk than short stock sale
• d. “Insurance” (hedging—Unit 20)

2. Short position

• a. Income from the premium
• b. Partial hedge
  
  • 1) Call hedges long stock position to extent of premium
  • 2) Put hedges short stock position to extent of premium

C. Risks of using options
1. Long

• a. Guess wrong—lose most or entire premium paid
• b. Time decay—option expires
• c. Inability to exercise
  
  • 1) European style—exercise only at expiration date (EE)
  • 2) American style—exercise any time (AA)

2. Short

• a. Profit generally limited to premium received
• b. Gains are invariably short-term (highest tax)
• c. Uncovered call has unlimited risk

Question 55

Define: Hedging Strategies - Straddles, Collar(zero cost), Protective Put

Answer 55

Straddle: Buying a Put and Buying a Call - The buyer does NOT own the stock. Thinks the stock price will move and can make money when stock goes up or down. (This a long straddle, a short straddle is the opposite, selling both a Put and a Call and not wanting the stock price to move)

Protective Put: Buying a stock (or already owning it) and a Put for the stock serving as insurance against the decline in the underlying stock. (Hint: A good answer for the exam)

Collar(zero cost):

investor OWNS the stock

buys a Put (at a lower price) for the stock serving as insurance against the decline in the underlying stock (protective put).

sells a Call (out-of-the-money) at a higher price to earn premium for the Put, thus zero cost(or lower cost)

Question 56

Calls, Rights, Warrants
A. Calls
1. Not issued by the underlying _

B. Preemptive Rights—existing shareholder has subscription rights or stock rights

• 1. Right to maintain _ ownership
• Only _ stockholders can have preemptive rights, not _ stockholders .
• 2. _ term
• 3. Exercise if _ market or sell
• Which is a sale? Is it Receipt of preemptive Rights or Exercise of preemptive Rights?

C. Warrants
1. Grant the owner the right to purchase securities from the issuer at a specified price

• a. _ term
• b. Issued with exercise price _ CMV, so no _ value.

Compare: Warrants vs. Call Options

• Warrants are issued by _, whereas Calls are issued by _.
• Warrants typically have maturities of several _.
• Warrant terms are not _. Call options are _.
• When a warrant is exercised, _ stock is issued, unlike Call options.
• Warrents have no _ value.

A subscription warrant may be issued with a bond or __ stock offering. A warrant is usually issued as a __ to make the issue more attractive. It entitles the holder to buy a proportionate amount of the issuer’s common stock at a specific price.

Answer 56

Calls, Rights, Warrants
A. Calls
1. Not issued by the underlying asset

B. Preemptive Rights—existing shareholder has subscription rights or stock rights

• 1. Right to maintain percentage ownership
• Only common stockholders can have preemptive rights, not preferred stockholders .
• 2. Short term
• 3. Exercise if below market or sell
• Although the receipt of preemptive rights is not a sale, the exercise of them is.

C. Warrants
1. Grant the owner the right to purchase securities from the issuer at a specified price

• a. Long term
• b. Issued with exercise price above CMV, so no intrinsic value.

Compare: Warrants vs. Call Options

• Warrants are issued by corporations, whereas Calls are issued by individuals.
• Warrants typically have maturities of several years.
• Warrant terms are not standardized. Call options are standardized.
• When a warrant is exercised, new stock is issued, unlike Call options.
• Warrents have no intrinsic value.

A subscription warrant may be issued with a bond or preferred stock offering. A warrant is usually issued as a sweetener to make the issue more attractive. It entitles the holder to buy a proportionate amount of the issuer’s common stock at a specific price.

Question 57

Forwards and Futures
A. Forward contracts (commitments)
1. _-party contract

• a. Primarily between grower and producer
  2. Liquid?
• No active _ market, no _ trading is possible.. Because each contract is between one buyer and one seller.

3. Standardized?
4. Terms negotiated

• a. Quantity
• b. Quality
• c. Time
• d. Place
• e. Price

B. Futures contracts—_ regulated (standardized

• 1. Quantity
• 2. Quality
• 3. Time
• 4. Place
• 5. Price

Answer 57

Forwards and Futures
A. Forward contracts (commitments)
1. Two-party contract

• a. Primarily between grower and producer
  2. Nonliquid
• No active secondary market, no exchange trading is possible.. Because each contract is between one buyer and one seller.

3. Nonstandardized
4. Terms negotiated

• a. Quantity
• b. Quality
• c. Time
• d. Place
• e. Price

B. Futures contracts—exchange regulated

• 1. Quantity
• 2. Quality
• 3. Time
• 4. Place
• 5. Price

Question 58

Forwards and Futures
C. Customer forward or futures positions
1. Long (buyer)

• a. Obligated to take delivery
  2. Short (seller)
• a. Obligated to make delivery

“When investors trade _ contracts, they do not generally expect delivery of the commodity; but with _ contracts, investors generally do expect delivery of the commodity.”

In almost all cases, the holder of the futures contract will purchase an _ contract canceling the original position or sell the contract prior to expiration. In isolated cases, delivery of the commodity may be made but is not required.

In January, the July soybean futures contract is being quoted at $5.00. Believing that soybean prices are going to increase, an investor purchases one July soybean futures contract. In May, the price of the July futures has increased to $5.50 and the investor decides to take the profit. Excluding transaction costs,
with a contract size of 5,000 bushels, the investor has realized
A. a profit of $250
B. a profit of $2,500
C. a profit of $25,000
D. a loss of $.50 per bushel

Answer 58

Forwards and Futures
C. Customer forward or futures positions
1. Long (buyer)

• a. Obligated to take delivery
  2. Short (seller)
• a. Obligated to make delivery

“When investors trade futures contracts, they do not generally expect delivery of the commodity; but with forward contracts, investors generally do expect delivery of the commodity.”

In almost all cases, the holder of the futures contract will purchase an offsetting contract canceling the original position or sell the contract prior to expiration. In isolated cases, delivery of the commodity may be made but is not required.

In January, the July soybean futures contract is being quoted at $5.00. Believing that soybean prices are going to increase, an investor purchases one July soybean futures contract. In May, the price of the July futures has increased to $5.50 and the investor decides to take the profit. Excluding transaction costs,
with a contract size of 5,000 bushels, the investor has realized

B. a profit of $2,500

Question 59

Benefits and Risks forwards/futures
Benefits of forwards/futures

• 1. Limit future price risk
• 2. Lock in profit or expense

Risks of forwards/futures

• 1. _ risk (forwards) - other party doesn’t show up
• 2. Lack of _ (forwards)
• 3. Daily _ requirement (futures)
• 4. Guess wrong

Answer 59

Benefits and Risks
Benefits of forwards/futures

• 1. Limit future price risk
• 2. Lock in profit or expense

Risks of forwards/futures

• 1. Counterparty risk (forwards)
• 2. Lack of liquidity (forwards)
• 3. Daily margin requirement (futures)
• 4. Guess wrong

Question 60

DPPs Flow-Through (RELP - RE Limited Partnership is an example)
A. _ of income and expenses
1. Historically viewed as tax _ when promoter’s tax stance is too aggressive or is without economic purpose, in the view of the IRS; economic consequences of the businesses flow through to investors. Not a corporation, thus no _.

2. Economic viability
   * a. Potential for profit must _

B. Usually organized as limited _
1. Limited liability

• a. Investor’s maximum loss is amount invested plus funds committed for

Answer 60

DPPs Flow-Through (RELP - RE Limited Partnership is an example)
A. Flow through of income and expenses
1. Historically viewed as tax shelters when promoter’s tax stance is too aggressive or is without economic purpose, in the view of the IRS; economic consequences of the businesses flow through to investors. Not a corporation, thus no dividends

2. Economic viability
   * a. Potential for profit must exist

B. Usually organized as limited partnerships
1. Limited liability

• a. Investor’s maximum loss is amount invested plus funds committed for

Question 61

DPP Partners
A. General partner
1. At least one general partner (the active investor)
2. GP has _ role.
3. GP has _ liability.

B. Limited partner

1. Limited partners take no _ role (passive).
2. If enter into management, lose _ liability

C. Benefits
1. Passive losses flow through to investors.

• a. As with most new businesses, early years operate at a loss.
• b. Can offset _ income with passive losses
• c. Limited liability

2. Tax credits

D. Risks
1. Limited or no _

• a. Nontransferable without _ consent

Answer 61

DPP Partners
A. General partner
1. At least one general partner (the active investor)
2. GP has management role.
3. GP has unlimited liability.

B. Limited partner

1. Limited partners take no management role (passive).
2. If enter into management, lose limited liability

C. Benefits
1. Passive losses flow through to investors.

• a. As with most new businesses, early years operate at a loss.
• b. Can offset passive income with passive losses
• c. Limited liability

2. Tax credits

D. Risks
1. Limited or no liquidity

• a. Nontransferable without general partner’s consent

Question 62

Pooled Investment Alts
A. ETNs, leveraged ETFs, and inverse funds
1. Generally for sophisticated investor
2. Stricter suitability requirements

B. Exchange-traded notes (ETNs)

1. Also known as _-linked notes (ELNs)
2. In spite of the name, are _ instruments
3. Return _ to market-index or benchmark
4. _ risk—unsecured debt of issuer

C. Leveraged ETFs
1. Attempt to return a multiple of index

• a. 2x or 3x
• b. Losses multiplied as well

D. Inverse funds

1. Attempt to return opposite of index (e.g., benchmark falls 2%, fund increases 2%)
2. Can also be 2x or 3x leveraged
3. Inverse and leveraged—daily or weekly _—not for long-term investors

Answer 62

Pooled Investment Alts
A. ETNs, leveraged ETFs, and inverse funds
1. Generally for sophisticated investor
2. Stricter suitability requirements

B. Exchange-traded notes (ETNs)

1. Also known as equity-linked notes (ELNs)
2. In spite of the name, are debt instruments
3. Return linked to market-index or benchmark
4. Credit risk—unsecured debt of issuer

C. Leveraged ETFs

1. Attempt to return a multiple of index
   a. 2x or 3x
   b. Losses multiplied as well

D. Inverse funds

1. Attempt to return opposite of index (e.g., benchmark falls 2%, fund increases 2%)
2. Can also be 2x or 3x leveraged
3. Inverse and leveraged—daily or weekly reset—not for long-term investors

Question 63

Real Estate Investing
A. Active rather than _ role as with REITs and DPPs
1. Buying single family homes

• a. Repair and flip for gains
• b. Hold and rent for steady income

2. Commercial property

B. Benefits

1. Historical hedge against inflation
2. Cash flow
3. Rental income may be partially tax _
4. Highly _ can lead to greater profits
5. Usually not _ with stock market returns

C. Risks

1. Not generally very liquid
2. Inability to find buyers/renters
3. High leverage in down market
4. Poor management skills

Answer 63

Real Estate Investing
A. Active rather than passive role as with REITs and DPPs
1. Buying single family homes

• a. Repair and flip for gains
• b. Hold and rent for steady income

2. Commercial property

B. Benefits

1. Historical hedge against inflation
2. Cash flow
3. Rental income may be partially tax sheltered
4. Highly leveraged can lead to greater profits
5. Usually not correlated with stock market returns

C. Risks

1. Not generally very liquid
2. Inability to find buyers/renters
3. High leverage in down market
4. Poor management skills

Question 64

Commodities
A. Types of commodities
1. Agricultural (corn)
2. Animal-based (pork bellies)
3. Natural resources (crude oil)
4. Industrial metals (copper)
5. Precious metals (gold)

B. Benefits of investing in commodities

1. Potential hedge against _
2. Diversification

• a. Not _ to stock market returns
  3. Profit potential

C. Risks of commodity investing

1. Loss of principal
2. Volatility
3. Foreign market risk

• a. Currency and political

4. High _ (precious metals)
5. Lack of _

Answer 64

Commodities
A. Types of commodities
1. Agricultural (corn)
2. Animal-based (pork bellies)
3. Natural resources (crude oil)
4. Industrial metals (copper)
5. Precious metals (gold)

B. Benefits of investing in commodities

1. Potential hedge against inflation
2. Diversification

• a. Not correlated to stock market returns
  3. Profit potential

C. Risks of commodity investing

1. Loss of principal
2. Volatility
3. Foreign market risk

• a. Currency and political

4. High spreads (precious metals)
5. Lack of income

Question 65

Listed options are also known as standardized options. Which of the following choices is not one of the standardized terms of a listed option?

A)

The premium

B)

The expiration date

C)

The exercise price

D)

The underlying asset

Answer 65

A