Investment Vehicles

To create a collar on XYZ stock when the stock is trading at $68, which option positions would be taken? StatusA A. Long 1 XYZ Jan 70 Call / Short 1 XYZ Jan 65 Put StatusB B. Long 1 XYZ Jan 70 Put / Short 1 XYZ Jan 65 Call Correct C. Long 1 XYZ Jan 65 Put / Short 1 XYZ Jan 70 Call StatusD D. Long 1 XYZ Jan 65 Call / Short 1 XYZ Jan 70 Put C

A "collar" on a stock position is designed to provide downside protection at minimal cost. The stock is trading at $68, so the purchase of an ABC Jan 65 Put (3 points "out the money") would be cheaper than the purchase of a 70 put (2 points "in the money"). To offset the cost of the put purchase, the sale of an ABC Jan 70 Call (2 points "out the money") would provide some premium income. If the stock drops, the 65 put would be exercised, protecting the position from further loss. On the other hand, if the stock rises above $70, the short call would be exercised, obligating the customer to deliver the stock at $70, with no further gain on the stock position. Thus, the price is "collared" between $65 and $70 per share.

Which of the following option positions is used to generate additional income against a long stock position? StatusA A. long call Correct B. short call StatusC C. long put StatusD D. short put B

A covered call writer owns the underlying stock position. He sells the call contract to generate extra income from the stock during periods when the market is expected to be stable. If he expects the market to rise, he would not write the call against the stock position because the stock will be "called away" in a rising market. If he expects the market to fall, he would sell the stock or buy a put as a hedge. The customer would not sell a put to generate extra income against the long stock position, because if the market falls, the customer would be exercised on short put, and thus would have to buy another 100 shares at the strike price. Thus, in a declining market, the customer would lose double.

An options strategy where the maximum potential loss is equal to the difference between the value of the underlying long securities position and premiums received is a: StatusA A. naked call writer Correct Answer B. covered call writer Incorrect Answer C. naked put writer StatusD D. covered put writer B

A covered call writer sells a call contract against the underlying stock that is owned by that customer. If the market drops, the call expires unexercised and the customer keeps the premium. However, as the market drops, the customer loses on the long stock position. Thus, the maximum potential loss is the full value of the stock position, net of collected premiums.

A customer who is short stock will buy a call to: StatusA A. hedge the short stock position in a falling market StatusB B. protect the short stock position from a falling market Correct C. protect the short stock position from a rising market StatusD D. generate additional income in a stable market C

A customer who has shorted stock is bearish on the market. However, the potential loss for a short seller of stock is unlimited if the market should rise, forcing the customer to replace the borrowed shares at a much higher price. ***To limit this risk, the purchase of a call allows the stock position to be bought at a fixed price (by exercising the call), if needed, in a rising market.

A customer sells short 100 ABC @ $37 and sells 1 ABC Jan 35 Put @ $4. The customer would NOT make money if the market price for ABC was at: Correct A. $42 StatusB B. $40 StatusC C. $37 StatusD D. $35 A

A customer with a short stock / short put position loses if the market rises. The customer sold the stock at $37 and collected $4 in premiums, for a total of $41. To breakeven, the stock must be bought for this amount. If the stock is bought for more than $41, the customer loses. Therefore, a loss is experienced at $42. To summarize, the formula for breakeven for a short stock / short put position is: [short stock / short put breakeven] = short sale price + premium

A farmer who is worried about declining corn prices should: StatusA A. buy a futures contract Correct B. sell a futures contract StatusC C. sell a put option on a futures contract StatusD D. buy a call option on a futures contract B

A farmer is a producer of the crop and is long the physical commodity (corn). One way to hedge (protect) against a future price decline is to sell a futures contract - the farmer has a contract that protects him against a price decline, since the future sale price is established in the contract. If the price of the commodity declines, either the farmer can close the contract at a profit since the price of the commodity has fallen or can deliver the commodity for the higher contract price. Also note that buying a put on a futures contract would also act as a hedge, since it establishes a fixed price at which the commodity can be sold. In contrast, buying futures contracts, buying calls on futures contracts and selling puts on futures contracts are all strategies that profit if the price rises. They are unprofitable if the price falls.

A customer with no stock position buys 1 ABC Call and buys 1 ABC Put. The customer would do this to maximize potential profit if the market: Incorrect Answer A. stays flat StatusB B. rises StatusC C. falls Correct Answer D. is volatile D

A long call position gives unlimited gain potential in a rising market; while a long put position gives ever increasing gain potential in a falling market. Thus, this strategy is profitable in a volatile market.

An investor wishes to be able to sell stock at a specified price up until a specified time in the future. To be able to do this, the investor would: StatusA A. buy calls on that stock StatusB B. sell calls on that stock Correct C. buy puts on that stock StatusD D. sell puts on that stock C

A put contract allows the holder to sell stock at a fixed price, good until the expiration of the contract. For such a contract, the put holder pays a premium to the put writer. In contrast, the writer (seller) of the contract is obligating himself to buy the stock at the strike price, if exercised.

Why are European style options considered to be derivatives? StatusA A. Because they can be traded at any time prior to expiration StatusB B. Because they can only be exercised during a stated period just prior to expiration Correct C. Because their value is determined by the movements in the value of an underlying security StatusD D. Because greater returns can be derived when trading options as compared to trading the reference asset C

All options, both American and European style, are derivatives because their price movements are based on the movements of the price of a reference asset.

What type of option can only be exercised at expiration? StatusA A. American Style Correct B. European Style StatusC C. Eastern Style StatusD D. Western Style B

An American style option is one that can be exercised at any time. In contrast, a European style option can only be exercised at expiration - not before. Individual stock options are American style; most index options are European style.

When comparing options to futures contracts, which statements are TRUE? I Options are securities that are regulated and exchange traded II Options are not securities and are unregulated and trade OTC III Futures are contracts that are regulated and exchange traded IV Futures are not contracts and are unregulated and trade OTC Correct A. I and III StatusB B. I and IV StatusC C. II and III StatusD D. II and IV A

Both options and futures are regulated, standardized, exchange-traded contracts. Only forward contracts are "custom" contracts that trade OTC.

Which of the following option positions is used to hedge a long stock position? StatusA A. long call StatusB B. short call Correct C. long put StatusD D. short put C

Buying a put allows the owner of stock to sell it a fixed price (strike price) if the market falls. This limits downside risk on the long stock position.

An investor owns a portfolio of large capitalization blue chip stocks, each of which happens to be in the Dow Jones Industrial Average. He wishes to protect his portfolio from a market downturn without selling the positions. The best recommendation is to: StatusA A. buy a narrow based index put StatusB B. sell a narrow based index put Correct C. buy a broad based index put StatusD D. sell a broad based index put C

Buying an index put, specifically the DJX option (Dow Jones Industrial Average), is the best way to protect the portfolio. The DJX is broad-based, because even though it only has 30 stocks, they are in differing industries. A narrow based index option is either industry specific or country specific.

A call option is "in the money" when the: StatusA A. current market value of the stock is less than the option contract strike price Correct B. strike price of the option contract is below the current market value of the stock StatusC C. option contract premium exceeds the option contract time value StatusD D. option contract time premium is less than the option contract premium B

Call options go "in the money" when the market price exceeds the contract strike price - which is the same as the contract strike price being below the current market value of the stock. The "in the money" amount will set the minimum premium for the contract. On top of this, the premium will increase based on the length of time remaining to the contract, the volatility of the underlying stock and market interest rate levels.

Which statements are TRUE? I A call option is out the money when the current market value of the stock is less than the option contract strike price II A call option is out the money when the strike price of the option contract is below the current market value of the stock III A put option is out the money when the current market value of the stock is less than the option contract strike price IV A put option is out the money when the strike price of the option contract is below the current market value of the stock StatusA A. I and III Correct B. I and IV StatusC C. II and III StatusD D. II and IV B

Call options go "out the money" when the market price is less than the contract strike price. Put options go "out the money" when the market price is above the contract price - which is the same as the contract strike price being below the current market value of the stock. Out the money contracts have very low premiums because they will not be exercised.

All of the following information is included in a (standardized) commodities futures contract EXCEPT the: StatusA A. exchange on which the contract is traded StatusB B. quantity of the commodity Correct C. price of the commodity StatusD D. delivery date(s) of the commodity C

Commodities futures contracts are "standardized," which makes them easier to trade. Each exchange has its own contract for a standard size (quantity) and quality of the commodity (the exchange sets the different varieties or grades that can be delivered at various price differentials to the contract price) and there are standardized future delivery dates for the underlying commodity, if the contract is not closed by trading as of that date. What is not standardized is the price of the commodity - this is determined in the marketplace.

Which of the following information is included in a (standardized) commodities futures contract? I Acceptable grades of the commodity II Quantity of the commodity III Delivery location of the commodity IV Price of the commodity StatusA A. I and II only StatusB B. III and IV only Correct Answer C. I, II, III Incorrect Answer D. I, II, III, IV C

Commodities futures contracts are "standardized," which makes them easier to trade. Each exchange has its own contract for a standard size (quantity) and quality of the commodity (the exchange sets the different varieties or grades that can be delivered at various price differentials to the contract price) and there are standardized future delivery dates for the underlying commodity, if the contract is not closed by trading as of that date. What is not standardized is the price of the commodity - this is set in the marketplace.

An investment adviser manages the portfolio of a client on a discretionary basis. The customer's objective is conservation of principal and income. Under prudent investor standards, which statement is TRUE about the use of options in the portfolio? StatusA A. The use of options strategies is unsuitable for this client based on her investment objective StatusB B. The use of options strategies is only suitable if the customer has previous investment experience with options Correct C. The use of options strategies is only suitable if the strategies are limited to the sale of covered options StatusD D. The use of options strategies is only suitable if the strategies are limited to the purchase of options C

Covered call writing is the most popular retail income strategy in a flat market, and is appropriate for conservative investors that are looking for extra income. The customer sells calls against stock that is already owned, getting premium income. If the stock stays flat, the calls expire and the customer keeps the premium. If the stock rises, the calls are exercised and the stock is called away at no loss to the customer. If the market falls, the calls expire and the customer loses on the stock (which he would have lost on anyway!).

The sale of covered calls is used to: StatusA A. hedge a long stock position in a falling market Incorrect Answer B. protect a short stock position in a falling market Correct Answer C. generate additional income in a stable market StatusD D. profit if the market drops C

Covered call writing is used to generate extra income from a long stock position in a stable market.

If an equity put writer is exercised, the writer has the obligation to: StatusA A. deliver cash in 1 business day StatusB B. buy stock in 1 business day at the market price StatusC C. buy stock in 3 business days at the market price Correct D. buy stock in 3 business days at the strike price D

Equity put writers have the obligation to buy the stock during the lifetime of the option at the strike price (NOT the market price, as the market will be lower than the strike if the contract is exercised). If exercised, the writer must pay the strike price for the stock position 3 business days after trade date.

The earliest that an American style option can be exercised is: Correct A. anytime before the expiration date of the contract StatusB B. the business day preceding the expiration of the contract StatusC C. the Wednesday preceding the third Friday of the month StatusD D. the Saturday following the third Friday of the month A

European style options can only be exercised on the business day prior to the expiration of the contract. Contracts expire on the Saturday following the third Friday of the month. The last time to exercise is the third Friday of the month, up until 5:30 PM ET. In contrast, American style options can be exercised anytime prior to expiration. Stock options are American style; the vast majority of index options are European style.

Forward contracts are: I standardized and exchange traded II non-standardized and OTC traded III can be easily offset with a closing trade IV cannot be easily offset with a closing trade StatusA A. I and III StatusB B. I and IV StatusC C. II and III Correct D. II and IV D

Forward contracts are custom contracts that are negotiated between buyer and seller. They are issued OTC and there is very limited trading - thus it may not be possible to do an offsetting trade with a forward contract. Forward contracts are not subject to federal regulation.

Forward contracts: I can be closed by trading on an exchange II cannot be closed by trading on an exchange III are standardized IV are not standardized Incorrect Answer A. I and III StatusB B. I and IV StatusC C. II and III Correct Answer D. II and IV D

Forward contracts require delivery of an asset at a fixed price and date in the future, but they are custom contracts that are created between 2 institutions. They are not standardized and only trade OTC.

The difference between a cash forward contract and a commodity futures contract is that the forward contract: Correct A. is traded over-the-counter StatusB B. has a standardized delivery date StatusC C. deals with a specific quantity of the commodity StatusD D. has an acceptable deliverable grade of range of grades of the commodity A

Futures contracts are standardized exchange traded contracts to deliver a commodity at a future date. The expiration/delivery date is standardized in the contract. The contract size is standardized, as is the minimum acceptable grade of the commodity to be delivered. The price of the contract is established by auction on the exchange, so it is not standardized. In contrast, a forward contract is NOT standardized. Rather, it is a custom-created contract between a buyer and seller for delivery of a specified commodity at a date in the future. All terms of a forward contract are negotiated, whereas the only thing negotiated in a futures contract is the price. Forward contracts are privately created and any trading (not likely) cannot occur on an exchange - rather, any trades would occur over-the-counter.

If it is expected that the price of an asset will fall in the future, all of the following strategies are profitable EXCEPT: StatusA A. Buy a put StatusB B. Sell a call Correct C. Buy a future StatusD D. Sell a future C

If a put is purchased and the market falls below the strike price, the put can be exercised and the asset can be sold at the strike price in a falling market, so this is profitable. If a call is sold and the market falls below the strike price, the call will expire worthless and the writer will keep the premium, so this is profitable. If a futures contract is purchased, the customer has a contract to buy the commodity or financial asset at a fixed price at a fixed future date. If the asset price falls, the client will have a loss. If a futures contract is sold, the customer has a contract to sell the commodity or financial asset at a fixed price at a fixed future date. If the asset price does down, the client will gain (because the asset can be purchased at the current lower price and delivered at the higher contract price).

The holder of a call on a listed stock exercises. The holder MUST: I deliver stock II deliver cash III take delivery of stock IV take delivery of cash StatusA A. I and III StatusB B. I and IV Correct C. II and III StatusD D. II and IV C

If the holder of a call option on listed stocks exercises, he must buy 100 shares of stock, for which the holder will pay the strike price in cash.

If an equity call holder exercises a contract, the holder MUST: StatusA A. deliver cash in 1 business day StatusB B. deliver stock in 1 business day Correct Answer C. deliver cash in 3 business days Incorrect Answer D. deliver stock in 3 business days C

If the holder of an equity call exercises, he is buying the stock at the strike price. Settlement is 3 business days after exercise date - this is a regular way stock trade.

A customer sells short 100 shares of DEF stock at $62 and sells 1 DEF Oct 60 Put @ $6. The maximum potential gain while both positions are in place is: Correct A. $800 StatusB B. $4,400 StatusC C. $5,400 StatusD D. unlimited A

If the market drops, the short put is exercised and the customer must buy the stock at $60. Since he sold the stock at $62, he gains 2 points, in addition to collecting 6 points of premiums. Thus, the maximum gain is $800. Conversely, if the market rises, the short put expires, leaving a short stock position that has potentially unlimited loss.

A customer buys 100 shares of ABC stock at 39 and sells 1 ABC Jan 45 Call @ 2 on the same day in a cash account. The customer's maximum potential gain until the option expires is: Incorrect Answer A. $200 StatusB B. $300 StatusC C. $700 Correct Answer D. $800 D

If the market rises above 45 the short call will be exercised. The customer must deliver the stock that he bought at 39 for the $45 strike price, resulting in a $600 gain. Since $200 was collected in premiums as well, the total gain is $800. This is the maximum potential gain while both positions are in place.

A customer buys 100 shares of ABC stock at 40 and sells 1 ABC Jan 45 Call @ 2 on the same day in a cash account. The customer's maximum potential gain until the option expires is: StatusA A. $200 StatusB B. $500 Correct C. $700 StatusD D. unlimited C

If the market rises above 45 the short call will be exercised. The customer must deliver the stock that he bought at 40 for the $45 strike price, resulting in a $500 gain. Since $200 was collected in premiums, the total gain is $700. This is the maximum potential gain while both positions are in place.

A customer buys 200 shares of Ford at 68 and sells 2 Ford 70 Calls @ $3. The maximum potential gain is: StatusA A. $500 Correct Answer B. $1,000 StatusC C. $6,800 Incorrect Answer D. unlimited B

If the market rises, the calls are exercised. The stock (which cost $68) must be delivered at $70 for a gain of $2 per share. Since $3 was collected in premiums for selling each call, the net gain, if exercised, is 5 points or $500 per contract x 2 contracts = $1,000.

A customer buys 200 shares of GE at 72 and sells 2 GE 70 Calls @ $6. The maximum potential gain is: Correct Answer A. $800 Incorrect Answer B. $1,200 StatusC C. $7,000 StatusD D. unlimited A

If the market rises, the calls are exercised. The stock (which cost $72) must be delivered at $70 for a loss of $2 per share. Since $6 was collected in premiums for selling the call, the net gain, if exercised, is 4 points or $400 per contract x 2 contracts = $800.

A customer sells 10 ABC Jan 50 Calls @ 4.75 when the market price of ABC is $51 per share. The maximum loss potential is: StatusA A. $4,750 StatusB B. $45,125 StatusC C. $50,000 Correct D. unlimited D

If the market rises, the calls will be exercised, requiring the writer to deliver stock that he does not own. The writer must go into the market to buy the stock at the higher market price. Since the market price can rise an unlimited amount, the loss potential is unlimited.

An investor sells short 200 shares of ABC stock at $60 and sells 2 ABC Jan 60 Puts @ 4 on the same day in a margin account. The maximum potential loss is: StatusA A. $800 StatusB B. $11,200 StatusC C. $12,000 Correct D. unlimited D

If the market rises, the short puts expire unexercised and the writer earns $800 in premiums. However, he is left with a short stock position which gives unlimited upside potential loss.

A customer buys 100 shares of ABC stock at 45 and sells 1 ABC Jan 45 Call @ 2 on the same day in a cash account. The customer's maximum potential loss is: Correct Answer A. $4,300 StatusB B. $4,500 StatusC C. $4,700 Incorrect Answer D. unlimited A

If the stock drops, the call expires "out the money". As the stock keeps dropping, the customer loses more and more on the stock position. Because he effectively paid $4,300 ($45 price - $2 premium collected) for the stock, this is his maximum potential loss.

A customer sells short 100 shares of ABC stock at 40 and buys 1 ABC Mar 40 Call @ 5. The maximum potential gain is: StatusA A. $500 Correct Answer B. $3,500 Incorrect Answer C. $4,500 StatusD D. unlimited B

If the stock falls, the customer gains on the short stock position. He sold the stock for $40. If it falls to "0," he can buy the shares for "nothing" to replace the borrowed shares sold and make 40 points. He lets the call expire "out the money" losing 5 points, so the maximum potential gain is 35 points.

A customer sells short 100 shares of ABC stock at 41 and buys 1 ABC Mar 40 Call @ 5. The maximum potential gain is: StatusA A. $3,500 Correct B. $3,600 StatusC C. $4,100 StatusD D. $4,600 B

If the stock falls, the customer gains on the short stock position. He sold the stock for $41. If it falls to "0," he can buy the shares for "nothing" to replace the borrowed shares sold and make 41 points. He lets the call expire "out the money" losing 5 points, so the maximum potential gain is 36 points.

If the writer of an equity call contract is exercised, the writer MUST: StatusA A. deliver cash in 1 business day StatusB B. deliver stock in 1 business day StatusC C. deliver cash in 3 business days Correct D. deliver stock in 3 business days D

If the writer of an equity call contract is exercised, the writer must deliver the stock, receiving the strike price in payment from the holder. Settlement is 3 business days after exercise date - this is a regular way stock trade.

If the writer of an equity put contract is exercised, the writer MUST: StatusA A. deliver cash in 1 business day StatusB B. deliver stock in 1 business day Correct Answer C. deliver cash in 3 business days Incorrect Answer D. deliver stock in 3 business days C

If the writer of an equity put contract is exercised, he is obligated to buy the stock at the strike price (paying cash) from the holder of the put. Settlement is 3 business days after exercise date - this is a regular way stock trade.

A customer buys 1 ABC Feb 40 Call @ $2 when the market price of ABC is $39.50. The customer's maximum potential loss is: Correct A. $200 StatusB B. $3,950 StatusC C. $4,200 StatusD D. unlimited A

In a falling market, a long call position will expire "out the money" and the holder loses the premium paid. This is the maximum potential loss.

A customer owning 100 shares of stock could receive protection by: StatusA A. buying another 100 shares of the stock Incorrect Answer B. buying a call Correct Answer C. buying a put StatusD D. selling a put C

In order to hedge a long stock position against a downside market move, the best choice is to buy a put. The long put option allows the holder to put (sell) the stock at the exercise price if the market falls - protecting the stock position from downside market risk.

hedging w/ options: protect a Long stock position by buying a Put, protect a Short stock position by buying a Call

LONG PUT to hedge LONG stock position: o to protect a long stock position fr a falling mkt o if mkt drops, can sell stock at strike price LONG CALL to hedge SHORT stock position: o to protect a short stock position fr a rising mkt o if mkt rises, can buy stock at strike price to cover

Selling a put against a stock position sold short is a suitable strategy when the market is expected to: Correct A. remain stable StatusB B. rise sharply StatusC C. fall sharply StatusD D. fluctuate sharply A

Selling stock short alone is a bearish position. Selling a put alone is neutral or bullish strategy. Selling a put against a short stock position is a neutral strategy (as is any income strategy). If the stock is sold short and a put is sold with the same strike price, then if the market stays the same, the put expires "at the money" and the premium collected is retained. If the stock falls, the short put is exercised, obligating the customer to buy the stock at the same price at which it was sold. In this case, only the premium is earned. If the put had not been sold, then the customer would have had an increasing gain on the short stock position as the market fell - so he does not make as much in a falling market. On the other hand, if the market rises, the short put expires "out the money" and the customer is exposed to unlimited upside risk on the short stock position that remains.

An investor wishes to be able to buy stock at a specified price up until a specified time in the future. To be able to do this, the investor would: Correct Answer A. buy calls on that stock StatusB B. sell calls on that stock Incorrect Answer C. buy puts on that stock StatusD D. sell puts on that stock A

Since a long call option allows the purchase of stock at a fixed price at the option of the holder, this is the appropriate option position. Selling a put is not appropriate, since the writer does not determine if the contract is exercised. The holder of the put can exercise, requiring the writer to buy the stock (and will only do so when the market has fallen - which is exactly when the writer of the put does not want to buy the shares).

A customer buys 100 shares of XYZ at 49 and buys 1 XYZ Jan 50 Put @ $5. The maximum potential gain is: StatusA A. $500 StatusB B. $4,400 StatusC C. $5,500 Correct D. unlimited D

Since the customer has a long stock position, his potential gain is unlimited. If the market moves up, he lets the put expire "out the money" and sells the stock in the market at the higher price.

A portfolio manager would: StatusA A. sell puts to enhance portfolio return when market prices are declining StatusB B. buy puts because he or she anticipates rising equity prices Correct C. buy calls in times of rising prices to lock in a lower purchase price StatusD D. sell calls against an existing portfolio in times of rising equity prices C

The buyer of a call contract locks in a fixed price at which the securities can be purchased, good for the life of the contract, making Choice C correct. The seller of a call receives a premium, in return for which, he or she is obligated to deliver (sell) the stock at a fixed price if the contract is exercised. The call seller would be exercised in a rising market, and would be required to deliver shares held in the portfolio at a price that is lower than the current market. This would be an opportunity cost, since the portfolio manager will no longer enjoy the gains on those shares. Thus, Choice D is wrong. The buyer of a put (right to sell) profits in a falling market, making Choice B incorrect. The seller of a put receives a premium, in return for which, he or she is obligated to buy the stock at a fixed price if the contract is exercised. The put seller experiences ever-increasing loss in a falling market, making Choice A incorrect.

The purchase of a call is a: Correct A. bull strategy StatusB B. bear strategy StatusC C. neutral strategy StatusD D. bear/neutral strategy A

The buyer of a call has the right to buy stock at a fixed price in a rising market. The buyer has unlimited gain potential as the market rises, so this is a bull market strategy.

A customer buys 100 shares of ABC stock at 48 and buys 1 ABC Jan 50 Put @ 7. The maximum potential gain is: StatusA A. $700 Incorrect Answer B. $4,300 StatusC C. $5,500 Correct Answer D. unlimited D

The customer has paid $48 for the stock and $7 for the put, for a total outlay of $55. If the stock declines, he is hedged, since he has the right to sell for $50 with the long put; so he can lose only 5 points (bought at $55 total; sold at $50 upon exercise). However, if the stock rises, he lets the put expire "out the money" and can ride the price of the stock up, with theoretically unlimited gain potential.

A customer buys 100 shares of XYZ stock at $56 and buys 1 XYZ Jan 54 Put @ $6. Which statement is TRUE? StatusA A. The breakeven point is $50 Correct B. The maximum loss is $800 StatusC C. If XYZ stock rises to $57, the customer will have a $100 profit StatusD D. If XYZ stock declines to $54, the customer will lose $200 B

The customer owns the stock at $56 and paid $6 per share for the protective put, for a total money outlay of $62 per share. This is the breakeven point. If the stock rises above this, the customer gains on the stock position. If the stock rises to $57, the customer makes 1 point on the stock, but paid 6 points in premiums for a worthless put option, so the customer loses 5 points = $500. If the stock declines to $54, the put expires at the money and the customer loses 2 points on the stock plus 6 points in premiums, for an $800 loss. If the stock falls anywhere below $54, the put will be exercised, limiting the loss on the stock to $800 (the stock purchased at $56 is sold via the exercise of the put at $54, for a $2 loss, in addition to losing the $6 per share premium = $8 per share loss or $800 on 100 shares).

A customer buys stock and wants to buy call options on the stock. The customer would do this to: Incorrect Answer A. hedge the stock position from an adverse market move StatusB B. generate additional income against the stock position as a covered call writer Correct Answer C. enjoy the certainty of a fixed price for a future purchase StatusD D. speculate on the possibility of a price decline C

The customer will profit on the long stock position if the market rises. The purchase of the call allows the customer to buy additional shares at a fixed price if the market rises. Only the purchase of a put against the stock position will protect it from an adverse market move. Only the sale of a call against the stock position will generate income. To speculate on a price decline, the customer would simply buy puts.

A customer buys 10 ABC Jan 50 Calls @ 4.75 when the market price of ABC is $51 per share. The maximum gain potential is: StatusA A. $4,750 StatusB B. $45,125 StatusC C. $50,000 Correct D. unlimited D

The holder of a call has unlimited gain potential. He has the right to buy stock at a fixed price - and the stock can rise an unlimited amount.

A customer buys 2 ABC Jan 60 Puts @ $4 when the market price of ABC is $59. The maximum potential loss for the customer is: Incorrect Answer A. $400 Correct Answer B. $800 StatusC C. $11,200 StatusD D. $12,000 B

The holder of a put buys the right to sell at a fixed price. If the contract expires "out the money," the maximum loss is the premium paid. $400 was paid per contract ($800 for 2 contracts), so $800 is the maximum potential loss. This occurs if the market price rises above the strike price.

A customer buys 1 ABC Jul 40 Put at $6 when the market price of ABC is 38. The maximum potential loss to the holder is: Correct A. $600 StatusB B. $3,400 StatusC C. $4,000 StatusD D. unlimited A

The holder of a put buys the right to sell at a fixed price. If the contract expires "out the money," the maximum loss is the premium paid. This occurs if the market price rises above the strike price.

A customer buys 1 ABC Jul 50 Put at $4 when the market price of ABC is 51. The maximum potential loss to the holder is: StatusA A. $0 Correct Answer B. $400 StatusC C. $4,000 Incorrect Answer D. unlimited B

The holder of a put buys the right to sell at a fixed price. If the contract expires "out the money," the maximum loss is the premium paid. This occurs if the market price rises above the strike price.

An investor purchases 1 ABC Jan 45 Put @ $3. The investor subsequently exercises his option contract. The holder has the right to: StatusA A. buy stock at $42 per share StatusB B. buy stock at $45 per share StatusC C. sell stock at $42 per share Correct D. sell stock at $45 per share D

The holder of a put has the right to sell stock at the strike price of $45 per share specified in the contract. For the contract, the holder initially pays a premium of $3 per share.

A customer sells short 100 shares of PDQ at 61 and buys 1 PDQ Jul 60 Call @ $3. The customer's maximum potential loss is: Correct A. $200 StatusB B. $300 StatusC C. $400 StatusD D. unlimited A

The long call allows the customer to buy in the stock position at $60. Since the stock was sold at $61, exercise results in a net gain of $1 on the stock. Since the customer paid $3 for the call, there is a net loss of 2 points or $200.

A customer buys 100 shares of XYZ at 51 and buys 1 XYZ Jan 50 Put @ $5. The maximum potential loss is: Incorrect Answer A. $500 Correct Answer B. $600 StatusC C. $4,600 StatusD D. unlimited B

The long put gives the stock owner the right to sell at $50. Since he bought the stock at 51, exercising results in a 1 point stock loss. In addition, the premiums paid of $5 are lost, for a total loss of 6 points or $600 maximum.

A customer buys 2 ABC Jan 15 Puts @ 2 when the market price of ABC is 14. The maximum potential gain is: Incorrect Answer A. $200 StatusB B. $1,300 Correct Answer C. $2,600 StatusD D. $3,000 C

The maximum gain for the holder of a put occurs if the market goes to "0". If it does, he can sell the stock at 15 and purchase it for nothing. Since he paid $200 in premiums for this right, the maximum potential gain is: $1,500 - $200 = $1,300. Since there are 2 contracts, the maximum gain becomes $2,600.

A customer buys 1 ABC Jul 40 Put at $6 when the market price of ABC is 38. The customer's maximum potential gain is: StatusA A. $600 Correct B. $3,400 StatusC C. $4,000 StatusD D. unlimited B

The maximum gain for the holder of a put occurs if the market goes to "0". If it does, he can sell the stock at 40 and purchase it for nothing. Since he paid $600 in premiums for this right, the maximum potential gain is: $4,000 - $600 = $3,400.

A customer sells 1 ABC Jan 50 Call @ 3 when the market is at 49. The maximum potential gain is: Correct A. $300 StatusB B. $5,000 StatusC C. $5,300 StatusD D. unlimited A

The maximum potential gain for the writer of a naked call option is the premium received. This occurs if the market drops and the call expires "out the money".

A customer sells 2 ABC Jan 15 Puts @ 2 when the market price of ABC is 14. The maximum potential gain is: StatusA A. $200 Correct B. $400 StatusC C. $2,800 StatusD D. $3,000 B

The maximum potential gain in any naked writing strategy is the premium received. If the put expires "out the money," the writer keeps the premium. In this case, 2 contracts were sold @ $2, so the maximum gain is $400.

A customer sells 2 ABC Jan 65 Puts @ 3 when the market price of ABC is 66. The maximum potential gain is: Incorrect Answer A. $300 Correct Answer B. $600 StatusC C. $12,400 StatusD D. unlimited B

The maximum potential gain in any naked writing strategy is the premium received. If the put expires out the money, the writer keeps the premium. In this case, 2 contracts were sold @ $3, so the maximum gain is $600.

A customer sells short 100 shares of PDQ at $47 and sells 1 PDQ Sep 50 Put @ $6. The maximum potential loss is: StatusA A. $4,100 Incorrect Answer B. $4,400 StatusC C. $5,300 Correct Answer D. unlimited D

The maximum potential loss for a customer with a short stock / short put position is unlimited. If the market rises, the put expires and the short stock position must be covered (bought in) in the market.

A customer that is long ABC stock in his portfolio buys call options on that stock. Why would the customer do this? Incorrect Answer A. To protect the ABC stock position from an adverse market move StatusB B. To derive additional income from the ABC stock position StatusC C. To speculate on the price of the stock going down Correct Answer D. To lock in a price at which shares can be added to the portfolio D

The purchase of a call gives the customer the right to buy shares at the strike price. ***The only reason why a person who is already long that stock would buy calls on the stock would be to give the customer the ability to buy more shares at the strike price if the market price of the stock should move up.

The purchase of a call has all of the same characteristics as buying stock EXCEPT: StatusA A. unlimited gain potential in a rising market Incorrect Answer B. limited loss potential in a falling market StatusC C. low liquidity risk if the position is to be liquidated Correct Answer D. no erosion of value as the position is held D

The purchase of a call has unlimited gain potential, as does the purchase of stock. The maximum loss for a call holder is the premium paid; the maximum loss for a stockholder is his investment - so loss potential is limited for both. Both options and stocks are actively traded on exchanges, so there is little liquidity risk for both. The holder of a call faces the loss of time premium as the position nears expiration; this is not true for stock positions.

A customer that is short ABC stock in his portfolio buys put options on that stock. Why would the customer do this? StatusA A. To protect the ABC stock position from an adverse market move StatusB B. To derive additional income from the ABC stock position StatusC C. To speculate on the price of the stock going up Correct D. To lock in a price at which the short position can be increased in the portfolio D

The purchase of a put gives the customer the right to sell shares at the strike price. The only reason why a person who is already short that stock would buy puts on the stock would be to give the customer the ability to sell more shares at the strike price if the market price of the stock should move down.

The sale of a call has all of the same characteristics as selling stock short EXCEPT: StatusA A. unlimited loss potential in a rising market Incorrect Answer B. limited gain potential in a falling market StatusC C. low liquidity risk if the position is to be liquidated Correct Answer D. no erosion of value as the position is held D

The sale of a call has unlimited loss potential, as does the short sale of stock. The maximum gain for a call writer is the premium collected; the maximum gain on a short stock position occurs if the market falls to "0" and the position can be closed for nothing - so gain potential is limited for both. Both options and stocks are actively traded on exchanges, so there is little liquidity risk for both. Options contracts lose time premium as the position nears expiration; this is not true for stock positions.

The sale of a put has all of the same characteristics as buying stock EXCEPT: StatusA A. limited loss potential in a falling market Correct Answer B. unlimited gain potential in a rising market Incorrect Answer C. low liquidity risk if the position is to be liquidated StatusD D. both are bull market strategies B

The sale of a put has limited gain potential in a rising market - the maximum that can be gained is the premium collected. In a rising market, the gain potential on a long stock position is unlimited. Because both are profitable in rising markets, they are bull market strategies. The maximum loss for both a short put and a long stock position occurs if the market falls to "0". Both have increasing loss as the market falls, all the way to a maximum loss at "0". Thus, the maximum loss is limited for both, since the market can fall no lower than to "0". Both options and stocks are actively traded on exchanges, so there is little liquidity risk for both.

A customer could be obligated to sell stock at a future date if the customer is the: StatusA A. buyer of a call Correct Answer B. seller of a call Incorrect Answer C. buyer of a put StatusD D. seller of a put B

The seller (writer) of a call is obligated to sell the underlying security at the strike price if the market rises. In a rising market, the buyer of the call will exercise the contract, buying the stock from the writer at the strike price. Because the writer had to sell the stock at a strike price that is lower than the market price, the writer will have a loss.

A customer could be obligated to purchase stock at a future date if the customer is the: StatusA A. buyer of a call StatusB B. seller of a call StatusC C. buyer of a put Correct D. seller of a put D

The seller (writer) of a put is obligated to buy the underlying security at the strike price if the market falls. In a falling market, the buyer of the put will exercise the contract, selling the stock to the writer at the strike price. Because the writer had to buy the stock at a strike price that is higher than the market price, the writer will have a loss.

The sale of an "at the money" call is a: StatusA A. bull strategy StatusB B. bear strategy Incorrect Answer C. neutral strategy Correct Answer D. bear/neutral strategy D

The seller of a call has the obligation to deliver stock at a fixed price in a rising market, in return for which the writer collects a premium. If the market stays the same, or falls, the call expires and the writer keeps the collected premium. This is a bear/neutral market strategy.

A customer with no stock position sells 1 ABC Call and sells 1 ABC Put. The customer would do this to maximize potential profit if the market: Correct Answer A. stays flat StatusB B. rises StatusC C. falls Incorrect Answer D. is volatile A

The seller of an option receives a premium, hoping that the contract expires worthless. If a call is sold, the contract expires if the market stays flat (or if the market falls). If a put is sold, the contract expires if the market stays flat (or if the market rises). Maximum profit occurs if the market stays flat and both contracts expire "at the money." Then the seller keeps the 2 collected premiums. If the market rises, the seller starts to lose on the short naked call. If the market falls, the seller starts to lose on the short naked put.

A customer sells 1 ABC Jul 45 Put at $5 when the market price of ABC is 41. The maximum potential loss to the writer is: StatusA A. $500 StatusB B. $3,300 Correct C. $4,000 StatusD D. unlimited C

The worst case for the writer of a put is being exercised and being forced to buy worthless stock at the strike price. In this case, the put writer agrees to buy the stock at $45, but collected $5 of premiums, for a net outlay of $40. If the stock is worthless, this is the maximum loss per share ($4000 for the contract).

Which of the following options strategies provides a gain equal to the premium in a bear market? StatusA A. Long Call Correct Answer B. Short Call StatusC C. Long Put Incorrect Answer D. Short Put B

The writer of a call (short call) collects a premium in return for agreeing to sell stock at a fixed price, no matter how high the market price of the stock may go. If the market price falls, the call expires "out the money" and the writer keeps the collected premium. This is the maximum potential gain.

A customer sells 1 ABC Feb 40 Call @ $2 when the market price of ABC is 39.50. The customer's maximum potential loss is: Incorrect Answer A. $200 StatusB B. $3,950 StatusC C. $4,200 Correct Answer D. unlimited D

The writer of a naked call is obligated to deliver stock that he does not own. If exercised, the stock must be bought in the market for delivery. Since the market price can rise an unlimited amount, the maximum potential loss is unlimited as well.

An investment adviser has determined that writing call options is a strategy that he wishes to employ for his clients. He does this in order to: Incorrect Answer A. hedge against a price decline of the securities held in the client portfolio Correct Answer B. increase the income earned from the securities held in the client portfolio StatusC C. guarantee a price at which the securities held in the portfolio can be purchased in the future StatusD D. speculate that the securities held in the portfolio will become more volatile over time B

The writing of call options (the sale of call options against a long stock position) is a fairly conservative strategy used to increase income when prices are expected to be stable. The options sold will expire "at the money" and the investment adviser will earn the premiums, increasing income. If prices move down, the calls expire worthless, but there will be a loss on the underlying stock position. If prices rise, the stock is called away, and no further gain is enjoyed on the stock. To hedge against a price decline on the stock portfolio, puts would be purchased. To guarantee a price at which securities can be purchased in the future, calls would be purchased. To speculate on volatility, straddles would be purchased (buy a call and buy a put).

What is the maximum potential loss for a customer who is long 100 ABC at 39 and short 1 ABC Jan 40 Call at $5? StatusA A. $500 StatusB B. $600 Correct C. $3,400 StatusD D. $3,900 C

This is a covered call writer. The maximum potential loss occurs when the market for ABC goes to zero. If it does, the customer loses $3,900 on the stock position, however, he received $5 in premiums for the now worthless call contract. The net maximum loss is $3,400. If the market rises, the call will be exercised and the customer will be obligated to sell stock at $40 that was purchased for $39. In addition to the $1 stock profit, the customer earns the premium of $5, for a total profit of $6 per share.

A speculator that initiates a long futures position in Euros: I believes that the Euro will decline II believes that the Euro will increase III will need to sell Euro futures to close his position if he wants to avoid taking delivery in the future IV can only satisfy the terms of the contract by taking delivery of Euros on the delivery date StatusA A. I and III StatusB B. I and IV Correct C. II and III StatusD D. II and IV C

When one goes long a futures contact, this is a "bet" that the price of the reference asset will increase. Futures contracts can be offset at anytime by trading, so the contract can be closed with an offsetting sale. If the contract is not closed with an offsetting sale, then the seller is required to take delivery and pay for the Euros on the delivery date.

call contract

allows hldr to buy a security fr writer at fixed price at any time during life of option; if writer is "called", the contract obligates writer to deliver sec to holder at fixed price

put contract

allows holder to sell a security to writer at fixed price at any time during life of option; if securities are "put" to writer, the contract obligates writer to buy securities at fixed price

speculative options strats

bull and bear strats LONG CALL strat: o hldr has "right to buy" underlying security o unltd upside gain potential o maximum loss premium paid SHORT CALL strat: o writer has obligation to deliver (sell) at the strike price o maximum potential loss - unltd / naked call writer o maximum potential gain = premium rec'd LONG PUT strat: o hldr has "right to sell" at strike price o potential gain incr' as mkt falls - maximum is strike price - premium o maximum potential loss = premium paid o breakeven = strike price - premium SHORT PUT strat: o writer has obligation to buy at the strike price o potential loss incr' as mkt falls; maximum loss is strike price - premium o maximum potential gain = premium rec'd :. purch of long call or sale of short put w/give speculator a profit in rising mkt > bull strats :. purch of long put or sale of short call w/give speculator profit in falling mkt > bear strats

def of option

contract entered into btw 2 parties, buyer = option holder, seller = option writer contract holder = contract buyer = long position contract writer = contract seller = short position

viatical settlements: return on invest depends upon how long person lives; if the seller dies bef est'd life expectancy, investor rec's a higher return; if seller lives longer than expected, the return is lower. :. the buyer of policy c/lose prin invest if person lives long enough so that investor has to pay addtl premiums to maintain the policy

developed in 1980s as source of liquidity for terminally ill patients w/ AIDS who had st life expectancies of 2-3 years; permits one to invest in ano person's life ins policy buyer of policy = viatical settlement provider (person/co) seller = orig owner of life ins policy, or viator viator gets immed cash in exchange for sale and transf of life ins policy ownership rights - < full amt db buyer pays future premiums and collects db when insured dies

alternative minimum tax (AMT): if this amt is higher than his reg tax bill, he pays the higher amt.

o AMT = "tax on tax preferences" items / flat AMT tax rate: - the alter comp adds back preference items to investor's tax income, AND a flat 26% tax rate is applied to the "alternative income", for such income upto $175,000, > $175,000, the rate incr's to 28% o tax preference items: - accelertd deprec amts in excess of SL - excess intangible drilling cost deductions, oil wells are given arbitrary 10 year life, since 100% of IDCs are deductible first year, 90% is "excess" - municipal int income fr bond issues that are "qualified private activity" bonds, and ltd dollar amts of "non-essential use, private activity" bonds - exercise of incentive stock options, where there is a "bargain element" (ie, if employee has option to buy that employer's stock at $20 and exercises when stock is worth $50, $30 / sh discount is added into AMT) ***(Note: There is an exclusion amount based on income that reduces AMT tax liability, but this is not tested. Only the basic concept that the higher amount of either regular income tax liability or AMT liability must be known for the exam.) ***o non-deductible items in AMT - certain deductions that are permitted in Regular income tax calculation are NOT permitted when calculating AMT - incr's amt of taxable AMT income: - personal exemption - standard deduction - State and local tax deduction - misc deductions, such as tax prep fees

exchange traded funds (ETFs): have diff structure than closed end funds - they c/trade at discounts to NAV AND this can very often be a steep discount if people are bearish on funds's prospects ***ETFs solves this by adding "arbitrage feature" --

o arbitrage mechanism keeps price at NAV: - if fund is trading at discount, designtd lg institutional investors are permitted to buy fund shs typically in minimum 50,000-100,000 sh blocks, and sell equivalent shs of stocks in underlying portfolio -- these inst investors are then permitted to exchange purch'd ETF shs for underlying stocks in port which c/b used to cover their short positions :. this action pushes up price of ETF shs, and it will stop when price reaches NAV o most ETFs are "open-end funds" registered under Invest Co Act of 1940: - almost all are index funds - "passively managed" b/c fund mgr is matching port comp to benchmark index - as compared to Index mf, ETFs offer follg advantages: oo continuously priced on exchange based on changes in value of stocks held in index and trade sim to any oth common stock oo purch'd w/o sales charge, regular stock trading commission is charged to buy or sell ETFs oo purch'd on margin, c/b sold short oo expenses assoc'd w/ running ETFs are comparable to or lower than those of sim mf, d/NOT h/12b-1 fees - "tax-efficient" b/c they are not obligated to distr capital gains to sharehldrs annually o leveraged ETF: use borrowing to magnify returns (and this will also magnify losses), ie, "S&P 500 200% Leveraged ETF" - designed to move 2X as fast as S&P 500 index, index 5%, ETF 10% up or down o inverse ETF: use short selling to move inversely to mkt - "S&P 500 Inverse ETF" - designed to move down 5% when S&P 500 Index moves up 5% o MUST deliver prospectus or product description ("Product Document", summ key info and details of where prospectus c/b obt'd)

placing a collar on a stock position

o collar on the price of a security o collar = LONG out the money PUT and SHORT an out of the money CALL

futures contract

o contract to take delivery of an asset at a future date at a fixed price o standardized and Exchange traded o hldr MUST take delivery at settlement unless contract is closed prior o lg contract sizes / low margins / daily mark-to-mkt / no counterparty risk

limited partnerships

o corporation is a taxable entity o partnership is NOT taxable / allows for flow thru of gain and loss o direct participation programs: these programs allow investors to directly participate in the profit and loss fr bus venture o ltd partnerships: tax shelters consists of at least 1 general (mgr, assumes unltd liability) and 1 ltd partner (passive investor whose liability is ltd to his investment) o rights of the ltd partner: - right to inspect books and records - right to his yearly pro-rata sh of partnership income and loss, and his sh of net partnership assets upon dissoln of venture - c/ sue genl partner for damages if genl partner d/NOT abide by agreement - c/vote on admission of new genl partner or on sale of partnership assets or "partnership democracy" :. if ltd partner exceeds these activities - he will be considered t/b a genl partner & takes on unltd liability o cert of ltd partnership: m/b filed in State - t/have public record of all partners and their %-age interest in venture major types of DPPs are: o real estate LP - tax benefits: oo SL 27-1/2 year life deprec write-off oo interest id deductible in full oo tax credits are avail for qualified low income housing and cretified historic structure rehabilitations o oil and gas LP - tax benefits: - cost of drilling is deductible in full (IDCs, intangible drilling costs) - as oil is sold, depletion deduction allows for arbitrary deduction based as %-age of value of oil sold, rather than actual cost of oil - results in a bigger deduction than actual amt "paid" for oil in ground :. incentive for oil discovery - they are illiquid, no trading mkt and are very difficult to sell - genl partner has right to "assess" ltd partners if more money is needed for venture, IF NOT, his %-age ownership is reduced

swaps: counterparties exchange benefits (usu cash flows) of one side's financial instrument for those of the other side (so they swap sides)

o custom contracts o no trading o interest rate swap o currency, commodity and credit default swaps

forward contracts

o custom contracts to take delivery of an asset at a future date o derivative security o non-standardized o no mark-to-mkt o no margin o counterparty risk

evaluating a ltd partnership

o factors to consider: - economic soundness - does bus venture stand on its own w/out tax benefits? - program objectives - are obj reasonable and conservative? Do they match w/ investor's obj? o blind pool: obj are stated, but specific invest are NOT known -beware! o track record: - sponsor track record - what h/b performance of genl partner in past w/ oth partnerships? - sponsor compensation - is mgmt fee reasonable? Is GP subordinating his claim on profits or capital to ltd partners? - sponsor conflicts - does partner agreement allow GP to compete, himself vs partnership? oo GP permitted t/take loans fr partnership oo GP allowed to commingle funds of one partnership w/ those of ano partnership that he is running oo adjacent leases in oil and gas programs - where effectively GP is using LP funds to find oil belonging solely to GP

equity-indexed annuities (EIAs): variation of fixed annuity; gains based on return of a broad-based index such as S&P 500 but also incl min guar rate of return sim to but lower than that offered by fixed annuity; ins co "collaring" its invest port, buying put options to protect downside and selling calls for extra inc to offset cost of put options - this limits upside gain

o gives return tied to broad based index - participation rate limits potential yearly gain / cap limits potential yearly gain: ie, assume S&P 500 Index incr's 20% w/ 70% part rate, capped at 9%, investor earns 70% of S&P rise of 20% = 14%, but since cap is 9% > this is growth in invest value for year! - minimum guar rate of return in bear mkt: ie, if S&P falls by 30%, investor is guar to earn 1%; majority of EIAs now offer floor rate of 0% *** if no floor rate is mentioned, this is default rate to use o index performance measures - EIAs base ann pymts on perf of broad based index: (assume 7 year return below) - point-to-point: compares index value at purch date to value at end date, 7 years later - any value fluctuations that occur in btw 2 measurement dates are irrelevant - annual reset: measures return achieved ea year over 7 year life and adds interest to annuity based on annual reset - high-water-mark: looks at index value yearly as of anniversary date of purch, and bases interest added on highest index value over 7 years vs. value at date of purchase o cpnd interest: mostly used by EIAs, where ann int credit is added to prin value and next year's int credit is applied to aggregate value o simple interest: int credited is NOT aggregated w/ prin amt, so ea yearly int credit is based on static prin amt; at end of 7 year term, total amt of int is finally added to prin amt and this base for next 7 year term calc o high expenses / surrender fees: higher than both fixed and variable annuities to pay for costs of collaring mkt, have steep surr fees if they are redeemed early, and often req that gains above min rate be forfeited if they are retired early : regultd only as ins, SEC h/ proposed that they b/ classified as "securities" and regultd as such

INSURANCE-BASED PRODUCTS: fixed annuities:

o guar rate of return / only subj to State ins regulation o ins co assumes invest risk / premiums deposited to general acct (conserv invest such as fixed income sec) - ins co assumes mortality risk - ins co assumes expense risk o annuitant assumes inflation risk (purch power risk) o perpetuity: annuity that has no end; it is a stream of fixed pymts that goes on forever ***concept for exam! o calculating value of a perpetuity: ie, a perpetuity of $6,000/year rec'd, when mkt rate of int is 6% - is worth $6,000/.06=$100,000

variable annuity

o no guar rate of return - investor assumes "invest risk" - a sec, regultd under Sec Act of 1933, Invest Co Act of 1940 o trust invests in mgmt co shs to fund annuities - open end mgmt cos o annuitant assumes invest risk / purch are made in separate acct - premiums deposited to designtd "sep acct", legally sep entity fr ins cos genl acct o bonus credit: inducement to purch annuity 1-5% - AIR - assumed interest rate, illustrated rate - accumulation units (vs. shares), NAV per unit is computed daily - mandatory reinvest / tax deferral on reinvest - annuity units: total accumulation units converted into "annuity" units, or "annuitization" - actual AIR set when contract is annuitized (cust chooses AIRs fr 3-6% set by ea State) - fixed number of annuity units / fluctuating unit value: depends on sex, age, habits o variable annuity pymts tend to keep pace w/ inflation o pymt options: - life annuity: cont's for life of annuitant, when person dies, pymts cease; results in highest periodic pymt - life annuity w/ period certain: covers life of annuitant, but if person dies early, annuity cont's for specified min period - joint and last survivor annuity: if annuitant dies, annuity cont's for life of ano person usu spouse - unit refund life annuity: if annuitant dies bef receiving full invest value fr sep acct, his estate gets "refund" of remain value - installments for designated period: annuitant specifies period of time over which he wishes to rec annuity, mo annuity amt is set to meet this require at which point the acct int is exhausted - installments for designated amount: specifies dollar amt that he wants in ea pymt; pymts cont of that amt until acct is exhausted - owner can outlive pymt stream: when "installments" are chosen, acct owner faces possibility of outliving pymts, NOT case if acct is annuitized o securities license and State ins license req'd o no deduction for contributions; earnings build tax-deferred o only distr of build-up amount is taxable: when distr commence, portion attributable to build-up is taxed at ordinary inc rates, while portion attributable to invest is non-taxable return of capital - distr taken prior to annuitization are taxed on LIFO basis

ALTERNATIVE INVESTMENTS: hedge funds

o open only to very wealthy investors / lightly regulated o aggressive invest strats: incl short selling, using lg smts of leverage and speculating in futures, commodities and foreign curr mkts o high fees: typically take both %-age of assets under mgmt, 2% plus %-age of cap gains in fund, 20% o performance fees: high fees can b/charged b/c they are not regulated under Invest Co Act of 1940 o ltd partnership structure: only avail to accredited investors as private placement - ltd to 99 investors otherwise at 100 they h/to register under Invest Co Act of 1940 -- these are illiquid securities that are NOT redeemable

DERIVATIVES: security is one that has its value "derived" fr price mvmts of underlying security or commodity

o options: derivatives based on security's price mvmt o futures: derivatives based on commodity, currency or index price mvmt o forward contracts: actual contracts btw 2 parties to buy or sell asset, usu currency at future certain time and price that is agreed on today

options income strats: overriding factor needed to understand income strats is that the stock position comes first and foremost

o sell contracts to earn premiums / "covered writer" has underlying security position o suitable in stable mkts - long stock / short call - short stock / short put

contract features

o strike price / expiration date o premium - paying premium of $ per share or X 100 o contract style - either American or European: - American: c/b exercised at any time, - European: c/b exercised only at expiration, not before

index-linked structured products

o structured products - derivative security: sec based on or derived fr basket of sec, an index or oth sec, commodities or currencies: - generally consist of a "bond" portion which pays int based on performance of well-known index such as S&P 500 Index comb'd w/ derivative component, embedded option that allows hldr to sell sec back to issuer at par at maturity o "mkt index linked CD" return tied to S&P 500 index: - mkt risk: most h/min of 3 year maturity, early redemption can result in loss of principal (3-5%) - issuer h/t/ buy put option at par for maturity date, penalty recovers premium - liquidity risk: only allow redemption on pre-set qtrly dates, not on demand - credit risk: backed by faith & credit of issuing bank, there may NOT be underlying pool of sec - cap on invest return / floor on invest return - participation rate: ie, if structured prod h/ 80% part rate, then in year when index rises by 10% prod w/only get 8% int pymt, subj to cap and floor oo tax issues: returns are taxed as "interest" at max rate of 39.6% o ETN - exchange traded note (debt instrument): elim liquidity risk of sec, gives return linked to mkt index, h/ set maturity date and is backed by credit rating of issuing bank oo gain is treated as tax cap gain, 15% or 20% o credit risk: if issuing bank fails, the purchaser if left w/ nothing o ETN has tax advantage as compared to oth debt instruments: as compared to structured product - no liquidity risk - tax efficiency o ETN investors can get access to exotic invest strats o ETN has NO relation to an ETF

life insurance: term, whole, universal, variable

o term life - pure ins - no cash value - non-renewable aft certain age: usu 65-75 :. insured m/NOT b/able to afford incr'd premium in later years o whole life - perm ins - straight life: b/c annual premium d/not change thru-out life of contract - cash value invested in general acct: invested in insurer's genl acct and grows w/ int at guar min rate o universal life - flexible ins: policy sets a min pymt amt to pay for COI - cash value - coverage amt and premiums may be varied - perm ins o variable - perm ins w/ cash value invested in separate acct: whole life policy invest cv in designtd sep acct; db c/incr over fixed amt if sep acct performs well - tax-free exchange of ins for ano policy type or annuity: 1035 exchange