Unit 3: KYC, Risk & Suitability, Product Flashcards
KYC
Know Your Customer. Rule that places an obligation on the firm and associated person to seek information from customers. Customers are not required to provide all information asked; therefore the KYC rule provides some flexibility when information is unavailable. Both financial and and nonfinancial information must be gathered before making investment recommendations.
What are a customers Financial Investment Considerations
Financial investment considerations can be expressed as a sum of money. Financial questions have answers that show up on a customer’s balance sheet or income statement.
Define P/E ratio.
Price to earnings ratio measures the relationship between a company’s stock price with the company’s earnings earnings per share. The P/E ratio indicates how much investors are willing to pay for every dollar of earnings.
Are municipal bonds suitable for retirement accounts?
No, as while muni-bonds provide federally tax-free income, they are not suitable for retirement accounts. The federally tax-free interest income will be fully taxable upon withdrawal.
List products based on the following customer objective: Preservation of capital/safety.
CDs, money market mutual funds, fixed annuities, gov’t securities and funds, agency issues, investment-grade corporate bonds and corporate bond funds.
List products based on the following customer objective: Growth
- balance/moderate growth
- aggressive growth
common stock, common stock mutual funds
blue chip stocks, defensive stocks
Technology stocks, sector funds
List products based on the following customer objective: Income
- tax-free income
- high-yield income
- from stock portfolio
- bonds (but not zero coupons), REIT’s, CMOs
- Municipal bonds, municipal bond funds, Roth IRAs
- below investment-grade corporate bonds, corporate bond funds
- preferred stocks, utility stocks, blue-chip stocks
List products based on the following customer objective: Liquidity
Securities listed on an exchange. Nasdaq stocks or bonds, mutual funds, publicly traded REITs
List products based on the following customer objective: Portfolio diversification
- mutual funds, in general; more specifically, asset allocation funds and balanced funds
- for equity portfolios, add some debt and vice-versa
- for domestic portfolios, add some foreign securities
- for bond portfolios, diversify by region/rating
List products based on the following customer objective: Speculation
-option contracts, DPPs, high-yield bonds, unlisted/non-NASDAQ stocks or bonds, sector funds, precious metals, commodities, futures.
Systematic vs unsystematic risks
Systematic risks affect all investments (e.g. stock market downturn). Unsystematic risks affect some but not other investments.
What is business risk?
Business risk is a form of unsystematic risk that affects companies and industries individually. Can be reduced by diversifying investments.
Define inflation risk.
Also known as purchasing power risk or constant dollar risk, inflation risk is the effect of continually rising prices on investments resulting in less purchasing power.
Define Capital risk.
Capital risk or principal risk is the potential for an investor to lose all his money (invested capital) under circumstances either related or unrelated to an issuer’s financial strength.
Define Timing Risk.
Risk of buying or selling at the wrong time and incurring losses or lower gains is known as timing risk.
Define Interest Rate Risk.
Refers to the sensitivity of an investment’s price or value to fluctuations in interest rates. Interest rate risk is a type of systematic risk.
What is the relationship between short-term interest rates and volatility.
Short-term interest rates are more volatile because they change more frequently (e.g. federal funds rate changes daily). Long-term debt securities, however, are more volatile (price wise) as investors are more likely to sell/buy in response to changes in interest rates.
Define Bond Duration
Bond duration is the measure of the amount of time a bond will take to pay for itself. Each interest payment is taken to be part of a discounted cash flow. The longer a bonds duration the greater its sensitivity to interest rate changes. The duration of an interest-paying bond is always shorter than its time to maturity because interest payments can be reinvested and earn more income. The duration of a zero-coupon bond always equals time to maturity.
Reinvestment Risk
ability to reinvest at same or higher interest rate. When rates decline, it is difficult for bond investors to reinvest the proceeds from investment distributions and maintain the same level of return at the same level of (default) risk.
Market Risk
a type of systematic risk. Both stocks and bonds involve some degree of “market risk”. An investor cannot diversify away market risk.
Credit risk
Also called financial risk or default risk involves the danger of losing all or part of one’s invested principal through an issuer’s failure. Associated with debt securities, not equity securities.
What are the 2 best known rating services
Moody’s Investor Service and Standard and Poor’s (S&P).
Legislative Risk
Risk associated with the possibility of unfavorable government action or social changes resulting in the loss of value.
Call Risk
Risk that a bond might be called by the issuer before maturity; and investors cannot reinvest their principal at the same or a higher rate of return. Investors concerned about call risk should look for call protection, a period of time during which a bond may not be called.
What are the advantages of a callable bond to issuer?
- If rates decline, issuer can redeem bonds with higher rate and replace them with bonds with lower rate.
- Issuer can call bonds to reduce debt.
- Issuer can replace short-term debt with long-term debt and vice-versa
- Issuer can call bonds as a means of forcing the conversion of convertible corporate bonds.
Asset allocation
Specifically Asset Class Allocation refers to the spreading of portfolio funds among different asset classes.
Tactical Asset Allocation
Refers to the short-term portfolio adjustments that adjust the portfolio mix between asset classes in consideration of current market conditions.
Modern Portfolio Theory
MPT. employs a scientific approach to measuring risk and choosing investments. It is the concept of minimizing risk by combining volatile and price-stable investments in a single portfolio. Created by Harry Markowitz. One key aspect is that diversification reduces risk only when assets whose prices move inversely, or at different times, in relation to one another are combined. In other words, MPT wants securities in a portfolio to have negative coorelation
CAPM
Capital Asset Pricing Model. Used to calculate the return an investment should achieve based on the risk that is taken.
Alpha
the extent to which an asset’s or portfolio’s actual return exceeds or falls short of its expected return. Positive alpha is desired.
List four types of industries (macro)
Defensive - food, pharmaceuticals, utilities, etc.
Cyclical - steel, heavy equipment, autos, capital goods
Countercyclical - gold, mining stocks
Growth - tech
Capital in Excess of Par
Often called additional paid-in capital or paid-in surplus is the amount of money over par value that a company received for selling stock.
Retained Earnings
Profits that have not been paid in dividends. Sometimes called earned surplus or accumulated earnings.
Working Capital
current assets minus current liabilities = working capital
Current Ratio
Current assets divided by current liabilities = current ratio
Quick Asset Ratio
Also known as acid-test ratio. Same as current ratio but only uses “quick” assets where are current assets minus inventory.
Debt to equity ratio
Best way to measure amount of leverage being employed by a company. Debt to total capitalization. Over 50% is usually considered highly leveraged but of course depends on industry.
Book Value per share
basically the liquidation value per share. Tangible assets - liabilities - par value of preferred / shares of common = book value per share.
EPS
EPS = earnings available to common / number of shares outstanding
Current Yield (stock)
CY = annual dividends per common share / market value per common share.
Dividend Payout Ratio
Annual dividends per common share / EPS
Cash flow from financing activities vs. Cash flow from operations.
Cash flow from operations will only use items from the income statement, while cash flow from financing activities will use the balance sheet.
P/E Ratio
P/E Ratio = current market price of a common share / Earnings per share.
Technical Analysis
Attempts to predict the direction of prices on the basis of historic price and trading volumes when laid out graphically on charts.
Fundamental Analysis
Concentrates on broad-based economic trends; current business conditions within an industry and the quality of a particular corporation’s business, finances and management.
Authorized stock
Refers to a specific number of shares the company has authorization to issue or sell. Laid out in company charter. If a company decides to sell more shares than are authorized, the charter must be amended through a stockholder vote.
Issued Stock
Stock that has been authorized and distributed to investors. Authorized but unissued stock does not carry the rights and privileges of issued shares and is not considered in determining a company’s total Capitalization.
Treasury Stock
Stock that has been issued and subsequently repurchased from the public.
Statutory voting
allows a stockholder to cast one vote per share owned for each item on the ballot (such as candidates for the BOD.)
Cumulative Voting
Cumulative voting allows stockholders to allocate their total votes in any manner they choose.
Tender Offer
When a company attempts to take over another company by acquiring a significant percentage of its voting shares. The SEC defines tender offer as “an active and widespread solicitation by a company or third party to purchase a substantial percentage of the company’s securities.
Participating Preferred Stock
offers owners a share of corporate profits that remain after all dividends and interest due other securities are paid. The percentage to which participating preferred stock participates is noted on the stock certificate. exampl.e . “XYX 6% preferred participating to 9%”
Callable Preferred
stock that a company can buy back from investors at a stated price on the call date or any date thereafter. Company usually pays a premium for the call privilege - $103 for a $100 par value stock.
Adjustable-rate preferred
Dividends are tied to rates of other interest rate benchmarks such as T-bills and money market rates.
Preemptive rights/stock rights
Rights that entitle an existing stockholder to maintain their proportionate ownership in a company. A rights offering allows stockholders to purchase common stock below the current market price. A stockholder who receives rights may:
- exercise the rights
- sell the rights (rights certificates are negotiable)
- let the rights expire.
Subscription right certificate
A certificate representing a short-term (typically 30-45 days) privilege to buy additional shares of a corporation. One right is issued for each common stock share outstanding.
Calculate for value of rights before and after ex date
before ex date: MP-SP/Number of rights to purchase 1 + 1
after ex date: MP-SP/Number of rights to purchase 1
Warrants
certificate granting its owner the right to purchase securities from the issuer at a specified price (normally higher). Warrants typically have a life of 5 years. Usually offered to the public as sweeteners or inducements in connection with other securities such as bonds or preferred stock to make those securities more attractive. Warrants are detachable and may trade separately from the bond or preferred stock.
ADRs
American Depositary Receipts: Issued by a domestic bank and trade on the US securities market. Each ADR represents a specific number of shares in a foreign company held by the custodian - typically a bank.
- Rights of ADRs: Generally same as common stock though typically no voting rights
- Delivery of Foreign Security: ADR owners have right to exchange for the foreign shares they represent.
- Taxes: Withholding tax on dividends is taken at the source as foreign income tax and investor may take credit against US income taxes.
- Currency Risk is an important consideration
- Dividends are declared in the foreign current but are payable in US dollars.
Sponsored ADRs
All exchanged listed ADRs are sponsored - that is, the foreign company sponsors the issue to increase its ownership base. Sometimes referred to as ADS - American Depositary Shares.
Penny Stocks
- non-Nasdaq listed
- less than $5 a share
- highly speculative
- BDs must determine suitability on basis of information about buyer’s financial situation and objectives.
- Customer must sign and date this suitability statement before trades
- Disclosure must have: name of stock, number of shares, current quote, compensation to BD/advisor
- if accounts hold penny stocks, then BD must provide monthly statement.
- Established customers are exempt from suitability requirement but not from disclosure. Established defined as account over 1 year and has at least 3 different penny stock purchases.
Mortgage Bonds
have the highest priority among all claims on assets pledged as collateral.
Collateral Bonds
Issued by corporations that own securities of other companies as investments and uses those securities as collateral. Collateral trust bonds may be back by:
- another company’s stocks and bonds
- stocks and bonds of partially or wholly owned subsidiaries
- pledging company’s prior lien long-term bonds that have been help in trust to secure short-term bonds
- installment payments or other obligations of the corporation’s clients.
Equipment Trust Certificates
Used by railroads, airlines, trucking companies and oil companies to finance purchase of capital equipment.
Debentures
Type of unsecured bond back by the general credit of the issuing corporation. Debentures are below secured bonds and above subordinated debentures and preferred and common stock in the priority of claims on corporate assets.
Liquidation order
- secured debt (bonds and mortgages)
- unsecured liabilities (debentures) and general creditors
- subordinated debt
- preferred stock
- common stock
Guaranteed Bonds
backed by a company other than the issuer such as a parent company
Income bonds
also known as adjustment bonds, are used when a company is reorganizing and coming out of bankruptcy. Only pays interest if corporation has enough income to meet the interest payment and the BOD declares a payment. Not suitable investments for customers seeking income.
Taxation of Zero-coupon bonds
Investors owe income tax each year on the amount by which the bonds have accreted, just as if the investor had received it in cash. The tax is due regardless of the direction of the market price. Customer is permitted to adjust cost basis upward each year by the amount of the annual accretion so that if held to maturity there is no capital gains as accreted value equals par. Zeros have no reinvestment risk because with no interest payments to reinvest, the investor has no reinvestment risk.
Advantages of convertible securities to the Issuer
- can be sold at a lower coupon rate than nonconvertibles because of the conversion feature
- company can eliminate a fixed interest charge as conversion takes place, thus reducing debt
- because conversion normally occurs over time, no adverse effect on stock price.
- company avoids immediate dilution of primary EPS
- at issuance, conversion price is higher than market price of the common stock
Disadvantages of convertible securities to issuer
- when converted, shareholders’ equity is diluted
- could lead to shift in control of company
- loss of leverage
- decrease in deductible interest raises taxable income.
Equity-Linked Notes (ELNs)
Debt instruments where the final payment at maturity is based on the return of a single, basket of stocks or an equity index. Not suitable for most investors.
CMOs
Collateralized Mortgage Obligations are a type of asset backed security. Asset-backed securities are ones whose value and income payments are derived from or backed by a specific pool of underlying assets.
Classes of CMOs
- principal only (POs). Income comes from principal - both scheduled and prepayments. PO sells for a discount and so tends to be more volatile.
- Interest-Only (IOs). Sells at a discount and its cash flow declines over time, just as the proportion of interest in a mortgage payment declines over time. Unlike POs, IOs increase in value when interest rates rise. Can be used to hedge a portfolio against interest-rate risk.
- Planned Amortization Class (PACs)
- Targeted Amortization Class
- Zero-Tranche: receives no payment until all preceding CMO tranches are retired (the most volatile CMO tranches). Not suitable not be suitable for an investor needing funds in a specified amount of time.
Risks of CMOs
- rate of principal repayment varies
- if interest rates fall and homeowner refinancing increases, principal is received sooner (prepayment risk)
- if interest rates rise and refinancing declines, CMO investor may have to hold his investment longer than anticipated (extended maturity risk).
T-notes
pay interest every 6 months and mature 2-10 years. Sold at auction every 4 weeks. T-notes are issued, quoted and trade as a percentage of par in 1/32%
T-bonds
long term (10-30 years) and pay interest every 6 months. Quoted exactly like par (1/32% of par).
STRIPS
Separate Trading of Registered Interest and Principal Securities. STRIPS are backed by full faith of US government. Receipts are not. Treasury Receipts are created by BDs and sold under names like Certificates of Accrual on Treasury Securities (CATS) and Treasury Income Growth Receipts (TIGRS).
TIPS
Treasury Inflation Protection Securities. A type of treasury that helps protect investors against purchasing power risk. Usually issued with fixed interest rate, but the principal amount is adjusted semiannually by an amount equal to the change in Consumer Price Index (CPI). Exempt from state and local income taxes just like other Treasuries and subject to federal taxx.
Settlement of Agency Securities
T+2. Yields of agency issues have higher yields than gov’t securities but lower than corporate debt securities.
Taxation for Agency Issues
Gov’t agency issues that are backed by mortgages are taxed at the federal, state and local levels. Other agency securities are generally taxed at federal level only.
GNMA
Ginnie Mae: Gov’t-owned corporation that supports the Department of Housing and Urban Development. Ginnie Maes are the only agency securities backed by the full faith and credit of the federal government.
What are the risks associated with MBS?
Mortgage Backed Securities are susceptible to reinvestment risk. When interest rates fall, mortgage holders typically refinance at lower rates and the early principal payments cannot be reinvested at a comparable return.
MMF
Money Market Mutual Funds. for retail investors have a stable NAV or $1.00 but are not guaranteed nor protected by FDIC. Rare but possible to lose money in a money market mutual fund.
Define Diversified Investment Company
Under the Investment Company Act of 1940, a diversified investment company is one that meets the requirements of the 75-5-10 test:
- at least 75% of fund’s total assets must be invested in securities issued by companies other than the investment company itself or an affiliate.
- of the 75%, no more than 55 of the fund’s total assets in any one company and no more than 10% of the outstanding voting securities of any one issuer is owned by the 75%.
- If a security represents 5% or less of the fund’s total assets at the time of purchase and thereafter exceeds 5% due to capital appreciation, no action is required in order to maintain a diversitifed status.
What are the advantages/disadvantages of ETFs?
Advantages -pricing and ease of trading -margin -operating costs -tax efficiency (limited to no capital gains) Disadvantages -commissions -overtrading
What are REITs and what are the advantages/disadvantages of REITs
REITs are not an investment company security but are extensively regulated in ways similar to the Investment Company Act of 1940.
Reasons someone might add REITs to portfolio:
-Ability to invest in real estate without incurring the degree of liquidity risk associated with real estate as REITS trade on exchanges and OTC
-provides some hedge to price movements in other equity markets
-provide reasonable expectation of income from dividends and capital appreciation
Risks
-investor has no direct control over portfolio
-Problematic loans can cause decreases in income flow
-Dividends paid by trusts do not meet the requirements of qualified dividends and therefore are taxable at full ordinary income tax rates.
Calculate a mutual funds expense ratio
Dividing a fund’s expenses by its average net assets. Stock funds generally have expense ratios between 1% and 1.5%.
What factors go into calculating a mutual fund’s expense ratio
BOD stipend, investment adviser fee, custodian fee, transfer agent fee, 12b1 fee, legal and accounting expenses.
Sales load is not included
How are mutual funds taxed?
Mutual fund investors pay taxes on any dividends or capital gains the fund distributes. Even if an investor elects to reinvest some or all of the distributions, the total amount is taxable in the year earned by the fund.
Calculate Net Investment Income
NII = Dividends + Interest - expenses of fund
*NII does not include capital gains.
Does a Bond Fund pay interest to investors?
No. Investors buy common stock of the bond fund and therefore will receive a dividend if declared. Interest paid in the form of a dividend is taxed as interest.
Cost basis of shares inherited/Gifted
Cost basis is either stepped up or stepped down to its FMV at the date of a decedent’s death. In the case of an open ended fund, this would be NAV. Sales of inherited shares are always considered long term capital gains if sold. If it’s a gift then donor’s cost basis is the donee’s cost basis.
Donor Taxes
When a person dies, tax is due on the estate. Tax is payable by the estate and not by heirs. If a person gives a gift, tax is due on the gift, payable by the donor.
Estate and gift taxes are taxed as….
progressive taxes (vs. flat rate).
Wash Sale
Capital losses may not be used to offset gains or income if the investor sells a security at a loss and purchases the same or a substantially identical security within 30 days before or after the trade date.
What are the 3 accounting methods to value fund shares when selling
FIFO - IRS assumes this unless investor uses other 2 methods
Share Identification
average basis.
Calculate NAV
total assets - liabilities = net assets of fund. Fund then divides the net assets by the number of shares outstanding.
What are Class A shares
Shares sold with a front-end load.
What is an LOI relative to a funds sales charges
Investor informs the investment company that they intend to invest the additional funds necessary to receive the breakpoint within 13 months and receives the breakpoint for the total amount invested. Only binding on the fund. LOI may be backdated up to 90 days.
Rights of Accumulation
Allows investor to qualify for reduced sales charges by reaching the breakpoint. Uses prior share appreciation and reinvestment to qualify. does not have a time limit.q
A head and shoulders bottom formation is an indication of:
A head and shoulders bottom formation is also known as an inverted head and shoulders formation. It is that part of a graph in which a downtrend has reversed to become an uptrend. It is not, however, an indicator of the bullishness or bearishness of the market as a whole. It is an indication only of the direction of a trend, which may be either short or long in duration.
A technical analyst is least concerned with:
A technical analyst is interested in statistics about market or price performance, not the fundamental factors, the market, or the company’s dividend policy. Technical analysts are interested in trading volume as a market statistic, new highs and lows, and open short positions, which could indicate future buying potential in the security.
Variable annuity.
Insurance companies introduced the variable annuity as an opportunity to keep pace with inflation. For this potential advantage, the investor, rather than the insurance company, assumes the investment risk. A universal variable life policy should be purchased primarily for its insurance features, not its investment features.
A technical analyst is concerned with…
Technical analysts are more interested in forecasting market trends and securities prices than in studying individual corporations. Therefore, they are concerned with market prices, trading volumes, changes in the Dow Jones Industrial Average, reversals, support and resistance levels, advance/decline lines, short interest, and many other factors that might help them time buying and selling decisions. Fundamental analysts, on the other hand, concentrate on a stock’s intrinsic quality and are concerned with PE ratios and earnings per share.
SEC rules require that open-end management companies distribute dividends to their investors from the firm’s:
net investment income.
A customer buys 100 XYZ at $30. Two years later, with the stock trading at $70, the customer makes a gift of the securities to his son…what is the value and cost basis
When making a noncharitable gift of securities, the donor’s cost basis is passed to the recipient. Value is $7,000 and cost basis is $3K
How are Treasuries taxed?
Interest on Treasury bonds is not taxed at the state level or local level.
How are CMOs taxed?
Interest earned on all mortgage-backed securities is fully taxable.
A purchase or redemption order for investment company shares must be executed at a price based on the:
net asset value next computed after the fund receives the order. Purchase or redemption of mutual fund shares occurs at the net asset value next calculated after the fund receives the order; this is known as forward pricing.
Reference: 3.15 in the License Exam Manual
U.S. government securities that are deposited with a trustee against which certificates are sold representing principal payments only on the securities are:
U.S. government securities that are deposited with a trustee and against which certificates are sold representing principal payments only on the securities are referred to as Treasury STRIPS. These are zero-coupon bonds issued by the U.S. government and are subject to annual taxation on the per-year accreted amount.
Which of the following balance sheet entries may be affected when a company pays a cash dividend?
When a company pays a cash dividend, the dividends payable (a current liability) and the cash account (current assets) are reduced by the same amount. Because liabilities and assets are each reduced by the same amount, working capital is not affected. Shareholders’ equity, or net worth, is also not affected when the dividend is paid.
When determining whether a tax swap of municipal bonds will result in a wash sale, each of the following are considered EXCEPT:
Principal amount: In judging whether bonds purchased are substantially identical to bonds sold for a loss, the tax code considers maturity, issuer, and coupon rate. If at least two of the three are different, a wash sale will generally not result.
What is the conduit theory?
Under the conduit, or pipeline, theory of taxation, a fund is liable for taxes only on the income retained, provided it distributes at least 90% of its net investment income. The investor benefits because the income is only taxed twice (at the corporate level and at the individual level), and avoids taxation at the fund level. There is no tax-free accumulation for the shareholder.
The POP for a mutual fund as quoted in the financial press reflects:
The public offering price for a quoted mutual fund includes the maximum sales charge the fund distributor can assess.
Once a variable annuity has been annuitized:
During the payout period, payments are based on a fixed number of annuity units established when the contract was annuitized. The value of an annuity unit varies from month to month according to the performance of the separate account in comparison to the assumed interest rate.
