Suitability Examination Flashcards
Which TWO of the following statements are
TRUE concerning hedge funds?
I. They might be suitable for investors
seeking exposure to distressed or
bankrupt companies
II. They are permitted only to sell short
securities with prior regulatory approval
III. They may charge both an annual fee
and a fee based on the funds’ profits
IV. They are subject to the same rules as
mutual funds
a. I and III
b. I and IV
c. II and III
d. II and IV
(A) A hedge fund is an investment fund that pools investors’ money. Hedge funds might be
suitable for investors seeking exposure to distressed or bankrupt companies since many of the restrictions placed on mutual funds are not applicable to hedge funds. They are
permitted to sell short, invest in privately issued securities, and invest in other types of risky strategies without regulatory approval. Hedge funds often have higher fees than mutual funds, and their fees may include a percentage of assets under management and a percentage of the gains (for example, a 2% management fee plus 20% of the gains). (73611)
Which of the following choices would be
LEAST suitable for an investor seeking
liquidity?
a. Preferred stock of a financial services company b. A mutual fund that invests in international markets c. A real estate investment trust (REIT) d. A hedge fund using leverage
(D) Of the choices listed, the hedge fund would be the least suitable since it does not offer liquidity. Hedge funds are not subject to the same regulations for requiring access to their funds as are mutual funds. The shares are not redeemable on a daily basis and are not suitable for an investor requiring a certain degree of liquidity. The preferred stock and REIT are exchange-traded and may be sold at any time. (73614)
A 28-year-old single investor has funds saved at a bank. He contacts an RR and wants to begin allocating funds to a retirement account. Which of the following choices is the most appropriate asset allocation?
a. 80% stocks, 20% bonds
b. 60% stocks, 40% bonds
c. 50% stocks, 50% bonds
d. 30% stocks, 70% bonds
(A) Long-term, risk-tolerant investors, such as those saving for retirement, are usually looking
for growth of capital as an objective. They are also usually concerned about the effects of
inflation. Over long periods, stocks usually keep pace or offer higher returns as measured
against inflation. Inflationary risk is also referred to as purchasing-power risk. Since the
investor is many years from retirement, a large percentage of his portfolio should be
allocated to stocks. (72515)
A customer in his late twenties wants
capital appreciation and tax-deferred
growth. He is willing to take a moderate
degree of risk in his initial investment. The
customer is also concerned about the
inflationary risk to his portfolio. Which of
the following investments is MOST suitable?
a. Equities
b. Corporate debt
c. Municipal debt
d. Variable annuities
(D) Since the investor is concerned about inflationary risk, wants tax-deferred growth, and is willing to accept a moderate degree of risk to his initial investment, variable annuities are the most appropriate investment. If the investor did not want a tax-deferred investment with the same objectives, equities would be the most suitable choice. (73693)
When determining whether a CMO is
suitable, an RR must offer to a client all of
the following information, EXCEPT a:
a. Glossary of terms
b. Discussion on how changing interest
rates may affect the prepayment rates
c. Discussion on how changing currency
rates may affect the value of the
securities
d. Discussion on the relationship between
mortgage loans and mortgage securities
(C) Broker-dealers must offer customers educational material about the features of CMOs. This material must include:
- A discussion of the characteristics and risks of CMOs. This includes: how changing
interest rates may affect prepayment rates and the average life of the security, tax
considerations, credit risk, minimum investments, liquidity, and transactions costs.
- A discussion of the structure of a CMO. This includes the different types of structures,
tranches, and risks associated with each type of security. It is also important to explain
to a client that two CMOs with the same underlying collateral may have different
prepayment risk and different interest-rate risk.
- A discussion that explains the relationship between mortgage loans and mortgage
securities
- A glossary of terms applicable to mortgage-backed securities Changing currency rates are not applicable to the risks associated with CMOs. (72865)
Pete and Danielle, a married couple, are in
their 20s. They both have jobs that pay well
and they have begun to think about
investing for retirement. Which of the
following portfolio allocations is MOST
appropriate for them?
a. 10% bonds, 90% stock
b. 100% common stocks
c. 80% bonds, 10% common stocks, 10%
money-market
d. 50% bonds, 50% common stocks
(A) To accumulate the assets they will need at retirement, Pete and Danielle should include
common stocks in their portfolio. A portfolio that is predominately bonds, choice (c), will
not likely produce the required long-term returns. However, a portfolio that mixes stocks
and bonds, choice (d), is probably a better choice for the couple than one that is exclusively common stock, choice (b). However, given their long time horizon (they are still in their 20s), Pete and Danielle can probably tolerate additional investment risk, so they can put the majority of their savings in stocks to increase their potential return. Choice (a) would be most appropriate, given their goals and risk tolerance. (73686)
Which of the following risks for an agency-backed CMO is LEAST important to an
investor in a rising interest-rate
environment?
a. Prepayment risk
b. Credit risk
c. Interest-rate risk
d. Extension risk
(A) Prepayment risk is associated with a falling interest-rate environment in which mortgage
holders refinance or repay their mortgages at a faster rate. The holder of a CMO, therefore,
receives a larger portion of the principal earlier than anticipated and is forced to reinvest at lower rates. Many CMOs are created from government agency mortgage-backed securities (MBS), which have a minimal amount of credit risk. Some CMOs are constructed without this backing and, therefore, credit risk is a greater concern. CMOs, as with most fixed-income securities, carry interest-rate risk. Extension risk is the opposite of prepayment risk, where interest rates are rising and the CMO holder receives a smaller portion of her principal back. (72866)
A married couple with a three-year-old
child would like to purchase an investment
that will be suitable to help pay for the
child’s college education. Which TWO of
the following choices are the most suitable
alternatives?
I. A CMO tranche scheduled to mature in 15 years II. A STRIP scheduled to mature in 15 years III. An ETF based on the S&P 500 Index IV. A money-market fund
a. I and III
b. I and IV
c. II and III
d. II and IV
(C) Since the child will attend college in approximately 15 years, a STRIP (zero-coupon bond) would be suitable. There is no need for current income. The CMO pays monthly income and, therefore, is not suitable. It can also offer a return of principal much earlier than 15 years due to the prepayment risk of this type of security. An exchange-traded fund (ETF) that tracks the S&P 500 may be suitable since the funds are not required for 15 years and the value of this security offers the investor a hedge against the rising price of college tuition. With this time horizon, a money-market is not suitable since it will not keep pace with inflation. (72134)
Which of the following interest-rate
environments makes call protection MOST
valuable to a purchaser of bonds?
a. Increasing interest rates
b. Stable interest rates
c. Volatile interest rates
d. Decreasing interest rates
(D) Call protection would be most valuable to a purchaser of bonds when interest rates decline. If interest rates fall, existing bond prices rise. A municipality or any issuer would likely call bonds when interest rates decline so it can issue new bonds with lower rates of interest. Although bonds may be callable at a small premium above par value, if the bonds are not callable, the investor may realize the full benefit of an increase in the market price of the bonds. (72722)
A high net worth investor seeking safety of
principal would MOST likely invest in:
a. Corporate convertible bonds
b. Non-investment-grade corporate bonds
c. An investment-grade corporate bond
fund
d. A variable annuity
(C) Safety of principal refers to a customer being able to preserve or retain the initial amount of the investment over its life. Many bonds and bond funds offer investors this feature. The higher the rating, the greater the likelihood the investor will achieve safety of principal. An investment-grade corporate bond fund would offer more safety of principal than non-investment-grade and convertible corporate bonds. A variable annuity may fluctuate in value based on the subaccounts chosen by the investor. (73678)
Which of the following securities would you
LEAST likely recommend to an investor
requiring a fixed sum of funds to be
received in 10 years?
a. A zero-coupon municipal bond
b. A high-yield corporate bond
c. Collateralized mortgage obligations
(CMOs)
d. Treasury Inflation-Protected Securities
(TIPS)
(C) The risk that an investor will receive her principal earlier than projected instead of at one time (i.e., prepayment risk) is the most important risk pertaining to mortgage-backed
securities such as CMOs. Since the investor wants to receive a fixed amount of funds in 10
years, a CMO would be the least suitable of the securities listed. (73556)
Which of the following option strategies is
most suitable in a retirement account under
ERISA guidelines?
a. A long straddle
b. Covered call writing
c. A credit spread
d. No strategies, since options are not
permitted in retirement plans
(B) Options may be used in the investment strategies of retirement plans subject to ERISA
provisions, but they tend to be limited to the most conservative approaches, such as the
sale of covered call options. (72047)
An investor is convinced that a stock will
decline in value. If the investor wishes to act
on that conviction, which investment
strategy will allow him to take advantage of
a decline with the smallest amount of cash
outlay?
a. The investor should sell the stock short
b. The investor should buy a call
c. The investor should buy a put
d. The investor should sell a put
(C) The investor should buy a put. By buying a put, the investor could go into the market if the
stock declined and buy the stock at a lower price. He would exercise the put and sell the
stock to the writer at the exercise price. Buying a put costs less money than selling short because the short position requires a 50% deposit with a minimum margin deposit of
$2,000. The investor will not sell (write) a put because the writer of a put option would profit
if the market price increased above the strike price and the put expired worthless. The
purchaser of a call anticipates an increase in market prices and, in this example, there is an
anticipation of a decrease in market prices. (71732)
Which of the following investors would
purchase an inverse exchange-traded note?
a. An investor seeking current income
b. An investor seeking long-term capital
gains
c. A buy-and-hold investor
d. An investor seeking to trade quickly
(D) Exchange-traded notes (ETNs) are a type of unsecured debt security. ETNs carry issuer risk
that is tied to the creditworthiness of the financial institution backing the note. These
securities are not like traditional fixed-income securities since they typically do not make
interest payments to investors. The returns are linked to the performance of an index,
currency, or commodity and would be suitable for investors who want to speculate on the
value of an index. An inverse ETN would pay the opposite of the benchmark that is being
tracked and would be suitable for a person interested in short-term trading. Most ETNs are
traded on a national exchange (e.g., the NYSE) and, therefore, an investor can quickly sell
the security to earn a short-term gain. (73607)
When engaging in a 1035 exchange an
individual should be aware that:
a. The exchange is a taxable event
b. The exchange is not a taxable event but
the new annuity may come with
additional restrictions
c. The exchange is not a taxable event and
the policies of the old annuity are
remain in place
d. The exchange is only permitted if it is
unsolicited
(B) The primary benefit of a 1035 exchange is that it is not taxable. However, the new annuity
may come with new restrictions making it unsuitable for the investor. (73799)
Buyers of municipal bonds would normally
NOT include:
a. Insurance companies
b. Banks
c. Defined benefit plans
d. Mutual funds
(C) A defined benefit plan is a type of pension fund. Pension funds and other tax-deferred
accounts would not benefit from the tax exemption provided by municipal bonds. As a
result, unless the bonds are taxable and offer yields equivalent to other taxable bonds,
pension funds would not include municipal bonds in their portfolio. The exception would
be Build America Bonds (BABs), which are taxable municipal bonds. (73509)
Which of the following securities may NOT
be purchased in a discretionary account
without prior written approval by the
customer?
a. An exchange-traded note
b. A variable-rate demand obligation
c. A direct participation program
d. A collateralized mortgage obligation
(C) A registered representative may not purchase a direct participation program in a
discretionary account without prior written approval by the customer. (73599)
Mr. Jones is a small business owner who has
purchased Treasury bills and other short-term
securities during times when he has
excess funds available in the business. He
likes the aspects of liquidity and safety. A
friend has told him he can get higher rates
from auction rate securities. He wants to
know why you have not recommended this
investment to him. Which TWO of the
following explanations would you cite as
your reasons?
I. Auction rate securities are long-term
investments
II. Interest or dividend rates are reset at
established intervals based on a Dutch
auction
III. If the auction fails, the client may not
have immediate access to his funds
IV. The interest or dividend rate is set as
the lowest rate to match supply and
demand at the auction
a. I and III
b. I and IV
c. II and III
d. II and IV
(A) Although auction rate securities are usually sold as an alternative to other short-term
securities, they are long-term securities. An RR must disclose to a client that, if the auction
fails, the client may not have immediate access to his funds. The RR also has a duty to
disclose to clients any material fact relating to the specific features of the auction rate
securities and the customer’s need for a liquid investment when recommending this type of
product. The fact that the interest or dividend rate is reset at specified intervals is a material
fact, but is not a reason to avoid recommending the investment. The same reasoning
applies to the fact that the rate is set at the lowest rate that matches supply and demand.
These investments may not be suitable for investors who have a need for liquidity. (72972)
A registered representative is required to
certify which TWO of the following choices
when a customer is purchasing a limited
partnership?
I. That the customer has been advised by an accountant II. That the customer is in a financial position to be investing in this type of product III. That the customer has a sufficient net worth to lose his entire investment IV. That the customer will not be investing in this type of product for a retirement account
a. I and III
b. I and IV
c. II and III
d. II and IV
(C) A registered representative would be required to certify that she informed the customer of
all relevant facts relating to the lack of marketability and liquidity of the limited partnership.
In addition, after obtaining information about the customer’s investment objectives,
financial and tax status, other investments, and future financial needs, the RR must have
reasonable grounds to believe the customer has sufficient net worth and income to lose his
entire investment, or has other liquid assets. The RR must certify that the customer is
suitable, and is in a financial position to be investing in this limited partnership. There is no
requirement to certify that the customer has been advised by an accountant or an attorney.
A limited partnership is permitted to be sold to a retirement account. (73590)
n investment in which of the following
securities requires a customer to sign a
statement attesting to her annual income
and net worth?
a. A variable annuity
b. A collateralized mortgage obligation
c. A variable-rate demand obligation
d. A direct participation program
(D) An investor purchasing a limited partnership or DPP is required to sign a subscription agreement. As part of this agreement a customer would be required to sign a statement attesting to her annual income and net worth. In order to be suitable for this type of investment, the customer must meet minimum annual income and net worth
requirements. By signing this statement, the customer has acknowledged the information
she disclosed is accurate. The other investments do not require this type of statement signed by the customer. (73598)
