QBank unit 12

A customer is considering an investment in a hedge fund, noting she has heard much about their high-yield potential from a business acquaintance. In a discussion with her about these types of funds, which of the following statements is true? A) Hedge funds often use higher degrees of leverage and more sophisticated investment strategies than mutual funds. B) Mutual funds pool investors' money and manage the entire portfolio with a single objective, whereas hedge funds manage each investor's assets separately to meet their individual investment objectives. C) Hedge funds tend to be more suitable for many different customer profiles, while mutual funds are generally more suitable for sophisticated, high-net-worth investors only. D) Mutual funds are subject to less regulatory oversight than hedge funds.

A) Hedge funds often use higher degrees of leverage and more sophisticated investment strategies than mutual funds. Hedge funds use aggressive investment strategies that are not limited to selling securities short and purchasing on margin. Often, hedge funds have minimum initial investment requirements and lock-up provisions, making withdrawals impossible for a time. These qualities of hedge funds make them less suitable for all investors and more suitable for high-net-worth and income (sophisticated) investors. Both mutual funds and hedge funds pool investors' money to manage a single portfolio of assets. Hedge funds are unregulated, while mutual funds are regulated under the Investment Company Act of 1940.

If interest rates are rising, which statements regarding collateralized mortgage obligations are true? Prepayment risk increases. Prepayment risk decreases. Extended maturity risk increases. Extended maturity risk decreases. A) II and III B) II and IV C) I and III D) I and IV

A) II and III If rates are rising, homeowners are less likely to refinance. Therefore, prepayment risk will decrease. Similarly, if prepayments are declining, the estimated life of the underlying mortgages should increase.

Hedge funds are highly regulated. use investment techniques suitable for most investors. are unregulated. use investment techniques most suitable for sophisticated investors. A) III and IV B) I and II C) I and IV D) II and III

A) III and IV Hedge funds are unregulated and have aggressively managed portfolios that employ investment techniques such as shorting positions, utilizing derivative products, and trading on margin—all generally considered suitable for sophisticated investors.

Which of the following regarding taxation of collateralized mortgage obligation (CMO) interest is true? A) It is subject to federal, state, and local taxes. B) It is taxed only on the state level. C) It is exempt from all taxation. D) It is taxed only on the federal level.

A) It is subject to federal, state, and local taxes. Interest earned on all mortgage-backed securities is fully taxable.

Which of the following is not a type of CMO tranche? A) PSA B) TAC C) Z D) PAC

A) PSA PSA is the Public Securities Association. What does that have to do with CMOs? Plenty. It is the PSA table that is used to project the prepayment schedule for CMO tranches. However, unlike the PAC (planned amortization class) or the TAC (targeted amortization class) and the Z (zero), it is not a tranche.

A registered representative speaking to a customer is explaining registered funds that invest in nonregistered hedge funds. Which of the following statements is not correct? A) These funds, called funds of hedge funds, eliminate all of the risks associated with hedge funds. B) To divest of your fund of hedge fund investment, the shares will need to be redeemed by the mutual fund issuer. C) These funds generally allow purchases with an initial investment that is lower than what is required to invest directly in a hedge fund. D) Hedge funds are directly available to sophisticated (accredited) investors, while funds of hedge funds allow all investors to invest in hedge funds indirectly.

A) These funds, called funds of hedge funds, eliminate all of the risks associated with hedge funds. Because the portfolio of the registered fund consists of shares of nonregistered hedge funds, virtually all of the risks associated with hedge funds are transferred to the mutual fund. Funds of hedge funds allow all investors—not just accredited investors—to have access to hedge fund investments, and they are likely to have lower initial investment requirements, making that access even easier. To divest of fund of hedge fund shares, the issuer would have to redeem them from the investor, as is the case with all registered mutual funds.

An investor wants to invest $20,000 but anticipates needing those funds in five years for a business investment. Currently, with inflation rising, the government is expected to take action to push interest rates up to reduce the money supply. Given these conditions, which of the following securities would be the least suitable for this investor who needs a specific amount of money in five years? A) Zero-tranche collateralized mortgage obligation (CMO) with an estimated five years of life B) U.S. Treasury bonds maturing in six years C) Corporate bonds maturing in five years D) Zero-coupon bond maturing in four years

A) Zero-tranche collateralized mortgage obligation (CMO) with an estimated five years of life A zero-tranche CMO is subject to interest rate risk as well as extension risk when interest rates rise, and therefore, it would not be suitable for a customer that needs her investment back at a specific point in the future. By contrast, a four-year zero coupon bond will mature within the anticipated time frame for needing the funds and would be the most suitable choice of the answers given.

A hedge fund would be an appropriate recommendation for A) a successful surgeon with ample savings and significant financial experience. B) a recent graduate with an Ivy League MBA who plans to make millions. C) a retiree with $2 million in savings and serious health issues. D) a couple saving for their child's college education.

A) a successful surgeon with ample savings and significant financial experience. No, you don't have to be a surgeon or a rocket scientist to own a hedge fund, but you do need enough assets and financial sophistication. Generally, these funds are limited to those meeting the accredited investor status who do not have a great need for liquidity and can afford loss.

Which of the following is not included in the definition of an investment company under the Investment Company Act of 1940? A) A closed-end fund B) A hedge fund C) An open-end fund D) A unit investment trust

B) A hedge fund Hedge funds do not meet the definition of investment company as described in the act. The three types of investment companies are the face amount certificate company, the unit investment trust, and the management investment company (closed-end and open-end).

A married couple with a two-year-old child have $25,000 to deposit towards an investment to help meet the financial obligations for the child's college education. Given the following choices, which of the following is likely the most suitable investment? A) A collateralized mortgage obligation (CMO) tranche rated AAA and scheduled to mature in five years B) A treasury STRIP scheduled to mature in 16 years C) A diversified portfolio of insured municipal bonds with an average duration of 18 years D) A money market mutual fund

B) A treasury STRIP scheduled to mature in 16 years Treasury STRIPs are zero-coupon bonds, backed in full by the U.S. government. Purchased at a discount and maturing at face value in the future, they are suitable investments for those wishing to save for anticipated future expenses, such as college tuition. A CMO maturing in five years doesn't align with the time horizon for this child's college education and carries other unsuitable risks. A money market fund would hardly meet the growth requirement needed to meet college tuition needs. For exam purposes, municipal bonds are a suitable choice only when something in the question indicates that the investor is in a high income tax bracket.

A customer expresses the need to invest a fixed-dollar sum now that will return a fixed-dollar sum in 10 years. He mentions several investments. Of those listed, which would not be a suitable recommendation for his objective? A) A high-yield corporate bond maturing in 10 years B) Collateralized mortgage obligations (CMOs) C) Treasury Inflation Protection Securities (TIPS) D) A zero-coupon bond maturing in 10 years

B) Collateralized mortgage obligations (CMOs) Due to the interest rate sensitivity of mortgage-backed securities and the possibility of high prepayment risk (receiving the invested funds back earlier than anticipated), CMOs would not be suitable. TIPS, designed to protect against inflation, and the high-yield corporate bond, if held to maturity, could each meet the objective. Zero-coupon bonds are specifically designed to meet the objective of investing a fixed sum now and realizing a fixed sum later, and in this regard, would be the most suitable of those listed.

All of the following statements regarding planned amortization class (PAC) collateralized mortgage obligations are true except A) PACs have a more certain maturity date than comparable TACs. B) PACs have higher yields than comparable TACs. C) PACs have companion tranches. D) PACs have a lower-than-average prepayment risk.

B) PACs have higher yields than comparable TACs. PACs have two companion tranches: one to absorb prepayments and one to buffer against extension risk. Because there is less risk and a more certain maturity date, PACs tend to have lower yields than comparable TACs.

Which of the following statements regarding collateralized mortgage obligations (CMOs) is true? A) Yield is locked in. B) They can be purchased for as little as $1,000. C) There is no prepayment risk. D) There is no extended maturity risk.

B) They can be purchased for as little as $1,000. CMOs can be purchased for as little as $1,000 but mainly trade in minimum amounts of $25,000. Both prepayment risk and extended maturity risk apply to these mortgage-backed securities. The only security where yield is locked in is a zero-coupon bond.

Investors in collateralized mortgage obligations (CMOs) tend to choose a tranche meeting their maturity expectations. Should the debt continue past the expected payoff date, it is an example of A) default risk. B) extension risk. C) reinvestment risk. D) prepayment risk.

B) extension risk. A CMO's yield and maturity are estimates based on historical data or projections of mortgage prepayments from the Public Securities Association (PSA). The particular tranche an investor owns determines the priority of their principal repayment. When the debt continues beyond the projected date, the investor has encountered extension risk. Prepayment risk is that the debt will be paid off early rather than later.

All of the following statements regarding collateralized mortgage obligations (CMOs) are true except A) CMOs are a derivative security. B) interest is paid semiannually. C) principal repayments are applied to earlier tranches first. D) interest payments are distributed pro rata when received.

B) interest is paid semiannually. CMO holders are paid interest monthly. As payments are received from the underlying mortgages, interest is paid pro rata to all tranches, but principal repayments are paid to the first tranche until it is retired. Subsequent principal repayments are then applied to the second tranche until it is retired and so on. CMOs are a derivative security because the value of each tranche is derived from the timing of principal repayments to that tranche.

All of the following statements regarding the tax treatment interest received from a collateralized mortgage obligation (CMO) investment is true except A) it is fully taxable at all levels. B) it is nontaxable at the local level. C) it is taxable at the federal level. D) it is taxable at the state level.

B) it is nontaxable at the local level. Interest received from CMOs is fully taxable at the federal, state, and local levels. It is treated exactly the same as interest on a corporate bond. The only testable debt securities where there is a tax benefit are those issued by the U.S. Treasury (exempt from state and local [city] income tax) and those issued by municipal issuers where the interest is exempt from tax at the federal level and possibly exempt on the state and local level (in-state issuer), as well.

An investor would assume all of the following risks when investing in a collateralized mortgage obligation (CMO) except A) interest rate risk. B) regulatory risk. C) extension risk. D) prepayment risk.

B) regulatory risk. Regulatory risk is generally not associated with investing in CMOs. All of the other risks are associated with CMOs. Extension risk is the uncertainty that the mortgages will be paid off later than expected. This typically happens when interest rates rise. After all, who is going to refinance a mortgage at a higher rate? Prepayment risk is just the opposite; the mortgages might be paid off more quickly and the income stream will cease. This typically happens when interest rates decline, but they are also factor in people moving and selling their homes. CMOs are subject to interest rate risk just like other debt securities.

Yield quotes on collateralized mortgage obligations (CMOs) are based on A) the underlying mortgage's interest rate. B) the tranche's expected life. C) the underlying mortgage's maturity. D) the underlying mortgage's average lif

B) the tranche's expected life. Yield quotes on CMOs are based on the tranche's expected life, not the average life of the mortgages in the pool backing all of the tranches.

A performance-based management fee is normally associated with which of the following pooled investments? A) An asset allocation fund B) A balanced fund C) A hedge fund D) A unit investment trust

C) A hedge fund One of the distinct characteristics of a hedge fund is the fee structure. A typical offering will describe the fee as "2 & 20." This means that the base fee is 2% of assets, with a bonus of 20% of the profits once the return reaches a specific range. It is unlikely that you will see this feature on your exam anywhere other than with hedge funds. It creates a strong incentive for the fund's manager to implement strategies that may produce high returns but carries with it a higher risk for the investors. There are no management fees with UITs and mutual fund fees are almost always below 1% (most significantly less that that).

The term tranche is associated with which of the following investments? A) FNMA B) SLMA C) CMO D) GNMA

C) CMO Collateralized mortgage obligations are a type of mortgage-backed security. A CMO issue is divided into several tranches, or slices, which set priorities for payments of principal and interest.

Which of the following debt securities does not have a fixed maturity date? A) Subordinated debenture B) Treasury STRIPS C) Collateralized mortgage obligation (CMO) D) General obligation bond

C) Collateralized mortgage obligation (CMO) CMOs are mortgage-backed securities. Because mortgages are often paid off ahead of the scheduled maturity, the exact maturity date of a CMO is uncertain.

Which of the following investments makes interest distributions to its investors? A) Business development corporations (BDCs) B) Closed-end funds (CEFs) C) Collateralized mortgage obligations (CMOs) D) Unit investments trusts (UITs)

C) Collateralized mortgage obligations (CMOs) CMOs (collateralized mortgage obligations) make periodic distributions of interest and principal to their investors. BDCs (business development corporations), UITs (unit investment trusts) and CEFs (closed-end funds) are all regulated investment companies and distribute their net investment income as dividends.

Collateralized mortgage obligations (CMOs) are a type of asset-backed security. What type of securities are frequently the assets behind a CMO? A) Real estate B) Mutual funds C) Ginnie Mae, Fannie Mae, and Freddie Mac products D) Stocks and bonds

C) Ginnie Mae, Fannie Mae, and Freddie Mac products CMOs usually bundle Ginnie Mae, Fannie Mae, and Freddie Mac products into a single product that passes through monthly payments from these investments to investors. They have been highly rated historically and are good income producers. REITs are created with real estate. Mutual funds and ETFs buy stocks and bonds.

Collateralized mortgage obligation (CMO) tranche A has been created to have the most predictable near-term principal pay off. A tranche set up in this way will have the highest reinvestment risk. the least reinvestment risk. a higher yield. a lower yield. A) II and III B) I and IV C) II and IV D) I and III

C) II and IV A CMO created to have the most predictable near-term principal pay off will have lower reinvestment risk and lower yield than other CMOs.

One of your customers approaches you with an interest in investing in hedge funds. When checking the customer's profile, you notice that the annual income is $68,000 and the net worth is just under $100,000. How should you respond to the customer? A) Hedge funds would be an excellent way to increase your net worth. Let me send you some offering documents for ones that I like. B) In most cases, hedge funds are limited to accredited investors. You do not appear to meet that standard, but, if you are really interested, I'll see if I can squeeze you in. C) In most cases, hedge funds are limited to accredited investors. Unless something has changed and you have not notified us, you do not qualify. D) Because hedge funds do not register with the SEC, they would not be a suitable addition to your portfolio.

C) In most cases, hedge funds are limited to accredited investors. Unless something has changed and you have not notified us, you do not qualify. Hedge funds are suitable only for those who are sophisticated investors and have the financial wherewithal to deal with high risk. In almost all cases, it is necessary to be an accredited investor and this customer is far from that. Offering to "squeeze" a client into an unsuitable investment is against FINRA's code of conduct rules. It is true that hedge funds do not register with the SEC, but that is not the reason they are unsuitable for this customer.

Which of the following assets would be least likely used to back a collateralized debt obligation (CDO)? A) Corporate receivables B) Auto loans C) Mortgages D) Credit card debt

C) Mortgages Unlike CMOs, which are backed by mortgages (as the M indicates), CDOs are invariably backed by some other form of asset. Remember that what someone owes is their debt, while it is an asset to the creditor.

In a rising interest rate environment, which of the following risks associated with mortgage-backed securities such as a collateralized mortgage obligation (CMO) is of least consequence to a potential investor? A) Credit risk B) Extension risk C) Prepayment risk D) Interest rate risk

C) Prepayment risk Prepayment risk is the risk that mortgage holders will refinance or repay their mortgages early as a result of falling interest rates. Therefore, in a rising interest rate environment, it would be less of a concern for a CMO investor. Extension risk is the risk that mortgage payments will be missed or slower than anticipated in a faltering economic environment. Credit and interest rate risks are always of concern with CMOs.

Planned amortization class (PAC) collateralized mortgage obligation were designed to provide which of the following benefits, compared to plain vanilla tranches? A) Eliminate prepayment risk for tranche holders B) Match the prepayment risk of plain vanilla tranches C) Reduce prepayment risk for tranche holders D) Increase prepayments to tranche holders

C) Reduce prepayment risk for tranche holders PACs reduce, but cannot eliminate, prepayment risk for tranche holders. The companion tranches will have higher prepayment risk than the PAC, as they were designed to absorb the bulk of the prepayment risk.

Which of the following disclosures regarding a collateralized mortgage obligation (CMO) is accurate? A) Repayment of principal is guaranteed. B) CMOs are unique in that they are suitable for small or unsophisticated investors to invest in mortgage-backed securities. C) The rate of return may vary as a result of early prepayment. D) All tranches have the same degree of risk and the same risk characteristics.

C) The rate of return may vary as a result of early prepayment. Prepayment risk is one of the major risks associated with CMOs and must be disclosed to prospective investors. Tranches are structured to have different degrees and characteristics of risk such as prepayment and extension risk, and therefore, they may not be suitable for smaller or unsophisticated investors. There is no guarantee of principal repayment.

Which of the following should a registered representative disclose when discussing collateralized mortgage obligations (CMOs) with a customer? A) All CMOs have similar risk. B) CMOs offer the same tax advantages as Treasury securities. C) The rate of return may vary because of early repayment. D) The federal government guarantees return of principal.

C) The rate of return may vary because of early repayment. CMOs are corporate mortgage-backed bonds that separate mortgage pools into different maturity classes called tranches. Like other mortgage-backed securities, CMOs subject investors to the risk of early repayment when interest rates fall; registered representatives should disclose this risk to CMO customers. CMO interest is taxed at all levels, and there is no government backing on CMOs. Different CMO tranches have differing levels of investment risk.

Many fixed-income investors diversify their portfolios by maturity. If one were investing in CMOs, that would be done by buying A) different issuers. B) yield-based options. C) different tranches. D) serial bonds.

C) different tranches. Although CMOs technically have maturity dates, it is rare for one to ever last that long. The standard way to vary the expected return of principal is by using different tranches. Serial bonds are generally issued by municipalities and are not mortgage-backed. Different issuers has nothing to do with maturities and yield-based options might be used as a hedge, but not to diversify maturities.

A risk faced by investors in most CMOs that is not found in corporate bonds is A) interest rate risk. B) purchasing power risk. C) extension risk. D) default risk.

C) extension risk. With mortgage-backed securities, there is an assumption that some of the mortgages will be paid off early. When interest rates are rising, there are fewer prepayments than assumed (no one is going to refinance their mortgage at a higher rate). This delayed repayment of principal is known as extension risk. Corporate bonds are expected to pay back the principal at maturity date, not earlier. All debt securities have the other risks to some degree or another.

Both mutual funds and hedge funds are pooled investment vehicles managed by a professional money manager. As their registered representative, one of your customers asks you to explain how these investment vehicles are different. You inform them that A) hedge funds are more liquid than mutual funds. B) mutual funds and hedge funds are equally liquid. C) hedge funds are less liquid than mutual funds. D) mutual funds use more aggressive investment strategies.

C) hedge funds are less liquid than mutual funds. Hedge funds typically have a lockup period during which time the investor cannot liquidate the investment. The capital is locked up. However, mutual funds are liquid. These are redeemable, so an investor can sell shares back to the issuing company at any time. While hedge fund managers can use aggressive investment strategies such as short selling, margin trading, and speculative derivative transactions, mutual fund managers cannot. The Investment Company Act of 1940 prohibits mutual fund managers from using these investment strategies

A client of your broker-dealer is interested in collateralized mortgage obligations (CMOs). While determining suitability for the client, all of the following should be discussed except A) how changing interest rates may affect the prepayment rates. B) the relationship between mortgage loans and mortgage securities. C) how currency exchange rates may affect the value of the securities. D) the tax consequences of CMOs.

C) how currency exchange rates may affect the value of the securities. Currency exchange rates are not applicable to the risks associated with CMOs. However, when determining suitability, a discussion of all of the characteristics and risks of CMOs should occur. This would include how changing interest rates may affect prepayment rates, and therefore, the average life of the security, tax considerations (CMOs are taxable at all levels), and the relationship between actual mortgage loans and mortgage-backed securities.

You have a high net worth client who is interested in investing in a hedge fund. Details of the offering would be found in the fund's A) subscription agreement. B) statement of additional information. C) private offering memorandum. D) registration statement.

C) private offering memorandum. Hedge funds do not register with the SEC, so there is no registration statement. However, the management does prepare an offering document. It could be called the private placement memorandum, the offering circular, or even the prospectus on the exam. The statement of additional information (SAI) is limited to registered management investment companies (open- and closed-ends) and ETFs.

A planned amortization class (PAC) collateralized mortgage obligation (CMO) offers A) protection from prepayment risk only. B) less protection than a targeted amortization class. C) protection from both prepayment and extension risk. D) protection from extension risk only.

C) protection from both prepayment and extension risk. A PAC offers protection from both prepayment and extension risk. This protection is greater than that offered by a targeted amortization class CMO, which protects against prepayment risk only.

A collateralized mortgage obligation (CMO) makes an interest-only payment to an investor. This payment will be A) tax free. B) treated partly as ordinary income and partly as a tax-free return of principal. C) taxed as ordinary income. D) taxed as a capital gain if the underlying mortgage is prepaid.

C) taxed as ordinary income. Interest-only payments made by CMOs are taxed as ordinary income.

All of the following concerning collateralized mortgage obligations (CMOs) are true except A) CMOs can be purchased and sold over-the-counter (OTC). B) CMOs are not backed by the federal government. C) z-tranche CMOs carry the lowest prepayment risk. D) most CMOs are backed by government agency pass-through securities held in a trust account.

C) z-tranche CMOs carry the lowest prepayment risk. Note that the question is asking for the false statement. The z-tranche is last in line when it comes to payouts. If prepayments occur at a rate faster than expected, this tranche suffers disproportionately more than the others. Even though CMOs generally are backed by pass-through securities from government agencies and government-sponsored corporations, they do not carry any type of government guarantee. CMOs are traded over the counter rather than listed on the exchanges.

Which of the following accounts would a collateralized mortgage obligation (CMO) Z-tranche be best suited for? A) A custodial account set up under the Uniform Transfer to Minors Act B) A joint account with a nonworking spouse C) An IRA account for a middle aged client D) A professionally managed hedge fund specializing in real estate portfolio securities

D) A professionally managed hedge fund specializing in real estate portfolio securities A zero-tranche (Z-tranche) CMO is considered to be among the most volatile CMO tranches because they receive no payments until all preceding tranches of the CMO are retired. Generally, CMO tranches are not suitable for smaller or unsophisticated investors, which is why customers are required to sign a suitability statement before purchasing any CMO tranche. Of the answer choices given, the best suited account would be the one that is professionally managed and already specializing in real estate investments.

Two registered representatives are discussing a collateralized debt obligation (CDO) backed by cash flow from credit card payments. Which of their statements during the discussion is not true? A) CDOs are securitized products where pooling or repackaging of individual loans has occurred. B) A customer would have to choose a tranche that has the right risk characteristics for him, in terms of suitability. C) CDOs are not considered suitable for all customers. D) CDOs always represent pools of assets that individually are very liquid, and that is why the CDOs themselves are very liquid.

D) CDOs always represent pools of assets that individually are very liquid, and that is why the CDOs themselves are very liquid. In most cases, the assets comprising the CDO portfolio are small and individually not very liquid. Generally, individual investors would not have an opportunity to purchase these assets separately. Repackaging the assets, however, facilitates them being sold to individual investors in the secondary markets.

The interest on which of the following instruments is subject to taxation at the federal, state, and local levels? A) Treasury notes B) Revenue bonds C) Public Housing Authority bonds D) Collateralized mortgage obligations (CMOs)

D) Collateralized mortgage obligations (CMOs) The interest on corporate debt securities is subject to taxation at the federal, state, and local levels, and CMOs are issued by corporations. Interest on Treasury instruments is taxable at the federal level only. Interest on municipal instruments is exempt from taxation at the federal level, and possibly the state level, if the holder is a resident of the state of issue. Public Housing Authority bonds and revenue bonds are types of municipal issues, which are tax free at the federal level.

Which of the following risk factors would be least important to disclose in recommending collateralized mortgage obligation (CMO) securities to public customers? A) Interest rate risk B) Prepayment risk C) Extended payment risk D) Credit risk

D) Credit risk Most CMOs offered to the public are backed by mortgages held by government-sponsored corporations like Fannie Mae, Ginnie Mae, Freddie Mac, et cetera. Credit risk would be a minimal consideration. The other risks are inherent to mortgage-backed securities.

Which of the following statements regarding hedge funds are true? They may not be suitable for discretionary accounts where account holders are not familiar with the risks associated with them. They are conservatively managed using no advanced or aggressive investment strategies without first receiving regulatory approval. They may charge both an annual fee and a fee based on the funds' profits. They are subject to the same rules as mutual funds. A) I and IV B) II and IV C) II and III D) I and III

D) I and III Hedge funds use aggressive investment strategies, and therefore, they might not be suitable for discretionary accounts where the customer may not be familiar or comfortable with the risks associated with the product. Because they are unregulated, there are no limits to the fees they may charge.

Which of the following statements regarding prepayment of CMOs are ordinarily true? If interest rates fall, prepayments increase. If interest rates rise, prepayments increase. If interest rates fall, prepayments decrease. If interest rates rise, prepayments decrease. A) I and II B) III and IV C) II and III D) I and IV

D) I and IV When interest rates fall, homeowners often refinance their homes to take advantage of lower interest rates, resulting in the existing mortgages being paid off early. Also, homeowners tend to sell their homes to upgrade to larger homes when mortgage interest rates (and monthly payments) are low. When interest rates rise, homeowners do not usually refinance, and housing turnover is reduced.

A customer of a registered representative is considering a hedge fund investment and asks what the lock-up period means? The registered representative correctly explains that it is A) the length of time required to have the hedge fund registered with the SEC, during which time, the fund may not sell any shares. B) a time when the fund manager will not make any changes (purchases or sales) within the hedge fund portfolio. C) the minimum length of time the hedge fund portfolio manager intends to hold any single investment within the portfolio. D) a time when liquidation of fund shares is prohibited by the fund, meaning there is an element of illiquidity to be considered.

D) a time when liquidation of fund shares is prohibited by the fund, meaning there is an element of illiquidity to be considered. Hedge funds generally employ a lock-up provision to ensure that capital invested by shareholders will remain with the fund long enough to ensure the manager's ability to implement the intended fund strategy, then begin to see the results of that strategy. There is no standard lock-up period, which can differ from fund to fund, and it should always be noted that during the lock-up period, the investment is essentially rendered illiquid.

Hedge funds do not register with the SEC under the Investment Company Act of 1940. As such, hedge funds A) are exempt from the SEC's antifraud provisions. B) are sold only in unsolicited transactions. C) are not considered a speculative investment. D) do not provide the same level of transparency as registered investment companies.

D) do not provide the same level of transparency as registered investment companies. Lack of SEC registration means that the amount of information made available in a hedge fund offering private placement memorandum is far less than what appears in the prospectus of a registered issue. That is what leads to a lower level of transparency. That is one of the reasons adding to the speculative nature of these funds. Exemption from registration does not mean exemption from the antifraud rules. Most hedge fund sales are in solicited transactions and limited to sophisticated or accredited investors.

Pooling assets such as auto loans and mortgages into investment vehicles for sale to the public is the process known as A) monetization. B) aggregation. C) capitalization. D) securitization.

D) securitization. Pooling assets, such as mortgages and various other types of loans into financial instruments allows them to be sold to general investors more easily than selling them individually. This process is called securitization. Remember, if someone owes you money, it is their debt but your asset.

All of the following are risks of investing in publicly traded mortgage-backed securities except A) borrowers might default on their mortgage payments. B) falling interest rates might accelerate early repayment of principal. C) rising interest rates might extend the date of repayment of principal. D) the market for mortgage-backed securities is illiquid.

D) the market for mortgage-backed securities is illiquid. As publicly traded securities, liquidity risk is not a major concern to investors in mortgage-backed securities. When interest rates decline, there is generally an increase in mortgage refinancing and that results in investors receiving repayment of principal ahead of schedule. That is prepayment risk. Although it is nice to get the money back, there is reinvestment risk because these lower interest rates mean that reinvesting the principal into new securities will now be at a lower return than previously earned. The opposite happens when interest rates increase. Homeowners are unlikely to refinance, causing principal repayments to slow. Without the repayment, investors holding these securities are receiving below market returns. This is an example of extension risk. As is the case with any loan, there is always default risk. Recent history has shown that it is possible for a large number of foreclosures where the lender does not recoup the full principal.

All of the following statements about targeted amortization class (TACs) CMOs are correct except A) they have high extension risk. B) in exchange for higher price risk, they generally offer a slightly higher interest rate. C) they have transferred prepayment risk to companion tranches. D) they are the most volatile of the tranches.

D) they are the most volatile of the tranches. The Z-tranche, just like a zero-coupon bond, is the most volatile. TACs transfer the prepayment risk to companion tranches like PACs do, but they retain extension risk. This causes greater price risk in the market that is compensated for with a somewhat higher interest rate.

One form of debt security attractive to many high net worth investors is the collateralized mortgage obligation (CMO). A CMO is a pool of mortgages structured into maturity classes called A) terms. B) series. C) serials. D) tranches.

D) tranches. The maturity classes on a CMO are called tranches (the French word for slice). A CMO pays principal and interest from the mortgage pool monthly; however, it repays principal to only one tranche at a time. Series bonds, bonds with a serial maturity, and term bonds are most commonly found in municipal securities.