Representative Draft Series 7 Content

Question 1

Series 7 retirement plan questions often focus on product suitability. What types of accounts are most commonly used for retirment planning?

Answer 1

• Roth IRA
• 401(k) and 403(b)
• SEP IRA
• Annuities
• Defined contribution / Defined benefit plans

Question 2

What are some of the characteristics of qualified and non-qualified retirement plans?

Answer 2

• Qualified plans always refer to income that has not yet been taxed.
• Non-qualified plan contributions are made with after-tax dollars - so the contributions grow tax-free.
• Non-qualified plan employee contributions may be at risk in a bankruptcy.
• Non-qualified plans are not IRS qualified or ERISA eligible to accept qualified pre-tax dollars as contributions to the plan.

Question 3

What are some characteristics of IRA accounts?

Answer 3

• IRAs encourage long term savings for retirement.
• IRAs have contribution limits that other retirement plans, such as SEP IRAs, do not have.
• Currently, the cap on contributions is $5,500 per year for participants under age 50, and $6,500 for those over 50.

Question 4

Up until what date may a prior-year contribution be made to an IRA?

Answer 4

Individuals may make prior-year IRA plan contributions until April 15th of the current year.

Question 5

What is the penalty for above-limit IRA contributions?

Answer 5

Contributions above the limits are assessed a penalty of 6% of the excess contribution; most plans do not even allow contributions above the limits, so this penalty is rarely invoked.

Question 6

What is the key distinction between ROTH IRAs and regular IRAs?

Answer 6

Unlike in regular IRAs, ROTH IRA contributions are not considered qualified dollars - they come from income that has already been taxed. The key benefit is that these tax dollars grow tax free, which is a significant benefit over long time-horizons.

Question 7

What are the key features of munis?

Answer 7

1. Interest subject only to state and local taxes - this is an important tax advantage for investors seeking to preserve income.
2. Unlike stocks, munis carry a legal opinion that confirms the issuer has the legal right to issue and that the security is bona fide - remember the two types of legal opinions?
3. Munis usually issue serial debt (multiple maturities) and pay interest annually instead of quarterly.

Question 8

For what types of projects do municipalities use general obligation (GO) bonds?

Answer 8

Non-Revenue Projects

GOs are supported by the taxing authority of the municipality issuing the bond. They are used for projects that produce no revenue and that will be paid for via taxes - basic service projects like utilities and schools.

Question 9

Where are the convenants of a revenue bond listed?

Answer 9

The Trust Indenture

The trust indenture lists all the obligations of the issuer as well as outlining specific protections that protect the investor. The trust indenture also specifies a trustee who will ensure compliance with the indenture.

Question 10

What are the characteristics of a negotiated muni offering?

Answer 10

This type of offering is carried out directly with a single institution of the issuer’s choice and is the most common type of offering.

Question 11

What is the importance of the dated date?

Answer 11

The dated date is the date on which the buyer begins to accrue interest, which accrues up to the settlement date. The date of settlement is the first day the buyer receives interest accruals.

Question 12

You would like to reduce a client’s exposure to WJT stock, currently trading at $15.00. Your client is the ex-CEO of the company and currently has $50mm in the company’s stock.

The trading desk provides you with a quote on a put option on the stock of $2.25. The put option has a strike price of $14.00 in one year’s time, at which point a large portion of your client’s stock will vest.

At expiration, the put option on WJT stock is at-the-money. Describe the relative magnitude of Delta and Gamma?

Answer 12

The Gamma value will be high and thus any requirement to hedge the position should be based on Gamma.

The value of Gamma is highest when an option is at-the-money and near expiration. This can lead to large swings in the price of the option for which Delta hedging is not well suited. Thus, it is best to manage an option position that is near expiry and at-the-money by Gamma-hedging the position.

Question 13

You would like to reduce a client’s exposure to WJT stock, currently trading at $15.00. Your client is the ex-CEO of the company and currently has $50mm in the company’s stock.

The trading desk provides you with a quote on a put option on the stock of $2.25. The put option has a strike price of $14.00 in one year’s time, at which point a large portion of your client’s stock will vest.

Given the price of the put option quoted by the desk, and a risk-free rate of 5%, calculate the value of a call option on WJT stock.

Answer 13

Using put-call parity:

Call - Put = Stock - Strike / (1 + Rf)T

Call = Stock - Strike / (1 + Rf)T + Put
= $15.00 - $14.00 / (1 + 5%)1 + $2.25
= $15.00 - ($14.00 / 1.05) + $2.25
= $15.00 - $13.33 + $2.25
= $3.92

Question 14

The following options are quoted on a derivatives exchange:

Stock price: $90

Volatility: 29%

Short-term interest rate: 3%

Dividend: none

Expiration: 1 year

Prices of European style options:

85 strike put, price: $6.65

What is the expected price of a call with an $85 strike price?

Answer 14

Based on the put-call parity relationship, the value of the call = Put + Spot - Strike × exp(-Rate × Time)

= 6.65 + 90 - 85 × exp(-0.03 × 1)

= 14.16.

Not discounting the strike, the incorrect value of 6.65 + 90 - 85 = 11.65 is obtained.
Discounting the spot but not the strike, the incorrect value of 6.65 + 87.34 - 85 = 8.99 rounded to 9 is obtained.

Question 15

Stock price: $60
Volatility: 23%
Short-term interest rate: 2.5%
Dividend: $0.06 after 3 months
Expiration: 4 months

Ask prices of American style call options:

55 strike, price: $0.95
60 strike, price: $2.90
65 strike, price: $6.25

How would an issuer of call options hedge his position?

Answer 15

Buying Delta stock for each option

The issuer is short (not long) call options, which is equivalent to a Delta short position in the stock. In order to hedge the position, the issuer will have to buy Delta stock for each option. This leads to a Delta-neutral position

Question 16

Are the following remarks about the effects of interest rates and volatility on options prices correct or incorrect?

I. “The value of call and put options increases when interest rates increase.”
II. “The value of call and put options increases when volatility increases.”

Answer 16

Incorrect in describing the effect of interest rates; correct in describing the effects of volatility

An increase in interest rates (Rho) increases call option prices and decreases put option prices.

An increase in volatility (Vega) increases both call and put prices.

Also note that both call and put options are directly related to time (Theta), i.e., the greater the time to expiration, the greater the option price.

Question 17

The sensitivity of an option to interest rates and volatility is ascribed which Greek names?

Answer 17

The various factors affecting options prices are as follows:

Rho: Risk-free rate (interest rate)
Vega: Volatility
Theta: Time
Delta: Sensitivity to a change in the underlying (similar to duration)
Gamma: Sensitivity of delta to a change in the underlying (similar to convexity)

Question 18

The underlying is a 90-day interest rate and is at 9 percent when the options expire.

The notional principal is $25 million, and the exercise rate is 8 percent.

What are the payoffs of calls and puts, respectively?

Answer 18

$62,500; $0

Calls: Max(0, 0.09 - 0.08) x (90/360) x $25,000,000 = $62,500

Puts: Max(0, 0.08 - 0.09) x (90/360) x $25,000,000 = $0

Question 19

What must happen if an employee, spouse, or child of a dealer firm opens a brokerage account?

Answer 19

The firm where the account is opened must notify the employer in writing and must send duplicate copies of all confirmations to the employer.

Question 20

According to the rules, with every sale of a municipal security, what document must either precede or arrive with delivery of the shares?

Answer 20

The Official Statement

A preliminary official statement is acceptable if the final is not yet available, so long as the final is sent when it is completed.

Question 21

What is the muni day count for days in a month and days in a year?

Answer 21

Munis trade 30/360

Question 22

How are munis taxed and which investors benefit most?

Answer 22

Muni bond interest payments are federally tax free but are taxed at the state and local levels. As always, capital gains are never tax exempt, so price appreciation of a muni is a taxable event. For this reason, investors in higher tax brackets benefit more from investing in muni securites than investors in lower tax brackets.

Question 23

What are triple tax free munis?

Answer 23

Some territories of the US, such as Puerto Rico and Guam issue muni securities that are local tax free to all investors, since they do not have a large local tax base. This makes these territorial muni securities triple tax free.

Question 24

How does tax exemption change the implied yield on muni securities?

Answer 24

In order to compare taxable and non-taxable securities, it is helpful to calculate the equivalent yield between the two securities.

• To calculate tax equivalent yield, divide the tax-free yield by (100% - tax bracket percentage) . Since this number will natuarlly be lower than 1, dividing it into the yield will “raise” the yield and make comparison easier.