Chapter 6 Insights

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A retired man has $100,000 to invest for growth. He also owes a $10,000 note due in 6 months, a $20,000 note due in one year and a $25,000 note due in two years. How much of the $100,000 should he allocate to growth investments?

$45,000. The man will pay a total of $55,000 over two years. This period is too short to invest in stocks for growth. The man can invest the remaining $45,000 because he will not need it to pay the notes.

Which investment is exposed to the greatest price sensitivity when interest rates increase?

20 year bond with a 4% coupon Duration is often used to assess the sensitivity of a bond in response to interest rate changes—the greater the duration, the greater the sensitivity, and thus greater interest rate risk in an environment of changing interest rates. Duration is a 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, so there is more to the calculation than simply adding up the interest payments. The 4% coupon has a longer duration than the 6% coupon. ($40 of interest per year versus $60 of interest per year means the 4% coupon will take more time for the bond to pay for itself.) Long term bond prices are more volatile than short term bond prices; therefore, the 20 year bond with the lower coupon represents the greatest risk when interest rates rise.

Which of the following investments is most susceptible to interest rate risk?

30-year Treasury bond

A young, recently married couple, would like to purchase a home within five years. They have $2,000 in savings and $400 a month to invest. In addition, they owe $35,000 on student loans to be repaid over the next ten years. What type of mutual fund investment would likely be the BEST recommendation?

Build up cash reserves and then save for a down payment on the new home. Investing must wait. Build up cash reserves and then save for a down payment on the new home. Investing must wait.

Your client, a wealthy business owner owns 40,000 shares of a stock that was amassed over many years. With this single holding equaling close to 5% of the client's investment portfolio the risks have been identified, discussed and ultimately acknowledged and accepted by the client. Suddenly, adverse unexpected news regarding the safety of a key product sold by the company sends the stock tumbling down, losing over 10% of its value in a single day. Regarding suitability, while a number of risks could have been discussed, which risk would have been the most important to discuss with the client?

Business Risk Business risk impacts companies individually and should have been discussed, especially with a substantial percentage of an investment portfolio allocated to a single stock. This is tied to the client's lack of diversification. Credit risk, the risk of losing principal due to the failure of an issuer is associated with debt securities, as is reinvestment risk. Timing risk has to do with trading in and out of the market and given that this single stock position was amassed over many years would not be of concern when risks should have been discussed.

A single premium immediate annuity will pay $2,000 a month for life. What is the annuitant's greatest risk?

Inflation risk

Your customer, age 37, makes $60,000 per year and wants to invest $10,000. He wants a conservative investment with annual returns in the 10-20% range. Which of the following should you suggest?

Managing and lowering your customer's expectations.

A type of systematic risk is

Market risk (the risk that investors may lose principal due to price volatility of the overall market) is a systematic risk. This type of risk cannot be diversified away.

Your customer, age 32, makes $48,000 annually and has $15,000 to invest. Although he has never invested before, he wants to invest in something exciting, with investment returns in the 20%+ range. Which of the following should you suggest?

Your customer should provide more information before you can make a suitable recommendation. It is necessary to get more information about this customer and his definitions of an exciting investment opportunity before making any recommendations. A suitability and risk-tolerance analysis should be performed before a recommendation is made.

Income tax free income high yield income from stock portfolio

bonds (but not zero coupons), REITs, CMOs municipal bonds, municipal funds, Roth IRAs below investment grade corporate bonds, corporate bond funds preferred stock, utility stocks, blue chip stocks

Growth Balanced/Moderate aggressive growth

common stock, common stock mutual funds blue chip stocks, defensive stocks technology stocks, sector stocks

Credit Risk (Financial Risk, Default Risk)

danger of losing all or part of one's invested principal due to an issuer's default. associated with debt, as opposed to equity securities, and varies with the investment product govt bonds = lowest credit risk junk bonds = highest credit risk

capital risk (principal risk)

risk investor loses all his money

A customer of yours owns a corporate bond fund with a long duration. Mortgage rates are going up. What impact will this have on the investment?

the current yield will increase since the price of the shares can be expected to fall. Bonds (the chief investment of this fund) display an inverse relationship between prices and interest rates. Since interest rates are going up, bond prices can be expected to decrease. A given bond, then, will experience a decrease in price and a corresponding increase in the calculated current yield. The same can be expected of mutual funds that invest in bonds.

Mr. and Mrs. Smith, both nearing retirement, want to maximize their income. They want to reallocate $100,000 of their $400,000 portfolio of securities for this purpose. Of the possible investment choices below, which would be the LEAST suitable recommendation given their investment objective?

AAA convertible corporate bonds NOT Preferred shares of stock Convertible bonds offer a lower coupon in exchange for the conversion feature, therefore is not a good choice for maximizing income.

preservation of capital/safety

CDs, money market funds, fixed annuities, government securities and funds, agency issues, investment grade corporate bonds and corporate bond funds

Credit risk involves:

Credit risk is the danger of losing all or part of the invested principal as the result of the issuer's failure.

Price differential

Differential pricing is the strategy of selling the same product to different customers at different prices. Consider the pricing behavior at an auction. Everyone has the same information and bids on the same item.

A complete customer profile includes both financial and nonfinancial investment considerations. Which of the following is considered financial investment information?

Discretionary income

Which of the following would be the least important to have in a customer profile?

Educational degrees earned by the customer

Which of the following is the least suitable mutual fund transaction?

Encouraging a mutual fund shareholder to sell an income fund purchased two years ago and use the proceeds to purchase another income fund from a better managed fund family. NOT Encouraging a retired investor to invest in a value managed equity fund Switching funds, unless there is a pressing reason for it, is rarely in the client's best interest. Better management is subjective and not a valid reason to switch.

Financial Considerations

Financial considerations involve real assets or debts, whether part of total income, debt, or net worth. The amount of money the customer is willing to risk involves attitude, not something that can be placed on a balance sheet or income statement, and is thus nonfinancial. Some financial considerations include tangible assets (home, car) marketable securities long term investment accounts net worth liquidity of net worth total gross income monthly expenses debts (and other liabilities) net spendable income after taxes

Your client has $50,000 to invest. His objective is monthly income that he can receive after he retires. Part of his customer profile stresses that he has had uncomfortable experiences in the past with the stock market and is not inclined to invest in anything that is based on stock market performance and would opt for principal protection instead. Based on the clients profile which of the following would be the best recommendation?

Fixed Annuity

Your 70-year old client with $400,000 wishes to assemble a portfolio that will provide her with a consistent cash flow for her projected life expectancy. She would like to maximize her return, but is not willing to assume a high degree of risk. Which of the following securities might you suggest for this portfolio? I.ABC Corporation debenture, S&P rating AAA. II.XYZ Railroad equipment trust certificate, rated AA. III.MNO Corporation convertible bond, rated AAA. IV.DEF Corporation common stock.

I and II Common stock will not provide her with a consistent cash flow because the dividends are not fixed or guaranteed. Although the convertible bond will provide income, this type of security pays a lower rate of interest than a nonconvertible security of the same quality. Therefore, the convertible bond will not help her maximize her return.

Which of the following would be valid when recommending investments for a client that does not believe in professional money management and is interested in long-term capital appreciation? I.Gather financial information from the client. II.Consider index funds for a portfolio mix that is appropriate for the client based upon risk tolerance, time horizon, and investment expectations. III.Place the client's assets in an asset allocation fund, providing diversification and reduced risk under most economic conditions. IV.Review the portfolio at least once every month to determine whether any changes or modifications are necessary.

I and II Investment recommendations must be both suitable and acceptable to the client; therefore knowledge of financial (and nonfinancial) information is important before making any recommendations. Index funds are a natural choice when someone does not believe in professional management of investments. Monthly review of a long-term capital growth portfolio, presumably with the intention of performing transactions, is far too frequent and will quickly offset the portfolio's growth unacceptably.

During a fact-finding interview with a prospective client, you are reviewing his balance sheet. Which of the following items would be found on a balance sheet and help you determine the client's net worth? I.Bank accounts II.Cars III.Rent IV.W-2 forms

I and II NOT III The balance sheet reflects a person's net worth by comparing assets and liabilities. Money in the bank and fixed assets such as automobiles are assets. Rent is an expense, and a W-2 shows income. Both of those items are found on an income statement.

You are reviewing an investor's balance sheet. Which of the following items would be found on a balance sheet and help you determine the client's net worth? I.401(k) balance II.Credit card balance III.Monthly income IV.Electric bill

I and II NOT IV (electric bill) The balance sheet reflects a person's net worth by comparing assets and liabilities. 401(k) balance is an asset and credit card debt is a liability. Income and monthly bills such as the electric bill are found on the income statement.

Your customer has heard that the price differential between low-risk and high-risk debt instruments is wider than expected. You tell him that this: I.is a bad economic indicator. II.is a good economic indicator. III.means investors will be more insistent on safety. IV.means investors will be less insistent on safety

I and III NOT IV) means investors will be less insistent on safety If the spread between low-risk and high-risk fixed income is wide, investors are more nervous about risk. Hence, they are not confident about the future and seek safety.

In order to minimize liquidity risk, you recommend which of the following to a 37-year-old prospect? I.A growth mutual fund II.A fixed annuity III.Real estate rental property IV.Listed stock on the NYSE

I and IV

Diversification helps protect against which of the following types of risk? I.Nonsystematic II.Systematic III.Market IV.Business

I and IV NOT market and systematic Diversification reduces nonsystematic risk such as business risk, which is associated with the decline of an individual security's value. Systematic risk, such as market risk, affects all securities and therefore is not significantly reduced by diversification.

The two most important factors in determining a member's suitability obligations when making recommendations to institutional customers are: I.the relationship of the customer with the investment banking department of the firm. II.the customer's capability to evaluate investment risk independently. III.the extent to which the customer intends to exercise independent judgment in evaluating a member's recommendations. IV.the number of transactions completed during the previous 12 months.

II and III FINRA is concerned about the ability of the person handling an institution's investment decisions to understand the nature of recommended transactions. Once it is established that the person understands the transaction, it is important to establish that he is the one who will make the investment decision. Number of transactions completed in a year DOESNT MATTER for this calculation of suitability

Which of the following statements regarding interest rates and price fluctuations of debt securities are TRUE? I.Short-term prices fluctuate more than long-term prices. II.Long-term prices fluctuate more than short-term prices. III.Short-term interest rates fluctuate more than long-term rates. IV.Long-term interest rates fluctuate more than short-term rates.

II and III NOT IV.Long-term interest rates fluctuate more than short-term rates. Long-term bond prices move more in response to interest rate changes than short-term bond prices because of the compounding effect of interest on bonds with longer maturities. Short-term interest rates fluctuate significantly in response to Federal Reserve Board actions and other changes in interest rates. Although long-term rates also respond and move in the same direction, their movements are not as large.

During a fact-finding interview with a potential client, your client information sheet is used to list detailed financial information. Which of the following items would be relevant in determining a prospect's net worth?I. $225,000 annual income. II. $78,000 current IRA balance. III. recently paid off a $3,000 credit card balance. IV. just installed a $25,000 home entertainment center.

II and IV Net worth is computed by subtracting liabilities from assets. The IRA balance and the home entertainment center are assets. The credit card debt was a liability, but since it has been paid, it no longer appears on the financial statement. Income is important, but it does not figure into net worth until it is deposited into a bank or invested in something. SO income does not factor into net worth because it is calculated solely by subtracting liabilities from assets

Rank the following from least to most capital risk: I.GNMA II.Treasury Bill III.Adjustable preferred stock IV.Zero-coupon bond

II, I, IV, III Capital or principal risk is the potential for an investor to lose all his/her money (invested capital) under circumstances either related or unrelated to an issuer's financial strength. Preferred stock has less capital risk than common stock but more capital risk than debt securities.

When comparing a short-term bond fund to a long-term bond fund, which of the following is generally true? I.The short-term fund has a higher yield. II.The long-term fund is less volatile. III.The long-term fund has a higher yield. IV.The short-term fund is less volatile.

III and IV The longer a bond portfolio's average maturity, the greater the price of the fund will fluctuate when interest rates move up or down. To compensate investors for this risk, long term bonds will offer higher yields than those with shorter maturities.

A married couple in their early 50's saving for retirement would most likely have which of the following objectives?

Moderate risk, moderate safety, low liquidity. Questions like this are the worst because they call for an opinion (and I really could defend each of these choices because we don't know enough about these people). However, we must pick the answer the test wants. Since they still have more than 10 years until retirement age, that long a time horizon allows them to take more risk than had they been in their early 60's. Since they won't need the money for a while, liquidity is not a concern.

Which of the following is the best recommendation for someone extremely averse to risk?

Principal protected fund NOT government bond fund Of the choices given, the most conservative is the principal protected fund. Principal protected mutual funds offer investors a guarantee of principal, adjusted for fund dividends and distributions, on a set future date (maturity). The other choices offer no guarantee for loss of principal. SO principal protected fund MORE conservative than government bond funds

When interest rates are changing, which of the following statements is typically TRUE?

Short-term interest rates are more volatile than long-term interest rates. NOT Long-term interest rates are more volatile than short-term interest rates. Short-term interest rates are considerably more volatile than long-term interest rates in response to changes in the general rate of interest. On the other hand, long-term prices are more volatile than prices of short-term bonds given a change in rates.

liquidity risk

The risk that a client might not be able to sell an investment

reinvestment risk

The risk that a decline in interest rates will lead to a decline in income from a bond portfolio and it becomes difficult for the investor to maintain the same level of return at the same level of risk occurs typically when bonds mature/are called by the issuer

An investor purchased 1,000 shares of the KLP Corporation common stock. KLP was late in introducing a new product and lost half of its market to a competitor, resulting in the investor's shares losing substantial value. This is an example of:

The shares' loss in value was caused by an event in the business world, not a new securities law or some other event in the securities markets. This is called business risk.

Which of the following would be appropriate recommendations for a customer looking for income?

Utility fund Many securities are purchased for income; these include stocks, bonds and mutual funds that pay consistent dividends such as a utility fund.

If an elderly widower wants his investments to provide high current income, the representative should recommend:

a mutual fund that matches the investor's stated objective. AS OPPOSED TO: the ABC Widow Fund. a growth fund. a zero-coupon bond. Investors should be careful not to be misled by a mutual fund's name. Although the name of a fund should bear a resemblance to its objective, the investor and the representative should read the fund's prospectus carefully to be sure that the fund's objective matches the investor's objective. Growth funds and zero-coupon bonds are not designed to meet the requirement of providing maximum current income.

Nonfinancial considerations

age marital status number and ages of dependents employment employment of family members current and future family educational needs current and future family health needs risk tolerance attitude towards investing tax status Then Customer's Aptitude for investing is also an important consideration that encompasses: what kind of risks can you afford to take? how liquid must your investments be how important are tax considerations are you seeking long term or short term investments what is your investment experience what type of investments do you currently hold how you react to the loss of 5% of your principal? 10%? 15%? what level of return do you consider good? poor? excellent? what combination of risks and returns do you feel comfortable with? what is your investment temperament? do you get bored with stable investments? can you tolerate market fluctuations?

legislative/political/social risk

exists because federal and state legislatures have the power to change laws and this can impact securities negatively and result in capital loss for investors. risk associated with the possibility of unfavorable government action or social changes resulting in a loss of value is also call SOCIAL RISK OR POLITICAL RISK especially important in discussing suitability when recommending foreign and international investments as some govts more stable than others

interest rate risk

generally associated with debt, refers to the sensitivity of a product to interest rate fluctuation the longer a bond's duration, the more volatile it is with respect to interest rates

Question ID: 642712 Phyllis purchased stock in a tobacco company several years ago. Last month the cigarette tax was increased by 25% and the stock price dropped significantly. Phyllis's investment was subject to:

legislative risk. When investments are affected by tax law or other changes made by the government, this is considered legislative risk.

Duration

length of time a bond takes to pay for itself (so two 20 year bonds with different coupon rates, the bond with the lower coupon would have a HIGHER duration)

Alternative Minimum Tax (AMT)

meant to ensure that high income taxpayers do not escape federal income taxes Items that receive favorable tax status under the AMT: Industrial Development Bonds (IDBs) local tax and interest on investments that do NOT generate income Incentive stock options to the extent that the fair market value of the employer's stock is in excess of the strike price of the option

An accredited investor, age 39, would like to invest $10,000 and wants an investment that is liquid. You recommend a(an)

mutual fund that invests in both stocks and bonds A product is liquid if a customer can sell it quickly at face amount (or very close to it) or at a fair market price without losing significant principal. A mutual fund is the only choice given that is considered liquid.

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 be region/rating

While prospecting for clients, you discover a potential investor who is 88 years old, retired, living on his savings, has never invested, and has very high medical expenses. As a registered representative, you would recommend:

no investment account be opened due to his financial situation. This prospect is retired, has limited funds, and has no investment experience. In addition, he has high medical expenses and must draw from his savings to support himself. This prospect's profile makes opening an account an unsuitable recommendation.

Speculation

options contracts DPPs high-yield bonds unlisted or non-Nasdaq stocks or bonds sector funds precious metals commodities futures

Liquefying home equity to generate funds for investment purposes

requires communication of the unique risks associated with this investment strategy by the broker-dealer NOT can never be a recommended investment strategy This investment strategy requires the broker-dealer to communicate the unique risks associated with it, which could include losing one's home.

business risk

risk that a business fails

market risk

risk that affects all companies in the stock market... that investments will decrease in value CANNOT diversify away market risk

call risk

risk that bond might be called by the issuer before maturity bc interest rates fall and bond owners might not be able to reinvest their principle at a bond with as favorable a coupon rate investors concerned with call risk should look for bonds with call protection (a period of time in which a bond may not be called)

currency risk

risk that changes in the rate of exchange will adversely affect an investment. rule of thumb for investors purchasing an international fund (foreign bond fund) will LOSE if the US dollar appreciates against the foreign currency investor PROFITS if US dollar weakens (depreciates) against the foreign currency

inflation risk

risk that the purchasing power of the investment will diminish acute for fixed income securities

liquidity

securities listed on an exchange, Nasdaq stocks or bonds, mutual funds, publicly traded REITS, money market

A prospect is heavily invested in the common stock of an employer's company, ABC, relative to other investments. The stock has performed well over the last 15 years and the prospect is very happy with the investment. After reviewing financial and nonfinancial criteria, you have determined that

selling a portion of ABC and using the proceeds to purchase mutual funds will reduce his nonsystematic risk NOT owning too much ABC stock has increased credit risk to an unacceptable level This prospect is exposed to a significant amount of business (nonsystematic) risk as indicated by the large investment in ABC common stock. Business risk can be reduced by diversifying the portfolio; and therefore, recommending the sale of a portion of the ABC stock and using the proceeds to purchase mutual funds is suitable. There will be tax considerations but the use of FIFO accounting will likely expose the prospect to higher capital gains taxes than other accounting methods and may not be the best approach to liquidation. NOT the credit risk example because that deals specifically with bonds (so not related to this)

If interest rates are dropping, an investor with a maturing bond will be most concerned with:

the difficulty in finding another investment with a like yield.

timing risk

the risk to an investor of buying or selling at the wrong time and incurring losses or lower gains

A new investor has just purchased several hundred shares of a mutual fund that invests chiefly in corporate bonds. He has heard that the Federal Reserve has just reduced the discount rate and wants to know what the immediate effect on his shares might be. You tell him that

the yield will probably decrease somewhat, since the price of the shares can be expected to rise NOT the yield should increase dramatically, but the price of the shares will go down Bonds (the chief investment of this fund) display an inverse relationship between prices and interest rates. Since interest rates can be expected to decrease with a fall in the discount rate, bond prices can be expected to increase. A given bond, then, will experience an increase in price and a corresponding decrease in the calculated current yield. The same can be expected of mutual funds that invest in bonds.

A widowed customer with no children has a portfolio invested in mutual funds valued at $250,000. The portfolio generates a monthly income of $1,600, an amount that exceeds her living expenses by $300. The investment portfolio is her sole source of income. Her agent recommends she sell $30,000 worth of her mutual funds and purchase a variable life insurance policy to take advantage of the tax deferral and death benefit features. This recommendation is:

unsuitable, since she has no need of the death benefit.


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