Series 7 Chapter 3
A customer bought a bond that yields 6-½% with a 5% coupon. If the bond matures at this point, the customer will receive
$1025 Upon redemption of a bond, whatever current interest rates may be, the investor receives par ($1,000) plus the final semiannual interest payment ($25 in this case), for a total of $1,025.
A customer purchased 100 shares of SNP at $38. At the time of purchase, the PE ratio was 12. Approximately what are the earnings per share of SNP?
$3.16 The PE ratio is a comparison of the current market price at the close to the earnings of the company. $38 (CMV) / 12 (PE ratio) = $3.16 approximate EPS.
A 7% convertible debenture is selling at 101, and it is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. What must the market price of the debenture be to be at parity with the common?
$920,000 To determine the parity price of the bond, first find the number of shares the debenture is convertible into (conversion ratio) by dividing par value by the conversion price ($1,000 / $25 = 40 shares). Next, multiply the current price of the common by the conversion ratio. The result is the parity price of the bond (40 shares × $23 = $920).
ABC Company has issued $20,000,000 of convertible bonds with a coupon of 5% and a current market value of 120. The conversion price is $40. If all the bonds are converted, how many additional shares of common stock will ABC have outstanding?
500,000 Each bond will convert to 25 shares of common stock ($1,000/$40). 20,000 bonds were issued ($20,000,000/$1,000). Therefore, 500,000 additional shares (20,000 x 25) will be outstanding if all the bonds are converted.
A mutual fund has a net asset value (NAV) of $7.80 per share, and the fund pays its underwriter a concession of $0.12 per share. If the fund has a sales load of $0.50 per share and an administrative fee of $0.15 per share, how much does the investor pay per share to purchase a Class A share of this fund?
8.30 The investor pays the public offering price (POP) when purchasing mutual fund shares. For a Class A share upon purchase, the POP is the NAV plus the sales charge.
Each of the following is a characteristic of money market funds EXCEPT
A beta of 1.00 means that a security (or portfolio) has the same price volatility as the overall market. That is certainly not the case with money market fund shares. Money market mutual funds invest in a portfolio of short-term debt instruments such as T-bills, commercial paper, and bankers acceptances. They are offered without a sales load or charge. The principal objective of the fund is to maintain a stable NAV ($1 per share).
An individual is deciding between a flexible premium variable life contract and a scheduled premium variable life contract. If she is concerned about maintaining a minimum death benefit for estate liquidity needs, she should choose
A scheduled premium variable life contract is issued with a guaranteed minimum death benefit. If the individual is concerned about having the minimum guarantee, you should recommend the scheduled contract.
If an investment company invests in a fixed portfolio of municipal or corporate bonds, it is classified as a:
A unit investment trust issues shares that represent units of a particular portfolio; management has no authority, or only limited authority, to change the portfolio. The portfolio is fixed, it is not traded.
Which of the following is an advantage of owning American depositary receipts?
ADRs permit an American investor to purchase, not stock, but a certificate of deposit for stock in a foreign company. The advantage is that the transactions are done in dollars, but the ADR itself does not carry a vote or stock rights, and subjects the owner to currency risk.
A bond would be considered speculative below which of the following Standard & Poor's (S&P) ratings?
BBB
Which of the following debt securities does NOT have a fixed maturity date?
CMOs Collateralized mortgage obligations (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.
Liquidity ratios measure the solvency of a firm or the firm's ability to meet short-term financial obligations. Which of the following is a liquidity ratio?
Current assets divided by current liabilities is the current ratio, a ratio that measures the liquidity of a firm. Gross profit divided by net sales is a profitability ratio that measures the gross profitability of the firm's business operations, not its liquidity. Net income divided by average total equity is the return on stockholders' equity which measures the efficiency of common shareholders' investment or equity in the firm. Dividend amount divided by earnings per share is the dividend payout ratio which measures how much of a company's earnings are distributed to common stockholders.
An inverted Head and Shoulders Formation would mean which of the following to a chartist?
Head and Shoulders Formations indicate the reversal of market trends to chartists. An inverted formation would forecast the reversal of a downtrend. A Head and Shoulder's Top Formation would forecast the reversal of an uptrend.
A customer who seeks to supplement his retirement income and has a high risk tolerance would find which of the following securities most suitable?
High-yield bonds yield more than investment-grade bonds. Since the client has a high risk tolerance, these bonds are more appropriate than investment-grade bonds that yield less.
If general interest rates increase, the interest income of an open-end bond fund will:
Increase Most mutual funds do not have 100% of their assets in securities and they continually receive new money from investors. Any increase in the general interest rate would allow the fund to purchase new, higher-yielding, lower-cost instruments, which would increase the fund's income.
Most rating services rate which of the following?
Quality
Debt normally issued by big corporations with reliable credit ratings who seek to finance short-term needs best describes:
commercial paper Also known as promissory notes this is the definition of commercial paper. They are short-term corporate issued instruments sold at a discount and maturing at par.
DMF Company has $50 million of convertible bonds (convertible at $50) outstanding. The current market value of DMF's stock is $42. The bond indenture contains a nondilution feature. If DMF declares a 10% stock dividend, the new conversion price will be:
lower than $50 With an antidilution feature, the issuer will increase the number of shares available upon conversion if the company declares a stock split or stock dividend. This means the bondholder must be able to convert it to more shares, which requires a lower conversion price.
In portfolio theory, the alpha of a security or a portfolio is
the difference in the expected return of the portfolio, given the portfolio's beta, and the actual return the portfolio achieved Alpha is the difference in the expected return of the portfolio, given the portfolio's beta and the actual return the portfolio achieved. The higher the alpha, the better the portfolio has done in achieving excess or abnormal returns. The risk of the portfolio associated with the factors that affect all risky assets is systematic risk.
Each of the following securities trade "and interest" EXCEPT:
zero-coupon bonds Trading "and interest" means trading with accrued interest. Debt instruments that pay interest periodically (e.g., municipal bonds or Treasury bonds) trade with accrued interest.
The minimum face amount of a negotiable CD is:
Negotiable CDs are issued in the minimum face amount of $100,000. These are called jumbo CDs and are traded in blocks of $1 million.
Your client wishes to invest $50,000 into shares of the ACE Mutual Fund. This morning's financial news indicated that the POP for ACE was $10.86 while the NAV was $10 per share. The client's order is placed at 2:00 pm eastern time. On the basis of this information, you could confirm to the client a purchase of
nothing yet, as you must wait for the POP to be computed based on the day's close
Under what circumstances will a dilution of equity occur?
Dilution of equity occurs when stockholders experience a reduction in their percentage ownership of the company. If bonds are converted, more common shares are issued and the shareholder's equity is diluted. A stock dividend or stock split does not change a stockholder's percentage of ownership. Refunding debts has no effect on stockholders.
A sophisticated client has expressed an interest in becoming more aggressive with their investment strategy. Her current portfolio consists of$50,000 cash$200,000 in retirement accounts$100,000 in various individual stocks in different industries$100,000 in a balance fundShe is willing to invest $25,000 for a minimum of 7 to 10 years and accepts that the investment can and will fluctuate in value over time. Which of the following investments would be the most appropriate?
For someone that is willing to take the risk and invest for the long haul, a small or mid-cap growth fund would be appropriate.
You are reviewing an investor's balance sheet. Which of the following items would be found on a balance sheet and help you determine the client's net worth? 401(k) balance Credit card balance Monthly income Electric bill
I and II The balance sheet reflects a person's net worth by comparing assets and liabilities. A 401(k) balance is an asset and credit card debt is a liability. Income and monthly bills such as the electric bill are found on the income statement.
Which of the following must be registered as investment companies under the Investment Company Act of 1940? Closed-end investment companies. Separate accounts of insurance companies offering variable products. Variable annuity contracts. Variable life insurance policies.
I and II Under the Investment Company Act of 1940, face amount certificate companies, unit investment trusts, open- and closed-end management companies, and separate accounts of insurance companies used to fund variable annuity and variable life contracts, must register with the SEC as investment companies. Note that the separate account is registered as an investment company, not the variable contract.
In July, a customer invested $10,000 in the ABC Mutual Fund. In December of the same year, ABC announced a long-term capital gains distribution. In May of the next year, the customer decided to redeem his shares for a capital gain. How are both of the capital gains treated for tax purposes? The capital gain distribution is treated as long term. The capital gain from redemption is treated as long term. The capital gain from redemption is treated as short term. The capital gain distribution is treated as short term.
I and III When long-term capital gains are distributed, the length of time an investor has owned the fund is not relevant; it's still a long-term distribution. However, redemption of shares follows the normal holding period rules. Therefore, when this customer sold shares 10 months (July to May) after the purchase, the gain, like any other gain from a holding period that does not exceed 12 months, is short term.
Regarding the taxation of dividends received from corporate securities, which of the following are TRUE? Nonqualified dividends are taxed at the rate the investor's ordinary income will be taxed. Nonqualified dividends are not taxed. Qualified dividends are taxed at a maximum rate specified by the IRS and will depend on the investor's income tax bracket. Qualified dividends are taxed at the rate the investor's ordinary income will be taxed.
I and III For income tax purposes, corporate dividends are divided into 2 categories; qualified and non-qualified. We don't expect you'll be tested on what makes a dividend qualified or not, but you will need to know the difference in taxation. Qualified dividends are taxed at the same rate as long-term capital gains, a rate significantly lower than the ordinary income tax rate levied against non-qualified dividends. That lower rate ranges from 0% to as high as 20% with an even higher effective rate for those with an extraordinarily high income. For most investors the rate is 15% and that is the number you should use in any computations. With ordinary income tax rates on non-qualified dividends as high (currently) as 37%, there is a real benefit for most investors to receive qualified dividends.
Under the conduit theory of taxation, which of the following statements are TRUE? A fund is not taxed on earnings it distributes if it distributes at least 90% of its net investment income. Investors are not taxed on earnings they reinvest. A fund is only taxed on interest income. Investors are taxed on earnings they receive in cash.
I and IV By qualifying as a regulated investment company (the conduit, or pipeline, tax theory), the fund is liable only for taxes on retained income if it distributes at least 90% of its net investment income to shareholders. Investors will pay taxes on distributed income whether received in cash or reinvested.
A customer purchased a 5% U.S. government bond yielding 6%. A year before the bond matures, new U.S. government bonds are being issued at 4%, and the customer sells the 5% bond. The customer probably did which of the following? Bought it at a discount. Bought it at a premium. Sold it at a discount. Sold it at a premium.
I and IV The customer purchased the 5% bond when it was yielding 6% (at a discount). The customer sold the bond when other bonds of like kind, quality, and maturity were yielding 4%. The bond is now at a premium. Therefore, the customer realized a capital gain.
A married couple with a two-year-old child wants a suitable investment to help meet the financial obligations for the child's college education. Which of the following choices are the most suitable alternatives? A CMO tranche scheduled to mature in 5 years A STRIP scheduled to mature in 15 years Treasury receipts A money-market fund
II and III STRIPs and treasury receipts are forms of zero-coupon bonds. STRIPs are backed in full by the US government and treasury receipts by the financial institutions that issue them. Purchased at a discount and maturing at face value in the future, they are suitable investments for those wishing to save for anticipated expenses such as college tuition sometime in the future. A CMO maturing in five years doesn't align with the time horizon for this child's college education and carry other unsuitable risks. A money market fund would hardly meet the growth requirement needed to meet college tuition needs.
If your customer invests in a variable annuity and chooses to annuitize at age 65, which of the following statements are TRUE? She will receive the annuity's entire value in a lump-sum payment. She may choose to receive monthly payments for the rest of her life. The accumulation unit's value is used to calculate the total value of the account. The annuity unit's value represents a guaranteed return.
II and III When a variable contract is annuitized (distributed in regular payments, not as a lump sum), the number of accumulation units is multiplied by the unit value to arrive at the account's current value. An annuity factor is taken from the annuity table, which considers, for example, the investor's sex and age. This factor is used to establish the dollar amount of the first annuity payment. Future annuity payments will vary according to the separate account's performance.
A customer buys 100 XYZ at $30. Two years later, with the stock trading at $70, the customer makes a gift of the securities to his son. Which of the following statements are TRUE? For gift-tax purposes, the value of the gift is $3,000. For gift-tax purposes, the value of the gift is $7,000. The son's cost basis on the stock is $3,000. The son's cost basis on the stock is $7,000.
II and III When making a noncharitable gift of securities, the donor's cost basis is passed to the recipient.
The price of which of the following will fluctuate most with fluctuating interest rates?
Long-term debt prices will fluctuate more than short-term debt prices as interest rates rise and fall. When buying a debt instrument, one is really buying the interest payments and final principal payment. Money has a time value: the longer it takes to receive the money, the less it is worth today.
A unit investment trust has 90% of its portfolio invested in high-grade bonds with an average maturity of almost 25 years. If the industry consensus were that long-term interest rates were about to increase sharply, which of the following actions would most likely be taken?
One of the key distinctions of a UIT is its lack of management. Once the portfolio has been created, it is fixed until maturity, in the case of debt securities, or until some predetermined liquidation point, in the case of an equity trust.
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?
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.
Which of the following is TRUE regarding GNMA?
Private lending institutions approved by GNMA originate eligible loans and sell the mortgage-backed securities to investors.
Which of the following securities is sold at auction?
T-Bills T-bills, T-notes, and T-bonds are sold through auction. These auctions award securities to the most competitive bids. Agency securities are sold through selling groups appointed by the agency.
A customer purchases an ABC 6-½% convertible preferred stock at $80. The conversion price is $20. If the common stock is trading 2 points below parity, the price of ABC common is:
The conversion ratio is computed by dividing par value by the conversion price ($100 par / $20 = 5). Parity price of the common stock is computed by dividing the market price of the convertible by the conversion ratio ($80 / 5 = $16). $16 − 2 = $14.
An investor has unexpectedly received $30,000 from an old debt he had written off. This money will come in handy for a business venture planned for 3 years from now. Meanwhile, he would like to generate some income on the money with as little risk and as little expense as possible. Which of the following recommendations is likely to be the most suitable for this customer?
The customer wants income with as little risk as possible, so our answer must be one of the choices that offer an investment-grade bond fund. Of those offered, Class C shares would be best, because the customer would pay no front-end sales charge and no CDSC after a short time, probably one year. He will pay somewhat higher 12b-1 fees than with Class A shares, but this will amount to only a fraction of 1% per year, and only for the 3 years of his investment.
Which of the following statements describing Section 529 plans is TRUE?
The features of Section 529 plans, including their contribution limits and fees, vary widely from state to state. Section 529 plans have no age limits as to participation; they are open to both children and adults who plan to attend college or graduate school. For college savings plans, there is no state residency requirement for either owners or beneficiaries of Section 529 plans.
An 18-year-old, unmarried high school student sought a safe investment for a $30,000 bequest until after she graduated from college. Her intent was to use the funds for the down payment on a house after graduation. Her agent recommended she choose a variable annuity as a safe haven for the funds. This recommendation is unsuitable because
The funds are not liquid due to the surrender fees, and there is also a 10% penalty on withdrawals before age 59½.
A corporation has determined that if it were to go bankrupt, common stockholders would receive $8.47 per share. This calculation is known as
The liquidating value of the company is its book value, the book value per share is what the common stockholders would receive.
If a customer believes that interest rates have peaked and wants to buy long-term, fixed-income securities providing semiannual interest payments, you would recommend
The purchase of noncallable bonds provides the investor with a constant flow of semiannual interest income until maturity. Treasury STRIPS do not make regular interest payments.
A registered representative calls a dealer for a quote an is given the following quote;Bid Ask2.0 1.5 What type of security did the registered representative ask for?
This represents a quote for a T-bill. The quote represents a percentage discount from 100%. It is easy to identify because it looks like the bid price is greater than the ask price. This is the only quote you will see on the Series 7 that looks like this. But if you take 2% from 100%, that is 98%, and if you take 1.5% from 100%, that is $985. Therefore the quote is Bid $980 and the ask is $985. For your exam it is only important to identify the quote as a T-bill quote, not do the calculation.
One of the ways in which U.S. government agency issues differ from those offered directly by the U.S. Treasury is that
agency issues typically carry higher returns than Treasury issue because of the lack of direct government backing
Dividends from American Depositary Receipts (ADRs) held by U.S. investors are declared in
the foreign currency but paid in U.S. dollars Although the dividends paid by ADRs held by U.S. investors are declared in the foreign currency, they are paid in U.S. dollars. This is one reason that currency risk is a factor for ADR holders.
