Series 7 Study Guide Navigation
- Series 7 Study Guide Home
- 1.1 Contact with potential and current customers, marketing material development, approval, and distribution
- 1.2 Describing investment products to potential and current customers
- 2.1 Tells potential customers about the account types available and discloses their restrictions
- 2.2 Secures and updates information about customers along with relevant information and documents
- 2.3 Gather customer investment profile information
- 2.4 Get necessary supervisory approval to open accounts and make account changes
- 3.1 Passing on all investment strategy information to customers
- 3.2 Analyze customer’s portfolio of investments as well as product options to determine suitability
- 3.3 Disclose to clients characteristics and risks of investment products
- 3.4 Communications with customers
- 4.1 Providing current quotes for investors
- 4.2 Processing and confirming customers’ transactions as per regulations
- 4.3 Notifies the correct supervisor, helps with solving discrepancies, disputes, errors, and all complaints
- 4.4 Dealing with margin issues
Give clients information regarding disclosures linked to the different characteristics of various investment products, the risks associated with them as well as the services offered and expenses charged
In this section of Module 3, we are specifically looking at how registered representatives must provide clients with various critical pieces of information.
This relates to various disclosures about the investment products they offer and the risks associated with them.
Required disclosures and risk types
When we talk about risks, these are borne by not only the investors but businesses too.
In this section, we are going to be looking at the most common risks that you should know about that might appear on the Series 7 exam.
But what is a risk in the world of securities?
Well, it’s anything that can stop an investment from not meeting its expected rate of return.
These risks can be defined into two categories:
- Systematic risk
- Unsystematic risk
These will be addressed individually along with customer-specific risks all registered representatives need to understand.
Types of risk: Systematic risk
What is systematic risk and how does it affect an investment’s return?
Well, while all investments have some form of risk (even the safest ones), generally systematic risk is going to affect those that one would consider riskier.
And that’s because this risk relates to macroeconomic factors that can affect investments.
To put it simply, these macroeconomic factors are related to changes in the economy that could have a negative effect on individual securities.
This is despite how financially healthy the issuer of those securities might be.
Note that these factors aren’t those that will affect all businesses, for example, global security issues, inflation, or even war.
Instead, systematic risk includes the likes of:
- Market risk
- Interest rate risk
- Reinvestment risk
- Purchasing power risk
These are also sometimes referred to as nondiversifiable risks.
That’s because, even through portfolio diversification, these risks cannot be avoided.
Let’s look at those systematic risks individually, starting with market risk.
Securities will lose value when the market falls away.
There have been countless examples of this over the years, just think of the stock market crashes like those from 1929, 1987, the early 2000s, and 2008.
As a result, securities were less valuable after the crash than before.
Again, we have to mention stock portfolio diversity.
It’s not going to help in this situation at all because ALL securities will be affected.
There is protection that investors can take to combat market risk and that’s through correlation.
This means having securities in a portfolio that will actually go up should the market go down.
These are known as negatively correlated securities.
When measuring market risk, it’s done by looking at a securities beta.
The second systematic risk to consider is interest-rate risk.
As we know, when it comes to interest rates, they are forever moving up and down.
When they are higher, either because of the Federal Reserve or market conditions, bond market prices will drop, which makes this a systematic risk.
Common stock prices can be bearish as well should this happen, especially for public utilities or other highly leveraged companies.
Again, diversification offers no protection from interest-rate risk as all bond prices will rise should this occur.
All types of fixed-income investments are susceptible to interest rate risk.
Also, the overall credit quality of a bond places no part in its ability to withstand a drop in price due to interest rate risk.
The Series 7 exam might mention common stock investments that are subject to interest-rate risk as well, for example, a public utility company’s common shares.
They are interest-rate sensitive because:
- Liberal dividend policies are associated with public utility stocks. Their dividend yield determines their price, so their stock prices go down as interest rates go up.
- Because they regularly borrow money, public utility companies are highly leveraged. This means that their borrowing cost will go up as interest rates rise. As a result, income is lowered and dividends may therefore be reduced as well.
Can interest-rate risk be reduced?
Yes, it can be and that’s by either laddering a portfolio.
This means buying bonds with different maturity times all at the same time.
These different maturities are like a ladder’s steps.
Shorter maturities are reinvested as soon as they become due and therefore turn into long-term maturities.
Another risk is reinvestment risk.
When it comes to reinvestment risk, there are two separate types to discuss.
- Reinvestment risk related to interest
- Reinvestment risk related to principal
A periodic cash (income) received from an investment may not be able to be reinvested at the same rate as paid by the security.
Because they have nothing to reinvest, zero-coupon bonds are a way to overcome reinvestment risk.
At maturity, this reinvestment risk can occur as well.
Purchasing bonds with a longer period to maturity can have advantages, however.
That’s because the fixed return the investor receives is right up until the point it matures far in the future.
Lastly, we have inflation risk or as it is often called, purchasing power risk.
When inflation rises, the buying power of the dollar diminishes.
That doesn’t mean it’s inherently bad.
In fact, in all growing, healthy economies, there is going to be inflation, it’s just that ideally it should be kept low.
It’s when it’s uncontrolled and spiraling upwards that inflation can be a problem as it creates uncertainty.
That’s not only uncertainty for investors looking to buy securities but for corporate managers as well.
That’s because uncontrolled inflation will make estimating the potential returns on various investment projects extremely difficult.
But there are investment types that are designed to work effectively, even when inflation levels are fluctuating and that’s TIPS which we spoke about earlier.
Also, while the most vulnerable securities to inflation risk are fixed-income securities, the least vulnerable according to historical data, are equity securities.
Other excellent hedges against inflation risk are gold and real estate.
Types of risk: Unsystematic risk
While unsystematic risk can be a problem for investors, unlike systematic risk, there is a way to help combat it and that’s through diversification of an investment portfolio.
But what are unsystematic risks?
Well, for the most part, when looking at a particular business or even a type of industry, there are the risks that are unique to that.
For example, in the manufacturing industry and for companies that make shares available to investors, an unsystematic risk could be labor union strikes.
Unsystematic risks could also include failure of a product or lawsuits against a company for any particular reason.
There are numerous types of unsystematic risk and we will look at each of them in a little more detail.
- Business risk
- Financial risk
- Regulatory risk
- Legislative risk
- Political risk
- Sovereign risk
- Liquidity risk
- Exchange (currency risk)
We start with business risk.
When we talk of business risk, this usually deals with bad decisions made by a company.
Think of Motorola having 22% of the cell phone market share in 2006 with their Razr model but not anticipating the giant leap that smartphones would make in the following years.
By the time they reacted, it was too late, and in three years between 2006 and 2009, share prices fell by 90%.
In the worst-case scenario, companies can go bankrupt and investors could lose everything.
Then we have financial risk.
It’s easy to get financial and business risks confused and they are similar.
Financial risk, however, is all about debt financing reaching a point where a company cannot pay its debt obligations.
This could lead to a total loss for investors should the company go bankrupt because of it.
This is also known as default or credit risk.
Next, we have regulatory risk.
This sees businesses and even industries severely affected by changes in government regulations, for example.
This could be changes in trade laws, tax policies, environmental regulations, and more.
What about legislative risk?
While this is commonly linked to regulatory risk, there is a difference.
Legislative risk is linked to actual law changes, not just changes in regulations.
Because this can be politically motivated in some cases, legislative risk is also called political risk.
The easiest way to explain a legislative risk would be a change to the tax code, for example.
Political risk is another type of risk that must be considered.
Again, it’s a risk type that could be seen as similar to regulatory or legislative risk.
The source of this is different from those, however.
While political risk could result in changes and regulations and laws, it’s the underpinning political aspect that we are worried about here.
For example, suppose a company has invested in a foreign country that’s not very stable from a political standpoint.
An example of a political risk in this situation would be the threat of a coup.
Another example would be when industries are nationalized.
This would see investors in those industries lose everything.
This is often a threat in emerging markets.
That doesn’t mean more sophisticated markets are exempt from the threat of political risk, however.
When a country might default on not paying its commercial debt, this is known as sovereign risk.
In cases like this, the overall credit rating of the country might be reduced which could impact markets.
Liquidity risk is very real in the world of securities.
There’s nothing worse for an investor than having a certain type of security and not being able to sell it when you want to just because no one is interested in buying it.
Remember, the ease of converting your investment to cash by selling it without affecting an overall disruption on the overall price is liquidity.
For exam purposes, this also might be referred to as marketability risk.
As an example, if we compare a Treasury bill to a real estate investment, the first is highly liquid while the latter isn’t.
There’s nothing wrong with investing in securities that are not liquid at all, like real estate, it’s just that these are long-term investments and not ones that can be turned over quickly.
Liquidity risk increases the longer it takes to move from an investment to cash (without selling something for well below its expected price).
When it comes to securities that offer virtually no liquidity risks, municipal funds, and listed stocks are the best option.
The final risk we are going to look at as part of unsystematic risks is that of currency risk.
This is also known as exchange rate risk.
This affects investors that are buying foreign securities.
They can do this either through American Depository receipts (ADRs) or directly.
The fluctuation in foreign currencies, however, can affect these investments.
Obviously, this type of unsystematic risk will only affect investors who choose to trade in foreign securities.
For those sticking to local ones, currency or exchange rate risk is not something that they need to worry about.
Disclosure is a core part of what a registered representative does when dealing with clients.
That’s true when it comes to risk disclosure too.
A potential investor needs to know all the details about a security that they might be interested in investing in, including any potential risks that it could have as we have described above.
We’ve mentioned risk disclosure documents numerous times.
Here’s some other critical information that it should include.
First, it should make mention of control relationships.
It’s from this that serious conflicts of interest will arise.
But what is a control relationship exactly?
Well, when the entity that issues securities owns the broker-dealer dealing with them or they are both under common ownership to another company, in both cases, that’s called a control relationship.
Should a broker-dealer own the entity that issues securities, that’s also a control relationship.
It’s easy to see how this could be something that an investor should be told about, right?
These relationships do exist and as long as they are disclosed to investors, there isn’t a problem if they do.
Various conflicts of interests could result because of these types of relationships, however.
These should always be disclosed to investors which then allows them to make an informed decision about the types of securities they want to invest in.
Here are some examples of the types of conflicts of interest that may occur:
- Offering investors a house fund or other proprietary products. This is a mutual fund where there is any affiliation between the underwriter or adviser and the broker-dealer
- Offering investors a DDP and the broker-dealer is sponsored by an affiliate
- Rewards or incentives for registered representatives selling products from a program sponsor of an investment company
- When the security offered to an investor is the same that a registered representative has a financial interest in
- Placing shares of their own stock in discretionary accounts when a broker-dealer goes public
- After they have underwritten an issuer’s stock offering, a broker-dealer publishes a research report that places it in a favorable light
These are just examples, when in doubt always make a full disclosure to a potential investor.
In the Series 7 exam, you might be tested on this by asking if disclosure is necessary to a client when you are selling shares for a company in which a family member is the chief financial officer.
Of course, the answer to this is a resounding yes!
While on the subject of control relationships and the disclosure that should take place as a result of them, let’s talk about regulation full disclosure (FD), a rule as set out by the SEC.
This is all about disclosure of information again but specifically information that can have an influence on the price of the stock in question.
Today, most regulation full disclosures result from unintentional leaks.
The rule was implemented, however, because in the past, passing on critical information could certainly benefit some parties.
Should an FD happen, before the next trading day, a disclosure must be made by the issuer.
These disclosures can be carried out through:
- Public conference calls
- Press releases or press conferences
- And other methods as agreed upon by the SEC
By obtaining a large percentage of voting shares, one company may try to takeover another in what is known as a tender offer.
When there is a fall in interest rates an issuer of noncallable bonds may also make a tender offer.
This is the best solution for retiring older bonds with higher interest rates because they do not have a call option.
When equity securities are involved, the go-ahead from shareholders is a must if a tender offer is to occur.
Note that because of their nature, adequate disclosure to clients is necessary where tender offers are involved.
And it can result in a very good deal for them.
That’s because based on the latest trade, it often takes place at a premium.
Note, however, that there is a time limit involved as well when it comes to informing clients of tender offers.
As for the Series 7 exam, here are some important facts that could be tested:
- SEC regulation 14 E states that from the date the offer was first announced, it must remain open for 20 business days unless it has been withdrawn
- When tender offers are revised, it remains open for a period of 20 business days as well as 10 business days for the dates on which the terms were revised.
- Shareholders of the company targeted by the tender offer must provide shareholders with information as to whether they will accept or reject it, or if they have no opinion on it, or that the company cannot take a position on it. This information must be made to shareholders within 10 business days of the announcement of the tender offer.
Note that short-tendering is never allowed.
While the target company shareholders are allowed to tender shares of their net long position, shares that they do not own cannot be sold back to the company.
When long a stock, a customer owns the stock, a convertible security with conversion instructions issued or a call option with excise instructions issued.
While on the subject of risk disclosure, let’s quickly chat about SEC Rule 10b-18.
While this probably won’t come up in the exam, it’s useful to look through it.
It specifically covers when their own stock is bought back by the issuer on the open market.
This rule will apply should they opt for this course of action.
Here are two points about the rule that you should know:
- The opening or closing of the security cannot be affected by these buy backs. This means that in the first trade of a day or the final 30 minutes of trading, the issuer cannot trade on that specific security.
- Transaction prices for the issuer are not allowed to be higher than the highest of either the last reported sale price or the highest independent bid.
Lastly, we need to mention the margin risk disclosure document.
This is just a reminder that a risk disclosure document must be made available to clients whenever a client is going to open a margin account.
Make sure you understand all about this document as it will appear often in the Series 7 exam.
Senior exploitation rules
This short section covers some of the actions a registered representative is expected to take should they like to determine whether a senior client’s account is being exploited.
When it comes to specified adults, such as seniors, due diligence must be paid by FINRA member firms and the associated persons that deal with them.
Sadly, this is a vulnerable group of investors that can easily be scammed, and often it’s by their own family members.
But what is financial exploitation as far as FINRA is concerned?
- The wrongful use, unauthorized taking, appropriation, or withholding of the funds or securities of a specified adult
- An act of omission, for example, guardianship or the power of attorney taken by a person with regard to a specified adult that will gain control of their property, money, or assets through intimidation, deception, or undue influence or convert that adult’s property, assets or money.
To help stop situations like this, a number of steps can be taken including:
- The needs of these clients should be addressed by following clear written procedures and instructions
- If exploitation is suspected, a clear plan should be made available to registered representatives outlining the steps to follow to escalate the concern
- Understand all the regulations surrounding exploitation, not only those from FINRA but also various state rules as well as those set out in the Senior Safe Act.
- Ensure registered representatives receive continual training on the subject. This includes what to look for to spot exploitation and more.