Unit 14 - Types of Risks and Required Disclosures
Which of the following statements regarding a bond ladder strategy is correct? A) A bond ladder strategy is a relatively easy way to immunize a portfolio against interest rate risk. B) A bond ladder strategy involves the purchase of very long-term and very short-term bonds. C) A bond ladder strategy works best when interest rates are stable. D) A laddered portfolio of bonds will provide lower yields than a portfolio consisting entirely of short-term bonds.
The best answer is A. A bond ladder strategy is a relatively easy way to immunize a portfolio against interest rate risk. A bond ladder strategy is a relatively easy way to immunize (protect) a portfolio against interest rate risk. By holding many positions across the yield curve, the individual is diversified in the event that yields behave differently in one part of the curve than in another. The laddered portfolio will generally provide higher, not lower yields than a portfolio consisting entirely of short-term bonds. Buying bonds with very short maturities and bonds with long maturities is the concept behind the barbell strategy. LO 14.a
Which of the following investments is most suitable for an investor seeking monthly income? A) Money market mutual fund B) Growth stock C) Mutual fund investing in small-cap issues D) Zero-coupon bond
The best answer is A. Money market mutual fund The money market mutual fund is the most suitable investment for an investor seeking monthly income. The other securities offer higher long-term growth potential, but they are not designed to provide monthly income. LO 14.a
Institutional managers are moving to increase their cash position. This action would be viewed as A) neutral bull. B) bearish. C) bullish. D) neutral.
The best answer is B. bearish When investment managers liquidate securities to increase their cash positions, stock prices are likely to fall. LO 14.a
Reinvestment risk is the chance that, after purchasing a bond, interest rates A) become volatile. B) remain stable. C) fall. D) rise.
The best answer is C. fall Reinvestment risk is the danger that after purchasing a bond, interest rates will fall. This means that the fixed interest payments received over the remaining life of the bond will be reinvested at lower rates. The good news is that the price of the bond has probably risen due to falling rates. LO 14.a
A couple with children ages 13 and 8 have $200,000 saved to put toward their children's college education. Which of the following would be most suitable for these investment dollars and objective? A) 10% zero coupon bonds, 90% corporate bonds B) 60% equities, 40% corporate bonds C) 80% zero coupon bonds, 20% T-notes D) 60% equities and equity funds, 30% T-bills, 10% corporate bonds
The best answer is C. 80% zero coupon bonds, 20% T-notes Of the portfolio mixes presented, zero coupon bonds, which are purchased at a discount and mature at face value, are a suitable investment for future anticipated expenses such as college tuition. The T-notes, which are medium-term U.S. government securities, would additionally be a suitable investment where risk of principal loss wouldn't be a concern like it would be with equities. LO 14.a
It is not uncommon for one company to attempt to take over another by acquiring a significant percentage of its voting shares. Under SEC rules, if the terms of the offer are changed, the revised offer must remain open for at least A) 20 business days from the commencement and 20 business days from the date the terms are changed. B) 20 business days from the commencement and 10 business days from the date the terms are changed. C) 10 business days from the commencement and 10 business days from the date the terms are changed. D) 10 business days from the commencement and 20 business days from the date the terms are changed.
The best answer is B. 20 business days from the commencement and 10 business days from the date the terms are changed. The rule is that the offer must remain open for at least 20 business days from the time the tender offer begins, and if there should be a change to the terms of the offer, if must be held open for 10 business days from the change. This is more a principal level question and unlikely to be on you exam, but we want to be sure you are exposed to the information. LO 14.b
A couple in their early 30s have been married for four years, their disposable income is relatively high, and they are planning to buy a condominium. If they need a safe place to invest their down payment for about six months, which of the following mutual funds is most suitable for these customers? A) XYZ Investment-Grade Bond Fund B) LMN Cash Reserves Money Market Fund C) ABC Growth & Income Fund D) ATF Capital Appreciation Fund
The best answer is B. LMN Cash Reserves Money Market Fund These customers are preparing to make a major purchase within the next few months, so they require a highly liquid investment to keep their money safe for a short amount of time. The money market fund best matches this objective. LO 14.a
The risk of a bond decreasing in value during periods of inflation is known as A) reinvestment risk. B) interest rate risk. C) credit risk. D) marketability risk.
The best answer is B. interest rate risk Interest rate risk is the possibility that interest rates might rise, causing bond prices to fall. Periods of inflation are accompanied by rising interest rates. LO 14.a
Which of the following may not be a reason to reach out to the trusted contact person of an elderly client? A) An email received that cannot be verified by the registered representative as having come from the customer B) An urgent request that funds be sent to an overseas bank account not previously known to be associated with the client C) A request by email regarding a joint account with instructions to sell all securities and forward a check made payable to the named parties to the account D) An emailed request to liquidate certain account holdings and transfer the sales proceeds to a third party
The best answer is C. Scenarios that should raise a red flag are those where unusual instructions are received. For accounts with owners age 65 or older, firms must try to obtain the name of a trusted contact person in the event of a red flag. All firms must have in place written supervisory policies and procedures for reviewing and monitoring the transmittal of funds and a method of verifying that instructions received by email came from the customer and not an unknown third party. Urgency that might be intended to circumvent or deter broker-dealer verification procedures should always be viewed with extreme caution. An email regarding a joint account to liquidate and forward a check to the parties named to the account would not generally be viewed as a red flag. However, if it gave instructions to forward a check to only one party named to the account, it would be deemed unusual and not in keeping with how distributions are made from joint accounts. LO 14.c
Which of the following risks would benefit most from portfolio diversification? A) Market risk B) Interest rate risk C) Default risk D) Purchasing power risk
The best answer is C. Default risk Diversification works best with nonsystematic (unsystematic) risks. Default risk, the possibility of losing money when a specific company cannot pay off its debts, is a common case where spreading the risk around (diversifying) reduces risk. The other choices are all systematic risk, and diversification is not very useful for them. LO 14.a
A risk associated with investing in most bonds is reinvestment risk. What type of bond can an investor buy that does not expose the investor to reinvestment risk of interest? A) Discount bonds B) Par bonds C) Zero-coupon bonds D) Premium bonds
The best answer is C. Zero-coupon bonds Zero-coupon bonds allow an investor to lock in a yield (or rate of return) for a predetermined, investor-selected time with no reinvestment risk. Zero-coupon bonds do not expose investors to reinvestment risk of interest. The risk is that as periodic income is received from an investment, such as bond interest, the investor cannot find another investment to reinvest into offering the same rate of return for the same level of risk. Because zero-coupon bonds do not pay periodic interest, (the return of the face value at maturity is the income), there is nothing to reinvest. The fact that a bond is selling at par, premium, or discount does not remove the reinvestment risk. LO 14.a
At 3:55 pm ET, a registered representative receives a market order from an officer of XYZ to buy 75,000 shares of XYZ for the company's account. The registered representative must A) advise the officer that a safe harbor under SEC Rule 10b-18 no longer exists before refusing the order. B) place the order without taking any further action. C) refuse the order. D) advise the officer that a safe harbor under SEC Rule 10b-18 no longer exists before placing the order.
The best answer is D. advise the officer that a safe harbor under SEC Rule 10b-18 no longer exists before placing the order Under SEC 10b-18, an issuer purchasing its own securities cannot affect the opening or closing of the security. A safe harbor is available if the issuer is not involved in the first transaction of the day or in any transaction in the last 30 minutes of trading (10 minutes if the security is actively traded). If the issuer were to purchase its own securities during the last 30 minutes of trading, it may be forced to justify that its purchase did not affect the closing price. If a registered representative receives an order from an issuer at 3:55 pm ET, he must advise the issuer that a safe harbor is not available. The representative may then place the order. LO 14.b
Under Section 28(e) of the Securities Exchange Act of 1934, which of the following is allowable soft-dollar compensation from a broker-dealer to an investment adviser under the safe harbor provisions? A) Vacations B) Cell phones to rapidly communicate with clients C) Office rental payments D) Custodial services provided by the broker-dealer
The best answer is D. Custodial services provided by the broker-dealer The use of a client's commission dollars to purchase a broker-dealer's custodial services is an allowable soft-dollar compensation. It is an investment benefit that accrues directly to the client and not to the adviser. Office rental payments, cell phones, and vacations are not allowable because their benefits do not accrue directly to the client. Other examples of permitted soft-dollar items are research and analytical software because they benefit the client whose commission dollars are, in effect, paying for them. LO 14.d
An investor who is 50 years old would like to save for a child's college education, which begins in 10 years. The investor is willing to take a moderate amount of risk. Which of the following would be the least appropriate recommendation? A) Open a Coverdell Education Savings Account B) Buy an BBB zero-coupon bond that matures in 10 years C) Fund a variable annuity and use equity-based subaccounts D) Fund an existing IRA with a municipal bond fund
The best answer is D. Fund an existing IRA with a municipal bond fund Although investing within an IRA in anticipation of needing the money after age 59½ is a pretty good idea, municipal bonds, which provide federally tax-free income, are not appropriate for retirement accounts. The federally tax-free interest income will be fully taxable upon withdrawal. In addition, municipal bonds are low risk, not moderate risk, as indicated in the question. LO 14.a
Prompt disclosure of unintentional selective disclosure of material corporate information is a requirement of A) Regulation S-P B) SEC Rule 10b-18 C) Regulation SHO D) Regulation FD
The best answer is D. Regulation FD Regulation FD (Fair Disclosure) is an issuer disclosure rule (all issuers) that addresses selective disclosure such as may be given to securities market professionals and others that may trade on the basis of the information. If the disclosure of information is intentional, the issuer must make a simultaneous disclosure to the public. If the disclosure was unintentional, the issuer must make disclosure promptly. Promptly means under the regulation not later than 24 hours or the commencement of the next day's trading on the New York Stock Exchange, whichever is later (which accommodates for weekends and holidays) after a senior official of the issuer learns of the disclosure. Regulation S-P deals with the privacy rules, and Regulation SHO is the locate requirement for short sales. Rule 10b-18 deals with an issuer buying back its own stock in the open market. LO 14.b
