Diagnostic Exam 2

ABC stock is trading at 25.75. ABC Jul 25 calls are trading at a premium of 2. What is the intrinsic value of these calls?

$75. The intrinsic value of an option is the in-the-money amount. These calls have intrinsic value because the market price is greater than the strike price. Intrinsic value = 25.75 25 x 100 (shares/contract) = $75.

The FINRA Conduct Rules state that I. the member or designated person must approve in writing each discretionary order entered and must frequently review all discretionary accounts to detect excessive trading II. a registered representative must have the client's prior written authorization before exercising any discretionary power III. transactions in discretionary accounts cannot be excessive in size My Answer:

1, II, and III. FINRA conduct rules state that a registered rep must receive written authorization from a customer before exercising any discretionary authority. Additionally, all trades in discretionary accounts must be approved by a supervisor in writing (but not before the execution of the trade), and must be supervised diligently to detect any excessive trades or churning.

Susan Jones writes an XMI 450 call at 13. The index closes that day at 463.34. Susan will break even on her short call if, on the expiration date, the index closes at which of the following prices?

463. The breakeven point for a call option = strike price+premium = 450 + 13 = 463.

When calculating total return on a bond, A) Interest earned is added to any capital gain, and this result is then divided by the initial purchase price B) Interest earned is divided by the redemption value of the bond C) Interest earned is subtracted from the redemption value of the bond. D) Interest earned is subtracted from any capital gain, and this result is then divided by the initial purchase price

A) Interest earned is added to any capital gain, and this result is then divided by the initial purchase price Answer Explanation Total return on a bond is determined by adding the interest earned during the time period to any capital gain, then dividing this result by the initial purchase price of the bond. Textbook Reference Please see textbook section 7.6.1.3

Of the following, which investment choice is most appropriate for a high net worth investor with a primary objective of long-term safety of principal? A) A C rated general obligation bond B) An investment grade revenue bond C) A non-investment grade corporate bond D) A highly rated tax anticipation note

B) An investment grade revenue bond Answer Explanation An investor that wants safety of principal wants to preserve the investment over its life. The higher the rating, the greater the likelihood the investor will achieve safety of principal. Investment-grade municipal revenue bonds will offer safety of principal and tax-exempt income. A highly rated note has a much shorter time horizon. Textbook Reference Please see textbook section 7.3.3

In presenting to a customer the opportunity to participate in an exploratory oil and gas program a registered representative must do which of the following? A) Offer the opportunity only to customers who have prior experience in limited partnerships B) Present a balanced description of the risks and rewards and ensure that the potential tax advantages of the partnership are appropriate for the customer's situation C) Require that the customer obtain authorization from a tax advisor that the IDCs are an appropriate tax benefit for the customer's situation D) Ensure that no more than 20% of the customer's liquid assets are considered for the investment

B) Present a balanced description of the risks and rewards and ensure that the potential tax advantages of the partnership are appropriate for the customer's situation Answer Explanation Representatives must fully present the potential rewards and the risks of any limited partnership program. They must be relatively certain that the tax benefits, if available, are appropriate for the customer, and that the customer has the financial means to afford the risk and lack of liquidity of the partnership interest. Textbook Reference Please see textbook section 7.1

An investor with a relatively high-risk tolerance would like to add a growth fund to his portfolio. Of the following, which type of fund may be most appropriate? A) Hybrid fund B) Small cap stock fund C) Junk bond fund D) Commodity fund

B) Small cap stock fund. Answer Explanation A stock fund is most appropriate for a growth objective. Because the investor is not risk averse, a small cap fund will offer the most growth potential of the choices offered. Textbook Reference Please see textbook section 7.3.4

In an effort to combat inflation risk, which of the follow investment vehicles should be avoided? a. Common Stock b. top rate corporate bond c. TIPS d. REITS

B. Top rated corporate bond investors concerned about inflation risk should focus on products that will offer a hedge against risking prices. One product that would not be helpful in this regard is a bond. The coupon payments on the bond will not change, even though goods and services have become more expensive.

Which of the following orders must be adjusted accordingly on the ex-dividend date?

Buy 2,000 shares of ABC at 15.75 AON" Explanation: Buy limit and sell stop orders must be adjusted based on the distribution terms on the ex-dividend date. A client may also provide specific instructions to indicate that their order should not be reduced.

Your client owns a portfolio of blue chip stocks. She informs you that she believes that the securities will provide good, long term appreciation but she is fearful that the market will decline over the short term. Which index options strategy should you recommend that will protect against the expected decline and still allow for long term capital appreciation?

Buy puts. To hedge against a decline in the market the investor needs a bearish position - she must either buy puts or sell calls. If she sells calls however, she will lose any potential capital appreciation if the market increases. Therefore, the only option that will protect her investment and still allow for capital appreciation is to purchase put options.

Rule G-47, Time of Trade Disclosure, applies to I. Solicited transactions only II. Both solicited and unsolicited transactions III. Retail customers IV. Customers that are sophisticated municipal market professionals (SMMPs) A) I. and IV. B) II. and IV. C) II. and III. D) I. and III.

C) II. and III. Answer Explanation Rule G-47 requires firms to disclose to customers in both primary and secondary market transactions all material information known about the security that is reasonably accessible to the market. The rule applies to both solicited and unsolicited transactions. Make a note that SMMPs are exempt from this rule. Textbook Reference Please see textbook section 7.1.

A customer believes that a municipal securities representative has effected transactions that are excessive in size or frequency in her discretionary account. This prohibited practice violates rules of A) Matched purchasing B) Quantitative pricing C) Quantitative suitability D) Fair and reasonable pricing

C) Quantitative suitability Answer Explanation Excessive trades and activity that are inappropriate for customers are violations of quantitative suitability requirements. This practice was formerly known as churning. Textbook Reference Please see textbook section 7.1.3

roker dealers and their representatives are held to suitability standards that apply to virtually all securities A) Transactions B) Purchases C) Recommendations D) Accounts

C) Recommendations. Answer Explanation It is the recommendation to buy, sell, exchange or hold securities that triggers suitability rules. When clients direct reps to complete a transaction (without a recommendation), suitability rules may not apply. Textbook Reference Please see textbook section 7.1

Nonagricultural employment is what kind of economic indicator?

Coincident. Nonagricultural employment is a coincident indicator as it give a snapshot of the rate of employment at a specific point in time. Note that average duration of unemployment is a lagging indicator as it must be calculated after an individual has successfully found a new job.

In which type of underwriting is a securities issuer most likely to get the best price with the least risk?

Competitive bid, firm commitment. If issuers want the best price for shares with the least risk for unsold shares, they should elect a competitive bidding process with a firm commitment by the underwriter. Issuers may choose a negotiated process if underwriter selection criteria, other than price are important. Firm commitment means the underwriter buys shares from the issuer, regardless whether these hares can be resold to the public.

An investor who wishes to avoid reinvestment risk would be unlikely to purchase a A) 60-day commercial paper B) 20-year zero coupon bond C) 7 -year Treasury Strip D) 15-year AAA debenture

D) 15-year AAA debenture. Answer Explanation Reinvestment risk can be avoided through the ownership of a zero-coupon bond. A debenture will make regular interest payments to the investor, which will then need to be reinvested at current interest rates. A coupon paying bond would not be appropriate for an investor who wants to avoid reinvestment risk. Textbook Reference Please see textbook section 7.2.5

A customer in the 15% tax bracket who is living in retirement wishes to conservatively invest $200,000 of his savings in fixed income securities. Which portfolio is most appropriate for this investor? A) 50% AAA in-state municipal bonds, 40% U.S. Treasury bonds, and 10% AAA out-of-state municipal bonds B) 60% AAA in-state municipal bonds, 20% AAA corporate bonds, and 20% U.S. Treasury bonds C) 40% AAA in-state municipal bonds, 40% AAA out-of state municipal bonds, and 20% U.S. Treasury notes D) 40% AAA corporate bonds, 40% U.S. Treasury bonds and 20% AAA in-state municipal bonds

D) 40% AAA corporate bonds, 40% U.S. Treasury bonds and 20% AAA in-state municipal bonds. A customer in a low tax bracket does not always benefit from the tax exempt income provided by municipal securities. Because this investor is living in retirement, safety of principal is very important. The portfolio of high grade corporate bonds with taxable income, Treasury bonds, and a smaller amount of municipal bonds is most appropriate of the choices given. The corporate bonds are likely to provide more after tax income to the portfolio than municipals that pay a lower tax exempt rate of interest. Textbook Reference Please see textbook section 7.3.2

Political risk may be mitigated when an investor focuses attention A) On the countries with the strongest economies B) On global assets for the widest possible diversification C) On mutual funds that have a composition of at least 50% US companies D) On US domestic securities

D) On US domestic securities Answer Explanation Political risk can be reduced by investing in US domestic securities in lieu of overseas investments. Textbook Reference Please see textbook section 7.2.9

Mary has a portfolio consisting primarily of small cap stocks and high yield bonds. Mary's most likely investment objective is

Speculation. Mary has an investment objective of speculation based on her current holdings. Investing in these types of products offers Mary the opportunity of higher returns but also carries greater risk.

What term do economists use to describe a downturn in the economy characterized by increasing price levels?

Stagflation. Stagflation is characterized by increasing prices amid high unemployment. Inflation is characterized by increasing prices amid an expanding economical period.

Which of the following orders would NOT be reduced on the ex-dividend date? I. Buy limit order II. Open sell stop order III. Buy stop order IV. Sell limit order

III and IV Explanation: All orders placed below the market are adjusted downward on the ex-dividend date by the amount of the dividend. Orders placed below the market are buy limits, sell stops, and sell stop limits. Sell limits, buy stops and buy stop limits are not adjusted on the ex-dividend date.

Which of the following is not a risk to limited partner in a direct participation program?

Limited liability. Limited liability is a benefit to an investor in a direct participation program, not a risk. The other choices are disadvantages to investors in these types of products.

Which of the following securities carries the highest degree of purchasing power risk?

Long-term, high-grade bond. Long-term debt carries the highest degree of purchasing power risk because the interest and principal received does not appreciate in value as inflation causes prices to increase. Thus, the purchasing power of the semi-annual interest payments decreases over time. Additionally, inflation causes interest rates to increase, subsequently lowering the price of outstanding bonds. Equity securities provide more protection against inflation.

The short-term effect of the Federal Reserve's Open Market Committee is to

Make credit more or less available. The Fed buys and sells securities in the marketplace to increase or decrease the money supply, making credit more or less available. When the Fed buys securities it is putting money into circulation, increasing the money supply and making credit more available. When the Fed sells securities it is taking money out of circulation, decreasing the money supply and making credit less available. Long term, these actions may check inflation or stop a recession.

A brokerage firm can open an account for all of the follow EXCEPT a(n)

Minor. A brokerage firm cannot open an individual account for a minor. It can open a UGMA account with an adult as the custodian for one minor.

Which of the following is not a leading indicator?

Personal income. Personal income is a coincidental economic indicator.

Brokerage accounts which are inactive must receive account statements

Quarterly. Brokerage accounts which are not active must receive account statements once per quarter. A statement must be provided for any month in which there is any account activity, such as a cash dividend or bond coupon being credited to the account, or a transaction being effected in the account. A margin account would typically receive a monthly statement, to reflect the interest charges that have been posted to the account during the prior month.

Shareholders of XYZ Inc. have received a letter advising them of an opportunity to sell their shares back to XYZ at a specified price on a specific date. XYZ Inc. is conducting a

Tender offer. This would be an example of a tender offer. The offer is usually made at a premium to the current market price of the security.

The fraud provisions of the Securities Exchange Act of 1934 apply to which of the following?

The fraud provisions of the act of 1934 apply to all persons and for all types of securities. No person or transaction is ever exempt from the antifraud provisions of the Securities Act of 1934.

Interest rates have risen rapidly in the current economic environment. The price of stock of companies in which industry below would be most impacted by this change?

Utility. Utility stocks are most affected by interest rates, as these are the most highly leveraged companies among these choices.

With respect to underwriting compensation, what fee is the largest?

The selling concession is typically the largest part of the spread. Based on industry standards, the manager's fee is typically the smallest part of the spread, while the selling concession is usually the largest portion.

What is the maximum number of accredited investors allowed in a private placement offering?

There is no limit. There is no limit on the number of accredited investors in a private placement.

Which of the following is true about short sales?

They must be executed in a margin account. All short sales must be executed in a margin account. Additionally, Reg T requires the customer to deposit 50% of the sale price. However, for initial short margin transactions below $4,000, FINRA rules supersede Reg T and instead the customer must deposit minimum equity of $2,000 regardless of how small the initial sale is.

Steven opened an options account with his RR Simon last week. Simon sent the options agreement to Steven but has not yet received the signed form in return. May Steven open new positions in this account?

Yes, but if he doesn't return the options agreement with his signature next week he will be able to liquidate his existing options positions only. Steven may place opening trade in his newly opened options account for fifteen days before returning the signed options agreement. If Steven doesn't return the signed form within 15 days of account approval, he will be limited to placing closing option trades only.

A company is about to pay a dividend of $.70. On the ex-dividend date, an open order to sell at 46 stop would

be automatically adjusted to 45.30 A sell stop order is adjusted downward on the ex-dividend date by the amount of the dividend. Therefore, an order to sell at 46 stop is adjusted to 45.30 on the ex-dividend date.

Exchange traded funds

can be purchased and sold anytime during the trading day. ETFs may be bought and sold continuously throughout the trading day, as they are publicly traded portfolios of an investment company. ETFs have lower operating expenses than traditional mutual funds and they may be purchased on margin.

Municipal bonds are most suitable for

corporations in the maximum tax bracket. Municipal bonds pay interest tax free and are therefore most suitable for individuals or firms in the maximum tax bracket. Note that muni bonds are not appropriate for pension funds as they already distribute income on a tax free basis, so the tax protection of muni bonds is unnecessary.