Representative Sample Draft Series 7 Cards

Question 1

Questions on the Series 7 about retirement plans often will focus on questions of suitability. What types of accounts are among the most commonly used for retirment planning?

Answer 1

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

Question 2

What are the differences between a qualified and a non-qualified plan?

Answer 2

• Qualified will always refer to income that has not been taxed yet
• A non-qualified plan has contributions made with after-tax dollars; so the contributions grow tax free
• If the employer is offering a non-qualified plan to employees, the employee contributions can be at risk in a bankruptcy
• A non qualified plan means it is not IRS qualified or ERISA eligible to accept qualified, pre-tax dollars as contributions to the plan

Question 3

What is the purpose of an IRA account?

Answer 3

• Individual Retirement Accounts (IRA) were set up to encourage long-term savings for retirement
• IRAs have contribution limits that other retirement plans, such as SEP IRAs, don’t have
• Currently the cap on contributions is $5,500 per year for those under age 50 and $6,500 for those over 50

Question 4

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

Answer 4

Individuals may make contributions to prior-year IRA plans, i.e., now in 2014 making a 2013 contribution, until April 15.

Question 5

What is the penalty for excessive IRA contributions?

Answer 5

6%

Contributions above the limits are reduced by 6% of the contribution. Most plans won’t even allow contributions above the limits, so this is rarely an issue.

Question 6

What is the key distinction between a ROTH IRA and a regular IRA?

Answer 6

Unlike with a regular IRA, ROTH IRA contributions are not considered qualified dollars. They come from income that already has been taxed. The key here is then those tax dollars grow tax free, which is a huge benefit over long time horizons.

Question 7

What are the key features of munis?

Answer 7

1. Interest only subject to state and local taxes – this is an important tax advantage for investors wanting to preserve income
2. Unlike stocks, munis come with a legal opinion that confirms the issuer has the legal right to issue and the security is bona fide – remember the two types of legal opinions?
3. Municipals 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 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 will be paid for via taxes – basic service projects such as utilities, schools, etc.

Question 9

Where are the convenants of a revenue bond listed?

Answer 9

The Trust Indenture

This will contain all the obligations of the issuer, as well as outlining specific protections that protect the investor. The indenture also will specify a trustee who will ensure compliance with the indenture.

Question 10

What are the characteristics of a negotiated muni offering?

Answer 10

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

Question 11

What is the importance of the dated date?

Answer 11

This is when the buyer begins to accrue interest, and it accues up to the settlement date. The day of settlement is the first day the buyer will receive 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

Gamma value will be large and any requirements to hedge the position should be based on Gamma.

The value of Gamma is largest 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 derivative 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

14.16

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

Question 15

Stock price: $60
Volatility: 23%
Short-term interest rates: 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 the issuer of call options hedge his position?

Answer 15

Buying Delta share 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 it, he 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 the price of options 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) will increase call options and decrease put option prices.

An increase in volatility (Vega) will increase 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 the price of options are as follows:

Rho: Risk-free rate (interest rates)
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 of a dealer firm or his/her spouse or child 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 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 prepared.

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 what investor benefits the most?

Answer 22

Muni bond interest payments are federally tax free but taxed at the state and local level. As always, capital gains are never tax exempt, so price appreciation of the 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 of the territories of the United States, such as Puerto Rico or Guam, issue muni securities that are local-tax free to all investors. Because they don’t have a large tax base locally, this makes the territorial muni securities triple tax free.

Question 24

If munis are tax exempt, how does that change the implied yield on the security?

Answer 24

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

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