Series 7 Exam

An agent may open a joint account for which of the following? I. Lee and his 13-year-old son, Tom II. Mary and Kelley, two adult college roommates III.Jerry and Mark, friends and partners in business for more than 20 years IV. Melinda and her minor nephew, John, for whom she is guardian A) I and IV B) II and III C) I and III D) II and IV

B. Joint account owners share ownership of the account and must be adults. A minor may not legally exercise control over an account and may not be an owner of record of an account. LO 1.b

When reading a corporation's annual report, a registered representative notices that there are 100 million shares authorized, 70 million shares outstanding, and 10 million shares in the treasury. Based on this information, the representative would deduce the number of unissued shares is A) 30 million. B) 20 million. C) 10 million. D) 80 million.

B. Of the 100 million authorized shares, 80 million have been issued (the 70 million outstanding plus the 10 million in the treasury). That leaves 20 million shares still unissued. LO 3.b

The manager of a portfolio that consists predominately of large- and mid-cap stocks could hedge against a market downturn and generate additional income by A) selling broad index puts. B) buying broad index calls. C) selling broad index calls. D) buying broad index puts.

C. The only way to generate income through the use of options is to sell them. If concerned that the market may fall, selling calls is the appropriate strategy. LO 10.g

The public offering price for a mutual fund, as quoted in the financial press, reflects A) the average sales charge for the preceding three months. B) no sales charge because the offering price depends on the quantity purchased. C) the maximum sales charge the fund distributor collects. D) the minimum sales charge the fund distributor collects.

C. The public offering price for a quoted mutual fund includes the maximum sales charge the fund distributor can assess. LO 8.c

An investor purchases $5,000 of the Quality Performance Balanced Fund, an open-end investment company, on a Thursday. The order is time-stamped at 10:45 am ET. The Thursday morning financial pages show the fund's NAV at $9.60 and the POP at $10.00. The Friday morning financial pages show the fund's NAV at 9.84 and the POP at $10.25 per share. Approximately how many shares did this investor acquire? A) 508.130 B) 520.833 C) 487.805 D) 500.000

C. There are several steps required to answer this question correctly. The first is to understand that the term open-end investment company always means a mutual fund, at least on the exam. Although most exchange-traded funds (ETFs) are structured as open-end companies, any question about them will always be clear that the subject is an ETF. The second is to recognize that mutual funds use the forward pricing rule to determine purchase or redemption prices. That is, the price is determined after the close of the trading day (4 pm ET). Therefore, this purchase will use the price that appears in the Friday morning financial pages. That purchase price will be the public offering price (POP). The POP is $10.25 per share. Divide the $5,000 purchase by the $10.25 and the result is 487.805 shares. Would you like to know how to do this question in seconds? As long as you realized the forward pricing rule and you know the new POP is higher than the previous one of $10.00 per share, it's a snap. At $10.00 per share, $5,000 buys 500 shares. With a POP above that, the choice must be lower than 500 shares and there is only one choice that is. All of the other choices use the NAV instead of the POP. That is the way the exam does things. LO 8.d

Which of the following terms are associated with over-the-counter (OTC) trading? I. Market maker II. Specialist III. Auction market IV. Negotiated market

The OTC market is a negotiated market. Within it, market makers are broker-dealer firms that provide a source for stock that customers wish to buy and a repository for stock that customers wish to sell. LO 3.h

You have a customer who is interested in reliable income. The customer recently added a bond maturing in 20 years to the portfolio. The bond has a duration of 12 years and four months, and the purchase price was $1,295.87. Which of the following statements is correct? A) The yield to maturity is less than both the current yield and the coupon rate. B) The coupon rate is lower than the yield to maturity, and the current yield should be higher than the coupon rate. C) The coupon rate is higher than the yield to maturity, and the yield to maturity is higher than the current yield. D) The current yield is higher than both the coupon rate and the yield to maturity.

Whenever a bond is purchased at a premium (a price above $1,000), the yield to maturity (YTM) is less than the current yield (CY) and the coupon rate (CR). Remember the relationship: Premium bonds: CR > CY > YTM Par bonds: CR = CY = YTM Discount bonds: CR < CY < YTM LO 4.e

All of the following statements regarding Government National Mortgage Association (GNMA) pass-through securities are true except A) GNMAs are considered to be the riskiest of the agency issues. B) investors receive a monthly check representing both interest and a return of principal. C) the minimum initial investment is $1,000. D) investors own an undivided interest in a pool of mortgages.

A. GNMA securities, which are backed by the full faith and credit of the U.S. government, are considered to be the safest of the agency issues. As is the case with most agencies, the minimum denomination is $1,000.

In most cases, new municipal bond issues are accompanied by a legal opinion. That legal opinion is drafted by bond counsel hired by A) the MSRB. B) the managing underwriter. C) the municipal issuer. D) the syndicate.

C. The legal opinion is written by an independent law firm hired by the municipal issuer. The underwriter or syndicate can also hire counsel, but that is not the official legal opinion attached to the bond.

One of the popular mortgage-back issues are those issued by the Government National Mortgage Association (GNMA). One of the reasons for their popularity is the elimination of A) credit risk. B) prepayment risk. C) interest-rate risk. D) extension risk.

A. Among mortgage-back securities, GNMAs have the unique distinction of direct backing of the government. At least for testing purposes, that eliminates credit risk (the U.S. government cannot go bankrupt). Extension risk is the uncertainly that mortgages will not be paid off as quickly as estimated and prepayment risk is just the opposite. Common to virtually all debt securities is interest-rate risk: as interest rates go up, the price of the security goes down. LO 7.c

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

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

To create a credit calendar spread, an investor should I. buy the near expiration. II. buy the distant expiration. III. sell the near expiration. IV. sell the distant expiration. A) I and IV B) I and III C) II and IV D) II and III

A. A credit calendar spread occurs when premium received exceeds the amount paid out. An investor creates a credit spread by selling the distant expiration and buying the near expiration. The distant expiration has more time value, and therefore, a higher premium. LO 10.e

Which type of risk is a mortgage-backed security most likely to experience? A) Reinvestment rate risk B) Business or corporate risk C) Exchange rate risk D) Market risk

A. A mortgage-backed security, such as a collateralized mortgage obligation, is most likely to experience reinvestment rate risk. As mortgages are paid off early and refinanced in the event of declining interest rates, the interim cash flows received from the obligation must be reinvested in lower yielding securities. This is the practical effect of prepayment risk. LO 7.c

A broker-dealer has set up a prime brokerage account for one of its customers. This customer is most likely A) an institutional customer. B) an investment club. C) an individual retail customer. D) two spouses, each having individual accounts and a joint account together.

A. A prime brokerage account is one in which a customer—generally an institutional customer—selects one member firm (the prime broker) to provide custody and other services, while other firms—called executing brokers—handle all trades placed by the customer.

All of the following are redeemable securities except A) real estate investment trusts (REITs). B) unit investment trusts. C) variable annuities. D) mutual funds.

A. A redeemable security has no secondary market. To sell (redeem) a redeemable security, the investor must go back to the issuer or its agent. REITs trade in the secondary markets either on exchanges or over the counter. LO 11.a

Which of the following is not an advantage of purchasing American depositary receipts (ADRs)? A) They eliminate exchange rate risk. B) They allow U.S. investors to buy foreign country stock denominated in dollars. C) Foreign taxes withheld can be claimed as a credit to offset income taxes on dividends received. D) Transactions are done on an organized exchange in the U.S.

A. ADRs are priced in U.S. dollars and therefore have exchange rate risk. That is, if the value of the currency in the home country of the company underlying the ADR should decline in relationship to the U.S. dollar, the investor could actually lose money even if the stock's price rises. For example, the foreign company's stock is selling for $50 per share Canadian. At the time of purchase, the Canadian dollar is worth $0.80 U.S. That would make the ADR value approximately $40 per share U.S. If the client decides to sell that ADR when the company stock is selling for $52 per share on its domestic exchange, but the Canadian dollar is now worth $0.70 U.S., the ADR's value will be approximately $36.40. Therefore, we've seen the price of the stock go up while the value of the ADR to the U.S. investor has declined. LO 3.g

For individual public investors, dark pools of liquidity A) lessen the transparency of the overall market as volume, quote and price information, and market participant identity is unknown. B) prevent them from having their own orders entered on exchanges for execution. C) allow them to give an order to their broker-dealer to buy or sell securities while only referencing an account known by a number and not their name. D) allow them to enter orders that are sent directly to the trading floors of stock exchanges.

A. For individual public investors, dark pools of liquidity lessen the transparency of the overall marketplace. The pools refer to transactions that take place primarily among institutional traders or trading desks in large block transactions away from stock exchange floors, where volume, quote and price information, and participant identity are unknown. Though the existence of dark liquidity pools detracts from market transparency, it does not prevent individual public investors from having their own orders executed on listed exchanges.

A municipality that has issued grant anticipation notes (GANs) (short-term municipal notes) does so in expectation that the debt service will be paid by the receipt of funds attained A) via grants from the federal government. B) from both tax and other anticipated revenue. C) through the issue of long-term bonds. D) from future tax revenue.

A. GANs are short-term municipal notes issued in anticipation of funds via grants that the municipality is expecting from the federal government. LO 6.b

An investor purchases a 3x leveraged ETF. The index value is $100. On day 1, the index falls by 10% and then on day 2 goes up by 10%. How has this affected the investor's account? A) It is down 9%. B) It is even. C) It is down 3%. D) It is up 3%.

A. If the index drops by 10 points on day 1, it has a 10% loss and a resulting value of 90. Assuming it achieved its stated objective, the leveraged ETF would therefore drop 30% on that day and have an ending value of $70. On day 2, if the index rises 10%, the index value increases to 99. For the ETF, its value for day 2 would rise by 30%, which means that the ETF would have a value of $91 (70 × 30% = 21). On both days, the leveraged ETF did exactly what it was supposed to do—it produced daily returns that were two times the daily index returns. But let's look at the results over the two-day period: the index lost 1% (it fell from 100 to 99) while the 3x leveraged ETF lost 9% (it fell from $100 to $91). That means that over the two-day period, the ETF's negative returns were 9 times as much as the two-day return of the index instead of 3 times the return. LO 8.h

In early September, a customer buys 100 shares of QRS stock for $83 per share and simultaneously writes 1 QRS Mar 90 call for $4 per share. If the QRS Mar 90 call was exercised and the QRS stock delivered, what would be the customer's per-share profit? A) $11 B) $7 C) $4 D) $0

A. If the stock rises above $90, the writer will be exercised and make $700 on the stock (buy at $83, deliver at $90) and keep the $400 received in premiums. Alternatively, the breakeven point is $79 ($83 − $4), and the stock was sold (delivered) at $90 for an 11-point gain. LO 10.h

One of your customers exercises a put option. The stock is in the customer's account and your firm makes timely delivery. The proceeds from the sale of the stock will be paid to your firm by A) the broker-dealer to whom the exercise notice was assigned. B) the writer to whom the exercise notice was assigned. C) the exchange where the option exercise took place. D) the OCC.

A. Look at this as a regular buy and sell. When the customer exercises the put, it is a sale of stock. When customers of member firms sell stock, those firms collect the sales proceeds from the contra party (the other member firm representing the buyer). The OCC assigns the exercise to a member firm that is then responsible for paying the broker-dealer representing the seller of the stock. LO 10.b

A real estate limited partnership is created for $800,000 with 1 general partner and 10 limited partners. Each of the limited partners has an equal 10% share. The proceeds are used to purchase an office building for $2 million. The additional financing is provided by a nonrecourse bank loan. Economic conditions cause the occupancy rate to fall dramatically, and the partnership is dissolved as insolvent. Each limited partner may claim a loss of A) $200,000. B) $2,000,000. C) $120,000. D) $80,000.

A. Losses may only be claimed to the extent of tax basis. The initial $800,000 was divided 10 ways, so each LP had a basis of $80,000. To this was added the share of the financing of $1.2 million. That is another $120,000 basis (10% of $1.2milion) bringing the total to $200,000 ($80,000 + $120,000). That is the maximum loss that can be claimed. It is important to note that nonrecourse financing adds to basis only in RELPs. Because the loan adds to the basis of all LPs equally, you could also solve this by taking the total $2 million investment and dividing it by 10 to arrive at the same $200,000. LO 11.f

A 38-year-old investor places $25,000 into a single premium deferred variable annuity. Twenty years later, with the account valued at $72,000, the investor surrenders the policy. If the investor is in the 25% marginal income tax bracket, the total tax liability is A) $16,450. B) $11,750. C) $18,000. D) $25,200.

A. Only the deferred growth is taxable. In this case, it is the difference between the surrender value of $72,000 and the cost basis of $25,000. That $47,000 is taxed at the marginal rate of 25%. Furthermore, because the investor is younger than 59½ (38 + 20 = 58), there is the additional 10% penalty tax. Effectively, this is a 35% tax on $47,000. LO 9.d

Losses from direct participation programs can be used to offset A) income from limited partnerships. B) none of these. C) portfolio income. D) earned income from salary or commissions.

A. Passive losses can be used only to offset passive income, which is earned from direct participation programs and rental real estate. LO 11.f

In which of the following investment strategies would it be illegal for a mutual fund's portfolio manager to engage? A) Taking a short position in shares of a mid-cap company B) Taking a long position in shares of a large-cap company C) Going long U.S. Treasury bonds D) Liquidating a position in shares of a small-cap company

A. The Investment Company Act of 1940 prohibits mutual funds from engaging in short selling. The fund's objective will affect the type of securities to be held in the portfolio, but they can only be long positions. LO 8.j

All of the following trade with accrued interest except A) zero coupon bonds. B) Treasury bonds. C) jumbo certificates of deposit. D) convertible bonds.

A. Zero coupon bonds are issued at a deep discount from face value instead of providing semiannual interest payments. T-bonds, convertible bonds, and CDs all make periodic interest payments; thus, the seller receives any accrued interest from the buyer. LO 6.e

An investor purchased 100 shares of AMNZ stock five years ago at $200 per share. With AMNZ currently selling at a price in excess of $1,000 per share, the investor would like to generate some income. Which of the following strategies would you recommend? A) Sell an AMNZ call B) Sell an AMNZ put C) Buy an AMNZ call D) Buy an AMNZ put

A. The only way to generate income is to sell something. Because the investor already owns 100 shares of AMNZ, selling a put is probably not the right suggestion. If the stock price goes down, the put will be exercised and the investor will have to buy 100 shares of the stock at the strike price. Selling the call while owning the underlying stock makes this a covered call. It provides income from the premium and offers some downside protection. If the stock goes up, the option will likely be exercised and the investor will have to deliver the stock purchased years ago. This will result in a long-term capital gain equal to the difference between the investor's cost ($200) and the proceeds received (the strike price plus the premium). LO 10.a

If MCS is trading at 43 and the MCS Apr 40 call is trading at 4.50, what is the intrinsic value and the time value of the call premium? A) Intrinsic value 3, time value 1.50 B) Intrinsic value 1.50, time value 3 C) Intrinsic value 4.50, time value 0 D) Intrinsic value 3, time value 4.50

A. The option is in the money by three points (the strike price on the call is 40 and the market price is 43). Because the actual premium is 4.50, the balance of 1.50 represents time value. Remember P - I = T (Premium minus intrinsic value equals the time value). LO 10.c

The put-call ratio can be used to A) gauge investor sentiment as being either bullish or bearish. B) determine which institutional trading desks are trading options. C) determine a stocks beta. D) calculate how many options contracts are needed to hedge a stock position.

A. The put-call ratio reflects the current open interest in the trading of put options to call options for a single stock, the broad market, or any market sector. The ratio can be used as a gauge of investor sentiment (bullish or bearish). The higher the ratio is, the more bearish an indicator it is. LO 10.d

Nancy is a 55-year-old tenured world history professor at the local state university. She has been participating in the school's 403(b) tax-sheltered annuity (TSA) program for a number of years. Her current account balance is $386,000, which is more than twice the amount of her pre-tax contributions. Nancy is taking a sabbatical for the year and plans to travel the world to visit many of the places she teaches about. To help pay for the trip, she plans to withdraw $60,000 from her account. If she is in the 24% tax bracket, the effect of this withdrawal will be A) a tax liability of $20,400. B) no tax because the money will come out of the invested principal before the earnings. C) impossible to calculate because we do not know her cost basis. D) a tax liability of $14,400.

A. The question tells us that her contributions were all tax-deductible (because her account is a TSA). That means her cost basis, for tax purposes, is zero. Every dollar withdrawn is subject to income tax, and, because Nancy has not yet attained age 59½, the 10% tax penalty applies. The math is $60,000 times 34% (the 24% plus 10%), and that equals $20,400. LO 1.h

A registered representative executes the following trades for an options account: Buy 1 FLB Apr 40 call at 9 Sell 1 FLB Apr 45 call at 4 Are these suitable trades? A) No, because the customer cannot make a profit on these trades. B) It depends on the customer's investment objectives. C) Yes, because the trades will result in a small profit. D) It is impossible to tell.

A. These trades are not suitable because the customer will not make a profit. In any price spread, the net debit represents maximum loss; in this case, the net debit is five points, or $500. Maximum loss added to maximum gain will always equal the difference between the strike prices. In this example, the difference between the strike price is five points; therefore, the maximum gain is zero. LO 10.e

A mutual fund, frequently used as the default option in employer-sponsored retirement plans, that adjusts its portfolio growth orientation to principal conservation as a specified date approaches is A) a target date fund. B) a Section 529 fund. C) a balanced fund. D) a hedge fund.

A. This is exactly what target date funds are designed for. As the investor gets closer to the target retirement age, the portfolio managers shift the concentration from equities to fixed income. That is why a high percentage of corporate retirement plans use those as the investment option when the employee does not make a selection. A balanced fund does adjust between equity and fixed income, but does so based on market conditions, not a specified future date. Investments in Section 529 plans do follow a similar strategy as college nears, but these are never available in retirement plans. LO 8.g

The risk that time value may erode the premium of an equity option, even while the underlying issuer remains financially sound, is an example of A) decay risk. B) interest rate risk. C) reinvestment risk. D) market risk.

A. Time decay is the loss of time value as an option nears its expiration date. At the expiration date, the time value is zero. The only value to the option is intrinsic value, if any. LO 10.c

Which of the following statements regarding Treasury receipts is not true? A) Interest income is taxed at maturity. B) Treasury securities held in trust collateralize the receipts. C) Treasury receipts pay interest at maturity. D) Treasury receipts are not backed by the faith and credit of the U.S. government.

A. Unlike Treasury STRIPS, which are issued directly by the U.S. government, Treasury receipts are indirect obligations of the government. Treasury receipts are issued by investment bankers who buy Treasury securities, place them in trust at a bank, and sell separate receipts against the principal and interest payments. Like most zeroes, interest must be accreted and taxed annually even though it is not received until maturity. LO 7.a

An investor owns a convertible debenture with a conversion price of $10. If a 10% stock dividend is paid on the company's common stock, which of the following is true? A) The conversion price will be adjusted to $9.09. B) The investor will receive 1 share of the common stock. C) The investor will receive 10 shares of the common stock. D) The conversion price will be adjusted to $11.00.

A. You can assume that any convertible security on the exam will have an anti-dilutive provision. That means that a stock dividend or stock split will not cause the investor's conversion privilege to be diminished. With a conversion price of $10, the investor was able to convert into 100 shares ($1,000 divided by $10). After the 10% stock dividend, the investor must be able to convert into 10% more shares (110 shares). To get 110 shares from a $1,000 principal, the price must be reduced. The computation is $1,000 divided by 110. That equals $9.09 per share. LO 5.c

An options trader goes long 1 XYZ Oct 60 put at 6 and purchases 1 XYZ Oct 60 call for 6. If XYZ is at 68 at expiration, what is the investor's gain or loss? A) $400 loss B) $200 gain C) $1,200 loss D) $400 gain

A. If the market price of XYZ is at $68 per share, the put is out of the money and will expire worthless. The call could be sold for the intrinsic value of 8. (There is no time value because the option is at the expiration date.) Because the investor originally spent $1,200 (a premium of $600 was paid for each option), the net result is a loss of $400. LO 10.f

Bondholders may not take action against the corporation if it fails to make interest payments for A) income bonds. B) debentures. C) convertible bonds. D) subordinated debentures.

A. Income bonds pay interest only if earnings are sufficient and declared by the board of directors. This is not true of any of the other fixed-income securities listed (debentures, subordinated debentures, or convertible bonds). LO 5.a

FINRA Rule 2111 places three obligations on members when determining if a specific recommendation to a customer is suitable. Which of the following is not one of those three? A) Qualitative-basis suitability B) Reasonable-basis suitability C) Quantitative suitability D) Customer-specific suitability

A. The rule does not refer to qualitative-basis suitability. It does say that a recommendation may be suitable if at least some investors would benefit from it (reasonable-basis suitability). The recommendation should also take the specific customer's profile into consideration (customer-specific suitability). Finally, although a specific recommendation may be suitable, when looking at the quantity of trading, there could be a churning violation (quantitative suitability). LO 2.f

Which of the following is considered a double-barreled bond? A) Build America Bonds B) Bridge authority revenue bonds guaranteed by the full faith and credit of a city C) Dome stadium bonds with provisions for emergency ceiling support D) Moral obligation bonds

B Double-barreled bonds are backed not only by a specified source of revenues, but also by the full faith and credit of a municipal issuer with authority to levy taxes. Even though they are rated and traded as if they were general obligation bonds, it is proper to include them in the revenue category because the initial backing is from revenue. The additional backing of PHAs is the full faith and credit of the U.S. government—not the issuer. The additional backing of moral obligation bonds are legislative appropriations, which are not mandatory. LO 6.b

A stockholder owns 200 shares of common stock in a corporation that features statutory voting. If an election is being held in which six candidates are running for three seats on the board, the stockholder could cast the votes in which of the following ways? A) 600 votes for any one director B) 200 votes for each of three directors C) 300 votes for each of two directors. D) 100 votes for each of six directors

B. A stockholder has one vote per seat for each share of stock he owns. Thus, in this case, the stockholder has a total of 600 votes. Under the statutory voting method, he must allocate an equal number to each seat, or 200 for each of three seats. LO 3.c

A quote of 2.20 bid 2.18 offered would most likely be a quote on A) a general obligation bond. B) a T-bill. C) a T-bond. D) a Ginnie Mae bond.

B. Discounted instruments (such as T-bills) are quoted on a discount yield basis. Even though the number representing the bid is higher than the ask, it would be lower when converted into dollars. The greater the yield, the lower the price. LO 7.b

A customer buys a real estate limited partnership interest by contributing $20,000 and signing a nonrecourse note for $50,000. The customer's beginning basis is A) $30,000. B) $70,000. C) $50,000. D) $20,000.

B. Generally, nonrecourse debt does not add to basis because the limited partner is not responsible (at risk) for the repayment of the debt. However, in real estate partnerships, the at-risk rules do not apply, and therefore, add to basis in this type of partnership. LO 11.f

Your customer has experienced $7,500 in capital losses this year. He has realized $2,000 in capital gains and has $65,000 adjusted gross income. How much of his loss will he be able to carry forward to next year? A) None B) $2,500 C) $5,500 D) $4,500

B. He will first offset his $2,000 in capital gains, leaving $5,500 in losses. He next offsets $3,000 in adjusted gross income, leaving $2,500 in losses to carry forward to next year. Provided the loss is offset to the maximum each year, there is no limit to how long losses may be carried forward. LO 3.i

A hedge fund has contracted with your broker-dealer to handle all of its clearing functions and provide all back-office support functions while it is executing transactions through numerous other broker-dealers with whom your broker-dealer will have agreements. This type of account is known as A) a custodial account. B) a prime brokerage account. C) a joint account. D) a numbered account.

B. In a prime brokerage account, a customer contracts with one broker—the prime broker—to provide a list of support services, such as clearing and settlement of transactions, while contracting with numerous other brokers for executions services. LO 1.b

All of the following are regulated by the Municipal Securities Rulemaking Board (MSRB) except A) quotes. B) issuers. C) dealers. D) sales representatives.

B. Quotes, dealers, and sales representatives are regulated by the MSRB, but issuers are not. LO 6.h

A customer sells an FLB Mar 35 call. To establish a straddle, she would A) sell an FLB Mar 40 call. B) sell an FLB Mar 35 put. C) buy an FLB Mar 35 put. D) buy an FLB Mar 40 call.

B. Straddles involve options of different types, but both options must be of the same series. An option series has the same strike price, expiration date, and underlying security. LO 10.f

An investor opens the following options position: Long 1 ABC Aug 50 call @ 5½; short 1 ABC Aug 55 call @ 3½. What is the investor's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $300; maximum loss is $200; breakeven is $53. B) Maximum gain is $300; maximum loss is $200; breakeven is $52. C) Maximum gain is $200; maximum loss is $300; breakeven is $53. D) Maximum gain is $200; maximum loss is $300; breakeven is $52.

B. The first step is to identify the position. This is a debit call spread. It is a debit spread because the option purchased costs more than the one sold. The investor purchased the 50 call for a premium of 5½ and sold the 55 call for a premium of 3½. That difference (5½ minus 3½), a debit of $200, is the most the investor can lose. This is a bullish spread (the investor bought the low strike price and sold the high strike price). If the investor is correct and the stock rises, the short call will be exercised. That means the writer will have to sell the stock at $55 per share. However, the investor will exercise the 50 call and deliver the stock purchased for $5,000 and receive proceeds of $5,500. The $500 profit is reduced by the $200 it cost to put on the spread (the debit). That means a net gain of $300. The fastest way to do a question like this is to subtract the debit from the strike price difference (5 points here) and you have your maximum gain. In this case, it is $5 minus $2 = $3. Breakeven follows the call-up rule; add the net premium (the debit of $2) to the lower strike price ($50) to arrive at $52. LO 10.h

A customer has a $75,000 bank CD that is about to mature, and she wants some recommendations from the registered representative handling her brokerage account. Which of the following items would be the least important when considering a suitable recommendation? A) The customer's need for liquidity B) The name of the bank issuing the CD C) The customer's current portfolio D) The customer's investment goals

B. The name of the bank is of little or no consequence, while the other three points are critical for making a suitable recommendation. LO 2.d

An investor purchased 200 shares of DCAST common stock at $200 per share. What is the adjusted cost basis per share of this position after the company pays a 100% stock dividend? A) $50 B) $100 C) $200 D) $400

B. The total value of the initial position is unchanged, remaining at $40,000 (200 times $200). After the stock dividend, the investor owns 400 shares (200 times 100% = 200 + 200 = 400). Therefore, the adjusted cost basis is $100.00 per share ($40,000 divided by 400 = $100). Perhaps you recognized that a 100% stock dividend has the same effect as a 2:1 split. That is, the stock's cost basis is cut in half. It is important to remember that anytime there is a distribution resulting in additional shares (stock split, stock dividend), the cost basis per share is reduced while the total account value remains the same.

A qualified legal opinion issued for a municipal bond underwriting means that A) the bond attorney is qualified to express her opinion on the bond. B) the legal opinion is qualified with restrictions and conditions. C) the bond counsel is considered competent. D) the revenue bond issue has certain debt limitations.

B. The word qualified describes the legal opinion, not the attorney (or bond counsel) who issued it. A qualified legal opinion is one in which the bond counsel expresses reservations about conditions that may affect the bond's status. An unqualified legal opinion is rendered without restriction or condition. LO 6.a

Unrealized gain in a mutual fund portfolio does which of the following? I. Increases the dividends paid to shareholders II. Represents the undistributed income and the growth in market value of securities held in the portfolio III. Is realized by shareholders only when they redeem their shares IV. Has no effect on shareholders until the annual long-term capital gains distribution is paid A) II and IV B) II and III C) I and III D) I and IV

B. Unrealized gains result from asset appreciation and undistributed income. This increase in value is reflected in an appreciation of the mutual fund shares. Investors realize this appreciation only by selling their shares. LO 8.c

A customer is long 10 XYZ Jan 60 calls, and XYZ declares a 20% stock dividend. On the ex-date, the customer will have A) 10 XYZ Jan 60 calls (100 shares per contract). B) 10 XYZ Jan 50 calls (120 shares per contract). C) 12 XYZ Jan 60 calls (120 shares per contract). D) 10 XYZ Jan 50 calls (100 shares per contract).

B. When adjusting options contracts for stock dividends and fractional splits, the number of contracts held will not change. The number of shares covered by each contract is increased (100 shares × 120%) so that in this example, each adjusted contract now represents 120 shares. The effective exercise price is adjusted so that the position value remains the same before and after the adjustment. Therefore, the new strike price will be 50 ($6,000 / 120 shares = $50). LO 10.j

Which of the following regarding yield-based (interest rate) debt options is true? A) Calls are purchased by those who believe prices of debt securities are rising. B) They are European-style exercise. C) Debt securities are delivered to the contract owner when exercised. D) Their strike prices reflect dollar amounts.

B. Yield-based debt options are European-style contracts, meaning that they can only be exercised on the last day of trading. All yield-based contracts, when exercised, are settled in cash. There is no delivery of debt instruments when these contracts are exercised. All strike prices reflect yield. (35 strike price represents 3.5% yield.) Yield-based options are a bet on future interest rates, not prices. Calls are bought by those who believe rates are going up (prices down) and puts by those who believe rates are going down (prices up). LO 10.j

An investor places $100,000 into an oil and gas limited partnership program. To comply with FINRA rules, what is the minimum amount of the investment that must be received by the business? A) $90,000 B) $85,000 C) $98,000 D) $95,000

B. Each of these choices uses a percentage that has some logic. Under FINRA Rule 2310, the maximum in total offering expenses is 15%. Therefore, at least 85%, or $85,000, must actually be put to work in the program. There is a maximum compensation of 10% to the member firm selling the program, and that is the largest part of the 15% total. The 5% policy does not apply to DPPs, and if this question were about a DPP roll-up, then there is 2% maximum to the member if recommending the client vote in favor of the roll-up. LO 11.h

The call provisions of a municipal issue would be detailed most completely in A) the official notice of sale. B) the bond resolution. C) the legal opinion. D) The Bond Buyer.

B. The bond resolution is the document that authorizes the issuance of a municipal bond. The resolution also describes the proposed issue's features and the issuer's responsibilities to its bondholders. LO 6.b

All of the following are characteristics of 529 plans except A) there is no age limit on the beneficiary. B) donor income limits apply. C) the assets can be transferred to a family member if not used by the original beneficiary. D) an official statement (OS) must be provided to any prospective purchaser.

B. Unlike the Coverdell ESA, there are no donor income limits with a 529 plan. All of the other statements are true as to 529 plans. LO 6.g

Which of the following statements describes an oil and gas blind pool offering? A) An unknown number of representatives participate in the sale of known partnership units. B) The oil exploration occurs in an area that is not adjacent to any known oil reserves. C) Money is raised without a specific property being stated, and the general partner selects the investments. D) The income from producing wells is purchased at a discount from the present value of the projected future flows.

C. A blind pool offering, also known as a nonspecified program, involves an investment in a program without specific prospects or properties being identified. LO 11.g

When discussing unit investment trusts with a prospect, it would be correct to state that these are A) sold without the requirement to deliver a prospectus. B) generally traded on the listed exchanges. C) nonmanaged investment companies. D) regulated under trust law rather than securities law.

C. A primary characteristic of the UIT is that, unlike the open-end and closed-end companies, it has no portfolio managers. That is why it is never referred to as a management company. It may have the term "trust" in its name, but it is an investment company registered under the Investment Company Act of 1940. UITs cannot be sold without a prospectus. Only securities traded in the secondary market are listed on an exchange. UITs are redeemable securities through the issuer. LO 8.a

Flag Mountain Floating Rate Capital, a business development company (BDC), has the majority of its assets invested in debt securities. Income distributions are made in the form of A) interest. B) a return of capital. C) dividends. D) capital gains.

C. Business development companies (BDCs) are closed-end investment companies registered under the Investment Company Act of 1940. In addition, they are regulated investment companies (RICs) under the Internal Revenue Code, meaning that BDCs must distribute at least 90% of their net investment income (NII) as dividends to shareholders. ** This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback. LO 8.f

Which of the following would be most likely to require a mandatory sinking or surplus fund? A) A tax anticipation note B) A general obligation C) A public housing authority. D) A water and sewer revenue bond

D. Sinking or surplus funds force revenue bond issuers to set aside a portion of their revenue for debt retirement. LO 6.a

An investor, age 40, earns $65,000 annually and contributes 3.5% to his employer's 401(k) plan. With the 401(k), his only retirement savings, he wants to do more for retirement and hopes to invest in such a way as to have some tax-free income when he takes distributions later in life. Which of the following is the most suitable given the investor's goals and objectives? A) Traditional IRA B) Municipal bonds C) Roth IRA D) A nonqualified variable annuity

C. Given the investor's current age (40), a safe assumption is that the investor will have owned the Roth IRA for at least five years before any distributions would be taken. Roth IRAs allow for tax-free distributions when owned for five years and the recipient is age 59½ or older, while traditional IRAs do not. Municipal bonds offer tax-free interest but do not grow tax deferred, and variable annuities should be used only after contributions to employer-sponsored plans and IRAs are maxed out. LO 1.g

An investor is short stock at $70. If the stock's market price is $40, and the investor anticipates the price will continue to decline, to hedge against a rise in the price, the investor should A) sell a call. B) buy a straddle. C) buy a call. D) buy a put.

C. If the investor buys a call on the stock, he has the right to buy it back (cover his short) at a fixed price. The best way to hedge an unrealized gain on a short stock position is to buy a call. LO 10.d

Which of the following securities is considered the most junior? A) Mortgage bond B) Prior lien preferred stock C) Common stock D) Debenture

C. In the event of a company's bankruptcy, common stock owners have the lowest priority in claims against corporate earnings and assets. This identifies common stock as the most junior security. LO 3.b

An investor purchased a single premium deferred variable annuity 20 years ago. The premium deposit was $50,000. The account is now worth $200,000 and the investor is still working. When does the investor have to begin taking required minimum distributions? A) At age 59½ B) At age 72 C) Never with a nonqualified annuity D) At age 72 or when no longer working, whichever is later

C. On the exam, unless stated to the contrary, every annuity is nonqualified. One of the benefits of nonqualified annuities is that there is no age at withdrawals must commence. In general, earnings withdrawn prior to age 59½ are subject to the additional 10% penalty on top of tax at ordinary rates. LO 9.d

Most exchange-traded funds (ETFs) are structured as open-end investment companies. However, they should not be confused with mutual funds. Among the differences between the two is that ETFs A) track indexes. B) can issued preferred stock. C) are traded in the secondary markets. D) compute their NAV hourly.

C. The ET in ETF stands for exchange-traded (not the movie character). That is a solid hint that these trade on the exchanges. Stock exchanges are secondary markets. Because mutual funds are always part of a continuous new issue, their sale takes place in the primary market. Redemptions are back through the fund, not on any securities marketplace. There are mutual funds that track indexes just as ETFs do. Both compute their NAV as of the 4 pm close of the markets. No open-end investment company can issue preferred stock. LO 8.h

The function of the Federal National Mortgage Association (FNMA) is to A) issue conventional mortgages. B) provide financing for government-assisted housing. C) purchase FHA-insured, VA-guaranteed, and conventional mortgages. D) guarantee the timely payment of interest and principal on FHA and VA mortgages.

C. The FNMA buys FHA, VA, and conventional mortgages and uses them to back the issuance of debt securities. FNMA currently issues debentures, mortgage-backed securities, and certificates. LO 7.c

One of your customers purchased a municipal bond at a basis of 3.35%. Several weeks later, the bond's basis is now 3.21%. Which of the following statements is true? I. The bond's yield to maturity has fallen by 14 basis points II. The bond's price has fallen by 14 basis points III. Market interest rates have likely decreased IV. The bond's rating has likely fallen A) II and III B) I and IV C) I and III D) II and IV

C. The basis quote is the bond's yield to maturity. The difference between a basis of 3.35% and a basis of 3.21% is 14 basis points. What is it that causes a bond's yield to fall? It is the inverse relationship between interest rates and bond prices. The price has gone up because interest rates have fallen. LO 6.a

One of your clients owns 300 shares of common stock in a publicly traded corporation. The acquisition cost of those shares was $60,000 and the last trade of the stock was $220 per share. There was a news report that the company was going to pay shareholders a 100% stock dividend. The client wants to know how this dividend will affect the holding. You would respond that the customer will A) now own 600 shares and the market price will be approximately $220 per share. B) still own 300 shares and the market price will be approximately $440 per share. C) now own 600 shares and the market price will be approximately $110 per share. D) now own 150 shares and the market price will be approximately $440 per share.

C. The effect of a 100% stock dividend is the same as a 2:1 stock split. The customer will have twice as many shares worth half as much each. That would be 600 shares worth $110 per share for a total value of $66,000. Note that the total value is unchanged from the pre-split value of 300 shares at $220 per share. LO 3.b

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

C. The interest on corporate debt securities is subject to taxation at the federal, state, and local levels, and CMOs are issued by corporations. Interest on Treasury instruments is taxable at the federal level only. Interest on municipal instruments is exempt from taxation at the federal level, and possibly the state level, if the holder is a resident of the state of issue. Public Housing Authority bonds and revenue bonds are types of municipal issues, which are tax free at the federal level. LO 12.d

If a customer buys a Mount Vernon Port Authority municipal bond in the secondary market at 109 and holds the bond to maturity, what are the tax consequences? A) Capital loss of $90 B) Capital gain of $9 C) No capital gain or loss D) Capital loss of $9

C. The investor's cost basis of bonds purchased at a premium is adjusted by amortization of the premium. In this case, there is a $90 premium that will have been completely amortized at maturity. At maturity, the adjusted cost basis equals the face value, and no loss or gain is realized. LO 6.e

Dollar cost averaging (DCA) will always result in a lower cost per share than the price paid per share except A) when the price for each purchase is fluctuating.. B) when the price for each purchase is decreasing. C) when the price for each purchase is the same. D) when the price for each purchase is increasing.

C. There are two requirements for a dollar cost averaging program to work. The first is that the same amount must be invested at each specified interval. The second is that the price per transaction does not remain the same. If that is the case, then the average cost per share and average price paid per transaction are the same. The price needs to move for DCA to show a benefit. LO 8.e

One of the advantages of writing a call option covered by shares of the underlying stock is A) the underlying stock can be purchased on margin. B) the investor has protected most of the downside risk. C) immediate income is generated. D) the investor retains all of the upside potential.

C. When an investor writes a call option and owns the underlying shares, the premium is credited to the account on the next business day (T+1). For this benefit, the investor has given up most of the upside potential because once the stock rises above the exercise price, it will likely be called away. That places a limit on the upside potential. There is downside protection, but it is limited to the extent of the premium received. The underlying stock can be purchased on margin, regardless of writing the call. LO 10.d

Assuming ABC is subject to a 60,000-contract position limit, which of the following customer accounts are in violation of the exchange's position limits? I. Long 35,000 ABC Jan calls, long 30,000 ABC Jan 08 LEAPS calls II. Long 35,000 ABC Mar calls, long 30,000 ABC Mar puts III. Long 35,000 ABC Mar calls, short 30,000 ABC Jan 08 LEAPS calls IV Long 35,000 ABC Mar calls, short 30,000 ABC Mar puts A) II and IV B) III and IV C) I and IV D) I and II

C. When aggregating contracts to determine if the position limit has been exceeded, we add together all positions in that security on the same side of the market. That is, we look at contracts that are hoping for a move to the upside and combine them, or we look for contracts that are hoping for a move to the downside and combine them. Long calls and short puts benefit from a move to the upside. The reverse is true of long puts and short calls. Let's look at the choices: I. Both positions are long calls so they are combined. 35,000 + 30,000 = 65,000. This is above the 60,000 limit. II. Long calls and long puts are on opposite sides of the market ("call up and put down"), so they are not combined and we haven't exceeded the 60,000 limit. III. Long calls and short calls are opposite positions (long call is bullish, short call is bearish), so they're not combined and there is no violation. IV. Long calls and short puts both benefit if the market is bullish, so they are combined and that total of 65,000 exceeds the position limit. Don't be mislead by the fact that some of the positions are LEAPS (options with expirations much longer than the normal 9 months). The position limits are not based on expiration dates or strike prices. The limit is based solely on the number of contracts with the same market sentiment. LO 10.j

Unit investment trusts differ from mutual funds in which two of the following ways? I. UITs have an expiration date; mutual funds do not. II. UITs generally have higher management fees than mutual funds. III. The portfolio of a UIT is fixed while that of a mutual fund changes as the managers look for investment opportunities. IV. UIT units are not redeemable while shares of mutual funds are. A) II and III B) II and IV C) I and III D) I and IV

C. When a unit investment trust is formed, there is a pre-determined expiration date. In the case of a trust containing debt securities, the trust expires when the securities mature. In the case of an equity trust, the date is fixed. There is no management fee because there is no ongoing management of a fixed portfolio. Both UITs and mutual funds issue redeemable securities. LO 8.a

Variable-rate municipal bonds are subject to all of the following risks except A) liquidity. B) default. C) market. D) interest rate.

D. A variable-rate bond is one whose coupon is adjusted periodically (semiannually or annually) to reflect current interest rates. Therefore, if rates rise and force prices down, the coupon on a variable-rate bond will be adjusted upward, thereby tending to keep the bond's price at or near par. Therefore, no interest rate risk is associated with these bonds. However, if rates fall, the coupon will be adjusted downward, keeping the bond's price at or around par. Normally, a fall in rates will force prices up, but not with variable-rate bonds. LO 6.b

An inherent risk associated with auction rate securities (ARS) is the potential to have A) a Dutch auction. B) a clearing rate. C) a reset rate. D) a failed auction.

D. An inherent risk associated with ARS is the potential for a failed auction. These can occur due to a lack of demand, resulting in no bids being submitted when it is time to reset the rate. ARS use a Dutch auction method to reset the clearing rate paid in the upcoming period. LO 6.b

The primary purpose for creating ERISA was to A) establish a means for self-employed persons to provide for their own retirement. B) provide all employees, both government and nongovernment, with an additional source of retirement income in the event that the Social Security system defaults. C) promote a retirement fund for government employees. D) protect employees from the mishandling of retirement funds by corporations and unions

D. ERISA was created to protect the retirement funds of union members and employees of large corporations. ERISA guidelines state that all qualified retirement plans must be in writing, segregate funds from corporate or union assets, make prudent investments, report to participants annually, and not be discriminatory. All of these activities are audited under ERISA. LO 1.i

In an IRA, a 6% penalty will be levied if the account owner A) fails to make a contribution by April 15. B) changes the beneficiary designation more than once during any calendar year. C) makes a premature withdrawal. D) makes an excess contribution.

D. Excess contributions to an IRA are subject to a 6% penalty tax. LO 1.g

A charge of churning would likely be brought against a registered representative who was found to have disregarded the FINRA rule on A) reasonable-basis suitability. B) investment goal suitability. C) customer-specific suitability. D) quantitative suitability.

D. FINRA Rule 2111 places three obligations on members when determining if a specific recommendation to a customer is suitable. One of those obligations is quantitative suitability. Churning is generally defined as excessive trading in a customer's account. The registered representative, having control over a customer account, has to have a reasonable basis for believing that a series of recommended transactions, even if suitable when viewed in isolation, are not excessive and unsuitable for the customer when taken together. LO 2.f

One of the key requirements in offering a DPP to a customer is that the program must be suitable. FINRA has some specific suitability requirements for DPPs. Among those is the investor A) has sufficient experience in the type of business the program is undertaking. B) does not own a DPP that will compete with the program being offered. C) has sufficient net worth to be deemed an accredited investor. D) has a net worth sufficient to sustain the risks of the DPP, including loss of investment.

D. FINRA's Rule 2310 lists a few suitability standards necessary for recommending DPPs. Among those is the need for the investor to have a net worth sufficient to sustain the risks of the DPP, including loss of the investment. Although many DPPs, but not all, are limited to accredited investors, that is not a FINRA suitability standard; that is an SEC requirement. It is the general partner who cannot be in a business that competes with the DPP. LO 11.h

Which of the following usually does not pay interest semiannually? A) Public utility bonds B) Treasury bonds C) Treasury notes D) Government National Mortgage Association (GNMA)

D. GNMA pass-through certificates pay principal and interest monthly. The others usually pay interest semiannually. LO 7.c

Another term for municipal overlapping debt is A) defeased debt. B) refunded debt. C) double-barreled debt. D) coterminous debt.

D. In the context of municipal securities, the term coterminous refers to two or more taxing agencies that share the same geographic boundaries and are able to issue debt separately. Overlapping debt occurs when two or more issuers are taxing the same property to service their respective debt. LO 6.b

Your married customers, ages 48 and 50, have a combined annual income of more than $200,000. They are concerned about the effects of rising inflation, and because they are heavily invested in bonds, they seek to invest a portion of their portfolio in a fund that will provide additional diversification. Which of the following mutual funds is the most suitable for these customers? A) NavCo Tax-Free Municipal Bond Fund B) XYZ Government Income Fund C) ABC Investment-Grade Bond Fund D) ATF Overseas Opportunities Fund

D. Investment in an overseas equity fund will provide diversification not necessarily subject to U.S. inflation. The tax-free fund will not provide additional diversification or the best hedge against inflation. A high-grade bond fund will not add diversification. LO 8.g

Which of the following securities is the least suitable recommendation for a qualified retirement account plan account? A) Blue-chip common stock B) Treasury bill C) A-rated corporate bond D) Investment-grade municipal bond

D. Municipal bonds provide tax-exempt interest payments and, consequently, offer lower yields. Because earnings in a qualified retirement plan account grow tax deferred, the municipal bond is not a suitable investment. In addition, they will be fully taxed upon withdrawal. LO 1.g

Revenue bond rate covenants require the user fees to be high enough to cover all of the following obligations of the issuing authority except A) the debt service. B) the operations and maintenance. C) the debt service reserve fund. D) the optional call provisions.

D. Optional call provisions are at the option of the issuer. Because it is not mandatory that the bond will be called, the rate covenants of an issue will not require enough to be collected to cover an optional call on the bonds. It is critical that the user fees be high enough to cover the cost of operations and maintenance. After all, if the issuer doesn't receive enough revenue to pay for the operating cost of the facility or the maintenance expenses, there won't be enough money to pay the debt service. The debt service is the annual interest cost plus and principal repayment. The debt service reserve is like an emergency fund to be sure there is enough money put away to cover the debt service if current revenues are insufficient. For those of you who are familiar with a home mortgage, we can compare these two items (debt service and debt service reserve fund) to the allocation of the monthly mortgage payment. In general, the largest portion of the mortgage payment goes to the debt service, paying the principal and interest (P&I). In addition, there is the portion set aside in the escrow account as a reserve to make sure there are sufficient funds to pay the annual property taxes and insurance. That is a similar concept to the debt service reserve fund. LO 6.c

A purchase or redemption order for investment company shares must be executed at a price based on A) the net asset value computed at the close of trading on the NYSE the day before the fund receives the order. B) the net asset value last computed before the fund receives the order. C) the best net asset value computed the same day the fund receives the order. D) the net asset value next computed after the fund receives the order.

D. Purchase or redemption of mutual fund shares occurs at the first net asset value calculated after the fund receives the order. This is known as forward pricing. LO 8.c

A moral obligation bond is one where A) the U.S. government is empowered, but not obligated to appropriate funds to prevent the bond from going into default. B) the board of directors of the entity is empowered, but not obligated to appropriate funds to prevent the bond from going into default. C) the bondholders are empowered, but not obligated to appropriate funds to prevent the bond from going into default. D) the governing legislature is empowered, but not obligated to appropriate funds to prevent the bond from going into default.

D. The MSRB defines a moral obligation bond as: "A bond that, in addition to its primary source of security, is also secured by non-binding covenant that any amount necessary to make up any deficiency in debt service will be included in the budget recommendation made to the governing body, which may appropriate funds to make up the shortfall. The governing body, however, is not legally obligated to make such an appropriation." LO 6.b

If a customer opens a spread on Canadian dollars (10,000 units) by purchasing 1 Dec 74 call for 2.30 and selling 1 Dec 77 call for 1.50, what is the total cost of this debit spread? A) $700 B) $4,970 C) $80 D) $800

D. The customer pays a premium of 2.30 ($230) and receives a premium of 1.50 ($150) for a net debit of 0.80, or $80. LO 10.g

An agent has recommended investments in the XYZ Fund family to her customers for 10 years. She is referred by one of her customers to a prospect who has inherited $500,000 as the beneficiary of a life insurance policy. The prospect tells the agent he has never invested in the market before, is risk averse, and wants safety of principal to be the first priority, with liquidity second. The agent recommends the following investments: XYZ government bond fund, B shares: $200,000 XYZ large-cap growth and Income B shares: $150,000 XYZ liquid reserve money market: $150,000 The recommendation is

D. The customer's objectives of safety and liquidity are not satisfied by these recommendations. The government bond fund and large-cap growth and income fund are both subject to market risk and, as Class B shares, are subject to a contingent-deferred sales charge in the event the customer wishes to access the funds before the back-end load expires. The back-end load is not consistent with the customer's liquidity objective. LO 8.g

All of the following are suitability considerations when a registered representative recommends a municipal bond purchase to a customer except A) the issuer's debt rating. B) the customer's tax bracket. C) the customer's state of residence being the same as the location of the issuer. D) whether or not the bond is in the broker-dealer's inventory to sell.

D. The customer's state of residence and tax bracket are important because these factors help establish the tax benefits offered by the municipal bond. The issuer's debt rating is important in evaluating the credit risk assumed by the investor. The bond's availability in the dealer's inventory is not a suitability factor. LO 6.c

The ELLA Distributing Company issued a bond with a nominal yield of 5%. The bond matures in 12 years and is currently trading at 94. The bond's yield to maturity is closest to A) 4.64%. B) 5.32%. C) 5.00%. D) 5.67%.

D. The first point to notice is that the bond is trading at a discount. When bonds trade at a discount, our yield chart and example tells us that the yields, in ascending order, are nominal yield, current yield, yield to maturity, and yield to call. That last one is of no relevance to this question because a call feature is not mentioned anywhere. Therefore, we know that the yield to maturity must be greater than the nominal (coupon) yield of 5%. There are only two choices that are, so if you are running out of time or do not remember how to do this, at least you have a 50% chance. However, 50% doesn't pass the exam, so let's make that 100%. The yield to maturity computation is tricky, but current yield is not. It is simply the coupon divided by the current market price. In our question, that is 5% divided by 94 equals 5.32% (or $50 divided by $940). We know the yield to maturity for a bond selling at a discount is higher than its current yield. That means the correct answer must be greater than 5.32%. If you have a question like this on the actual exam, there will be only one choice higher than the current yield. As shown in the LEM, the YTM calculation goes like this: [annual interest + (discount divided by the number of years to maturity)] divided by the average price of the bond Plugging in the numbers, we get a numerator of $50 + ($60 divided by 12 years) = $50 + $5 = $55. The denominator is ($940 + $1,000) divided by 2 = $1,940 divided by 2 = $970. Solve by dividing $55 by $970 and the answer is 5.67%. LO 4.e

An investor opens the following positions: Sell short 100 shares of FEW @80; buy one FEW Jan 80 call @5. What is the customer's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $500; maximum loss is $7,500, breakeven is $75. B) Maximum gain is unlimited; maximum loss is $500; breakeven point is $75. C) Maximum gain is $7,500; maximum loss is unlimited; breakeven point is $85. D) Maximum gain is $7,500; maximum loss is $500; breakeven point is $75.

D. The first step is to identify the position. This is a short sale with a protective call. That is, the customer has shorted the stock and purchased a call to protect the upside. This investor will breakeven when the stock's price is equal to the sale price ($80) minus the premium paid ($5), or $75. Short sellers lose when the price of the stock goes up. That means a short sale has potentially unlimited risk of loss. A way to ensure that the loss is limited is to purchase a call on the stock. If the stock should rise significantly above the $80 received on the short sale, instead of having to cover the short in the market at that high price, the investor will exercise the long call and be able to cover at $80. That means the maximum loss is the $500 premium paid for the protection. If the stock's price falls, and it can decline to zero, the investor's cost to cover is zero, resulting in a profit of $8,000 minus the premium of $500. Why doesn't the breakeven follow the "call-up" rule? That rule applies when the only positions are options. Once there is a long or short stock position along with an option position, it is the stock controlling the breakeven. LO 10.h

If a customer buys 1 XYZ Nov 70 put and sells 1 XYZ Nov 60 put when XYZ is selling for 65, this position is A) a combination. B) a straddle. C) a bull spread. D) a bear spread.

D. The first step is to identify this position. A spread is the simultaneous purchase of one option and sale of another option of the same class (puts or calls). A call spread is a long call and a short call. A put spread is a long put and a short put. On the exam, it is not unusual for there to be a question about a spread that does not contain the premiums. In this case, we have a put spread, and all we are shown is the strike prices. In the case of a put (the ability to sell stock), the higher the strike price, the more valuable the option. Therefore, we know the 70 put will have a higher premium than the 60 put (wouldn't you rather be able to sell XYZ at 70 instead of 60)? That makes the option purchased (the 70) cost more than the one sold (the 60), resulting in a debit spread. A debit spread is a net buy, while a credit spread is a net sale. Therefore, a debit put spread is like buying a put, which is bearish. LO 10.d

The management fees paid by an investment company are part of A) the custodial fees. B) the sales load. C) the underwriting agreement. D) the operating expense of the fund.

D. The management fees paid by an investment company are part of the operating expenses of the fund. Custodial fees are also part of the operating expenses. A sales load is a selling cost contained within the underwriting agreement. LO 8.i

An investor opens the following position: Buy 1 COD Jan 40 put at 6.50 Write 1 COD Jan 30 put at 2.10 His maximum loss is A) $2,100. B) $560. C) $2,600. D) $440.

D. The maximum loss on a debit spread is the net debit. LO 10.e

An investor wishes to invest $5,000 into the KAPCO Balanced Fund, an open-end investment company. How many shares will the investor receive if the next computed NAV per share after receipt of the order is $41.30 and the fund has a sales charge of 4%? A) 121.065 B) 43.021 C) 116.414 D) 116.225

D. The investor will pay the POP (public offering price) of $43.02 per share. That price is computed by dividing the NAV of $41.30 by (100% ‒ 4%). Remember, the 4% sales charge is a percentage of the offering price, not the NAV. Dividing the $5,000 investment by the POP of $43.02 results in a purchase of 116.225 shares. LO 8.d

A customer buys five municipal bonds maturing in 20 years for 104. If he sells the bonds after 10 years at 103, the customer has A) a $50 capital gain. B) a $50 capital loss. C) a $100 capital loss. D) a $100 capital gain.

D. The premium on the municipal bonds must be amortized. The tax rules require that when you purchase a bond at a premium, you have to reduce the cost basis of the bond each year. Even though there are five bonds in the question, here's the math on one bond and then we'll multiply by five to get the total amount. The investor buys the bond at 104 or $1,040 and the bond is due to mature in 20 years. Take the $40 premium divided by the 20 years to maturity and that will tell us the amount that we amortize/reduce the cost basis by each year. $40/20=$2. It then tells us that the bond is sold after 10 years. Ten years of amortization is $2 per year x 10 years = $20. That lowers the basis of the bond to $1,020 ( $1,040 - $20 = $1,020). The bonds are sold at 103 or $1,030, so the gain is $10 per bond times five bonds for a total gain of $50. LO 6.e

In a scenario of falling interest rates and a positive yield curve, assuming all to be of equal face value, which of the following bonds will appreciate the most? A) 1-year bond selling at a premium B) 20-year bond selling at a premium C) 1-year bond selling at a discount D) 20-year bond selling at a discount

D. This is all about duration. The longer the duration, the greater the price volatility of the bond. That is why prices of long-term bonds are more volatile than prices of short-term bonds. We know from the inverse relationship between bond prices and interest rates that falling interest rates lead to higher bond prices. Therefore, the 20-year bonds will appreciate more than the 1-year bonds when interest rates fall. Also, prices of bonds with low coupon rates tend to be more volatile than prices of bonds with high coupon rates because they have a longer duration. A bond sells at a discount when its coupon is lower than prevailing interest rates. Because of its lower coupon, the 20-year discount bond tends to appreciate more than the 20-year premium bond. LO 4.e

An investor with no other positions sells 4 DWQ Jun 45 calls at 4. The calls are exercised when the stock is trading at 47.25. What is the investor's profit or loss? A) $175 loss B) $175 profit C) $700 loss D) $700 profit

D. When the calls were exercised, the investor had the obligation to sell the stock to the owner of the call at 45. Because the investor had no other positions, we know that to fulfill the obligation to sell, they will first need to purchase the stock in the open market for 47.25. 4 was received when the call was sold, and 45 was received when the stock was sold to the owner of the call. Therefore, a total of 49 was received. 47.25 had to be paid to purchase the stock in the open market. Therefore, 47.25 paid and 49 received equals 1.75 point profit ($175) per contract. $175 × 4 contracts = $700 total profit. Here's how it looks on a t-chart: Sell 4 45 calls @ 4 = $1,600 (4*4) Credit ($ coming in) Exercised 4 calls @ 4 = $18,000 (45*4) Credit ($ coming in) Buy 400 shares @ 47.25 = $18,900 Debit ($ going out) Total Credit = $19,600 Total Debit = $18,900 Net profit - $700 LO 10.h

An investor opens the following positions: Sell short 100 shares of BAF @61; short 1 BAF Sep 60 put @3¼. What is the customer's maximum gain, maximum loss, and breakeven point? A) Maximum gain is $5,775; maximum loss is $425; breakeven point is $64.25. B) Maximum gain is $425; maximum loss is $5,775; breakeven point is $57.75. C) Maximum gain is $425; maximum loss is unlimited; breakeven point is $64.25. D) Maximum gain is $325; maximum loss is unlimited; breakeven point is $57.75.

The first step is to identify the position. This is a short sale of stock and a sale of a put option. The sale of the put provides some income and offers protection only to the extent of the premium. Short sellers want the stock's price to decline. They lose when it rises. The investor has received $6,425 ($6,100 from the sale of the stock and $325 from the sale of the option). That makes the breakeven point $64.25 per share. Once the price of the BAF stock goes above that, the investor loses money. Because there is no limit as to how high the stock's price can go, the maximum loss is unlimited. If, on the other hand, the stock's price declines into the 50s or lower, the owner of the 60 put will exercise and our investor will pay $6,000 to purchase the stock. That stock will be used to cover the short sale. That means the investor sold the stock (short) at $61 and bought it back at $60 for a gain of $100. At that point, the investor's profit is the $325 from the premium on the sale of the put plus the $100 gain (the difference between 61 and 60). That is why the maximum gain is $425. Why doesn't the breakeven follow the "put-down" rule? That rule applies when the only positions are options. Once there is a long or short stock position along with an option position, it is the stock controlling the breakeven. LO 10.h