Chapter 7: Suitability and Investment Risks UNIT EXAM

Which one of the following investments would not be compatible with an investor objective of preservation of capital? A. Dividend-paying common stock B. Short-term Treasury securities C. Bank CDs D. Money market mutual funds

A Dividend-paying common stock An investor with a preservation of capital objective seeks no decline in the value of the investment or portfolio. Stocks are not compatible because they can decline in value. Short-term Treasuries, bank CDs, and money market funds have very stable principal values.

Which type of investment is the most vulnerable to credit risk? A. High-yield bonds B. Mortgage-backed securities (MBS) C. Small-cap stocks D. Money market mutual funds

A High Yield bonds Credit risk measures the potential for an issuer to default on bond interest or on paying bond principal due at maturity.

One year ago, Don bought a stock at a price of $40, and it is now worth $35. He has received two dividends of 50 cents each. What has been the total return? A. −12.5% B. −10.0% C. Zero D. +2.5%

B -10% The formula for calculating total return over a holding period is to add the dividends and capital gains and divide the result by the initial purchase price. +$1 − $5 = −$4.−$4/$40 = −10%

An elderly customer seeks no decline in the value of her investment portfolio. This objective is: A. guaranteed principal. B. capital preservation. C. price stability. D. liquidity

B Capital Preservation

Mildred's financial planner has suggested that she participate in an asset allocation program. What is the most important benefit of such a program? A. Current income B. Diversification C. Capital appreciation D. Safety

B Diversification Asset allocation programs choose an appropriate mix of different asset classes to build a portfolio. These classes typically include stocks, bonds, and cash. The objective is to ensure the overall portfolio includes asset classes that react differently under changing market conditions—i.e., that the portfolio is well diversified. Often, the program will make periodic adjustments to keep the asset class mix appropriate for the current environment, as well as the investor's life phase and objectives.

For an investor who owns a substantial portfolio of stocks, when will systematic risk be high? A. In a bull market for stocks B. In a bear market for stocks C. When interest rates are rising D. When inflation is rising

B In a bear market for stocks Systematic risk reflects the performance of an individual security that is impacted by the direction of the overall market. For owners of stocks, it is highest in a bear ( falling) stock market. Since systematic risk is symmetrical, it also exists in a bull market. But it generally helps stock investors in this case, by putting the tailwind of the market behind their stocks' performance

An investor purchasing Treasury securities would be most concerned with which of the following risks? A. Default risk B. Interest rate risk C. Credit risk D. Political risk

B Interest rate risk An investor purchasing Treasury securities would be most concerned with interest rate risk, as if interest rates increase, the price of their bonds would decrease. Because Treasuries are backed by the U.S. Government, the investor would not be concerned with credit risk, also known as default risk. Also, for exam purposes, assume that the U.S. Government has little political risk as compared to foreign countries.

Patrick is setting aside money for his retirement in 20 years, and he wants capital appreciation with a high degree of predictability and safety. Which of the following investments can best meet his need? A. Money market mutual funds B. Long-term, zero-coupon US Treasuries C. Long-term municipal bonds D. None, because his two objectives are not compatible

B Long-term, zero-coupon US treasuries The objectives of capital appreciation and safety are somewhat incompatible. However, long-term, zero-coupon US Treasuries can meet both objectives. Since interest is not currently paid but builds up inside the bond and is paid at maturity, it is actually a form of capital appreciation (the bond will be worth far more at maturity). The lack of reinvestment risk helps meet the need for predictability and safety.

The Morrisons have an asset allocation program set up for their children's college educations. Lately, the stocks in this program have been performing well and the bonds have been performing poorly. If the portfolio is rebalanced, what effect will this event have on the program's asset mix? A. Buy more stocks, sell bonds B. Sell stocks, buy more bonds C. Add money and buy both stocks and bonds D. Subtract money and sell both stocks and bonds

B Sell stocks, buy more bonds When asset allocation programs are rebalanced, the goal is to return asset classes to their original weights, to ensure that no class is over-emphasized. This means that recent winners will be sold and recent losers will be bought. Rebalancing can be done automatically and mechanically or it can use a professional manager's discretion. In either case, the goal is to compensate for market actions and keep the asset allocation guidelines intact

As a registered rep, Clyde has determined that an investment is in the best interest of a certain client. However, he believes there is a substantial amount of liquidity risk in it. What could Clyde suggest to address this particular risk so that the client could go ahead with the investment? A. Increase portfolio diversification B. Increase portfolio liquidity C. Buy the investment in a retirement plan D. Hedge the investment

B increase portfolio liquidity An investment that cannot be readily sold or converted to cash in the open market has liquidity risk. Examples include real estate, limited partnerships, and hedge funds with lock-ups. The illiquid character of these investments cannot be changed, and it also usually cannot be hedged. The risk is that an investor will need access to cash but will not be able to obtain it. To address this, the client can increase liquidity in the rest of his portfolio, so cash can be obtained from other sources

What will determine whether a common stock investment is in the best interest of a customer with an objective of achieving current income? A. Whether the market is rising or falling B. Company size and stability C. Consistency of stock dividend payments D. The stock's track record

C Consistency of stock dividend payments Stocks only generate current income from their dividends, which are somewhat predictable, not their appreciation, which is not predictable. However, stock dividends are not guaranteed, so it's important to evaluate not only the rate of dividends paid but also the consistency of historic dividend payments.

Which of the following investment objectives would be met by investing in preferred stock? A. Growth B. Tax-free income C. Current income D. Preservation of capital

C Current Income Preferred stock does not have much growth potential and is not stable enough in price to preserve capital. Preferred dividends can be attractive to investors with a current Unit Exam—SolutionsChapter 7: Suitability and Investment Risks income objective. Since preferred dividends are taxable, investors seeking tax-free income should look elsewhere.

ABC stock is trading for $30 and pays a quarterly dividend of $0.60. What is the company's current yield? A. 2% B. 4% C. 6% D. 8%

D 8 Current yield of a stock is calculated as annual dividend divided by the current market price. Make sure that if a quarterly dividend is provided, as is the case in this question, it is annualized by multiplying by 4. Therefore, current yield = ($0.60 x 4)/$30 = 8%. Unit Exam—Solutions (Continued)Chapter 7: Suitability and Investment Risks

If an investment fails to qualify under reasonable-basis suitability, under what circumstances can it be recommended to an institutional client? A. Only if the client is a sophisticated institution B. Only if it qualifies under both customer-specific and quantitative suitability standards C. Only if the client waives reasonable-basis suitability D. Never, because passing reasonable-basis suitability is essential for any institutional client

D Never, because passing reasonable-basis suitability is essential for any institutional client Reasonable-basis suitability determines that an investment is suitable for at least some investors. If the investment fails to meet this standard, it cannot be recommended to anyone by that firm.

Paul has an objective of tax-free income, and his broker recommends that he consider mutual funds. What will determine whether this is an appropriate recommendation for him? A. The rate of income the fund pays B. The fees and expenses of the fund C. The track record of the fund D. The type of securities the fund hold

D type of securities the fund holds Mutual funds can be used to pursue diverse investment objectives, depending on how funds are managed and what securities they hold. The type of mutual fund that is compatible with an objective of tax-free income is a municipal bond fund.

Regulation Best Interest (BI) provides that a customer relationship summary (Form CRS) be provided to retail clients: A. Prior to the execution of a recommended transaction B. Within 24 hours of the delivery of a recommendation but prior to the execution of a recommended transaction C. Prior to the delivery of a prospectus for a recommended mutual fund transaction D. At the time of or prior to a recommendation for a particular investment product or strategy

D. At the time of or prior to a recommendation for a particular investment product or strategy