Series 7 Midterm Exam
Your new customer lists tax-free income as an investment objective but notes that he will need access to $50,000 within the next four to six months for a down payment on a vacation home he is purchasing. To meet the objective of tax-free income, a registered representative considers municipal securities for the $50,000. Which of the following municipal securities recommendations would be the least suitable? A) An auction rate security (ARS) B) A bond anticipation note (BAN) C) A variable rate demand note (VRDN) D) A tax anticipation note (TAN)
Answer is A E: An ARS is a long-term instrument tied to short-term interest rates and, therefore, would not be suitable for someone with a short-term time horizon. Each of the remaining answer choices are short-term notes aligning better with the customer's need to access the funds in the next four to six months.
The unqualified legal opinion on a municipal bond states that A) the issuer has the authority to issue bonds that are legal, valid, and enforceable obligations of the issuer. B) the bond counsel needs more time to qualify the opinion. C) the bond has passed the additional bonds test (parity test). D) the bond is marketable.
Answer is A E: An unqualified opinion means the bond counsel attests that, to the best of its knowledge, the issuer has the legal right to issue the securities in question. In the case of tax-exempt bonds, the interest the issuer will pay on the bonds is exempt from federal taxation and the bonds are exempt from federal registration requirements. The legal opinion does not evaluate the issue's marketability, or safety, debt service requirements.
Each of the following is a defined contribution plan except A) a stock option plan. B) a profit-sharing plan (qualified). C) a money-purchase pension plan. D) a 401(k) plan.
Answer is A E: Money-purchase pension plans, 401(k) plans, and qualified profit-sharing plans are all examples of defined contribution plans. An employer may offer stock options that give an employee the right to purchase a specified number of shares of the employer's common stock at a stated exercise price over a stated time period. No actual contribution is made, just payment when the employee decides to exercise the option. Unlike the other choices, this is not a qualified plan.
A customer has invested a total of $10,000 in a nonqualified deferred annuity through a payroll deduction plan offered by the school system where she works. The annuity contract is currently valued at $16,000, and she plans to retire. On what amount will the customer be taxed if she chooses a lump-sum withdrawal? A) $6,000 B) $10,000 C) $16,000 D) No taxes owed because annuity was nonqualified
Answer is A E: Payments into a nonqualified deferred annuity are made with after-tax money; taxes must only be paid on the earnings of $6,000.
All of the following option strategies could be effectively used in a bear market except A) a short straddle. B) a debit put spread. C) a short call. D) a credit call spread.
Answer is A E: Short straddles are appropriate only in flat or neutral markets. The writer will lose in a rising market (the call will be exercised) or a falling market (the put will be exercised). Short calls and short call spreads are bearish, as are debit (long) put spreads.
If a customer writes 2 ABC Feb 90 puts at 8 and buys 2 ABC Feb 80 puts at 2, which of the following statements are true? The spread is bullish. The spread is bearish. The breakeven point is 84. The breakeven point is 86. A) I and III B) I and IV C) II and III D) II and IV
Answer is A E: This is a credit put spread (the net credit being 6 points per share) in which the breakeven point is calculated by subtracting the net premium (debit or credit) from the higher strike price (90 - 6 = 84). A credit put spread is like the net sale of a put, and buying the lower strike price in any spread (put or call) is bullish.
Trade confirmations must show yield to call on which of the following bonds? A) 6½%, 7% basis, maturing 2038 B) 5½%, 5% basis, maturing 2038 C) 6½%, at par, callable 2025, maturing 2059 D) 5½%, 5½% basis, maturing 2038
Answer is B E: Bond confirmations must disclose the lower of the yield to maturity (YTM) or yield to call (YTC). On a premium bond, the YTC is the lower of the two. The terminology here shows the coupon, the basis (YTM), and the maturity date (and, in one case, the call date). The 5½% bond with a 5% basis is the only bond trading at a premium because the YTM (or basis) is lower than the coupon. Even though the 6½% bond maturing in 2059 is callable relatively soon, because the bond was purchased at par, CY, YTM, and YTC are all equal to the coupon (nominal) rate, so the investor won't suffer a loss of principal with an early call.
All of the following securities are issued at a discount except A) Treasury bills. B) CDs. C) commercial paper. D) zero-coupon bonds.
Answer is B E: CDs are interest-bearing debt instruments issued by banks at their face value. All of the others are issued at a discount.
If ABC Corporation reports a loss for the year, it is obligated to pay interest on all of the following except A) convertible bonds. B) adjustment bonds. C) variable rate bonds. D) debentures.
Answer is B E: Even if a corporation reports a loss, the corporation is obligated to pay interest on all of its outstanding debt except for income (adjustment) bonds. Adjustment bonds require interest to be paid only if ABC has sufficient earnings and the payment is declared by the board of directors.
Interest received from which of the following federal agency securities is exempt from all state and local taxation? A) Government National Mortgage Association pass-through securities B) Farm Credit System bonds C) Federal National Mortgage Association bonds D) Federal Home Loan Mortgage Corporation bonds
Answer is B E: FCS securities are part of a small group of federal agency securities where the interest is exempt on a state and local (but not federal) level. A key to remembering is that any agency with the title mortgage is fully taxable.
A customer long 100 shares of XYZ stock who wishes to reduce risk and generate income should A) buy an XYZ put. B) sell an XYZ call. C) buy an XYZ call. D) sell an XYZ put.
Answer is B E: If the customer sells a call, the risk of owning the stock is reduced by the call's premium. Receipt of the premium satisfies the customer's income objective.
The market attitude of a customer who establishes a credit call spread is A) bullish. B) bearish. C) speculative. D) neutral.
Answer is B E: In a call spread, a customer is buying one call and selling another with different strike prices and/or expirations. In any spread, one of the options is dominant. In a short call spread, the short call position is dominant because it has the higher premium; writing calls is bearish.
Which of the following is an issuer of federal agency securities? A) The California Urban Development Authority B) The Tennessee Valley Authority C) The U.S. Treasury D) The Indiana Highway Authority
Answer is B E: The TVA is a federal agency formed as an act of Congress in 1933. As such, the debt securities it issues are considered federal agency securities. Treasury issues are simply that—issues of the Treasury, not an agency. The other two choices are municipal bonds.
An investor purchases a TIPS bond with a 3% coupon. During the first year, if the inflation rate is 8%, the principal value of the security at the end of that year will be closest to A) $1,080.00. B) $1,081.60. C) $1,030.00. D) $1,030.23.
Answer is B E: The principal value of a TIPS bond is adjusted semiannually by the inflation rate. The exact calculation would be $1,000 × 104% × 104%, which equals $1,081.60. Each six months, the interest is paid on that adjusted principal and that is why the security keeps pace with inflation. There is a shortcut that will always work on the exam. Just recognize that the principal value increases based on the inflation rate compounded semiannually. Take the simple interest rate and choose the next highest number. In this example, 8% simple interest would be $80 (which would always be one of the choices). Because the computation is done twice per year, the compounding effect makes the correct choice slightly higher.
Payment of interest and principal on which of the following securities is a direct obligation of the U.S. government? A) Federal National Mortgage Association bonds B) Government National Mortgage Association pass-through securities C) Federal Home Loan Mortgage bonds D) Federal Housing Authority bonds
Answer is B E: These are unique because they are the only agency with direct backing of the U.S. government.
If an investor purchased a municipal bond in the secondary market, which of the following would not be a factor in calculating the total dollar amount paid for the bond? A) The coupon rate B) The dated date C) The scale D) The settlement date
Answer is C E The scale, or reoffering scale, represents the prices and/or yields (listed by maturity date) at which new issue securities are offered for sale to the public by the underwriting syndicate. Because this question refers to a secondary market purchase, the scale would not apply. When computing the total price of a bond purchase, we need to know the accrued interest. Because interest is computed up to—but not including—the settlement date, clearly that is required information. The dated date is the date from which interest begins to accrue. True, this is only applicable for the first interest payment, but the question doesn't specify that this bond has already made that payment. Remember, secondary market transactions can take place the same day the new issue is released. Finally, it would be impossible to compute the accrued interest without knowing the interest rate being paid by the issuer. There is an important test-taking tip here. Scale has not appeared in the material yet, so we do not expect you to know what it means. But you should know that the other three items are necessary to compute the total purchase price. By process of elimination, scale must be the correct choice. This logic can be helpful on the real exam.
Which of the following securities would most likely have the lowest expense ratio? A) Variable annuity B) Balanced mutual fund C) Exchange-traded fund D) Closed-end fund
Answer is C E: Generally, most exchange-traded funds (ETFs) have a lower expense ratio than comparable mutual funds. Variable annuity expense ratios tend to be higher than mutual funds, and the expense ratio for closed-end funds is similar to that of open-end (mutual) funds.
Investors who are subject to AMT must have which of the following preference items added to adjusted gross income to calculate their tax liability? A) Distributions from a corporate bond mutual fund B) Income from a municipal security issued to finance parking garages C) Interest on a municipal bond issued to finance highway construction D) Interest on a private purpose municipal bond
Answer is D E: On the exam, whenever you see a private purpose municipal bond, the interest on the bond is a tax preference item for the purpose of the alternative minimum tax.
Explanations
Municipal bond quotations between dealers are required to be bona fide, or firm, quotes. They are required to be fair and reasonably related to the current market. The withdrawals from Section 529 plans are federally tax exempt, but they may be taxed as income in some states. The money that is invested in a Section 529 plan is always after tax. To avoid taxation, the withdrawals must be used for qualified education expenses (e.g., tuition, books, lecture fees, lab fees), including up to $10,000 per year for K-12 education. Withdrawals to pay expenses that are not qualified incur tax liability. The owner of a life annuity with 10-year period certain will receive payments for life, subject to a minimum of 10 years. If the contract holder dies before the period expires, the remaining payments are made to the beneficiary. An example would be if a contract holder of a life annuity with 10-year period certain died after 5 years, payments would continue for 5 more years to the beneficiary and then stop. Regulation SP deals with protection of client information. Initially, and annually, the firm's privacy policies must be disclosed to its retail (individual) customers. Remember, consumer has a special meaning under SP. It is a one-time relationship, such as someone who received stock as a gift and wants to sell it through the member firm, take the money, and conduct no further dealings. Business and institutional clients are not covered by the regulation. Only the closed-end company is legally permitted to issue senior securities (preferred stock and bonds). Any tax taken on dividends received from ADRs is taken in the country of origin. This is a foreign withholding tax for U.S. investors. The foreign withholding tax may later be taken as a credit against any U.S. income taxes owed by the U.S. investor. In a variable life insurance policy, a minimum death benefit is guaranteed, but no cash value is guaranteed. There is a contract exchange privilege during the first 24 months, allowing the conversion of the variable policy to a comparable form of permanent insurance, and the 75% cash value loan minimum applies after the third year of coverage. Nonqualified plans do not provide a tax deduction to the employer until the employee receives the economic benefit as income at some point in the future. They are, however, more flexible because they do not have to comply with ERISA reporting and nondiscrimination requirements. Warrants usually have lifetimes of 2 to 10 years; rights expire in 30 to 45 days. A corporation may attach warrants to other securities, such as bonds, to make the bonds more marketable. Warrants have no intrinsic value when issued and may expire without ever having intrinsic value. Before expiration, they may be, and often are, traded in the secondary market.
