- A registered representative of a FINRA member firm is going to present a seminar on retirement planning. It will be a slide show, and no specific advice will be given. The expected attendance is approximately 50 people. Under the FINRA rule on communications with the public,
- The slides are considered a retail communication and need principal approval before first use
- A registered principal is required to attend to ensure that the standards of ethical conduct are maintained
- This seminar can take place only if the recommendations are tailored to the specific needs of the audience
- This is a public appearance and no approvals are necessary
Correct answer: The slides are considered a retail communication and need principal approval before first use
Under the FINRA rule on communications with the public, it is only an unscripted presentation that needs no principal approval. The use of slides changes things, and once more than 25 individuals will see them within a 30-calendar-day period, those slides are retail communications. As such, principal approval is required. Because the question states that no specific advice will be given, suitability of recommendations is irrelevant. However, all presentations at seminars should consider the nature of the audience and keep the presentation at the appropriate level.
- An increasing percentage of registered representatives of FINRA member firms are using social media to increase their business. When using social media to reach out to clients and prospects, compliance with FINRA rules requires
- Oversight limited to notes aimed at current account owners
- Approval by a principal and supervisor before each posting
- Firm supervision of postings sent to clients and prospects
- Advance filing with FINRA of all public promotional pieces
Correct answer: Firm supervision of postings sent to clients and prospects
Social media is electronic communication with the public, so a member firm must supervise it whether the audience is an existing client or a prospective one; retail communication is expressly defined to include prospective customers, which is why oversight limited to current account owners falls short. Most social media is not filed with FINRA in advance, and real-time interactive posts are supervised rather than approved by a principal beforehand.
- FINRA Rule 2210 deals with communications with the public. The rule classifies these communications into three different categories. Which of the following is not one of those categories?
- Advertisements
- Retail communications
- Institutional communications
- Correspondence.
Correct answer: Advertisements
Advertising is not one of the three categories. When FINRA rewrote the old rule, it removed the term advertising and sales literature.
- Which of the following statements is true?
- Institutional material needs no prior principal review when staff are trained on procedures
- Correspondence shall receive prior principal approval before it is sent to retail investors
- Each institutional message requires prior principal approval before it is ever first issued
- Retail communications require no advance principal approval after they are filed with FINRA
Correct answer: Institutional material needs no prior principal review when staff are trained on procedures
A member has a choice for institutional communications: review them before use, or train associated persons in the firm's institutional communication procedures, document that training, and follow up with surveillance. The training alternative removes the prior principal review requirement, so a blanket statement that every institutional message needs advance approval is wrong. Correspondence is subject to supervisory review procedures rather than pre-approval of each item, and filing a retail communication with FINRA never replaces the principal approval that must come before its use.
- A registered representative is reading an article in a popular magazine about the advantages of tax deferral in retirement planning. There is a note that reprints of the article are available. In order to send these reprints to existing and prospective customers,
- Principal approval and firm review must occur within ten business days of issue
- The name of the sponsoring underwriter has to appear beside the reprint heading
- A copy of this reprint must reach FINRA advertising regulation before first use
- Firm changes to the text are limited to factual errors and regulatory standards
Correct answer: Firm changes to the text are limited to factual errors and regulatory standards
The article is an independently prepared reprint. The member may not rewrite it: changes are confined to correcting factual errors and making the piece consistent with applicable regulatory standards. Approval by a principal comes before first use, not within ten business days after it, and independently prepared reprints are not filed with FINRA advertising regulation. If the publisher had been paid by an issuer or underwriter the piece could not be used at all, so printing that sponsor's name beside the heading would not cure the defect.
- After a mutual fund's 10th year, performance statistics must show results for each of the following periods except
- 5 years.
- 10 years.
- 1 year.
- 3 years.
Correct answer: 3 years.
Mutual fund performance statistics must show results for one, five, and 10 years, or for the life of the fund—whichever is shorter.
- The latest issue of a newsletter your firm subscribes to is especially relevant to one of your firm's investment products. If you decide to send it to clients and prospects, you must disclose that
- Future articles sent will provide similar discussions and information
- The newsletter discusses only those products that you have available through your firm
- The newsletter's purpose is to provide clients with a choice of products that are suitable for everyone's portfolios
- The newsletter is written and produced by a third party
Correct answer: The newsletter is written and produced by a third party
If a third party is the creator of the newsletter, that fact must be disclosed, along with the name of the third party and the date of publication.
- The FINRA rule on communications would consider communications that are posted on an online interactive electronic forum (i.e., a chat room) to be
- Institutional communications
- A public appearance
- Retail communications
- Correspondence
Correct answer: Retail communications
This type of communication is included in the definition of retail communications. FINRA Rule 2210 treats interactive electronic forum posts, such as social media status updates, as retail communications rather than public appearances. However, unlike most retail communications (and similar to public appearances), the rule specifically excludes these posts from both the principal pre-use approval requirements and the filing requirements. That does not mean member firms should not monitor the activities of their associated persons, but that is a real world situation and we're sticking with what the test covers.
- A registered representative has been doing some research on his own. He would like to share the information with some of his clients and sends an email to 15 of them. He also has some prospects he's been working on and sends the email to 12 of them during the same week. Under the FINRA rule on communications with the public, this would be considered
- Retail communication
- Exempt from the principal approval requirements
- Correspondence
- An electronic communication
Correct answer: Retail communication
FINRA defines a retail communication as "any written (including electronic) communication that is distributed or made available to more than 25 retail investors within any 30-calendar-day period." It is important to understand that retail investors includes current and prospective customers. Because this report will be sent to 27 within the 30-calendar-day period, it fits the definition. Like virtually all retail communications, principal approval is necessary before it is used. Is this an electronic communication? Yes it is, but the exam will want the more specific response—retail communication.
- FINRA Rule 2210, communications with the public, describes several different categories of communications. One of those categories is called
- Email
- Public appearances
- Social media
- Correspondence
Correct answer: Correspondence
The three categories of communications with the public are correspondence, institutional communications, and retail communications. The other choices shown here may fit into one of those categories but are not a distinctive category in the rule.
- A registered representative reproduced a research report prepared by an independent research analyst on his broker-dealer's letterhead, with no mention of the party who prepared the report. If this literature is forwarded to a select group of clients only, the registered representative's action is
- Allowed with the written approval of a principal of the broker-dealer
- Allowed only if the research report has been filed with FINRA
- Allowed
- Not allowed
Correct answer: Not allowed
A broker-dealer is prohibited from presenting to a client research reports, analysis, or recommendations prepared by other persons or firms without disclosing that they were prepared by a third party.
- Each of the following is a category of communication with the public designated by FINRA except
- Market letters
- Institutional
- Retail
- Correspondence
Correct answer: Market letters
The three categories of communication with the public designated by FINRA are retail, correspondence, and institutional. Market letters, as with other pieces of sales or advertising, can fall under any of the three communication categories, depending on to whom they are sent or made available to and the number of recipients.
- Which of the following would not be considered institutional communications with the public?
- A letter sent to another broker-dealer about a pending bond issue
- A firm's internal memo circulated to its own licensed sales staff
- A note offering underwriting help to a rural water agency's board
- A message sent to the party designated by an institutional client
Correct answer: A firm's internal memo circulated to its own licensed sales staff
Institutional communications are written or electronic communications distributed to institutional investors, and the definition expressly excludes a member's internal communications. A memo that circulates only among the firm's own sales staff never leaves the firm, so it falls outside the category. Another broker-dealer, a municipal entity such as a rural water agency, and a person designated to act on behalf of an institutional customer are all institutional investors, so communications with any of them are institutional communications.
- All of the following would be considered either retail communications or correspondence except
- An email to several municipalities sent out in a single day offering your firm's services for underwriting their municipal securities
- A written communication to all of the firm's customers regarding a new mutual fund being offered
- A letter to 10 individual investors within the past week regarding a new investment strategy
- An electronic communication distributed through the firm's website regarding potential opportunities with the firm as a registered representative
Correct answer: An email to several municipalities sent out in a single day offering your firm's services for underwriting their municipal securities
Communications with government entities, which includes municipalities, fall under the heading of institutional communications. The others are all examples of either retail communications or correspondence, depending on how many recipients there are within a 30-calendar-day period. (Retail equals more than 25 retail investors within any 30-calendar-day period, and correspondence is 25 or fewer retail investors within any 30-calendar-day period.)
- Correspondence—one of the three categories of communication with the public—is defined as
- Written or electronic notes reaching 25 or fewer retail investors in 30 days
- Paper circulars alone that travel to 25 or fewer subscribers over six months
- Digital messages alone that travel to fewer than 26 new clients each quarter
- Any publication or posting going to more than 25 retail investors each month
Correct answer: Written or electronic notes reaching 25 or fewer retail investors in 30 days
Correspondence is any written communication, including electronic, distributed or made available to 25 or fewer retail investors within any 30 calendar-day period. Both the medium and the window matter: the definition is not confined to paper and not confined to electronic messages, and neither a six-month nor a quarterly measuring period appears in it. Passing the 25-investor threshold does not create a longer window either; it moves the piece out of correspondence and into retail communications.
- Communications with the public include all of the following except
- A market outlook piece mailed to the larger institutional accounts
- A televised interview given by the firm's chief investment officer
- A magazine reprint forwarded to the firm's active retail customers
- A new mutual fund factsheet published for internal sales personnel
Correct answer: A new mutual fund factsheet published for internal sales personnel
Communications with the public are correspondence, retail communications and institutional communications, and a member's internal communications are excluded from all three. Material about a new fund that is published for the firm's own sales personnel never leaves the firm, so it is internal rather than public. Institutional sales material sent to the firm's institutional accounts, an officer's televised appearance, and an independently prepared reprint forwarded to customers all reach persons outside the firm and are therefore communications with the public.
- All of the following are unlawful except
- Letting a customer purchase a newly offered security using margin credit
- Telling a purchaser in writing about the dealer's own principal capacity
- Telling a purchaser that the SEC has authorized this registered security
- Leaving out a material fact while recommending an issuer's bond purchase
Correct answer: Telling a purchaser in writing about the dealer's own principal capacity
A broker-dealer must disclose its capacity to the customer in writing on the confirmation, so telling a purchaser that the dealer acted as principal is precisely what the rules require. New issues may not be bought on margin. The SEC does not approve, authorize or endorse any security, broker-dealer or registered person, and representing otherwise is unlawful. Omitting a material fact in connection with the purchase or sale of a security is fraud, and a recommendation to buy an issuer's bonds is no exception.
- A testimonial used by a member firm in connection with retail communications must state all of the following except
- The qualifications of the person giving the testimonial if a specialized or experienced opinion is implied
- That past performance is not indicative of future performance and that other investors may not obtain comparable results
- The fact that compensation was paid to the person giving the testimonial if more than $100 in value was paid
- The time period covered by the testimonial
Correct answer: The time period covered by the testimonial
The specific time period the testimonial is relating to is not a disclosure item. If a member uses a testimonial in its retail communications, the following rules apply: if more than $100 in value is paid for the testimonial, you must state the fact that it is a paid testimonial; the communication must not suggest that past performance (or the personal experience of the person making the testimonial) is an indication of future performance; and if the testimonial implies that the person is making the statement based on special knowledge or experience, the communication must state the person's qualifications. ** This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- FINRA's rule on communications allows member firms to use testimonials in retail communications as long as certain disclosures are made. Among those disclosures is
- Indicating that if any compensation is paid for the testimonial, the fact that it is a paid testimonial
- Indicating that if more than $100 in value is paid for the testimonial, the fact that it is a paid testimonial
- Indicating that if $100 or more in value is paid for the testimonial, the fact that it is a paid testimonial
- Indicating that if less than $100 in value is paid for the testimonial, the fact that it is a paid testimonial
Correct answer: Indicating that if more than $100 in value is paid for the testimonial, the fact that it is a paid testimonial
Retail communications or correspondence providing any testimonial concerning the investment advice or investment performance of a member or its products must prominently disclose that if more than $100 in value is paid for the testimonial, the fact that it is a paid testimonial. Would the exam ever want you to know that it is more than $100 rather than $100 or more? Yes. ** This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- A FINRA member firm sends a promotional piece to 35 individuals over a three-day period. Twenty of these individuals are current customers of the firm. The other 15 are prospects whose names came from a commercially available mailing list service. Under the FINRA rule on communications with the public, this promotional piece would be considered
- Correspondence to the existing customers, retail communication to the prospects
- Direct mail
- Retail communication
- Correspondence
Correct answer: Retail communication
Retail communication means any written communication that is distributed or made available to more than 25 retail investors, whether current or prospective customers within any 30-calendar-day period. The fact that some of the recipients are customers and others are prospects is irrelevant. It is simply the number of people during the 30-day period.
- Which of the following do not represent communications with the public?
- Research reports
- Market letters
- Billboards
- Internal memos
Correct answer: Internal memos
Each of the terms qualifies as either a form of advertising or sales literature except internal memos, which are communication pieces intended only for use within the broker-dealer and not for public distribution.
- A registered representative of a FINRA member firm uses her personal smartphone to send a client a text message about a security in the client's portfolio. This practice is
- A personal message and does not come under the FINRA rules on communications with the public
- Considered a retail communication and must have principal approval
- Not permitted under FINRA rules; all electronic communications must be on company-owned devices
- Considered an electronic communication and must be reviewed by a principal
Correct answer: Considered an electronic communication and must be reviewed by a principal
Although many member firms do not permit use of personal devices, that is a firm's decision, not a FINRA rule. When permitted, a single message like this is considered correspondence delivered electronically. As with all correspondence, review by a principal is required. This review may be on a pre- or post-use basis. A text message sent to more than 25 persons within a 30-day period becomes retail communication.
- Lorne Walters is a registered representative with Pecuniary Profits Securities, PPS, a FINRA member firm. Walters has decided to conduct virtual meetings using a system called Xoom. Because he has never used the system before, Walters decides to make a trial run of his securities presentation to six family members who are PPS customers. All of these family members are accredited investors. Which of the following choices best describes this situation?
- Prior approval of PPS may be required, but it is not mandated by FINRA for this public appearance.
- Walters may not recommend securities during the presentation, unless a principal of PPS provides prior approval.
- This constitutes an institutional communication to accredited investors and does not require preapproval by a principal of the firm.
- The virtual meeting may not be archived for later viewing.
Correct answer: Prior approval of PPS may be required, but it is not mandated by FINRA for this public appearance.
The virtual meeting is defined as a public appearance. Prior approval of a broker-dealer is not mandated by FINRA but may be required by the broker-dealer. An associated person of a broker-dealer may make a recommendation of a security in a public appearance but must have a reasonable basis for the recommendation. Individual accredited investors are not institutional investors unless they have assets of at least $50 million, and there is nothing in the question to indicate that is the case with these customers. If such electronic presentations are recorded, the recording must be preserved for a minimum of three years.
- A registered representative wants to place advertisements in his daughter's youth athletic league quarterly sponsorship booklet and in the weekly bulletin at his church describing that he specializes in retirement planning and 529 plans. Which of the following statements regarding these advertisements is true?
- Preapproval by a principal of the broker-dealer is required.
- The piece will be regulated as correspondence because it is only being forwarded to two organizations.
- The advertisement is considered institutional communication because it is placed in literature being distributed by organizations such as the youth athletic league and the church organization, and therefore, no principal preapproval is required.
- No approval is required because both the youth athletic league and the church would be recognized as bona fide nonprofit organizations by the IRS.
Correct answer: Preapproval by a principal of the broker-dealer is required.
Any piece promoting securities services and/or products intended to be received by more than 25 retail customers within any 30-calendar-day period must be preapproved by a principal before use. Given the intended placements of the piece, there is no way to determine the exact number of retail customers who will be exposed to it and within what time frames; therefore, it must be regulated as retail communication. It does not fit the definition of correspondence or institutional communication.
- FINRA Rule 2210, communications with the public, has a number of filing requirements. Some communications are prefiled, others are postfiled, and some are excluded from filing with FINRA. Included in the list of exclusions would be retail communications
- That do no more than identify a national securities exchange symbol of the member or identify a security for which the member is a registered market maker
- That do no more than identify and recommend a specific registered investment company or family of registered investment companies
- That do not make any financial or investment recommendation, but only promote a service offered by the member
- Dealing with specific index funds that previously have been filed with FINRA and that are to be used, with the only change being a recommendation of index exchange-traded funds from the same sponsoring organization
Correct answer: That do no more than identify a national securities exchange symbol of the member or identify a security for which the member is a registered market maker
A communication limited to identifying the member's exchange or market-maker symbol is excluded from the FINRA filing requirements. A communication that identifies and recommends a specific investment company or companies must be filed. When previously filed material is used, no filing is necessary as long as there is no material change. However, changing from recommending specific funds to specific ETFs is a material change and would require filing. A retail communication promoting a service offered by a member firm is a communication that would likely need filing with FINRA.
- A registered representative is preparing a PowerPoint slide presentation, to be delivered in a live seminar, for a group of invited institutional clients. To use the slides, they may have to be
- Reviewed by a principal of the broker-dealer
- Submitted to both FINRA and the SEC for preuse approval
- Submitted to the SEC for review and approval
- Approved by FINRA in writing
Correct answer: Reviewed by a principal of the broker-dealer
Communications material that is intended for use with institutional customers only need be supervised and reviewed by a principal of the member firm. Alternatively, if the member's procedures do not require review of institutional communications, they must include a provision for the education and training of associated persons so that they will understand the firm's requirements. Though FINRA can request spot checks of any material used to communicate with the public, submission of institutional communications to FINRA or the SEC for review or approval is not required.
- If another member broker-dealer has already received clearance from FINRA for a retail communication, filing the piece with FINRA so that your broker-dealer can now use it
- Must be done 10 days before your broker-dealer can use it, even if unaltered
- Is not necessary if unaltered and used as originally intended
- Must be done before publication by your broker-dealer, whether it is altered or unaltered
- Must be done within three days after use by your broker-dealer, even if unaltered
Correct answer: Is not necessary if unaltered and used as originally intended
If unaltered and used as it was originally intended, refiling with FINRA is not required. If the piece had been altered or was intended to be used in a manner inconsistent with how it had been originally intended to be used, filing with FINRA would be required.
- A principal of a member firm with the responsibility of supervising registered representatives would perform all of the following duties except
- Approve each securities transaction, whether for retail or institutional customers
- Approve the opening of all new accounts, whether for retail or institutional customers
- Review a registered representative's correspondence with the firm's customers in accordance with the firm's written procedures
- Write all sales material and advertising copy intended to be used as a means of communicating with the public
Correct answer: Write all sales material and advertising copy intended to be used as a means of communicating with the public
There is no industry requirement that sales or advertising material intended to be used to communicate with the public be written by a principal of the firm. A principal must approve all retail communications before use, new accounts, and each transaction. All correspondence must be reviewed by a principal, but FINRA rules state that principal review of correspondence can take place before or after use, in accordance with the member firm's written procedures.
- All of the following communications are exempt from filing with FINRA except
- Prospectuses and preliminary prospectuses
- Retail communications that make a financial or investment recommendation
- Communications that refer to an investment solely as part of a listing of products offered by the member
- Retail communications previously filed with FINRA
Correct answer: Retail communications that make a financial or investment recommendation
Retail communications previously filed with FINRA, prospectuses and preliminary prospectuses, and communications that refer to an investment solely as part of a listing of products offered by the member are all exempt from filing with FINRA. Any retail communication that makes a financial or investment recommendation would require filing.
- A registered representative may never
- Act as a buyer's agent
- Approve advertising
- Act as a broker
- Act as a sales agent
Correct answer: Approve advertising
Advertising or sales pieces are considered to be a form of communication with the public. All such pieces must be approved by a principal of the member firm.
- Popular Investment Securities, a FINRA member firm, produces short videos describing the general characteristics of different types of securities. Periodically, an interstitial appears during the video. Under FINRA's rules on communications with the public,
- The appearance of the interstitial defines the video as retail communication requiring filing
- Video presentations of any kind must be filed with FINRA within 10 days after first use
- As long as the presentation is strictly generic, filing with FINRA is not required
- Interstitials may not be used in public communication without the consent of the viewer
Correct answer: The appearance of the interstitial defines the video as retail communication requiring filing
Probably the best example of an interstitial is the pop-up ad. Sometimes it is a full-page ad causing the viewer to see the advertisement before being able to see the rest of the content. Without the interstitial, a generic video describing general characteristics of a type of security would not require filing. But, once that advertisement pops up, it is now retail communication and must be filed.
- Municipal securities advertisements must be approved by
- A Municipal Securities Rulemaking Board senior staff officer
- A Securities and Exchange Commission market conduct examiner
- A municipal securities principal at the member broker-dealer
- A financial and operations principal over back-office duties
Correct answer: A municipal securities principal at the member broker-dealer
Advertising is a communication with the public, and MSRB rules require that municipal advertising be approved before use by a principal of the member firm, meaning a municipal securities principal or a general securities principal. The MSRB writes the rules but does not clear individual pieces, and the SEC neither approves nor endorses advertising. A financial and operations principal is responsible for the firm's net capital, books and records, and has no role in approving communications with the public.
- Which of the following is not a factor when a communication to be distributed to the public is either being reviewed or approved within the broker-dealer?
- Whether the piece will be distributed in written form or via electronic media
- The nature of the audience to which the communication is intended to be distributed
- Whether achieving past performance results has been implied
- Whether statements of benefits are balanced with statements of potential risks
Correct answer: Whether the piece will be distributed in written form or via electronic media
FINRA holds broker-dealers to certain general standards regarding all member firm communications. Consideration must be given to whether all statements in a communication are clear and not misleading, are balanced regarding the representation of risk and reward, do not omit material facts or make exaggerated claims, and do not imply that past performance can be projected to future outcomes. These standards would apply and be the same, whether the communication was distributed in written or electronic form.
- Advertising relating to municipal securities must be approved by which of the following?
- A general securities or a municipal securities firm principal
- A senior supervisory analyst or a research department manager
- A financial and operations principal or a compliance director
- A Securities and Exchange Commission or MSRB regional officer
Correct answer: A general securities or a municipal securities firm principal
Under MSRB rules, advertising relating to municipal securities must be approved in writing before first use by either a municipal securities principal or a general securities principal. A supervisory analyst approves research reports, not municipal advertising. A financial and operations principal supervises net capital and recordkeeping, and a compliance officer who is not a qualified principal cannot give the approval. Neither the SEC nor the MSRB reviews individual advertisements; the MSRB writes the rules and examination is carried out by FINRA and the SEC.
- Which of the following statements could legally appear in mutual fund advertising or sales literature?
- Our managers are dedicated to giving you the very best service.
- Our growth fund net asset value will increase faster than the market in general.
- The fund never yielded less than 8% and will continue at that rate in the future.
- Our management is unequaled in the investment industry.
Correct answer: Our managers are dedicated to giving you the very best service.
A statement such as, "Our managers are dedicated to giving you the very best service," makes no promises and is therefore not in violation of the FINRA Conduct Rules. Exaggerated claims about the management's investment expertise are prohibited, as are predictions of future fund performance or unsubstantiated claims of superiority.
- Which of the following observations may a registered representative make when giving a sales presentation based on performance statements and charts?
- Yield over the past five years has fluctuated between 6% and 8%, indicating it will continue at 6% or better.
- The portfolio's broad diversification will ensure the continuation of the 6% yield.
- The fund has had a positive performance in the past few years.
- The fund has consistently outperformed the market and should continue to do so.
Correct answer: The fund has had a positive performance in the past few years.
Predictions are strictly prohibited, and conjecture about future trends or occurrences must be labeled as such.
- Démodé Classic Investments (DCI) is planning a direct mail campaign to several thousand potential investors. The topic of the campaign deals with owning real estate through direct participation program limited partnerships. Under FINRA Rule 2210 on communications with the public, this is considered
- A retail communication and must be filed with FINRA at least 10 business days before first use or publication
- A retail communication that needs approval, but not filing, by a designated DCI principal
- Correspondence and needs review, not approval, by a designated DCI principal
- A retail communication and must be filed with FINRA within 10 business days of first use or publication
Correct answer: A retail communication and must be filed with FINRA within 10 business days of first use or publication
A direct mail communication to more than 25 existing and/or potential clients within a 30-day period is a retail communication. Unless an exception applies, a designated principal of the firm must approve all retail communications. DPPs are part of a group of securities (other common examples are investment companies and CMOs) where filing with FINRA within 10 business days of first use or publication is the rule.
- Under Options Clearing Corporation (OCC) rules regarding options communications with the public, if an educational piece making no projected performance figures or recommendations is distributed to customers, it
- Need not be preceded by an options disclosure document (ODD)
- Can only be distributed to retail customers
- Need not be approved by a registered options principal (ROP)
- Can only be distributed to institutional customers
Correct answer: Need not be preceded by an options disclosure document (ODD)
OCC communications rules do not distinguish between retail and institutional customers. Therefore, their communications rules apply to all customers. All communications pieces must be approved by an ROP. If the educational piece makes no recommendations or performance projections, it need not be preceded by an ODD, but it must be accompanied by a notice containing a name and address where the ODD can be obtained.
- Pristine Brokerage Services, (PBS), accepted as a FINRA member firm seven months ago, is planning a direct mail campaign to several thousand potential investors. The topic of the campaign deals with owning real estate through direct participation programs. Under FINRA Rule 2210 on communications with the public, this is considered
- Retail material that must reach FINRA within ten full days after its appearance
- Correspondence that a firm principal reads after it reaches a few retail buyers
- Retail material that a firm principal signs before use without any FINRA filing
- A retail communication that must reach FINRA ten business days before first use
Correct answer: A retail communication that must reach FINRA ten business days before first use
A mailing to several thousand potential investors reaches more than 25 retail investors in a 30-day period, so it is a retail communication and not correspondence subject only to supervisory review. The decisive fact is that the firm has been a FINRA member for seven months. During its first year of membership a firm must file retail communications with FINRA at least ten business days before first use, not within ten days after publication, and that filing is required in addition to the principal approval that comes first.
- Which of the following statements is an accurate interpretation of FINRA Conduct Rules governing the use of communications with the public?
- Institutional communications need not be preapproved by a principal.
- Sales and product promotion materials distributed to registered representatives and other employees are retail communications and must be submitted for FINRA review, even though such materials are not intended for public distribution.
- All retail communications must be filed with FINRA before first use.
- All communications with individual clients are considered retail communications.
Correct answer: Institutional communications need not be preapproved by a principal.
FINRA does not require principal preapproval of institutional communications. The same is true for internal communications. Not all communications with individual clients are retail communications. Many times, they are correspondence. There could even be an individual client with assets of at least $50 million, and then it would be institutional communication. Prefiling with FINRA can depend on a number of factors such as the product. For example, prefiling of retail communications is required for certain pieces having to do with investment companies and variable annuities, but not for pieces having to do with direct participation programs or collateralized mortgage obligations.
- Filing with FINRA within 10 business days of first use is required for all of the following except
- Retail communications concerning public direct participation programs (DPPs),
- Retail communications that promote or recommend a specific registered investment company or family of registered investment companies including exchange-traded funds (ETFs)
- Retail communications concerning collateralized mortgage obligations (CMOs) registered under the Securities Act,
- Retail communications that promote or recommend a specific real estate investment trust (REIT)
Correct answer: Retail communications that promote or recommend a specific real estate investment trust (REIT)
Real estate investment trusts (REITs) are not included in FINRA's list of retail communications requiring postfiling.
- All the following retail communications must be prefiled with FINRA except
- Retail communications concerning investment companies with custom ratings
- Retail communications concerning public DPPs
- Retail communications concerning the member firm's opening for business last month
- Retail communications concerning options without previously providing an ODD
Correct answer: Retail communications concerning public DPPs
Retail communications concerning public DPPs do not need to be prefiled. Retail communications for all new member firms, concerning investment companies with custom ratings or options without previously providing an ODD must be prefiled with FINRA. New member firms, defined as being in their first year of business, must file retail communications with FINRA 10 business days in advance of use.
- Under FINRA's Rule 2210 on communications with the public, which of the following is excluded from the filing requirements?
- Correspondence with prospective clients that is delivered through electronic media
- Retail communications concerning public direct participation programs
- Retail communications that previously have been filed with FINRA and that are to be used with material change
- Retail communications concerning collateralized mortgage obligations registered under the Securities Act of 1933
Correct answer: Correspondence with prospective clients that is delivered through electronic media
In most cases, retail communications must be filed with FINRA while correspondence, regardless of the method of delivery, is not. If the retail communication has previously been filed with FINRA and is being used without material change, it does not have to be refiled.
- All of the following may be included in an advertisement for a collateralized mortgage obligation (CMO) issue except
- A generic description of the CMO tranche
- A disclosure of the CMO's coupon rate and final maturity date
- A statement that the CMO is guaranteed by the U.S. government.
- A disclosure that payment assumptions may or may not be met
Correct answer: A statement that the CMO is guaranteed by the U.S. government.
The U.S. government does not issue or back CMOs. It is also misleading to state or imply that a CMO's anticipated yield or average life is guaranteed. CMOs must include the coupon rate and the final maturity date, a generic description of the CMO tranche, and disclosure that payment assumptions may or may not be met.
- Guarantees on insurance products
- Cover the stated principal values held in the separate investment account
- Extend to insurers that carry the highest outside financial health rating
- Apply to the specific promises written into the insurance contract itself
- Depend on the state insurance regulator approving the firm's sales pieces
Correct answer: Apply to the specific promises written into the insurance contract itself
A guarantee may be described only where the insurance contract itself creates one, such as a stated death benefit or a minimum in a fixed account. Nothing may be presented as guaranteeing the investment results or the principal value held in a separate account, because those values fluctuate with the underlying portfolios. A high financial strength rating speaks to the insurer's ability to pay claims and can never be offered as a guarantee, and no state insurance filing of sales material creates one either.
- All of the following are excluded from the FINRA filing requirement for communications with the public except
- Written correspondence sent to fewer than 26 retail buyers each month
- Retail material posted on a website behind a customer password screen
- Retail material posted on an online forum open to interactive replies
- Retail material that only names the member firm without other content
Correct answer: Retail material posted on a website behind a customer password screen
Retail communications must be filed with FINRA unless a specific exclusion applies, and putting the material behind a password or customer login is not one of them, so that piece still has to be filed. Correspondence, which reaches 25 or fewer retail investors in a 30-day period, is outside the filing requirement. So is a retail communication posted in an online forum that is open to interactive replies, because the firm cannot control the exchange in advance, and so is a piece that does no more than identify the member.
- The ABC Insurance Company is advertising its variable annuity product as "ABC Lifetime Income—income generated from mutual fund returns." This advertisement is
- Permitted because the product name is a registered trademark
- Prohibited because it ties income to mutual fund performance
- Prohibited because the wording omits the term annuity itself
- Permitted because its fund returns carry no stated guarantee
Correct answer: Prohibited because it ties income to mutual fund performance
A variable annuity and the separate account behind it may not be presented to the public as a mutual fund, and tying the contract's income to mutual fund performance does exactly that, so the advertisement is prohibited. A proprietary or trademarked product name is permitted, and the rules do not require the word annuity to appear when such a name is used. Whether the returns are described as guaranteed is a separate question and does not cure the mutual fund comparison.
- In a competitive offering of municipal bonds, the issue is usually awarded to the syndicate that offers to sell the bonds
- At the smallest gross spread taken by the syndicate
- At the highest resale prices for retail bond buyers
- At the fastest pace after the official award notice
- At the lowest net interest cost to the municipality
Correct answer: At the lowest net interest cost to the municipality
In a competitive municipal offering, syndicates submit sealed bids and the issuer or its financial advisor awards the issue to the bid producing the lowest net interest cost, the measure of what the borrowing actually costs the municipality over the life of the bonds. The size of the syndicate's gross spread, the price at which the bonds are later resold to retail buyers, and how quickly the syndicate expects to distribute them are the syndicate's own concerns and do not decide the award.
- For the underwriting of a municipal bond issue, competitive bids are submitted by underwriters as
- A firm commitment
- A standby underwriting commitment
- An all-or-none commitment
- A best efforts underwriting commitment
Correct answer: A firm commitment
For new municipal bond issues, underwriters must submit bids for the entire bond offering—a firm commitment. Standby commitments are used only for corporate stock rights offerings. Best efforts commitments are used for corporate securities, and an all-or-none commitment is a type of best efforts commitment.
- A syndicate member in a municipal underwriting wishes to place an order with the manager for its own portfolio. Under Municipal Securities Rulemaking Board rules, an order for a related portfolio must be
- Entered as a designated order
- Entered as a group order
- Entered as a presale order
- Disclosed to the manager
Correct answer: Disclosed to the manager
Disclosure is necessary to allocate orders. An order for a related portfolio will be accorded member status—the lowest priority.
- A due diligence meeting occurs between
- The underwriters and the SEC to insert the agreed offering price into the prospectus
- The member firm and FINRA staff to review the underwriting compensation for the deal
- The issuer and its underwriters to review and settle final terms before the offering
- The syndicate manager and the selling group to set and post concessions before sales
Correct answer: The issuer and its underwriters to review and settle final terms before the offering
A due diligence meeting is held between the issuing corporation and the underwriters shortly before the effective date so both sides can re-examine every detail of the pending offering and settle the final terms that go into the underwriting contract. Inserting the agreed offering price is done by a pricing amendment filed with the SEC, not at a meeting. FINRA's review of underwriting compensation is a separate corporate financing filing, and the concession paid to the selling group is fixed by the syndicate, not at due diligence.
- In a new municipal bond offering, which of the following orders is placed after the bid is awarded and credits the entire syndicate with the takedown?
- Designated
- Presale
- Member
- Group
Correct answer: Group
A presale order is entered before the bid is awarded. If the syndicate wins the bid, the takedown is credited to all syndicate members. A group order is entered after the bid is awarded and the takedown is credited to all syndicate members. A designated order, entered after the bid is awarded, credits some, but not all, syndicate members with the takedown. A member order, entered after the bid is awarded, credits only the syndicate member entering the order with the takedown.
- Within a firm commitment underwriting, which document details the responsibilities and liabilities of each firm?
- The signed agreement of syndicate members
- The underwriting agreement with an issuer
- The registration statement on public file
- The selected dealer agreement for brokers
Correct answer: The signed agreement of syndicate members
The agreement among underwriters, also called the syndicate letter, is signed by the syndicate members and sets out what each firm is responsible for, how much of the issue it is liable for, and how the account is settled. The underwriting agreement runs between the issuer and the syndicate manager and covers the purchase of the issue itself. The registration statement is the issuer's disclosure filing, and the selected dealer agreement governs the selling group, whose members take no liability for unsold securities.
- XYZ Corporation is preparing a registration statement for a new issue consisting of 300,000 new shares and 200,000 existing shares held by officers. The offering price is $30 per share, and the spread taken by the underwriters is $2 per share. After the offering is complete, XYZ will receive
- $14,000,000.
- $9,000,000.
- $8,400,000.
- $15,000,000.
Correct answer: $8,400,000.
XYZ Corporation will receive $28 per share for each of the 300,000 new shares being issued ($30 per share price less the $2 spread). The proceeds from the 200,000 shares sold by the officers will benefit the officers themselves, not XYZ Corporation.
- Better Bond Sales (BBS) is the syndicate manager of new GO municipal bond issue. Should BBS sell some of the bonds, its earnings would be
- The total takedown
- The spread
- The spread plus the manager's fee
- Negotiated between the issuer and the manager
Correct answer: The spread
When the syndicate manager makes the sale of a new issue of bonds, the manager earns the entire spread (the difference between the amount paid to the issuer and the offering price). The manager's fee is included in that spread. The syndicate members earn the total takedown on bonds they sell.
- New issue municipal bond orders are allocated according to priorities the syndicate sets in advance. The MSRB requires syndicates to establish priority allocation provisions for orders. Which of the following is the most common priority?
- Presale, designated, group net, member
- Presale, group net, designated, member
- Member, designated, presale, group net
- Group net, presale, designated, member
Correct answer: Presale, group net, designated, member
Remember our abbreviation: PGDM (Pro Golfers Don't Miss) and that will get you the correct answer to any of these order allocation questions.
- Cutting Edge Securities is the managing underwriter for a new issue of 1 million shares of ABC common. While the underwriter has agreed to sell as much stock as possible in the market, ABC will cancel the offering if any portion of the stock remains unsold. This arrangement is known as what type of underwriting?
- Mini-max
- Standby
- Best efforts
- All or none
Correct answer: All or none
All-or-none underwritings require the underwriter to either sell the entire issue of stock or cancel the offering completely.
- Stabilizing bids may be entered at
- A price no higher than the public offering price
- A price not exceeding 5% above the public offering price
- Whatever stabilizing price is stated in the prospectus
- Any reasonable price necessary to support the public offering price
Correct answer: A price no higher than the public offering price
Stabilizing bids cannot be used to raise the market price of an issue. Stabilization may only be used to support a new issue security at or below the public offering price.
- If a customer purchases a new issue of stock from a syndicate member, the customer will pay the public offering price
- Plus a separately negotiated markup or commission
- Free of markup or separately collected commission
- Minus the regular selling group dealer concession
- Plus the syndicate's full underwriting spread fee
Correct answer: Free of markup or separately collected commission
A new issue is sold to the public at the public offering price, and a syndicate member selling at that price adds nothing to it and takes nothing off it. The underwriters are compensated out of the spread paid by the issuer, so the customer pays neither a markup nor a commission on top of the offering price, is not charged the syndicate's spread, and does not get the price reduced by the selling concession, which belongs to the distributing firms. Markups and commissions arise in the secondary market.
- If municipal securities are offered on an inverted scale, this means
- The coupon rates on short-term bonds are higher than coupon rates on long-term bonds
- The yields on short-term maturities are higher than the yields on long-term maturities
- The yields on long-term bonds are higher than yields on short- term bonds
- The coupon rates are higher than the yields
Correct answer: The yields on short-term maturities are higher than the yields on long-term maturities
A normal scale of prices consists of lower yields on short-term maturities and higher yields on longer maturities. An inverted scale is the opposite.
- What is the profit to a syndicate member if a syndicate is offering an 8.5% bond at 100, the syndicate manager is giving a 0.75 concession and a 1-point total takedown, and the syndicate member sells 1,000 bonds?
- $17,500
- $10,000
- $7,500
- $1,000
Correct answer: $10,000
When a member of the syndicate sells a bond, the member is entitled to the total takedown. In this case, one point ($10) per bond (1,000 bonds sold × $10 per bond = $10,000 profit). Remember that the concession would only go to those who are not members of the syndicate but are part of the selling group instead.
- A syndicate won the bid for a general obligation bond of $1 million issued by a city. The syndicate has received the following orders: $500,000 net designated, $500,000 presale, and $1 million member at takedown. The orders would be filled as
- $500,000 presale, $250,000 net designated, $250,000 to members.
- $500,000 presale, $500,000 net designated, none to members.
- None to presale, none to net designated, $1 million to members
- $250,000 presale, $500,000 net designated, $250,000 to members.
Correct answer: $500,000 presale, $500,000 net designated, none to members.
Municipal syndicate customs dictate that presale orders have first priority, with group orders, net designated orders, and member orders following in that order.
- Which of the following documents sets forth the priority of sale of securities?
- A tombstone
- The official notice of sale
- An offering circular
- The syndicate letter
Correct answer: The syndicate letter
The syndicate letter lists the terms under which members will conduct the sale of the bonds. It also describes each member's sharing of profits and expenses, the type of business entity (i.e., joint venture or partnership), and the good faith deposit required.
- One member of a municipal syndicate is opposed to bidding on a particular issue because of some of the restrictions outlined in the official notice of sale. The other eight members of the syndicate have agreed on a price and vote to submit their bid. In this situation, the syndicate manager can do all of the following except
- Allow the objecting firm to withdraw and admit another replacement
- Present the syndicate bid once the participants reach a compromise
- Withdraw the entire syndicate from the bidding before the deadline
- Require the objecting firm to accept its entire prorated allotment
Correct answer: Require the objecting firm to accept its entire prorated allotment
Syndicate membership is voluntary, so the manager cannot compel a member that objects to the terms in the official notice of sale to take its prorated share of the issue. What the manager can do is let the dissenting firm withdraw and bring in another member, submit the bid once the remaining participants agree on terms, or decide not to bid at all. The manager runs the account but has no authority to force a member to assume liability it has refused.
- Which of the following best describes how a syndicate determines the amount to bid for a new municipal issue?
- The average reoffering price minus the spread
- The average reoffering price plus the takedown
- The gross spread minus the takedown
- The average sales price divided by the interest cost
Correct answer: The average reoffering price minus the spread
A spread is analogous to the gross profit margin in other businesses. A syndicate's bid is based on the average reoffering price (the price the public will pay) less the syndicate's spread (the amount the syndicate will charge for bringing the issue to market).
- The underwriting agreement is signed by
- The issuer and the managing underwriter
- The issuer and the SEC
- The selling group members and the syndicate members
- The managing underwriter and the syndicate members
Correct answer: The issuer and the managing underwriter
The underwriting manager represents all underwriting members, and on behalf of the underwriting group, signs the underwriting agreement with the issuer. The agreement among underwriters is the document signed by the managing underwriter and all syndicate members. The selling group members have no formal agreement to be signed with the underwriters.
- Shares of Marc Lighting Manufacturing Company trade on the NYSE with the ticker symbol MLM. The company wants to raise equity capital by issuing additional shares. An investment bank buys MLM's new shares and sells them to interested retail and institutional buyers. This transaction is most accurately described as
- An initial registered public offering
- A registered secondary share offering
- An additional primary public offering
- An agency basis subscription offering
Correct answer: An additional primary public offering
The shares are newly created and sold by the company itself, so the proceeds go to the issuer and the transaction is a primary offering. Because the stock already trades on the NYSE it cannot be an initial offering; this is a follow-on, or additional, primary offering. A secondary distribution moves shares already outstanding from existing holders and raises nothing for the company, and the investment bank bought the entire issue outright, which makes this a firm commitment rather than a best efforts, agency basis deal.
- An underwriter in an Eastern syndicate has a 15% participation. The underwriting is for $20 million, and the underwriter has sold its $3 million allotment. The underwriting closes with $1 million remaining unsold. This underwriter's liability is
- $1,000,000.
- $15,000.
- $150,000.
- $0.00.
Correct answer: $150,000.
An Eastern syndicate is an undivided account. That means that each member is responsible for its share of any unsold portion. This underwriter's commitment is 15%, so that percentage of the $1 million remaining is $150,000. If this were a Western syndicate (divided), the underwriter would have had no liability.
- The primary difference between an underwriting syndicate member and a selling group member in a firm commitment underwriting is that
- The securities offered by each differs within the offering
- The size of a syndicate member firm will always be larger than a selling group member firm
- The syndicate assumes liability for unsold shares, while the selling group does not
- The price per share paid by the public is more if purchasing new shares from a selling group member
Correct answer: The syndicate assumes liability for unsold shares, while the selling group does not
The underwriting syndicate makes a financial commitment in a firm underwriting to bring a new issue to market and take liability for unsold shares. A member of a selling group only agrees to provide a sales service for a certain number of shares in exchange for a commission on shares it sells. It has no responsibility for any unsold shares. The securities offered are identical, and the public offering price is the same. Both large and small firms can be either syndicate members or selling group members.
- In the underwriting of a municipal bond, which of the following is determined by the issuer rather than the underwriter?
- Underwriting spread
- Yield to maturity
- Net interest cost
- Maturity
Correct answer: Maturity
The maturity is determined by the issuer and stated in the official notice of sale before bids are received.
- An official notice of sale publicizes all of the following except
- The bond counsel's name
- The amount of good faith deposit required
- The bond's rating
- The issuer's name
Correct answer: The bond's rating
The notice of sale is the advertisement placed by a municipality soliciting bids from underwriters for an issue it wishes to sell. It does not include the bond's rating.
- Nonmembers of a syndicate who are assisting in its sale of bonds buy the bonds at a discount called
- A takedown
- A concession
- The basis price
- A net designated price
Correct answer: A concession
Members of the syndicate buy the bonds at the offering price minus the takedown, and nonmembers buy at offering price minus a concession. The basis price is the yield to maturity.
- In the context of municipal bond underwritings, the true interest cost (TIC) is different from the net interest cost (NIC) because it
- Reflects the credit risk
- Produces a lower cost of borrowing for the issuer
- Is the method required by the IRS
- Reflects the time value of money
Correct answer: Reflects the time value of money
The TIC method uses present value calculations that consider the time value of money (as opposed to NIC, which does not consider the timing of interest payments). It is a more complicated calculation than NIC. The IRS is not concerned with this issue.
- When describing a new offering of municipal bonds, which statement is true regarding presale orders?
- The takedown on presale orders is credited to the account of the syndicate member making the sale.
- There is no takedown on a presale order; the buyers purchase at a discounted price.
- The takedown on presale orders is split among the syndicate members based on their participation.
- The takedown on presale orders is credited to the account of the syndicate manager.
Correct answer: The takedown on presale orders is split among the syndicate members based on their participation.
Unlike registered corporate issues, investors may place orders for a new municipal bond issue before the issue has even been awarded to the syndicate. These presale orders have the highest priority in terms of allocation, and all syndicate members share proportionately in the takedown (their underwriting compensation).
- When an underwriting syndicate commits to distribute an entire offering, it may enlist other FINRA member firms to help in the offering. These member firms are known as
- Co-managers
- Selling group members
- Affiliated members
- Syndicate participants
Correct answer: Selling group members
Underwriting syndicates often enlist other FINRA member firms to help with the distribution of an offering. These members become part of the selling group. Unlike the syndicate members, selling group members have no capital commitment. They are acting as agents of the syndicate and earn a selling concession on their sales.
- An issuer may engage in a primary offering
- As frequently as the issuer decides
- Only once for each registered class
- Whenever a whole calendar year ends
- Once every ninety full trading days
Correct answer: As frequently as the issuer decides
No rule limits how frequently an issuer may sell new securities to the public. Each offering carries its own registration or exemption requirements, but there is no annual limit, no ninety-day waiting period, and no restriction to a single offering for a class of stock; open-end investment companies in fact make a continuous primary offering every business day. The frequency is the issuer's own decision, subject only to meeting the requirements that apply to each individual offering.
- Which of the following is least likely to impact an underwriter's considerations when establishing the offering price for a new issue?
- Demand for the security by the investing public
- Projected earnings for the company
- Earnings multiples for other companies in the market in the same industry
- Geographic location of the company headquarters
Correct answer: Geographic location of the company headquarters
Of the choices given, unless the geographic location of the company was critical to its financial success in some way it is the least likely factor to be considered by underwriters when pricing the new issue. Indications of interest (demand for the securities), projected earnings, and comparative financial data for similar companies in similar industries are much more likely to impact pricing of the new issue.
- Which of the following is typically the largest component of a corporate underwriting spread and is received by members of the selling group?
- Underwriting fee
- Concession
- Manager's fee
- Reallowance
Correct answer: Concession
The concession tends to be the largest component of a corporate underwriting spread. That is paid to the members of the selling group. The manager's fee is generally the smallest component.
- All the following statements are false about the process of awarding an underwriting to a syndicate except
- A competitive bid underwriting is the standard for corporate offerings
- A competitive bid underwriting is the standard for general obligation municipal underwritings
- In a competitive bid situation, the contract is award to the syndicate bid that reflects the highest net interest cost to the issuer
- A negotiated underwriting is the standard in a general obligation municipal underwriting
Correct answer: A competitive bid underwriting is the standard for general obligation municipal underwritings
The double negative in the question tells us we are looking for the true statement. A competitive bid underwriting is the standard for general obligation municipal bond underwritings. In many cases, state law requires competitive bidding. On the other hand, negotiated underwritings seem to dominate municipal revenue bonds. Negotiated is also the primary method for corporate issues. The award in a competitive bid is to the syndicate submitting a bid representing the lowest net interest cost (NIC). In some underwritings, it is the lowest true interest cost (TIC). TIC accounts for the time value of money.
- The spread in a municipal competitive bid is
- The gap between the takedown price and the dealer resale price
- The gap between the winning bid and the total reoffering price
- The gap between the winning dollar price and quoted par values
- The gap between the fixed coupon rate and the reoffering yield
Correct answer: The gap between the winning bid and the total reoffering price
In a competitive municipal bid the winning bid is the price the syndicate pays the issuer for the bonds, and production is the total amount the syndicate expects to receive when the bonds are reoffered to the public. The spread is the difference between those two figures and is the syndicate's gross compensation. The difference between the takedown and the price a dealer resells at is the concession, the amount by which a winning dollar price exceeds par is simply a premium, and comparing a coupon rate with a reoffering yield describes pricing rather than compensation.
- In the underwriting of a new municipal GO bond issue, who would earn the selling concession?
- A member of the syndicate
- The syndicate manager
- The registered representative who actually sold the bonds
- A selling group member
Correct answer: A selling group member
When a selling group member is part of the underwriting, their compensation is the selling concession. The manager earns the management fee. The syndicate members earn the takedown.
- Which of the following statements regarding a negotiated underwriting is not true?
- Every state must sell all of its general obligation bonds using negotiated sales
- The issuer always selects its own underwriter rather than taking any sealed bids
- Either revenue debt or general obligation debt can also be underwritten this way
- The investment banker consults with the issuer when setting the final bond price
Correct answer: Every state must sell all of its general obligation bonds using negotiated sales
Nothing in state or federal law forces general obligation bonds into a negotiated underwriting, so that statement is false and is the answer here. Issuers choose the method, and either revenue debt or general obligation debt may be brought competitively or on a negotiated basis. The defining feature of a negotiated deal is that the issuer selects its underwriter directly instead of taking sealed bids, and the investment banker then works with the issuer on a price that satisfies the issuer while still allowing the bonds to be sold at a profit.
- If a corporation issues stock to the public at $10 per share, and the syndicate manager's fee is $0.10 per share, the underwriting fee is $0.25 per share, and the selling concession is $0.45 per share, what is the spread?
Correct answer: $0.80.
The spread is the sum of the manager's fee, the underwriting fee, and the selling concession.
- The underwriting of most corporate issues is done on a negotiated basis. The investment banker who negotiates with the issuer on a firm commitment underwriting is known as
- The chief negotiator
- The principal underwriter
- The syndicate manager
- The prime investment banker
Correct answer: The syndicate manager
When a syndicate is formed, it is the responsibility of the syndicate manager to negotiate with the issuer and keep the syndicate records of the underwriting. You might also see this position referred to as the managing underwriter or the lead underwriter.
- Which of the following competitive bids on a new municipal issue is most likely to be awarded the bid?
- Six percent coupon with no premiums over par
- Eight percent coupon with premiums over par
- Six percent coupon with premiums over par
- Seven percent coupon with no premiums over par
Correct answer: Six percent coupon with premiums over par
In a competitive bid bond sale, the winning bid is the one that provides the issuer with the lowest net interest cost. If the syndicate pays the issuer more than par for the bonds, the issuer is taking in more money than it must pay out at maturity. Therefore, its net interest cost is lower than the 6% coupon on the bonds.
- Which of the following municipal securities could have been sold in a negotiated underwriting?
- School bonds
- All of these
- Industrial development bonds
- Limited tax bonds
Correct answer: All of these
Either municipal revenue or general obligation (GO) bonds can be underwritten using a negotiated underwriting process to set the terms of the new issue. Industrial development bonds are revenue bonds, while both limited tax bonds and school bonds are types of GO issues.
- In its notice of sale in The Bond Buyer, an issuer states that it will take into consideration the timing of interest payments when evaluating bids. The issuer will be using which of the following methods in its bid selection?
- Net interest cost
- Real interest cost
- Low interest cost
- True interest cost
Correct answer: True interest cost
The true interest cost (TIC) method takes into consideration the time value of money. The issuer discounts future interest payments to arrive at a present value.
- When an existing, long established publicly traded corporation issues a large block of new shares in order to expand or modernize, it is
- A refunding
- An IPO
- A primary distribution
- A secondary distribution
Correct answer: A primary distribution
New shares are always part of a primary distribution. When it is the first time, it is an initial public offering (IPO). That does not apply here because this company already has shares publicly trading.
- In an undivided syndicate, liability for unsold securities rests with
- The syndicate members that failed to sell their allotment
- The syndicate manager
- The syndicate members on a pro rata basis
- The issuer
Correct answer: The syndicate members on a pro rata basis
In an undivided (Eastern) account, liability for unsold securities rests with each syndicate member based on its participation percentage. For example, if a syndicate member has a 10% participation, that member would be responsible for 10% of any unsold securities (even if that member sold all of its participation). Sales do not affect undivided accounts.
- A firm underwriting of a municipal bond issue usually has a number of different broker-dealers involved. Those who earn a commission on each sale they make are performing in the role of
- A selling syndicate member
- A selling group member
- A registered representative
- The syndicate manager
Correct answer: A selling group member
Selling syndicate members use selling group members to expand their reach. These selling group members receive a selling concession (a commission) on each sale they make. They have no financial commitment and return any unsold bonds to the syndicate member. Although registered representatives will typically earn a commission on the bonds they sell, the question asks about the broker-dealers involved in the underwriting. Be sure to answer the specific question asked.
- A municipal issuer publishes an official notice of sale to indicate that the offering will be made
- Through a private placement
- On a competitive basis
- For none of these
- On a negotiated basis
Correct answer: On a competitive basis
An official notice of sale is the issuer's method of inviting competitive bids on a new issue. It sets forth all of the information about the issue that a dealer would need to make a bid, including the size of the offering; the maturity dates; and the date, time, and place of the sale.
- A firm underwriting of a municipal bond issue usually has a number of different broker-dealers involved. Those who earn the total takedown on each sale they make are performing in the role of
- A dealer joining the selling group
- The lead manager of that syndicate
- The advisor employed by the issuer
- A member inside the bond syndicate
Correct answer: A member inside the bond syndicate
Syndicate members commit to the issue and are allotted bonds to sell, and on each bond a member sells it earns the total takedown, which is the takedown plus the additional takedown. A dealer that joins only the selling group has no liability for unsold bonds and earns just the concession. The lead manager earns the full spread on bonds it sells itself plus a management fee on the rest, and the issuer's financial advisor works for the issuer and takes no part in the syndicate's compensation.
- Your manager notifies you that a new municipal revenue bond issue you have been working on has been oversubscribed. How is the order acceptance priority for this issue determined?
- By the terms of the issue's governing indenture
- By the terms of the unqualified counsel opinion
- By the terms of the underwriters' own agreement
- By the terms of the executed purchase agreement
Correct answer: By the terms of the underwriters' own agreement
Order priority for a new municipal issue is established by the syndicate manager and set out in the agreement among underwriters, as amended by the release terms letter sent to members once the bid is won. The indenture describes the security and covenants behind the bonds, bond counsel's approving opinion addresses validity and tax status, and the bond purchase agreement records the price and terms on which the syndicate buys the issue. None of those documents decides which orders the syndicate fills first when an issue is oversubscribed.
- The true interest cost (TIC) method of evaluating municipal bids
- Can only be used for term bonds
- Is required by the MSRB if a financial advisory relationship exists
- Is required by the MSRB if a control relationship exists
- Considers the time value of cash flows
Correct answer: Considers the time value of cash flows
The calculation of TIC (as opposed to net interest cost) takes the time value of money into account. The Municipal Securities Rulemaking Board has no requirement as to which method is used.
- The manager will credit each syndicate member based on sales of that particular maturity allotted to the member, and such credits shall extinguish liability based only on such securities that are sold by the member. This statement describes an agreement among underwriters that is
- An Eastern account
- An undivided account
- A divided account
- A proportionate underwriting
Correct answer: A divided account
This is part of an agreement for a Western (divided) syndicate.
- An underwriting spread is
- The amount the underwriters receive beyond the issuer's own proceeds
- The discount the selling dealer receives for each underwritten issue
- The income the managing underwriter receives for running the account
- The proceeds the syndicate members receive on the firm's commitments
Correct answer: The amount the underwriters receive beyond the issuer's own proceeds
The underwriting spread is the underwriters' gross compensation: the amount they receive over and above the proceeds that reach the issuer. It is then divided into the manager's fee, the takedown and the concession, so each of those is a component of the spread rather than the spread itself. What a selling dealer keeps on an underwritten issue is the concession, what the managing underwriter earns for running the account is the management fee, and what syndicate members earn on their commitments is the takedown.
- An initial public offering is conducted
- By the issuer through open secondary markets
- By large shareholders through a private sale
- By the issuer through its underwriting group
- By an exchange through the listing divisions
Correct answer: By the issuer through its underwriting group
An initial public offering is a primary offering: the issuer sells newly created shares to the public and receives the proceeds, and it almost always does so through an underwriting group that buys or places the issue. The open secondary market is where investors trade with one another after the distribution is over, so no new issue is sold to the public there and no money reaches the company. A private sale by large shareholders is not a public offering at all, and an exchange lists shares rather than selling them.
- When syndicate members agree to share financial responsibility for any unsold securities on an undivided basis, this contractual arrangement comprises what type of account?
- Eastern
- Selling group
- Western
- Best efforts
Correct answer: Eastern
An undivided account, which is a shared underwriting liability for unsold securities, is an Eastern account.
- ABC Corporation is offering 500,000 units to the public at $5 per unit. Each unit consists of two shares of ABC preferred stock and one perpetual warrant for half of a common share of ABC, exercisable at $5. How much capital was raised by the initial sale of the issue?
- $2.5 million
- $1.25 million
- $5 million
- $7.5 million
Correct answer: $2.5 million
Because the issuing corporation is offering 500,000 units to the public at $5 per unit, the total amount of capital to be raised by this sale will be $2.5 million (500,000 units × $5 per unit). Be sure to read the question carefully. It is only referring to the initial sale of the units. If those warrants are exercised in the future, the company will receive additional capital.
- An order confirmed for the entire underwriting syndicate's benefit is called
- A group net order
- A market order
- A net designated order
- A member at the takedown order
Correct answer: A group net order
A municipal group net order is credited to syndicate members according to their percentage participation in the account. This order type is given priority over designated or member takedown orders (but not over presale orders). The normal order of priority is presale orders, group or syndicate orders, designated orders, and member orders.
- One of your clients is an active investor using a tactical asset allocation strategy. As such, the client engages in numerous transactions every month. With each transaction, the client pays a separate transaction fee. Your firm has just begun offering an account to its clients whereby the client can pay one flat fee to cover all the trades in that account. You immediately bring this news to the client and suggest making the change. What type of account is this?
- A pattern day trading account
- A margin account
- A fee-based account
- A wrap-fee account
Correct answer: A fee-based account
With a fee-based account, the customer pays one fee that covers all transactions in an account. This account is most suitable for active, rather than passive investors. A wrap-fee account is one where a fee, usually based on assets under management, is charged to a customer to cover various services provided by a firm. Those services would include portfolio management and transaction fees. Firms that offer wrap-fee accounts are required to be registered as investment advisers as well as broker-dealers.
- A margin account may not be used
- To purchase corporate bonds
- When opening a fee-based account
- For retirement accounts
- To purchase listed stocks
Correct answer: For retirement accounts
Investors cannot open a margin account for retirement plans. There are other restrictions on margin accounts, including accounts for minors. Listed and many OTC stocks and corporate bonds can be purchased on margin.
- To be defined as a pattern day trader, the customer must execute at least
- Four day trades on a single business day
- Five day trades in five business days
- Four day trades in five business days
- Four day trades in the same week
Correct answer: Four day trades in five business days
FINRA defines a pattern day trader as one who executes 4 or more day trades in a 5-business-day period. That can stretch over two different weeks.
- The term churning refers to
- Repeatedly purchasing stock to keep the price up
- Purchasing calls on a particular stock for your own account before entering a large customer order for the stock
- Entering more transactions than necessary, solely for the purpose of generating commissions
- Repeatedly selling a stock short to prevent a price rise
Correct answer: Entering more transactions than necessary, solely for the purpose of generating commissions
Unnecessary transactions entered into for the purpose of generating commissions constitute churning. A charge of churning can result from both an excessive number and the excessive size of transactions.
- Which of the following accounts are billed a single fee annually for a group of services?
- Margin account
- Cash account
- Wrap account
- Option account
Correct answer: Wrap account
Wrap accounts are accounts for which firms registered as both broker-dealers and investment advisers provide a group of services, such as asset allocation, portfolio management, executions, and administration, for a single fee. Wrap accounts are generally investment advisory accounts.
- A large institution dealing with several different broker-dealers would probably find it beneficial to open
- A combined cash and margin account
- A prime brokerage account
- An institutional brokerage account
- An accredited investor account
Correct answer: A prime brokerage account
A prime brokerage account is one in which a customer—generally an institution—selects one member firm (the prime broker) to provide custody, trading, and other services, while other firms, called executing brokers, typically execute most of the trades placed by the customer.
- Which of the following accounts allow ownership of real estate?
- An UTMA account
- A cash account
- A margin account
- An UGMA account
Correct answer: An UTMA account
One of the primary differences between UTMA and UGMA is the investment flexibility. Real property can be transferred into an UTMA, while no such provision exists with UGMA. Brokerage accounts, cash or margin, are used to trade securities. Real estate is not a security (REITs and RELPs are, but that is not direct ownership of the real estate). There is nothing to stop an investor from depositing fully paid-for marginable securities into a margin account and using the margin loan to purchase real estate. However, that purchase is done outside of the margin account.
- When a customer instructs a registered representative to transfer and ship, the representative instructs the margin department to transfer ownership into
- The customer's name and deliver the securities to the customer's bank for safekeeping
- The brokerage firm's name and deliver the securities to the customer
- The customer's name and deliver the securities to the customer
- The brokerage firm's name and deliver the securities to the brokerage firm's commercial bank for safekeeping
Correct answer: The customer's name and deliver the securities to the customer
The term transfer and ship means to transfer the securities into the name of the customer and ship (deliver) the securities to the customer. To hold in street name would require the securities to be transferred into the name of the broker-dealer and held for safekeeping.
- Which of the following statements best describes the term churning?
- Manipulation of market prices by a firm
- Purchasing the same security in more than one customer account at a time
- Trading in a customer's account considered excessive and for which no discernible investment purpose is detected
- Making false or misleading statements to a customer for the purpose of inducing the customer to purchase or sell a security
Correct answer: Trading in a customer's account considered excessive and for which no discernible investment purpose is detected
Churning is excessive trading for a particular customer's circumstances or exceeding what would normally be considered suitable. This is equally true for both discretionary and nondiscretionary accounts.
- In an account opened by two individuals as joint tenants with right of survivorship (JTWROS), all of the following statements are true except
- Stock certificates may be delivered in the name of either party
- In the event of death, the other party assumes full ownership of the account
- Orders may be entered by either party
- Mail may be directed to the joint owner agreed upon by both parties to the account
Correct answer: Stock certificates may be delivered in the name of either party
In a JTWROS account, each party has an equal, undivided interest in the account. Upon the death of one party in a two-party account, the other party assumes full ownership of the account. Orders may be entered by either party, and mail may be directed to either party. However, disbursements of cash or securities must be in the name of all parties to the account.
- Which of the following individuals may not open a joint account?
- Two spouses
- Two business partners
- Three sisters
- A parent and a minor
Correct answer: A parent and a minor
A minor may not be a party in a joint account because a minor cannot legally exercise control over the account. A custodial account may be set up for the minor.
- Many parents find that opening an UTMA account for their child is not only a good way to accumulate funds for the future but also a good way for the child to gain an appreciation for investing. The account custodian may use principal as well as income generated in the account to pay for all of the following for the child except
- Private school
- The latest model smartphone
- New clothes
- Summer camp
Correct answer: New clothes
The Uniform Transfer to Minors Act permits the custodian to use the funds for almost anything that is a benefit to the minor. The primary exceptions are those that most states consider to be the parental obligations of food, clothing, and shelter.
- You have a client who is an active trader in his margin account. Wishing to take advantage of the tax benefits of the Roth IRA, he asks for the form to open the Roth. While attempting to complete the form, he calls to ask, "How do I indicate margin trading on this form." You would respond,
- ""Let me check with our operations department for that information.""
- ""Because our minimum for margin accounts is $20,000 is above the IRA maximum contribution, you will have to open it in a cash account.""
- ""IRAs, traditional or Roth, can only be opened as cash accounts.""
- ""Only traditional IRAs can be opened as margin accounts.""
Correct answer: ""IRAs, traditional or Roth, can only be opened as cash accounts.""
IRAs, and other retirement accounts, cannot be opened in margin accounts. They are limited to cash accounts only.
- All of the following are the advantages of a margin account except
- Less cash is needed
- Money is borrowed
- Leveraging is possible
- Losses are minimized
Correct answer: Losses are minimized
Any losses on a margin trade are magnified because of the leverage.
- A customer opens an account, and payment and delivery instructions are established. Beyond the opening of the account, these instructions may
- Be revised for a single trade but never for later trades
- Be revised for a specific trade or for all future trades
- Be revised for later trades but never for a single trade
- Be revised only after a new account or mandate is signed
Correct answer: Be revised for a specific trade or for all future trades
Payment and delivery instructions are normally set when the account is opened, but they are not frozen there. A customer may give different instructions for one particular transaction, such as asking for a certificate on a single purchase, and may also change the standing instruction so it governs every transaction from that point forward. Neither choice rules out the other, and no new account or fresh mandate has to be signed before the change can be made.
- The Customer Identification Program requires that a tax identification number must be obtained when opening a new account. When the account is an UTMA, the Social Security number used is that of
- The minor who is the beneficiary of the account
- Either the custodian, a parent or guardian, or the minor
- The appointed custodian
- A parent or guardian of the minor
Correct answer: The minor who is the beneficiary of the account
The minor's Social Security number is required because the account is fully owned by and taxed to the minor, not to the custodian or the parent.
- All of the following people could open a joint account except
- A married couple
- A mother and 22-year-old daughter
- A father and 10-year-old son
- Two business partners
Correct answer: A father and 10-year-old son
Joint accounts can only be opened between adults.
- Which of the following persons must sign a stock or bond power to effect good delivery of securities sold from an account set up under the Uniform Transfer to Minors Act?
- The minor who owns the account's securities
- The adult donor who established the account
- The parent of the minor's brokerage account
- The custodian listed on the account records
Correct answer: The custodian listed on the account records
Securities in an account opened under the Uniform Transfer to Minors Act are registered in the custodian's name for the benefit of the minor, and only the custodian can sign the stock or bond power required for good delivery. The minor owns the securities but has no authority to act on the account until reaching the age of majority. The donor's gift is irrevocable and gives up control, and a parent who was never named as custodian has no more signing authority over the account than any other adult.
- All of the following characteristics describe a joint tenants with right of survivorship (JTWROS) account except
- In the event of the death of one of the tenants, the surviving party assumes control of the entire account
- Orders may be given only by the party listed first on the account
- Mail may be sent to either party with the permission of the other party
- Checks must be made out in the name of the account
Correct answer: Orders may be given only by the party listed first on the account
In a JTWROS account, when the surviving party assumes control of the entire account in the event one of the tenants dies, any party named on the account may enter orders for the account. While distributions from the account must be sent in the names of all of the owners, mail could be sent to one party only, with permission from all other parties to the account.
- If three individuals have a tenants in common account with your firm, and one individual dies, which of the following statements is true?
- Trading is discontinued until the executor names a replacement for the deceased.
- The account is converted to joint tenants with right of survivorship.
- Two survivors continue as cotenants with the decedent's estate.
- The account must be liquidated and the proceeds split evenly among the two survivors and the decedent's estate.
Correct answer: Two survivors continue as cotenants with the decedent's estate.
The decedent's estate becomes a tenant in common with the survivors.
- Services offered by prime brokers include all of the following except
- Clearing and settling that client's executed trades
- Reviewing that client's advertising for FINRA rules
- Providing back office reporting and DTC settlements
- Lending funds for the client's marginable positions
Correct answer: Reviewing that client's advertising for FINRA rules
A prime broker serves institutional customers by clearing and settling trades executed away at other firms, financing marginable positions, holding assets and supplying back-office reporting such as consolidated statements and depository settlement. Reviewing an institutional client's own advertising is not among those services: every firm is responsible for approving and supervising its own communications with the public, and that duty cannot be handed to the prime broker along with the clearing and financing functions.
- Which of the following is not a benefit gained by using a TOD account?
- Estate taxes are reduced.
- Percentage allocations can be changed at any time.
- Beneficiaries can be changed at any time.
- Probate is avoided.
Correct answer: Estate taxes are reduced.
The TOD (transfer on death) designation offers many benefits, but reducing estate taxes is not one of them. The assets in the account are included in the decedent's estate. However, the hassles of probate are avoided, and without any legal impediments, the owner of the account can make changes at will.
- What type of account allows for the irrevocable transfer of almost any kind of asset, including works of art and real estate, for the benefit of a minor?
- UGMA
- Coverdell ESA
- UTMA
- Tenants in common
Correct answer: UTMA
UTMA expanded the types of property that are transferable into a custodial account. One of the main differences between an UTMA and UGMA is the types of assets they can hold. Assets within an UGMA are limited to cash (bank deposits), stocks, bonds, mutual funds, and other securities and insurance policies. UTMAs allow almost any kind of asset, including works of art and real estate. As with other assets, the title is registered in the name of a custodian for the benefit of the minor. Although there are a few states that allow the custodial property to remain in an UTMA account until the minor reaches age 25, more than half of the states set the age of majority for UTMA at 21 instead of 18.
- Designating a beneficiary with a transfer on death (TOD) provision may be done in which of the following accounts?
- Individual account only
- Individual account, joint tenants with right of survivorship (JTWROS), and joint tenants in common (TIC)
- Individual account and joint tenants with right of survivorship (JTWROS)
- Individual account and joint tenants in common (TIC)
Correct answer: Individual account and joint tenants with right of survivorship (JTWROS)
The TOD designation is limited to the individual account and the JTWROS account.
- A customer and her spouse own shares in the ABC Fund as joint tenants with right of survivorship (JTWROS). If the customer dies, what happens to the shares in the account?
- The spouse would own all the shares.
- Ownership of the shares must be determined by probate court.
- The account would be frozen until the estate was settled.
- Half of the shares would belong to the spouse, and the remaining half would be distributed to the customer's estate.
Correct answer: The spouse would own all the shares.
In a JTWROS account, securities pass to the surviving owner. The account does not have to be frozen but can continue to enter orders.
- Two siblings have an account with your broker-dealer registered as joint tenants with right of survivorship (JTWROS). Both live in a state that recognizes community property as an ownership designation. If one of the siblings dies, which of the following will occur?
- The entire account will be liquidated and divided in accordance with the community property laws of that state.
- The deceased sibling's interest in the account will be divided in accordance with the community property laws of that state.
- The deceased sibling's interest in the account will pass to the surviving sibling in accordance with the JTWROS account registration.
- The deceased sibling's interest in the account will become the property of her estate.
Correct answer: The deceased sibling's interest in the account will pass to the surviving sibling in accordance with the JTWROS account registration.
This account, registered as JTWROS, will be handled in accordance with that account registration at the time of the death of either sibling. The deceased sibling's interest in the account will pass to the surviving sibling. Community property laws in jurisdictions presuming that type of ownership designation only applies to marital property (property acquired by the two individuals while married). Therefore, community property laws would not be applicable to siblings.
- Three brothers open a joint account instructing you that if one of them dies, they want the cash and securities in the account to go to the remaining parties to the account. The account should be opened
- As tenants in common
- As community property
- With right of survivorship
- As tenants by the entireties
Correct answer: With right of survivorship
Using tenants with right of survivorship, each brother's interest in the account would go to the surviving brothers.
- All of the following statements regarding a transfer on death (TOD) account are correct except
- Estate taxes are reduced
- The owner of the account may change beneficiaries at will
- Only those assets held at the broker-dealer are transferred
- Probate is avoided
Correct answer: Estate taxes are reduced
A TOD account avoids probate but not estate taxes. The owner of the account may change beneficiaries and their percentages as she wishes. The TOD account is an account at a specific broker-dealer and only relates to the assets in that account.
- An agent is permitted to open all of the following customer accounts except
- A private account opened by the listed owner's own spouse
- A minor's account opened by the adult custodian of record
- A corporate account opened by the officer named in bylaws
- A partnership account opened by the partner it has chosen
Correct answer: A private account opened by the listed owner's own spouse
An individual account may be opened only by the person in whose name it is carried, so an agent may not let one spouse open a private account for the other; that requires the named owner or a valid power of attorney. The other three are ordinary openings by the person the law or the entity has authorized to act: a custodian of record acts for a minor under the transfer to minors act, a corporate resolution or bylaw names the officer who may act, and the partnership names the partner who may act.
- An agent taking which of the following actions would be committing a violation?
- Buying in a margin account on the customer's own telephoned instruction that afternoon
- Selling from a corporate account under a written limited trading authorization on file
- Buying in a joint account on one co-tenant's instruction without the other's knowledge
- Selling from a custodial account on the minor's own request without custodian approval
Correct answer: Selling from a custodial account on the minor's own request without custodian approval
In a custodial account the custodian, not the minor, holds the authority to make investment decisions, so selling on the minor's own request without the custodian's approval is a violation even though the minor is the beneficial owner. A customer's own verbal instruction is enough to enter an order in that customer's account. A written limited trading authorization lets an agent act for a corporate account, and any tenant in a joint account may give instructions that bind the account without consulting the other.
- Which of the following businesses would have the simplest requirements for opening an account at a FINRA member firm?
- A limited partnership.
- An S corporation.
- A general partnership
- A sole proprietorship
Correct answer: A sole proprietorship
A sole proprietorship is opened up as an individual account because, legally, the business is the individual. The other entities require various forms authorizing named individuals to transact business in the account.
- Which of the following is not true in jurisdictions that recognize the marital property designation known as community property?
- Assets that one spouse receives as a purely personal gift stay outside community property
- Assets that one spouse inherits under a relative's will stay outside the marital property
- Assets that one spouse owned alone before the marriage will now become community property
- Assets owned as community property can trigger a federal tax charge after spouses divorce
Correct answer: Assets that one spouse owned alone before the marriage will now become community property
Community property covers what a couple acquires during the marriage; separate property that one spouse already owned before the marriage does not turn into community property simply because the marriage takes place, so that statement is the false one. Property one spouse receives as a personal gift and property one spouse inherits under a relative's will also remain separate. Community property status does carry federal tax consequences, and those consequences surface when the arrangement ends through divorce, annulment or death.
- Prime brokerage accounts are most often used by
- Broker-dealers
- Institutions
- Investment advisers
- Investment bankers
Correct answer: Institutions
Although any of these could use prime brokerage accounts, their primary users are institutional investors.
- A broker-dealer has set up a prime brokerage account for one of its customers. This customer is most likely
- An investment club
- Two spouses, each having individual accounts and a joint account together
- An individual retail customer
- An institutional customer
Correct answer: An institutional customer
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.
- Under the Uniform Transfer to Minors Act (UTMA), how can stock subscription rights be handled in a custodial account?
- The custodian can exercise, sell, or allow the rights to expire as he deems prudent.
- The custodian cannot exercise rights; they can only be sold.
- The custodian can exercise or sell the rights as he deems prudent.
- The rights can be exercised or sold only if the custodian is also the donor.
Correct answer: The custodian can exercise or sell the rights as he deems prudent.
One thing that is never considered prudent is to let the rights expire. Even if the custodian does not believe adding more of the stock to the account is proper, there is a value to the rights, and the best interest of the minor is served by turning those rights into cash. Custodians in these accounts are able to sell or exercise the right, regardless of any relationship existing between them and the donor.
- An incorporated business model that allows flow-through of business income and losses directly to shareholders in order to avoid double taxation is
- A limited partnership
- An S corporation
- A C corporation
- A general partnership
Correct answer: An S corporation
The S corporation, the general partnership, and the limited partnership are business models where all income or loss flows through to the owners. This avoids the double taxation on the business level and owner level, as is the case with the C corporation. With C corporations, corporate earnings taxed once at the business level and again when they are paid out to shareholders as dividends. Because the question is asking about the incorporated business model, the correct choice is the S corporation.
- A registered representative of a FINRA member firm specializes in handling business accounts. In which of the following accounts are the business owners subject to double taxation?
- Sole proprietorships
- S corporations
- LLCs
- C corporations
Correct answer: C corporations
It is the C corporation whose owners are subject to double taxation. First, the corporation pays income tax on its earnings. Then, any dividends paid from the after-tax income are taxed again, this time to the shareholders.
- Many businesses open brokerage accounts to invest surplus funds. For which of the following business forms would suitability information on the owners not be required?
- An S corporation
- A sole proprietorship
- An LLC
- A C corporation
Correct answer: A C corporation
A C corporation is the only business form where the tax and other consequences of the account do not accrue to the individual owners. Can you imagine a well-known publicly traded corporation with several million shareholders opening an account where the registered representative would have to obtain suitability information on all of them? Even when it is a small business, because the C corporation is its own taxable entity, the suitability requirements are not as critical as with the pass-through businesses (partnerships, LLCs, and S corporations). Of course, the sole proprietorship is the individual, so that is where the suitability is focused.
- If a customer wants to open an account in the name of her adult son and wants the account to be approved for uncovered option writing, her request should be refused because
- Opening an account for a third party is prohibited without the consent of that party
- Discretionary authorization may not be granted with respect to writing uncovered options
- Writing uncovered options is not suitable for minors
- Uncovered options can only be written in margin accounts
Correct answer: Opening an account for a third party is prohibited without the consent of that party
An adult cannot open an account and name another adult as the beneficial owner unless approval is granted by that adult. The type of option trades and the third party's investment experience are not relevant. Furthermore, the child is an adult, not a minor, and we have no suitability information.
- For which of the following business structures is the income taxed to the business?
- A general partnership
- A limited partnership
- A C corporation.
- An S corporation
Correct answer: A C corporation.
Partnerships, limited or general, and S corporations do not pay income tax. Any income earned by the business flows through to the owners. On the other hand, C corporations are taxable entities and must pay tax on their income before they can distribute dividends to shareholders.
- On Monday, John bought and sold 1,000 shares each of MEDX and CETN stock. On Wednesday, he purchased an additional 500 shares of CETN and 1,600 shares of KRS, which he closed in two trades of 800 shares each, later that day. On Friday, John executed a trade to purchase 2,000 shares of BUV and sell 300 shares of the CETN he purchased on Wednesday. Under FINRA rules, John meets the definition of
- An intermittent stock day trader
- A portfolio margin options buyer
- A restricted cash account holder
- An identified pattern day trader
Correct answer: An identified pattern day trader
A day trade is a purchase and sale of the same security in the same account on the same day. John made two on Monday, two more when he closed the sixteen hundred shares of KRS in two trades on Wednesday, and none on Friday, since the CETN he sold that day had been bought two days earlier. Four or more day trades within five business days makes him a pattern day trader, a defined regulatory status that carries a higher minimum equity requirement and is not the same as trading in a restricted or portfolio margin account.
- The type of brokerage account that does not pass assets to other participants at the death of a participant is
- Transfer on death
- Joint tenants with rights of survivorship (JTWROS)
- Tenants in common
- Community property
Correct answer: Tenants in common
At the death of a participant in a tenants in common account, the decedent's assets do not pass to the other members. Rather, they pass to the estate of the deceased. With JTWROS, at the death of a participant, the assets are distributed equally to the surviving members. In those states where community property is the law, upon the death of a spouse, the assets in the account generally pass to the surviving spouse. Transfer on death is simply a designation that allows an account to avoid probate court. It is not available with tenancy in common.
- A joint account could be opened for any of the following except
- Two partners in a limited partnership
- A parent and minor child
- A corporation
- Three business associates
Correct answer: A parent and minor child
Minor children cannot be a party to any account except an UGMA or UTMA.
- If a new joint tenants with right of survivorship account is opened, all of the following statements are true except
- Orders may be given by either party
- In the event of death, the decedent's interest in the account goes to the other party
- Checks may be drawn in the name of either party
- Mail may be sent to either party (with the permission of each party)
Correct answer: Checks may be drawn in the name of either party
While either party may enter an order, any money or securities delivered out of the account must be in the names of both owners.
- 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
- An omnibus clearing broker account
- A prime brokerage services account
- A numbered advisory client account
- A directed custodial trust account
Correct answer: A prime brokerage services account
In a prime brokerage arrangement an institutional customer names one firm, the prime broker, to clear and settle everything, finance positions and provide consolidated back-office reporting, while trades are executed through a number of other firms under agreements with the prime broker. An omnibus account holds many customers' positions under a single name at a clearing firm. A numbered account conceals the owner's name on statements, and a custodial account is held and directed for someone else's benefit.
- Dale Wells, a British citizen temporarily working in the United States, wants to form a business venture with other investors. Wells is looking for favorable tax treatment of earnings and losses. Wells also wants to limit the number of investors but is willing to share control of the enterprise with others to attract them. What business form would you advise?
- S corporation
- C corporation
- Limited partnership
- General partnership
Correct answer: General partnership
Limited partnerships would not work because the other investors have limited say in how the enterprise is run. C corporations do not provide favorable tax treatment of gains or losses. Although an S corporation appears to be the right answer, only U.S. citizens or resident aliens can own one.
- If a business owner's goal is to establish an entity that features ease in raising capital and limits personal liability, which of these entities is the most appropriate?
- A limited liability company vehicle
- A general partnership between firms
- A sole proprietorship trading alone
- A subchapter S corporation election
Correct answer: A limited liability company vehicle
A limited liability company shields its members' personal assets and places no limit on how many investors it may have or where they live, which makes raising capital straightforward. An S corporation election also limits liability but caps the company at one hundred shareholders, none of whom may be a nonresident alien, so its ability to raise capital is restricted. A general partnership and a sole proprietorship both leave the owners personally liable for everything the business owes.
- Which of the following businesses must have more than one owner?
- An S corporation
- An LLC
- A C corporation.
- A partnership
Correct answer: A partnership
If you think about it, how could you have partners with less than one person? Although the other business forms usually have more than one owner, it is legally possible, for them to have a single owner.
- Tenants in common (TIC) ownership provides that a deceased tenant's fractional interest in an account is retained by which of the following?
- Will be decided during probate
- The registered representative for the account
- The surviving tenant
- The deceased tenant's estate
Correct answer: The deceased tenant's estate
- One of your customers has a JTWROS account and an individual account. The individual account is the one approved for options trading. The customer wishes to make a large options trade and asks you to transfer a substantial sum from the cash balance in the joint account to the individual account. To do this,
- You need the approval of a designated principal
- The check would have to be made payable in the name of all the owners of the JTWROS account
- You need the authorization of the customer
- You need the authorization of both parties on the account and the approval of a designated principal
Correct answer: The check would have to be made payable in the name of all the owners of the JTWROS account
- Which of the following employer-sponsored plans is not required to meet the nondiscrimination provisions of ERISA?
- Employee salary-deferral 401(k) plans
- Unincorporated Keogh retirement plans
- Executive deferred compensation plans
- Insured defined-benefit pension plans
Correct answer: Executive deferred compensation plans
Deferred compensation plans for executives are nonqualified arrangements funded from the employer's general assets, so they fall outside the ERISA nondiscrimination provisions and an employer may offer one to selected people while excluding everyone else. Salary-deferral plans, Keogh plans covering an unincorporated business and its staff, and defined-benefit pension plans are all qualified plans: the employer takes a current deduction, the plan must be offered on a nondiscriminatory basis, and the ERISA coverage and participation rules apply.
- All of the following are true regarding nonqualified deferred compensation plans except
- Employees may use accumulated funds as collateral for a bank loan
- Income taxes on compensation are not due until constructive receipt
- IRS approval is not needed for deferred compensation plans.
- The plans need not be offered to all employees
Correct answer: Employees may use accumulated funds as collateral for a bank loan
Deferred compensation is a promise made by an employer to defer a certain amount of an employee's salary upon retirement. The employee has no right to the money until retirement, death, or disability, and thus cannot use it as collateral.
- Which of the following types of business organizations does not protect owners' personal assets from losses incurred by the business?
- Limited liability companies organized under state law
- Single owner proprietorships operated under state law
- Privately owned business corporations under state law
- Limited liability partnerships formed under state law
Correct answer: Single owner proprietorships operated under state law
A sole proprietorship is not a separate legal entity from its owner, so business debts and judgments reach the owner's personal assets without limit. A limited liability company gives its members that separation, an ordinary business corporation gives it to its shareholders, and a limited liability partnership shields each partner from obligations arising elsewhere in the firm. Only the unincorporated single-owner form leaves personal assets exposed.
- Which of the following business structures will generally have the fewest number of owners?
- A general partnership
- An LLC
- An S corporation
- A sole proprietorship
Correct answer: A sole proprietorship
A sole proprietorship has only one owner. That is what the "sole" means. Although S corporations and LLCs can be formed with a single shareholder or member, that would be the exception rather than the rule. A partnership needs at least two persons.
- The concept of double taxation applies to shareholders of
- General partnerships
- Limited partnerships
- S corporations.
- C corporations.
Correct answer: C corporations.
It is the C corporation where the owners contend with double taxation. The first tax is on the corporation's earnings. After that, any dividends distributed to the shareholders are subject to tax.
- Which of the following forms of business is preferred when the goal is raising a significant amount of capital?
- C corporation
- S corporation
- LLCs
- General partnership
Correct answer: C corporation
When there is a need for significant capital, it is the C corporation that is the form to use.
- Which of the following occurs in a partnership account if one partner dies?
- The surviving partners receive the deceased partner's share.
- The account is frozen until a new or amended partnership agreement is received.
- The surviving partners are considered joint tenants.
- The surviving partners are considered joint tenants and receive the deceased partner's share.
Correct answer: The account is frozen until a new or amended partnership agreement is received.
Upon a partner's death, a partnership account is automatically frozen until a new or amended partnership agreement is received. The deceased partner's share usually goes to an estate, not to the other partners.
- Under FINRA's rules governing the activities of member broker-dealers, prior notification to the employing firm and prior written consent from the employing firm would be required to open a brokerage account for all of the following except
- An officer of another member firm opening a cash account
- A registered representative of another member opening an options account
- A clerical employee of another member opening a margin account
- A registered representative of another member opening a 529 plan
Correct answer: A registered representative of another member opening a 529 plan
FINRA requires prior written notification be made and prior written consent be received before any employee can open a brokerage account with other members or financial institutions. Exceptions include accounts where the only activity will be in 529 plans, mutual funds, or variable annuities.
- When opening a new retail account or updating account information for a specified adult, FINRA Rule 2165 urges member firms to obtain the name and contact information of a "trusted contact person." If the client supplies that information, the person
- May enter buy and sell orders for the account without any further authorization
- May be mailed duplicate trade tickets and account statements by the member firm
- May be contacted when the member suspects exploitation or neglect in an account
- May withdraw cash or securities from the account after clearing with the branch
Correct answer: May be contacted when the member suspects exploitation or neglect in an account
Naming a trusted contact person gives the firm someone to reach out to when it sees signs of possible financial exploitation, neglect or diminished capacity, which is the purpose behind the rule on senior investors. The designation conveys no authority over the account itself. It is not a power of attorney or a trading authorization, so the trusted contact may not enter orders, may not move cash or securities out of the account, and has no right to receive duplicate trade tickets or account statements.
- Jack Mercure, age 72, has been a client of yours for many years. You have noticed he's a bit slower than before, but nothing troublesome. This morning, you get a call from Jack, and he wants you to wire a relatively substantial sum from his account to someone with a foreign address. Fearing this might be a case of senior exploitation, you discuss this with your manager. If the feeling is mutual, FINRA rules would permit your firm to
- Report the requested wire to the Office of Foreign Assets Control
- Freeze the cash account and refuse orders the client enters later
- Place a temporary hold on the disbursement of the requested funds
- Obtain a written opinion on capacity from the client's own doctor
Correct answer: Place a temporary hold on the disbursement of the requested funds
FINRA Rule 2165 lets a member that reasonably believes financial exploitation of a specified adult is occurring place a temporary hold on the DISBURSEMENT of funds or securities from the account, initially for no more than 15 business days. The rule reaches the disbursement, not the account itself, so it gives no authority to freeze the account or to reject the client's own orders. Reporting a wire to the Office of Foreign Assets Control is a sanctions screening step that has nothing to do with suspected exploitation of a senior. Nothing in the rule lets a firm seek a capacity opinion from a client's doctor; the firm works through the trusted contact person instead.
- All of the following pieces of information must be obtained from new individual customers except
- Date of birth
- Educational background
- Residence address
- Social Security number.
Correct answer: Educational background
A customer's educational background is not required to open a new account. In the case of an account opened in a business's name, the business address and tax identification number are required.
- All of the following may be used to verify a customer's identity except
- A certified birth certificate
- A current drivers license
- A valid passport
- A valid military ID card
Correct answer: A certified birth certificate
Verifying a customer's identity requires presentation of at least one government-issued document with a photograph. Your birth certificate may have had a photo of you as a newborn, but that certainly will not suffice to identify you today.
- If a person wishes to enter orders in his spouse's account, he
- Could never be permitted to do so, as there is no provision that would allow for it to occur
- Needs verbal permission from his spouse
- Is free to do so
- Needs written permission from his spouse through a power of attorney
Correct answer: Needs written permission from his spouse through a power of attorney
The only persons permitted to enter orders in an account are the account owners. For a person to enter orders in his spouse's account, the spouse whose name is on the account must sign a power of attorney.
- If a member firm suspects exploitation in the account of a specified adult, proceeds from sales may be put on temporary hold for
- 15 calendar days.
- 15 business days.
- Until the need for the hold ends
- One month
Correct answer: 15 business days.
FINRA Rule 2165 permits a member that reasonably believes that financial exploitation has occurred, is occurring, has been attempted, or will be attempted, to place a temporary hold on the disbursement of funds or securities from the account of a "specified adult" customer. The maximum length of the hold is 15 business days. Do we expect the exam will ask you to choose between 15 business and 15 calendar days? No, that is not FINRA's style, but we do want you to know the correct count.
- An employee of a FINRA member firm wishes to open an account at another member firm. The employee opening the account must
- Notify FINRA, in writing, of the intent to open the account
- Obtain prior written consent from FINRA before opening the account
- Make written notification to the SEC before the account can be opened
- Receive prior written consent from his employer
Correct answer: Receive prior written consent from his employer
Persons associated with one FINRA member firm may open securities accounts at other member firms, as long as prior written notice was made to, and prior written consent was received from, the employing broker-dealer before the account is opened. Neither notification nor consent is required from FINRA or the SEC.
- One of your clients has appointed his daughter as the trusted contact person per FINRA Rule 2165. She contacts you to explain that her father's cognitive abilities are declining. Because of that, before it gets too late, she wants to know what can be done to give her control over the account. It is likely that the best suggestion would be to have her father sign
- A durable power of attorney
- The discretionary power authorization
- A limited power of attorney
- A full power of attorney
Correct answer: A durable power of attorney
A durable power of attorney is used when the account owner has diminished physical or mental capacity. It is durable because it survives the client becoming legally incompetent (but does not survive death).
- A new customer is opening a cash account with your broker-dealer. The new account form must contain the signature(s) of
- The principal and the registered representative working with the customer
- The customer only
- The customer and the registered representative working with the customer
- The principal only
Correct answer: The principal only
To open a cash account, only the signature of the principal accepting the account is required. For margin accounts, the signature of the customer would be required on the margin agreement.
- Broker-dealers are required to maintain customer identification programs and check the names of new clients against
- The FBI's most wanted list
- A list maintained by the Securities Exchange Commission
- A list of sanctioned people and organizations maintained by the Department of Enforcement
- A list compiled by the Office of Foreign Assets Control (OFAC)
Correct answer: A list compiled by the Office of Foreign Assets Control (OFAC)
All financial institutions are required by federal law to maintain a customer identification program and check the identifying information against a list maintained by the OFAC for suspected terrorists or terrorist organizations.
- Dale Johnston has been a registered representative with Consolidated Investment Services (CIS) for over 20 years. Taylor Kahn has been Johnston's client for most of that time. Kahn recently reached full retirement age for Social Security and has begun using those funds for investment. Johnston's practice is to speak with clients on a quarterly basis, unless something merits a special call. It seems to Johnston that on the last call, Kahn seemed a bit confused over the strategy being used with the Social Security funds. A second call seemed to verify that Kahn was still a bit fuzzy. This morning, a phone call came in from Kahn's son asking Johnston to sell one of the holdings and forward the proceeds to his bank. Kahn's son does have a full power of attorney over the account but has never given instructions to have money sent to him before. What is the most appropriate action for Johnston to take?
- Refuse to complete the trade
- Place a temporary hold on the withdrawal
- Freeze the account
- Place the trade after receiving approval from your supervising principal
Correct answer: Place a temporary hold on the withdrawal
Member firms may place a temporary hold on the distribution of funds or securities from the account of a specified adult. The temporary hold is also allowed in certain circumstances where the member reasonably believes that financial exploitation of the specified adult has occurred, is occurring, has been attempted, or will be attempted. FINRA considers temporary to be up to 15 business days.
- Jack has a margin account in his own name with BR Securities, Inc. He also has a joint tenancy account with his father, Roberto. Rosa, Jack's spouse, calls Joe, the registered representative who is assigned to both accounts, and instructs him to sell 100 shares of AOL from Jack's margin account. Which of the following should the registered representative do?
- Not execute the order until he receives verbal authority from Jack, which authorizes his father to act with discretionary authority over his margin account
- Transfer the AOL to the joint account and then execute the transaction in the joint account
- Not execute the order until he receives written power of attorney from Jack, authorizing his spouse to act with trading authority over his margin account
- Execute the transaction immediately
Correct answer: Not execute the order until he receives written power of attorney from Jack, authorizing his spouse to act with trading authority over his margin account
A registered representative may not execute a third-party order (one given by someone other than the account owner) without a signed written power of attorney from the account owner that has been accepted by the representative and a principal of the firm.
- When an individual associated with another FINRA member firm wishes to open up an investment account at another member firm, the executing member must
- Receive permission from the employer member before the initial transaction may take place
- Provide duplicate statements and confirmations if requested by the employer member
- Obtain a copy of the individual's Form U4 to verify registration status
- Notify the employer member of the associated person's intent to open the account
Correct answer: Provide duplicate statements and confirmations if requested by the employer member
FINRA Rule 3210 requires that an executing member shall, upon written request by an employer member, transmit duplicate copies of confirmations and statements. The associated person is the one who must notify the employer member of the intent to open the account and receive written consent to do so. Furthermore, the associated person is required to give written notice to the executing member that the individual is associated with the employer member.
- What can a broker-dealer do if it suspects tampering with the account of a senior investor?
- Place a temporary hold upon the disbursement of cash or securities
- Suspend all of the securities transactions in this account for now
- Reverse the disputed transfers and put back the prior cash balance
- Liquidate the positions and place the proceeds into a firm account
Correct answer: Place a temporary hold upon the disbursement of cash or securities
FINRA Rule 2165 permits a member that reasonably believes exploitation is occurring, has occurred, or is being attempted to place a temporary hold on the disbursement of funds or securities from a specified adult's account, for up to 15 business days. The authority stops at disbursements. The rule does not let the firm shut off the customer's securities transactions, does not let it unwind trades or transfers that have already settled, and does not let it liquidate positions and park the proceeds; each of those would itself be unauthorized activity in the customer's account.
- A new client turns in the new account form. While reviewing the information on the form, the registered representative handling the account notices that the space for listing the Social Security number is blank. Under the provisions of the USA PATRIOT Act of 2001,
- The account can be opened without the number if at least two pieces of government ID are presented
- The account cannot be opened until the number has been received
- The account can be opened if the client assures you that an application will be filed
- The account can be opened if the client has already applied for a number
Correct answer: The account can be opened if the client has already applied for a number
The customer identification program (CIP), a part of the USA PATRIOT Act of 2001, requires a Social Security or tax identification number included on the new account form. The firm can open the account if the number has been applied for. In this instance, the firm must obtain the number within a reasonable period and the account card must be marked applied for.
- While interviewing a person to fill out the new account form, a registered representative asks the potential new client a number of questions. Information regarding which of the following would not be required on the form?
- Social Security number or tax ID number
- Educational background.
- Name
- Physical address
Correct answer: Educational background.
When opening a new account, the registered representative must obtain the name, date of birth, physical address, and Social Security number. Information such as educational background may be inquired about and useful to know, but is not required to open the account.
- An employee of another broker-dealer would like to open an account with your firm. Under FINRA rules, all of the following statements regarding the employee and the account are true except
- The employer must grant prior written approval to open the account
- The employer must be notified, in writing, of the opening of the account
- If the employer requests them, they must receive duplicate copies of all account transactions
- The employer must approve each transaction before entry of the order
Correct answer: The employer must approve each transaction before entry of the order
FINRA rules do not require prior approval of individual transactions by either the broker-dealer at which the account has been opened or the employing broker-dealer. The rules do require that the employing broker-dealer be notified, in writing, and that they give prior written consent before the account can be opened. Duplicate copies of account statements and confirmations must be supplied only if the employing broker-dealer has requested them.
- Which of the following individuals could most likely open an account at a FINRA member firm without notifying or receiving permission from her employer?
- A bank employee selling fixed annuities only
- An agent who sells variable annuities
- A government security trader employed by a member
- A purchases and sales clerk of a member
Correct answer: A bank employee selling fixed annuities only
Whenever an employee of a FINRA member wants to open a securities account with another FINRA member firm or financial institution, the employee must give prior written notice to her employer and receive prior written consent from her employer before the account can be opened. Someone selling fixed annuities only (not a security like variable annuities) is most likely not associated with a member.
- Two friends would like to open a joint account but have the tax filed under the name of the nonemployed individual. That could be done in
- A JTWROS account with the Social Security number of the designated person used
- A tenants in common account with the percentage ownership in the name of the designated person
- An account opened as a partnership
- A joint account with a TOD designation
Correct answer: A JTWROS account with the Social Security number of the designated person used
In a JTWROS account, the assets are considered jointly owned. Only one tax identification number (Social Security number) is placed on the account. If it is the number of the nonemployed individual, the Form 1099 will go to that person and that is whom the IRS will expect to pay the taxes. That might be the correct answer to a test question. In the real world, it might not satisfy the IRS that the one in the lower tax bracket is being credited with all the income and gains. If the IRS audits the account and sees that the funds came from the working individual, there could be tax issues. However, the exam does not always deal with the real world and we won't either on this one.
- An employee of a firm registers to open an account at another member firm. Under FINRA rules, all of the following statements are true except
- The employing member firm must receive duplicate statements and confirmations if requested in writing
- FINRA must receive duplicate statements and confirmations for each transaction.
- The employing member firm must be notified, in writing, of the intent to open the account
- The employee must receive prior written permission from the employing member firm
Correct answer: FINRA must receive duplicate statements and confirmations for each transaction.
Under FINRA rules, the employing member must be notified, in writing, of the prospective account and must give prior written approval before the account can be opened. It must be provided with duplicate statements and confirmations only if it makes a written request. There is no requirement that FINRA be either notified or provided with duplicate statements and confirmations.
- Which of the following is required to sign a new account form for a cash account?
- The customer
- The principal
- The spouse of the customer
- The registered representative
Correct answer: The principal
To open a cash account, only the signature of the principal accepting the account is required. For margin accounts, the signature of the customer is required on the margin agreement. The signature of the spouse is required only for a joint account.
- Obtaining all of the following complies with the regulations regarding customer identification programs except
- A passport number issued by a foreign country's own government
- A residential street address for the natural person opening it
- A tax identification number kept for a corporate account owner
- A post office box substituted for a residential street address
Correct answer: A post office box substituted for a residential street address
A customer identification program must collect a name, a date of birth for a natural person, an address, and an identification number. The address has to be a residential or business street address; a post office box standing in place of one is not acceptable, so obtaining only the box does not comply. Each of the other three is an element the rule expressly contemplates: a non-U.S. person may be identified by a passport number and country of issuance, a residential street address for the natural person is exactly what the rule asks for, and a legal entity is identified by its taxpayer identification number.
- If a customer who has granted a durable power of attorney to her son dies, which of the following statements regarding the power of attorney is true?
- It remains in effect only if the son is the sole heir to the estate.
- It remains in effect until the son cancels it.
- It remains in effect until the executor of the estate cancels it.
- It is canceled upon the death of either principal.
Correct answer: It is canceled upon the death of either principal.
When the customer or her son dies, the power of attorney also expires. However, a durable power of attorney will survive a declaration of mental incompetence and is useful in those cases where a parent suffers from dementia.
- The federal legislation that requires broker-dealers to verify the identity of any person opening an account is
- The Maloney Act
- The USA PATRIOT Act of 2001
- The Insider Trading Act
- The Securities Exchange Act of 1934
Correct answer: The USA PATRIOT Act of 2001
The USA PATRIOT Act of 2001 requires firms to obtain identifying information on each new customer, verify the identity of each new customer, maintain records relating to identity verification, and determine if any new customer appears on a list of known or suspected terrorist groups compiled by the Office of Foreign Asset Control.
- The child of one of your recently deceased clients comes to your office with several properly signed stock certificates inherited from a parent. The child does not have an account and wishes to sell the securities. An account is opened for the purpose of the liquidation. Regulation S-P would refer to this child as
- A covered person
- A consumer
- A customer
- A beneficiary
Correct answer: A consumer
Regulation S-P makes a distinction between consumers and customers. That is important because it makes a difference when it comes to annual reporting. A consumer is basically a "one-shot" client, as in this case. After the liquidation, this account will be closed and you probably won't ever hear from the child again. A customer has an ongoing relationship and requires annual privacy notices—the consumer does not.
- If a customer wishes to open a cash account, who must sign the new account form?
- Only the registered representative
- The customer, the registered representative, and the principal
- Only the principal
- Only the customer
Correct answer: Only the principal
Neither the customer's signature nor the registered representative's signature is required to open a cash account. A principal must review and accept the new account by signing the form.
- A new account is opened at your firm and you notice that there is a trusted contact person form attached to the documentation. You could safely surmise that this is an account for
- A corporate entity
- A specified adult
- A revocable trust
- A custodial minor
Correct answer: A specified adult
A trusted contact person is the safeguard FINRA built around the specified adult, defined in Rule 2165 as a natural person 65 or older, or 18 or older whom the member reasonably believes has a mental or physical impairment that leaves the person unable to protect his own interests. Seeing that form on a new account points to such a customer. A corporation and a trust are not natural persons and already act through officers or trustees, and a minor's account already has a custodian of record, so none of the three is the customer the trusted contact requirement was written for.
- Under the USA PATROIT Act of 2001, which of the following must be maintained by financial institutions, such as banks and broker-dealers, to prevent the financing of terrorist operations and money laundering?
- Customer identification programs (CIPs)
- Do-not-call lists
- Specially Designated Nationals and Blocked Persons list
- Privacy notices
Correct answer: Customer identification programs (CIPs)
The USA PATRIOT Act of 2001 requires financial institutions to maintain CIPs to protect against financing terrorist operations or activities and potential money laundering activities. The Office of Foreign Asset Control (OFAC) publishes and maintains the Specially Designated Nationals and Blocked Persons list, which financial institutions use to determine if any customers or potential customers have been identified by OFAC as posing a terroristic threat or are involved in money-laundering activities.
- A 71-year-old client calls her registered representative and asks him to wire $10,000 to an offshore account. The rep asks the reason and she responds that she won money in a lottery and this is to pay the taxes. The registered representative is concerned that this might be a case of senior exploitation and should
- Reach out to the trusted contact person and describe the request
- Send the wire quickly and then file a suspicious activity report
- Refuse the request and close out the client's cash account today
- Record the wire details and forward the matter to his supervisor
Correct answer: Reach out to the trusted contact person and describe the request
At 71 the client is a specified adult, so the firm should already have obtained a trusted contact person for the account. When a request carries the marks of exploitation, that contact is exactly who the rule was built for, and describing the request to that person is the step the rules contemplate. Sending the wire first defeats the purpose, whatever is filed afterward. Refusing outright and closing the account is not a remedy the firm has and it punishes the customer. Passing the wire instructions to a supervisor is an internal handoff that does nothing to test whether the client is being exploited.
- An individual has given full power of attorney (POA) to a third party. This means that the designee is permitted to
- Originate trades in the account and remove funds or securities
- Remove funds or securities from the account but not originate trades
- Originate trades in the account but not remove funds or securities
- Close the account and reopen it in the designee's name
Correct answer: Originate trades in the account and remove funds or securities
Full POA gives the named third party—the designee—all of the power of the owner except the right to change the name on the account.
- If a customer wishes to open a cash account in her name only and allow her spouse to make purchases and receive checks in his name only, she must instruct her broker-dealer to open
- A margin account
- A cash account with full power of attorney
- A cash account with limited power of attorney
- A cash account
Correct answer: A cash account with full power of attorney
For anyone other than the account owner, entering trades and withdrawing assets requires a full power of attorney. A limited power of attorney enables a nonaccount owner to enter trades but not to withdraw assets.
- When opening a new account for an individual investor, FINRA asks its member to make a reasonable effort to obtain certain information about the account. Included information would be all of the following except
- The occupation of the customer and name and address of the employer
- The customer's tax identification or Social Security number
- Whether the customer is an associated person of another member
- The name(s) of the customer's dependents
Correct answer: The name(s) of the customer's dependents
Nowhere in the FINRA rules on account opening does it require or suggest obtaining personal information about family members. That information becomes important when we look at the suitability rules. Please note that the tax ID or Social Security number is required under the customer identification program (CIP), but not FINRA rules.
- When an investor opens a new account at a member firm, FINRA rules require
- The signature of the applicant on the freshly opened account form
- The recorded date of birth of the individual opening this account
- The Social Security number listed by the applicant at the opening
- The signature of a registered principal to accept the new account
Correct answer: The signature of a registered principal to accept the new account
The only signature FINRA requires on a new account form for an individual is that of a partner, officer, or manager, a registered principal, showing that the account has been accepted under the member's own procedures. The customer does not have to sign the form at all. A date of birth and a Social Security or tax identification number are collected under the customer identification program rather than by the FINRA new account rule, and FINRA asks only for a statement that the applicant is of legal age.
- A customer wants to open a new cash account and give her sibling trading authorization. The required documents to accommodate her request would be
- A margin agreement and a limited power of attorney
- A new account form and a loan consent agreement
- A margin agreement and a loan consent form
- A new account form and a limited power of attorney
Correct answer: A new account form and a limited power of attorney
When a customer wants to give trading authorization or discretionary privileges to a third party in a cash account, a member firm requires a new account form (as with all new accounts) and a limited power of attorney. A limited power of attorney gives the third party trading authority but prohibits that party from withdrawing assets (cash or securities) from the account.
- All of the following must be verified or determined about a new customer except
- Whether she appears on a list of known or suspected terrorists
- Whether she has a brokerage account at another broker-dealer
- Whether she is employed by another broker-dealer
- Citizenship
Correct answer: Whether she has a brokerage account at another broker-dealer
Though individual firms may require it, there is no industry requirement to verify or determine that a customer has an account at another broker-dealer.
- When a broker-dealer sends a communication to its customers that the sweep account used for customer credit balances will be changed from one money market fund to a different one, the communication must include
- A detailed explanation of the reason for the change
- A statement that the change will not take place until at least 45 days after the communication was sent
- A description of the objectives of the new fund and its prospectus
- A tabular comparison of the nature and amount of the fees charged by each fund
Correct answer: A tabular comparison of the nature and amount of the fees charged by each fund
The only one of these meeting FINRA's requirement when a negative response letter is sent is the tabular comparison. While a description of the new fund and its prospectus is required, the communication must also include a comparison of the objectives of the two funds. The minimum time is 30 days (not 45) and there is no requirement to include an explanation.
- A FINRA member firm making a bulk transfer of customers' assets would most likely give notification through
- FINRA's Central Registration Depository (CRD).
- A broadly circulated publication such as the Wall Street Journal
- A negative response letter
- A positive response letter
Correct answer: A negative response letter
An example of a bulk transfer is the member firm deciding to switch money market funds used for sweeps of customer credit balances. A negative response letter is one where the customer's agreement is assumed unless responding negatively to the change.
- You have two customers who are a couple. Each person has an individual account. They also have a JTWROS account in both names. One of the customers asks you to transfer funds from the other person's individual account in order to meet a margin call in the requesting customer's margin account. To do this,
- You need the approval of a designated principal
- You need the authorization of both customers
- You need the authorization of both parties on the account and approval of a designated principal
- Because they are both signatories on the joint account, you need the authorization of this customer only
Correct answer: You need the authorization of both customers
Because the customer asking for the transfer is not a signatory on the other customer's individual account, you need the authorization of both of them. As long as both consent, there is no need for authorization by a principal. However, in the real world, your firm may want to look at transfers of this type. Just remember, we are teaching the test world.
- A married couple has several individual and joint accounts with your firm. One spouse calls you and requests that you make a transfer of funds between the accounts. This would not present a problem if
- You verify the identity of the caller
- The caller is a signatory on the account receiving the funds
- The caller is a signatory on both accounts
- You have the caller send the request in writing
Correct answer: The caller is a signatory on both accounts
It is only when the party initiating the transfer of funds between accounts is not a signatory on both accounts that this request presents a problem. In that case, a principal of the firm needs to get involved.
- A married couple has had an account with your FINRA member firm for many years. The account is registered in both names, JTWROS. Upon the advice of their estate-planning attorney, they wish to move the assets in equal proportion to individual accounts. This would require all of the following except
- Before obtaining approval of the account designation change, a designated principal must be personally informed of the essential facts relative to the change
- Authorization of the change by a qualified registered principal designated by the member
- A statement from the couple's attorney explaining the reason for the change
- The essential facts relied upon by the person approving the change must be documented in writing and preserved with the customer account records
Correct answer: A statement from the couple's attorney explaining the reason for the change
There is no FINRA requirement to receive any information from the couple's lawyer. All the other statements are correct.
- One of your customers with a JTWROS account contacts you to remove the other tenant and put the account into the customer's own name. This can be done only
- If the surviving joint tenant produces a certified record of death
- If a qualified registered principal of the firm accepts the change
- If the customer already holds a complete written power of attorney
- If the removed joint tenant signs a written and witnessed approval
Correct answer: If a qualified registered principal of the firm accepts the change
No change in an account name or designation may be made unless a qualified registered principal designated by the member has authorized it. Before approving, that principal must be personally informed of the essential facts and must record them in writing with the customer account records. The death of a joint tenant, a power of attorney, and a release signed by the other tenant may each be part of the essential facts the principal reviews, but none of them by itself lets the change be made. The documents go to the principal, not to the registered representative.
- A financial institution sends a communication to its clients indicating an action the institution plans to change. The communication states that this change will take place in 45 days and any client wishing to opt-out must notify the institution before the end of that period. This is known as
- An informational communication
- An unethical procedure
- A negative response letter
- A change letter
Correct answer: A negative response letter
A negative response letter is a communication where, unless the recipient responds negatively, the proposed action is accepted. The letter must contain certain disclosures such as different costs or features.
- Sally Williams is a customer of your FINRA member firm. Sally was recently married and wishes to change the name on her individual account to her new last name. To do this,
- A court of proper jurisdiction must first approve the name change
- A notarized copy of the marriage record must reach FINRA promptly
- A registered principal of the member must approve the name change
- A replacement account must be opened under the newly married name
Correct answer: A registered principal of the member must approve the name change
A change in the name on an account is a change in account designation, and it may be made only when a qualified registered principal designated by the member has approved it. The principal will ask to see evidence of the change in status, such as a marriage certificate, and will document the essential facts in writing. No court order is needed for a name change that follows a marriage, the marriage record stays in the firm's own files rather than going to FINRA, and there is no need to close the account and open a replacement.
- Which of the following retirement plans must be ERISA compliant?
- Traditional IRAs
- Nonqualified plans
- 401(k) plans
- Roth IRAs
Correct answer: 401(k) plans
For exam purposes, if it is a private employer (nongovernmental) qualified retirement plan, it must be ERISA compliant. The most widely used of those today is the 401(k) plan. The "E" in ERISA stands for employee. IRAs are individual retirement accounts; there is no employer-employee relationship. Nonqualified plans are retirement plans that do not have to follow ERISA regulations. These non-qualified plans include deferred compensation plans, individual annuities, and some payroll deduction plans.
- A similarity between common and preferred stock is
- The dividend rate is fixed at the initial offering date
- The holder receives a single vote for every share owned
- The security is evidence of borrowing done by an issuer
- The dividend must be declared by the board of directors
Correct answer: The dividend must be declared by the board of directors
Dividends are never automatic on either class of stock. Whether the shares are common or preferred, the board of directors must declare the dividend before it becomes payable, and that is the similarity the question is after. A fixed rate is a preferred feature, not a common one. Voting runs the other way: common shares normally vote and preferred shares usually carry no vote or a very limited one. And both are equity securities, evidencing ownership rather than money the issuer has borrowed.
- Which of the following statements regarding preferred stock is not true?
- Unlike debt, preferred stock has no set maturity date.
- Because there is no set maturity value or redemption date, the holder of preferred stock has to sell her shares in the open market to close out her position.
- Voting rights of preferred shareholders take precedence over those of common shareholders.
- The dividend is fixed except in the case of adjustable preferred.
Correct answer: Voting rights of preferred shareholders take precedence over those of common shareholders.
Preferred shareholders do not generally have voting rights. Voting rights are characteristic of common stock, not preferred. Preferred stock is unlike debt securities in that it has no set maturity date. It is true that the dividend on a preferred stock is fixed, except in the case of an adjustable preferred where the dividend can be tied to a market interest rate and readjusted. The holder of a preferred has to sell the shares in the open market to close out her position.
- An investor purchasing an ADR for a company domiciled in South Korea should understand that
- Any Korean taxes on dividends will be added to U.S. tax on those dividends.
- The investor will be subject to currency risk
- The investor will not be able to receive a stock certificate for that company
- The ADR has greater market risk than the stock itself
Correct answer: The investor will be subject to currency risk
ADRs facilitate the purchase of foreign stock. This is because everything is in dollars and English. However, because the trading price and value of this security is based on the South Korean won, U.S. investors have currency (exchange) risk. Although not commonly done, investors can request the actual certificate to replace the ADR. There is a withholding tax in Korea, but as with any ADR on the exam, that tax paid may be taken as a credit against the U.S. tax due on the dividend. There is essentially no difference in market risk between the actual stock and the ADR.
- The term plain vanilla describes which of the following preferred stock issues?
- Straight
- Convertible
- Callable
- Cumulative
Correct answer: Straight
Plain vanilla means there are no added features, just the fixed dividend.
- When an issuer of a preferred stock exercises the call, it is usually at a price somewhat above the stock's par value. This excess over par is
- The call privilege
- The yield to call
- The call premium
- The call price
Correct answer: The call premium
Call premium is the term used to describe that excess over par that the issuer pays when calling in the preferred stock (or callable bond).
- If a corporation attaches warrants to a new issue of debt securities, which of the following would be a resulting benefit to the corporation?
- Reduction of the debt securities' interest rate
- Increase in earnings per share
- Reduction of the number of shares outstanding
- Dilution of shareholders' equity
Correct answer: Reduction of the debt securities' interest rate
Usually, a warrant is issued along with a debt instrument, which is an enhancement that allows the issuer to offer a slightly lower interest rate.
- Investors should always be aware of taxes applicable to investments they own. Which of the following taxes might be associated with income derived from American depositary receipts (ADRs) but not income from other investments?
- Federal income tax
- State income tax
- Excise tax
- Foreign income tax
Correct answer: Foreign income tax
In most countries, a withholding tax on dividends is taken at the source. To the holder of an ADR, this would be a foreign income tax. The foreign income tax paid may be taken as a credit against U.S. income taxes owed.
- A customer owns cumulative preferred stock (par value of $100) that pays an 8% dividend. The dividend has not been paid this year or for the previous two years. How much must the company pay the customer per share before it may pay dividends to the common stockholders?
Correct answer: 24
If the company is going to pay a common stock dividend, it must pay the preferred dividends first. A cumulative preferred stockholder must also receive all dividends in arrears. There is $16 due in back dividends, in addition to $8 this year, for a total of $24.
- The Securities Exchange Act of 1934 deals with all of the following except
- Monitoring accounts for insider trading violations
- Filing of financial statements by broker-dealers
- Marking sales long or short on an order ticket
- Filing an updated prospectus
Correct answer: Filing an updated prospectus
Prospectus filing is a requirement of the Securities Act of 1933.
- In a proceeds transaction for a customer where the proceeds from the liquidation of one stock are used to purchase another stock, the 5% markup policy is computed on the basis of
- The greater of the two amounts the dealer earned overall
- The sum of the dealer's compensation on both trade sides
- The amount of dealer compensation on the sell side alone
- The compensation on each of the two sides measured alone
Correct answer: The sum of the dealer's compensation on both trade sides
A proceeds transaction is treated as one transaction. The dealer adds what it made on the sell side to what it made on the buy side and measures that combined figure against the inside market on the buy side for purposes of the 5% policy. It is the SUM of the two and not the larger of them: taking whichever leg paid more still leaves part of the compensation out. Looking at the sell side by itself, or at each leg as a separate transaction, understates the total in the same way, and that is exactly the treatment the policy was written to prevent.
- An investor who purchased 100 shares of REDP common stock on February 28, 2019, would receive long-term capital gain treatment if the stock is sold at a profit starting
- March 1, 2020.
- February 29, 2020.
- March 2, 2020.
- February 28, 2020.
Correct answer: March 1, 2020.
Investors must own a security for more than 12 months before it becomes long term for tax purposes. The first day after February 28, 2019, is March 1, 2019. Twelve months later is March 1, 2020. Always count 1 day and then add 12 month so that, in this case, you don't come up with February 29 because 2020 is a leap year.
- An investor establishes a $5,000 position by purchasing 100 shares at $50 per share. She then sells all the shares six months later at $60 per share. Her taxable consequences are
- A $1,000 short-term capital gain
- A $1,000 short-term capital loss
- A $1,000 long-term capital gain
- A $6,000 short-term capital gain
Correct answer: A $1,000 short-term capital gain
The taxable consequence for this investor is a $1,000 short-term capital gain. She sold shares for $6,000 and purchased them for $5,000 resulting in a $1,000 gain. It is short-term gain because she did not hold the shares longer than one year. Short-term capital gains are taxed as ordinary income at the investor's marginal tax rate. Long-term capital gains are taxed at lower tax rates.
- Aenical Corporation issued $100 million of $100 par value preferred stock a number of years ago. The stock pays quarterly dividends of $1.25. Recent issues of comparable preferred stock carry a dividend yield of 4%. One could expect the market price of the Aenical preferred stock to be closest to
Correct answer: $125.
As with other fixed-income securities, as market yields change, the price of previously issued securities increases or decreases to offer a comparable return. The logic is that investors will purchase fixed-income securities only if they can receive a return comparable to the current market rate. This stock is paying an annual dividend of $5 ($1.25 per quarter times four). Investors purchasing this stock expect their return to be approximately 4%, the current rate being paid in the market. The math here needs to first answer "$5 is 4% of what number?" Divide $5 by 4% and the answer is $125. At $125 per share, Aenical stock paying a $5 annual dividend is offering a 4% return on investment.
- A key term in the SEC's lexicon is transparency. It is often said that "disclosure is the religion of the SEC." When investigating a security for a potential recommendation to a customer, it is likely that the least transparency exists when the stock trades in
- The OTC market
- The grey market
- The secondary market
- The listed market
Correct answer: The grey market
Securities trading on the "grey market" are not quoted on any U.S. quotation system. Broker-dealers are not willing or able to publicly quote these securities because of a lack of investor interest, company information availability, or regulatory compliance. Without quotes and reports to the SEC, there is little if any transparency. **This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- The over-the-counter (OTC) market could be characterized as what type of market?
- Auction
- Primary
- Dealer
- First
Correct answer: Dealer
The OTC market is a dealer market.
- For individual public investors, dark pools of liquidity
- Allow them to enter orders that are sent directly to the trading floors of stock exchanges
- Lessen the transparency of the overall market as volume, quote and price information, and market participant identity is unknown
- Prevent them from having their own orders entered on exchanges for execution
- 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
Correct answer: Lessen the transparency of the overall market as volume, quote and price information, and market participant identity is unknown
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.
- The 5% markup policy applies to
- New issue shares priced under an effective prospectus
- Purchases of shares in an open-end investment company
- Principal trades in corporate stocks over the counter
- Agency trades in exempt bonds of a municipality
Correct answer: Principal trades in corporate stocks over the counter
The 5% policy covers agency and principal transactions in nonexempt securities, whether they trade on an exchange or over the counter, so a principal trade in an over-the-counter stock sits squarely inside it. Securities sold by a prospectus are outside the policy, which removes new issues and open-end investment company shares, because the compensation there is disclosed in the offering document. Exempt securities such as municipal bonds are outside the policy as well.
- All of the following are subject to the 5% markup policy except
- The spread realized on a registered new equity offering
- The markup on a principal purchase using firm inventory
- The markdown on a principal sale into trading inventory
- The commission charged on an agency trade for customers
Correct answer: The spread realized on a registered new equity offering
The 5% policy is applied to markups, markdowns, and commissions in nonexempt secondary market transactions, so all three of those are subject to it. The spread earned on a new issue distributed under a prospectus is not: that underwriting compensation is disclosed in the offering document itself and is governed by the offering rules rather than by the 5% policy.
- Without an exemption, member firms are required to provide purchasers of penny stocks each of the following except
- Compensation to be earned by both the member firm and the associated person
- Quarterly statements
- Current inside bid and ask quotation
- A risk disclosure document
Correct answer: Quarterly statements
If an exemption is not available, purchasers of penny stocks must receive the risk disclosure document, current inside bid and ask quotation, information on the compensation to be received by both the representative and the member in connection with the transaction, and monthly, not quarterly, statements.
- An investor in the 28% tax bracket has a $5,000 loss after netting all capital gains and losses realized. How much may the investor deduct from income that year?
Correct answer: $3,000
The maximum deduction of net capital losses against other income in any one year is $3,000; any remaining loss can be carried forward into the next year.
- A corporation pays a 10% stock dividend to common stockholders. All the following are true regarding this dividend except
- The beauty of stock dividends is that they are nontaxable
- The dividend is taxable in the year the sale of the shares takes place
- The total value of the position is unchanged when the dividend is paid
- The cost basis per share is adjusted based on the stock dividend
Correct answer: The beauty of stock dividends is that they are nontaxable
The stock dividend is taxable, but unlike cash dividends, which are taxed when received, stock dividends are taxable in the year the shares are sold. When the stockholder receives the additional shares, the cost basis is adjusted on a per-share basis with the total value of the position remaining unchanged. For example, if an investor owned 100 shares purchased at a price of $22 per share and the company paid a 10% stock dividend, the numbers would look like this. The number of shares owned is now 110 [100 + (10% of 100)] = 100 + 10. The adjusted cost basis per share (used when any of the shares are sold) is now $20 per share. The original cost is $2,200 (100 shares times $22 per share). After the stock dividend, the customer owns 110 shares, but there was no additional cost. Divide that original $2,200 by the new number of shares ($2,200 divided by 11) to arrive at an adjusted cost basis of $20 per share. The account value is still $2,200 (110 shares times $20 per share = $2,200).
- An investor purchased 200 shares of Hightown National Bank (HNB) common stock at $120.06 per share. Thirteen months later, HNB pays a 15% stock dividend. Three months after that, the investor sells the shares received from the stock dividend at $112.57 per share. The tax consequence to the investor is
- $245.10 short-term capital gain.
- $245.10 long-term capital gain.
- $122.55 short-term capital gain.
- $$1,879.10 long-term capital gain.
Correct answer: $245.10 long-term capital gain.
The total value of the initial position is unchanged, remaining at $24,012 (200 times $120.06). After the stock dividend the investor owns 230 shares (200 times 15% = 30 + 200 = 230). Therefore, the adjusted cost basis is $100 per share ($24,012 divided by 230 = $104.40). The question tells us that the investor sells those 30 additional shares at $112.57 per share. That is a difference of $8.17 per share. Multiply that gain by 30 shares and the result is a profit of $245.10. It is a long-term gain because the holding period of shares received from a stock dividend or stock split begins with the initial purchase, not the receipt of the new shares. 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. If you have to guess, or are running out of time, when you see two identical numbers with the only difference being short- or long-term gain, in almost all questions, one of those two is the correct answer. Now you have a 50% chance of guessing correctly and, if you remember that the holding period always begins with the initial purchase, then the odds are 100% in your favor.
- An investor has received a cash dividend on a stock that they have owned for over 10 years. It is the first dividend the company has paid. The cash dividend would be taxable to the investor as
- A short-term capital gain in the year in which it is received
- A return of principal
- A long-term capital gain in the year in which it is received
- Income in the year in which it is received
Correct answer: Income in the year in which it is received
Cash dividends are always treated as income and are taxable to the investor in the tax year in which they are received by the investor. In those cases where the dividend is qualified, it will be taxed at a lower rate than the investor's ordinary income. That does not affect this question because the answer is the same if the dividend is qualified or not. A capital gain occurs when an investor sells an asset for more than its cost basis.
- Which of the following is true with respect to excess capital losses realized by an individual taxpayer?
- They may be carried back up to three years and carried forward indefinitely until exhausted.
- They may be carried forward indefinitely until exhausted.
- They may be carried forward with a time limit of five years.
- No more than $3,000 per year may be used against capital gains
Correct answer: They may be carried forward indefinitely until exhausted.
Any taxpayer is permitted to reduce capital gains with realized capital losses. If the capital losses exceed the capital gains, up to $3,000 of the net capital loss may be deducted against taxable income. Anything in excess of that is carried forward and used against gains without limitation, or if there are no gains, taxable income, again with a $3,000 annual limit. Those losses can be carried forward with no time limit until they are all used against gains or income. Remember, the $3,000 limit applies only to the net losses that may be deducted against income; there is no limit to the amount of loss that can be netted against gains.
- Before effecting a penny stock transaction with a customer, the member firm must
- Provide the customer with a current bid and asked quote on the stock
- Verify that the customer has sufficient funds in the account
- Provide the customer with the price of the most recent trade in the stock
- Receive the signed copy of the risk disclosure document
Correct answer: Provide the customer with a current bid and asked quote on the stock
To avoid price gouging, SEC Rule 15g-3 requires that no penny stock transaction may take place without the member firm providing the customer with the current inside market quotes. Those are the highest bid and the lowest ask price currently quoted. The current quotes are more important to the customer than the most recent trade because that trade may have been hours or even days ago. Trading may commence two business days after sending the risk disclosure document.
- After a company splits its stock 2 for 1, an investor who owns 100 shares receives
- Notice to send in the current certificate to be replaced by a new certificate for 200 shares
- Notice that the investor's 100-share certificate now represents 200 shares
- Another certificate for 200 shares
- Another certificate for 100 shares
Correct answer: Another certificate for 100 shares
After a 2-for-1 split, the transfer agent will send the investor another certificate for 100 shares. The investor is not required to return the existing stock certificate.
- When compared to statutory voting, cumulative voting gives an advantage to
- Management rather than the board of directors
- Minority stockholders
- Majority stockholders
- Participating preferred stockholders
Correct answer: Minority stockholders
Cumulative voting allows shareholders to aggregate their votes and cast them as they please. For example, they could cast all of their votes for a single candidate. Cumulative voting makes it easier for a minority group of shareholders to gain representation on the board.
- A corporation is having a rights offering. The terms of the offering require eight rights plus $88 to purchase one share. With the stock's current market price at $112 per share, the theoretical value of one right on the ex-rights date is
Correct answer: $3.00.
Because the question is asking about the value on the ex-rights, it means we use the regular formula. That is, the (market price minus the subscription price) divided by the (number of rights it takes to buy one share). Plugging in the numbers gives us ($112 − $88) ÷ 8 = $24 ÷ 8 = $3.00
- Holders of common shares may generally vote on
- Which member of the board of directors should be chairman
- Whether a cash dividend is to be declared
- Whether the company should issue additional preferred stock
- Whether an administrative assistant should be promoted to management
Correct answer: Whether the company should issue additional preferred stock
Common shareholders must vote to approve the issuance of additional preferred stock because additional preferred shares dilute the common shares' residual assets under a liquidation. Common shareholders do not vote to declare dividends. Board members select the chairman of the board. Shareholders do not get involved in the daily operational activity of the corporation.
- Which of the following would least likely occur when a corporation engaged in a rights offering?
- After successful completion of the offering, the market price would rise slightly.
- After successful completion of the offering, the market price would decline slightly.
- The corporation would use a standby underwriter.
- The number of outstanding shares would increase.
Correct answer: After successful completion of the offering, the market price would rise slightly.
Successful completion of a rights offering generally results in a slight decline in the market price of the stock. This is because the subscribers were able to purchase at a price below the current market. This would have a small dilutive effect, causing a slight reduction in the market price. The rights offering is of additional shares, so the number outstanding would increase. Most corporations use a standby underwriter who will buy any shares that were not exercised.
- Stockholders' preemptive rights include the right to
- Vote on the election of the board that runs the corporation
- Buy enough of any new issue to preserve the same percentage
- Receive a share of the assets left over after a liquidation
- Inspect the books and the current list of the firm's owners
Correct answer: Buy enough of any new issue to preserve the same percentage
A preemptive right is the right to keep the same proportionate ownership when the corporation issues additional shares. A holder of 5% of the outstanding stock may subscribe for 5% of the new shares before they are offered to anyone else, so the stake is not diluted. Voting for directors, sharing in the residual assets on liquidation, and inspecting the books and the shareholder list are all genuine rights of a common stockholder, but none of them is the preemptive right.
- A corporation wishes to raise additional capital by making use of a rights offering. One of your clients owns 200 shares of the issuing corporation's common stock and 100 shares of its preferred stock. The terms of the offering state that four rights will be necessary to purchase one new share at the subscription price of $20. The current market price of the stock is $24 per share. How many rights will your client receive?
Correct answer: 200
No matter how many new shares are being offered and how many rights it takes to buy each new share, on your exam, shareholders will always receive one right for each share of common stock they own. With this client owning 200 shares, that is 200 rights. There are never rights with preferred stock.
- Gargantuan Computers, Inc., (GCI) conducts a rights offering to its current shareholders at $50 per share, plus one right. If the current market price of GCI is $70, what is the value of one right before the stock trades ex-rights?
Correct answer: 10
The stock is trading cum rights (before the ex-date). The formula to calculate the value of one right before the ex-date is follows: CMV minus subscription price divided by the number of rights to purchase one share plus 1. Therefore, one right is valued at $10, computed as ($70 − $50) / 2 = $10.
- One of your customers is looking for growth with some income. It would not be suitable for you to recommend
- Convertible preferred stock paying a stated quarterly rate
- American depositary receipts of a leading overseas company
- Long-term warrants to acquire the underlying common shares
- Blue-chip common shares paying a modest quarterly dividend
Correct answer: Long-term warrants to acquire the underlying common shares
The objective is growth with some income, so every recommendation has to be able to produce both. A warrant can appreciate if the stock rises above the exercise price, but it pays nothing along the way, so it fails the income half of the objective and is the unsuitable choice. Convertible preferred pays a stated dividend and moves with the common it converts into. American depositary receipts pass through the foreign issuer's dividends and can appreciate. A dividend-paying blue chip supplies both directly.
- Which of the following statements regarding warrants are true? I. They pay dividends. II. They represent ownership in the issuing corporation. III. They allow for the purchase of common stock at a fixed price. IV. They do not give holders voting rights.
- I and II
- II and III
- III and IV
- II and IV
Correct answer: III and IV
Holders of warrants have the right to buy stock from the issuer at a stated price for a specific time period. They do not pay dividends that are only paid to stockholders or give holders voting rights. The owner of the warrant does not own the stock until the warrant is exercised.
- Five years ago, a corporation issued a portion of its authorized shares. Those shares currently trade on the New York Stock Exchange. In an effort to reduce the number of shares outstanding, the issuer purchases 30 million shares from existing shareholders. The shares purchased by the issuer in the secondary market are now known as
- Treasury stock
- Unissued stock
- Authorized stock
- Issued stock
Correct answer: Treasury stock
When an issuer acquires its own issued and outstanding stock, it becomes treasury stock. It can be an outright purchase, as described here, or stock received as a donation from a stockholder. Treasury stock has no voting or dividend rights. A corporation's charter specifies the number of shares that are authorized for issuance. When the corporation issues those authorized shares to raise capital, they represent the number of issued shares. When they begin trading in the secondary markets, they are issued and outstanding shares. Treasury stock is issued, but no longer outstanding. In Unit 13 when we compute some ratios, we use only the outstanding shares.
- In order for an investor to be eligible to receive a previously declared cash dividend, the stock must be purchased
- The day after the ex-dividend date
- Before the ex-dividend date
- On the ex-dividend date
- The day before the record date
Correct answer: Before the ex-dividend date
The ex-date (it can be ex-dividend, ex-rights, or ex-split) is the first day on or after which a purchaser is not eligible to receive the dividend (or the rights or the split). With regular way delivery at T+2, one would have to buy the security at least 2 business days before the record date (the day the issuer makes a record of all eligible owners). Therefore, in most cases, the ex-date will be one business day prior to the record date. Buying then or afterwards is going to be too late to get the purchaser's name on the record books.
- All of the following are advantages of investing in American depositary receipts (ADRs) except
- Transactions are done in U.S. currency.
- ADRs fall under the oversight of the SEC.
- Dividends are received in U.S. currency.
- Currency risk is virtually eliminated
Correct answer: Currency risk is virtually eliminated
ADRs carry currency risk because distributions on ADRs must be converted from foreign currency to U.S. dollars on the date of distribution. In addition, the trading price of the ADR is affected by foreign currency fluctuation.
- Investors in all of the following securities could receive dividend payments that increase over time except
- Adjustable-rate preferred stock
- Participating preferred stock
- Cumulative preferred stock
- Common stock
Correct answer: Cumulative preferred stock
The dividend rate on cumulative preferred stock is fixed. It is never more than the stated rate. The cumulative feature simply means that if there are skipped dividend payments, those must be made up before dividends may be paid on common stock. That is not considered an increase in the dividend rate. Adjustable-rate preferred stock has a dividend that adjusts based on market interest rates. In a period of increasing interest rates, the dividends will increase. Participating preferred stock has a tie-in to the common stock dividend. As companies become more profitable or the need for retaining earnings decreases, the common stock dividend tends to increase, and that increases the payout to the participating preferred shareholders.
- The issuer of an American depositary receipt (ADR) is
- A foreign branch of a foreign bank
- A domestic bank
- A foreign branch of a domestic bank
- A domestic branch of a foreign bank
Correct answer: A domestic bank
The ADR is issued by a domestic bank. Everything is in English and in U.S. dollars. The foreign certificates are usually held on deposit at a foreign branch of the domestic bank, and the ADRs are issued domestically.
- Lambda Corporation has received a donation of 100,000 shares of its common stock from the spouse of the deceased founder of the company. This would appear on the company's books as
- Treasury stock
- Unissued stock
- Authorized, but unissued stock
- Reacquired stock
Correct answer: Treasury stock
When a corporation reacquires shares of outstanding stock, whether through open market purchase or, as in this case, donation, the stock is treasury stock.
- Synapse Communication Corporation (SCC) is growing. To finance the expansion, the company has a $100 million debenture offering. Attached to the offering are five-year warrants to purchase SCC common shares. Each warrant allows for the purchase of one SCC share at a price of $53 per share. Three years after the issue date, SCC stock is trading at $63 per share. Each warrant has
- No intrinsic value, only time value
- An intrinsic value of $5 per warrant
- An intrinsic value of $10 per warrant
- An intrinsic value of $20 per warrant
Correct answer: An intrinsic value of $10 per warrant
A warrant has intrinsic value when the exercise price is lower than the stock's current market price. In this question, each warrant allows the holder to purchase one share of a $63 stock for $53 per share. That is a $10 per share difference. Therefore, intrinsically, the warrant is worth $10. With two years to go, it also has time value, but the question is not dealing with that. ** This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- In a 3-for-2 stock split, an investor will
- Have two-thirds fewer shares at a 50% higher price
- Have 50% more shares at two-thirds the price
- Have 50% more shares at half the price
- Have 50% fewer shares at twice the price
Correct answer: Have 50% more shares at two-thirds the price
If a stock splits 3 for 2, an investor will receive an additional 50 shares for every 100 shares owned. The price will decline by one-third, but the total value of the position will stay the same. For example, if a shareholder owns 100 shares priced at $60 per share ($6,000 total value) before the 3 for 2 split, the shareholder will have 150 shares after the split (3/2×100=150). Because the total market value will remain the same, the new price per share will be $6,000 ÷ 150 shares = $40 per share. There is a mathematical trick to determine the new price per share. Simply reverse the fraction and that is the new price per share. In this question, a 3:2 split results in a price that is 2/3rds the pre-split price. In a 2:1 split, the price becomes 1/2 ($30 in our example) and in a 5:4 split, the price becomes 4/5ths ($48 in our 100 shares at$60 example).
- An investor owns 400 shares of ABC common stock. ABC's board of directors has declared a 5:4 stock split. As a result, the investor will receive how many additional shares?
- 80 shares
- 100 shares
- 40 shares
- 500 shares
Correct answer: 100 shares
In a 5:4 stock split, the shareholder will own five shares for each four shares currently held. This investor owns 400 shares so, after the split, the account will have 500 shares in it. The difference between 400 and 500 is 100 additional shares. If you chose 500, that is the total number of shares that will be owned, but the question does not ask for that—it asks for the number of additional shares.
- Marcus owns 5,000 shares of KYZ stock. He recently received proxies in the mail. Marcus would be able to use the proxies for all of the following except
- To vote on a proposed 2:1 stock split
- To vote on the proposed issuance of 100,000 shares of convertible preferred stock
- To vote for three members of the board of directors
- To buy additional shares of KYZ common stock after the stock splits 2:1
Correct answer: To buy additional shares of KYZ common stock after the stock splits 2:1
A proxy is a form of absentee ballot used by stockholders to vote on company matters such as stock splits, members of the board of directors, and issuance of additional equity-related securities such as convertible securities. Stockholders do not vote on dividend-related matters, nor are proxies used to purchase shares of stock.
- DJX Corporation's charter has authorized 10 million shares of common stock. It has issued 5 million shares and has 1 million shares in its treasury. How many shares of DJX common stock are authorized but unissued?
- 6 million
- 9 million
- 4 million
- 5 million
Correct answer: 5 million
This company has 10 million shares of common stock authorized. It has issued 5 million shares of which 1 million shares have been reacquired as treasury stock. That means there are 4 million shares still outstanding. The remaining 5 million are authorized but unissued. Remember that treasury stock is authorized and issued stock that is no longer outstanding.
- If all other factors are equal, an investor would expect which type of preferred stock to pay the highest stated dividend rate?
- Cumulative
- Convertible
- Callable
- Straight
Correct answer: Callable
When the stock is called, dividend payments are no longer made. With callable preferred stock, to compensate for that possibility, the issuer pays a higher dividend than with straight preferred. Cumulative and convertible preferred have positive characteristics that would justify a lower fixed dividend than straight.
- As interest rates fall, prices of straight preferred stock will
- Become volatile
- Remain unaffected
- Rise
- Fall
Correct answer: Rise
Preferred stock is interest rate sensitive. As rates fall, prices of preferred stocks tend to rise, and vice versa.
- Corporations issue equity securities. One category of equity is preferred stock. A number of different adjectives can apply to preferred stock issues. All of the following are types of preferred stock except
- Straight cumulative preferred
- Adjustable callable preferred
- Noncumulative callable preferred
- Callable cumulative preferred
Correct answer: Straight cumulative preferred
Straight preferred is the name given to preferred that is NOT cumulative: once a dividend is skipped the holder has no further claim to it. Cumulative preferred is the opposite, carrying skipped dividends forward as arrearage that must be paid before common holders receive anything. One issue cannot be both at once, so straight cumulative preferred is not a type of preferred stock. Adjustable callable, noncumulative callable, and callable cumulative preferred are all real combinations, because the rate feature and the call feature are independent of the cumulative feature.
- Preferred stock comes with many different options. What type of preferred stock would be most advantageous to the investor if the issuing company had strong revenue and earnings that exceeded industry estimates?
- Callable preferred
- Adjustable-rate
- Participating
- Cumulative
Correct answer: Participating
Participating preferred stock may receive an additional amount paid to shareholders based on superior performance of the issuer. Cumulative refers to unpaid dividends that accrue on a preferred issue. Those must be paid before common stockholders receive a dividend. That could be a benefit if the company had dividends in arrears and these higher earnings made it possible to pay them. However, unless something in the question indicated that these higher earnings followed several years of losses, there is no way to infer that the company is behind on its dividends. As you hear us say many times, do not read something into the question that is not there. Adjustable-rate preferred stocks adjust their dividends based on market interest rates, not on the company's earnings. Although it is possible that higher earnings could encourage the company to call in some of the outstanding callable preferred stock, doing so would be considered a benefit to the issuer rather than the investor.
- A corporation has $25 million of 5% bonds outstanding. The bonds are callable at 102. Current market interest rates are 6%. If the company would like to retire $10 million of the debt, it might be smart to
- Make a tender offer to purchase $10 million face amount of the bonds
- Exercise the call provision for $10 million face amount of the bonds
- Issue $10 million of new bonds at current rates and use the proceeds to call in outstanding ones
- Issue $10 million of treasury stock and use the proceeds to retire the bonds
Correct answer: Make a tender offer to purchase $10 million face amount of the bonds
When current market interest rates are 6%, bonds with a 5% coupon are selling at a discount. That means the company could make a public offer to buy the bonds back at a price somewhat below par value. In simple terms, they could retire $10 million of debt for less than $10 million. It would make no sense to call the bonds at 102 ($1,020) when they can be purchased for less than $1,000 each in the open market. Issuing new bonds to retire old ones, a practice known as refunding, is done when interest rates have fallen. In this question, interest rates have gone up making that plan incorrect. A company cannot issue treasury stock. Issued and outstanding stock becomes treasury stock when it is reacquired by the issuer.
- The CAST Corporation's first mortgage bond has a 5% coupon and a yield to maturity of 7%. The bond is callable in 10 years at 103. The bond is trading at
- A discount
- The call price
- Par
- A premium
Correct answer: A discount
The only way a bond with a nominal (coupon) rate of 5% can have a yield higher than 5% is by having a price below the par value. This is an example of the inverse relationship between bond prices and their yields. If the yield is above the coupon, the price is below par (a discount). If the yield is below the coupon, the price is above par (a premium). As we say in the study materials, "if you pay more, you get less" and "if you pay less, you get more."
- When a bond is issued by a national government, it is referred to as
- High-quality debt
- Treasury debt
- Sovereign debt
- National debt
Correct answer: Sovereign debt
The term sovereign debt applies to securities issued by national governments. U.S. Treasuries are an example of sovereign debt issued here. Other countries have their versions, such as the Gilts of the United Kingdom. These are not considered alternative investments. Alternative investments are structured products that are complex and not easy to understand. Two of the most popular structured products are the ELNs and the ETNs.
- A bond has a 7% coupon and an offering price of 108. The bond matures in ten years. An investor purchasing this bond at the offering price would have a yield to maturity closest to
Correct answer: 5.96%
"When you pay more, you get less," Anytime a bond is purchased at a premium (a price above par), the yield to maturity (as well as the current yield and yield to call) must be lower than the nominal yield (the coupon rate). If you stop and think for a moment, there can be only one possibly correct answer. With a coupon rate of 7%, the answer must be something less than that. As will likely be the case on the exam, there is only one choice that is less than 7%. If you want to do the computation using our formula, it is: Annual interest − (premium ÷ years to maturity) ÷ average price of the bond. Plugging in the numbers we have: $70 − ($80 ÷ 10) ÷ [($1,080 + $1,000) ÷ 2]. This works out to: $62 ÷ $1,040 = 5.96%. However, as stated above, with only one number below the coupon rate, that has to be it. A variation of this question has two choices below the coupon. If that were the case here, the other choice would be 6.48%. That is the current yield ($70 ÷ $1,080). You need to remember that with a bond selling at a premium, the YTM will always be lower than the CY.
- What is the amount of interest payable semiannually on a $1,000 par value, 5% corporate bond currently selling at 80 and redeemable at par in 20 years?
Correct answer: $25
The interest is based on the par value of $1,000. The current market price is irrelevant. With a coupon rate of 5%, this bond pays $50 per year. That would be $25 semiannually
- Which of the following money market instruments is most often used by those in the import/export business?
- Commercial paper.
- Bankers’ acceptances
- Negotiable CDs
- Variable rate demand notes
Correct answer: Bankers’ acceptances
Bankers' acceptances are loans guaranteed by a commercial bank that are typically used to finance international transactions. Although all of the choices are money market instruments, it is the BAs that are primarily used by those engaged in international business.
- 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
Correct answer: 5.67%.
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 study materials, 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%.
- Which of the following bonds is most affected by interest rate risk?
- 7.8s of '42
- 7.6s of '45
- 7.5s of '39
- 7.3s of '37
Correct answer: 7.6s of '45
To begin with, let's be sure you understand the nomenclature used here. Each of the choices has two numbers. The first is the coupon rate of the bond and the second is the year the bond matures. For example, the 7.3s of '37 pay interest at a rate of 7.3% of the $1,000 par value per year and mature in 2037. The s is just to separate the two numbers. Interest rate risk is the loss in value due to a rise in interest rates. Because there is little difference in coupon rates, the bond with the longest maturity (highest duration) will experience the greatest fall in a rising interest rate market.
- An investor anticipating a fall in interest rates would likely purchase
- Noncallable bonds
- Noncallable and callable bonds
- None of these
- Callable bonds
Correct answer: Noncallable bonds
If rates fall, bonds are likely to be called.
- Which of the following debt instruments trades with accrued interest?
- Negotiable CDs
- Zero-coupon issues
- Treasury bills
- Bankers acceptances
Correct answer: Negotiable CDs
To trade with accrued interest, the security must pay interest. Of the choices, the only one that is interest bearing is the negotiable (jumbo) CD. All of the others are issued at a discount and return the face value at maturity.
- Which of the following callable municipal bonds trading on a 7% basis is most likely to be called?
- 7.5% coupon, callable at 100 in 2030
- 6.5% coupon, callable at 100 in 2030
- 6.5% coupon, callable at 105 in 2030
- 7.5% coupon, callable at 105 in 2030
Correct answer: 7.5% coupon, callable at 100 in 2030
An issuer will call the higher coupon bonds before calling the lower coupon bonds. Of the two bonds with coupons of 7.5%, the one with the lower call price will likely be called first.
- An economist is comparing the yields on 20-year U.S. Treasury bonds and AAA-rated corporate bonds with the same maturity. The economist is analyzing
- The risk spread
- The credit spread
- The duration spread
- The value spread
Correct answer: The credit spread
You should understand that the greater the risk, the higher the yield on the bond. Many analysts compare the difference between yields on bonds with the same maturity but different quality (rating) to get a sense of the market sentiment. One common measurement is the difference in yields between Treasuries and corporate bonds. This difference is called the yield or credit spread and tends to widen when economic conditions sour and narrow when they get better. ** This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- Market interest rates have been rising, which means the price of bonds traded in the secondary market has
- Not changed because bond prices are not affected by interest rates
- Not changed because only new bond prices are impacted by changes in interest rates, not the price of bonds already trading in the secondary market
- Decreased
- Increased
Correct answer: Decreased
When interest rates rise, bond prices fall.
- If the dollar price of a municipal bond is 101 and, at that price, the basis is 6.10, the nominal yield is
- Less than 6.10%
- Exactly 6.10%
- Greater than 6.10%
- Less than the coupon rate
Correct answer: Greater than 6.10%
Basis is a common synonym for yield to maturity, especially for municipal bonds. For any bonds trading at a premium, the nominal yield (or coupon) is higher than the basis (YTM). For bonds at a premium, yields from lowest to highest are as follows: yield to call, yield to maturity, current yield, and nominal yield.
- Which of the following statements regarding a bond quoted as QRS Zr 32 is true?
- The bond pays 120 dollars of interest to its holders yearly
- The accrued interest is taxed only at the point of maturity
- The bond was originally sold to investors at a huge premium
- The bond makes no interest payment at all before it matures
Correct answer: The bond makes no interest payment at all before it matures
Zr in a bond quotation marks a zero coupon bond, here issued by QRS and maturing in 2032. A zero pays no cash interest at all during its life; the investor buys it at a discount and receives par at maturity, and the difference is the interest. There is no annual coupon of 120 dollars or of any other amount. The accretion is not deferred either, because the holder is taxed each year on the imputed interest even though no cash arrives. And a zero is sold at a deep discount to par, never at a premium.
- Three 3% bonds are listed in the newspaper. One bond will mature in one year, another bond will mature in 10 years, and the third bond will mature in 20 years. If interest rates are going up, which bond will have the greatest decrease in value?
- The bond with the 10-year maturity
- None, as they will all have the same decrease in value
- The bond with the 1-year maturity
- The bond with the 20-year maturity
Correct answer: The bond with the 20-year maturity
Interest rate risk is based on a bond's duration. The longer the duration, the greater the effect of changes to interest rates. Duration consists of two components: coupon rate and length to maturity. When comparing bonds where the coupons are essentially equal (as in this question where they are all 3%), the bond with the most time remaining until maturity (such as the one with 20 years to go) will have the longest duration. Conversely, the bond maturing soonest (such as our one-year bond) will have the shortest duration and will be affected the least from changes to market interest rates. Although not relevant to this question, when the time remaining to maturity is essentially the same for all of the choices, the bond with the lowest coupon will have the longest duration. The closer a bond gets to its maturity date, the closer its price gets to par because there is so little time for changes in interest rates to have any effect.
- A corporate bond with a nominal yield of 6% is currently trading at a yield to maturity (YTM) of 5.8%. It would be accurate to state that this bond is trading at
- Par
- Parity
- A discount
- A premium
Correct answer: A premium
If YTM is less than the nominal or coupon yield, the bond is trading at a premium.
- An investor sells 10 5% bonds at a profit and buys another 10 bonds with a 541% coupon rate. The investor's yearly return will increase by
- $2.50 per bond.
- $2.00 per bond.
- $1.00 per bond.
- $1.50 per bond.
Correct answer: $2.50 per bond.
The first bonds are 5% and pay $50 per year per bond. The new bonds are 541% and pay $52.50 per year per bond, for a difference of $2.50 per bond.
- Which of the following expressions describes the current yield of a bond?
- Yield to maturity divided by par value
- Annual interest payment divided by current market price
- Annual interest payment divided by par value
- Yield to maturity divided by current market price
Correct answer: Annual interest payment divided by current market price
The current yield on a bond is calculated by dividing the annual interest payment by the current market price of the bond.
- The 5% markup policy applies to all of the following secondary market transactions except
- Agency transactions on an exchange
- Municipal bond transactions
- Agency transactions in nonexempt unlisted securities
- Principal transactions in the over-the-counter (OTC) market
Correct answer: Municipal bond transactions
The 5% policy applies to secondary market transactions. The secondary market is where trades are made in outstanding securities between buyers and sellers rather than a new issue. Excluded from the 5% policy are transactions in exempt securities such as municipal and government bonds. The policy applies to nonexempt securities and transactions on an exchange and in the OTC market, and it applies to both agency and principal trades. In the case of a primary offering (new issue) sold by prospectus, the 5% policy does not apply because the underwriting spread and commissions are already stated in the prospectus or other offering document.
- 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?
- The yield to maturity is less than both the current yield and the coupon rate.
- The coupon rate is higher than the yield to maturity, and the yield to maturity is higher than the current yield.
- The coupon rate is lower than the yield to maturity, and the current yield should be higher than the coupon rate.
- The current yield is higher than both the coupon rate and the yield to maturity.
Correct answer: The yield to maturity is less than both the current yield and the coupon rate.
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
- Moody's Investment-Grade (MIG) rating would be applicable to
- A New York state revenue bond
- A New York state university bond
- A New York state revenue anticipation note
- A New York state general obligation bond
Correct answer: A New York state revenue anticipation note
A MIG rating is provided for short-term municipal debt commonly referred to as notes (revenue anticipation notes).
- The term high-yield bond would apply to a bond with a Moody's rating of
Correct answer: Ba.
High-yield bonds are those whose ratings fall below investment grade. Investment grade is the top four. Using Moody's descriptions, ratings run from Aaa to Aa to A to Baa to Ba to B and then below. The first rating below the top four is Ba. That is equivalent to a BB rating from Standard & Poor's (but the question asks specifically about Moody's).
- It would be expected that your firm would employ heightened suitability standards when evaluating recommendations for
- Structured products
- Cumulative preferred stock
- Sovereign debt
- Nonvoting common stock
Correct answer: Structured products
The higher the risk of the investment, the greater the need for checking suitability. Structured products, such as equity-linked notes and exchange-traded notes, are considered complex products. In many cases, FINRA has discovered that registered representatives had inadequate understanding of the investment, leading to their making unsuitable recommendations.
- In a discussion with one of your customers, the topic of alternative debt instruments is brought up. It seems that the customer was competing in a duplicate bridge tournament in town and one of the other competitors mentioned that they have been obtaining higher income returns from ELNs. When the customer asks you for the meaning of that abbreviation, you would reply
- Exchange-linked notes
- Equity-linked notes
- Exchange-leveraged notes
- Equity-leveraged notes
Correct answer: Equity-linked notes
An ELN is an equity-linked note. That is a strange name for a debt product. The equity refers to the specific stock, a basket of stocks, or an equity index upon which the return is based. Therefore, the return is not fixed and can be higher or lower than anticipated depending on the selected equity's performance. There are foreign exchange-linked notes where the performance is based on currency rates, but that is unlikely to ever be a topic covered on the exam. There are no such products as exchange or equity-leveraged notes.
- Corporate bonds that are guaranteed are
- Insured by Assured Guaranty Corporation
- Guaranteed as to payment of principal and interest by another corporation
- Guaranteed as to payment of principal and interest by the U.S. government.
- Required to maintain a self-liquidating sinking or surplus fund
Correct answer: Guaranteed as to payment of principal and interest by another corporation
A guaranteed corporate bond is one guaranteed by another corporation that typically has a higher credit rating than the issuing corporation and is in a control relationship with it.
- With the advent of the horseless carriage (a.k.a. the automobile), the Acme Buggy Whip Corporation's revenues fell to the point where it could no longer cover expenses. This led to an involuntary bankruptcy. The priority of payout was
- Senior notes, preferred stock, common stock, general creditors
- Senior notes, general creditors, preferred stock, common stock
- Common stock, preferred stock, general creditors, senior notes
- General creditors, senior notes, preferred stock, common stock
Correct answer: Senior notes, general creditors, preferred stock, common stock
Senior debt refers to obligations that have priority in the event of default. It parallels the use of senior when comparing preferred stock to common stock, the most junior of all securities.
- An issuer of a bond will apply to the rating services for a rating for the purpose of
- Reducing liquidity risk
- Reducing interest rate risk
- Reducing the bond's duration
- Reducing credit risk
Correct answer: Reducing credit risk
What does the bond rating measure? It is a measurement of the credit risk. The higher the rating, the lower the credit risk and the reverse. With lower credit risk, the issuer will be able to borrow at a lower interest cost. Does the rating have an effect on the bond's liquidity? Possibly, but as is so often on the exam, you must select the answer that best fits the question.
- If ABC Corporation reports a loss for the year, it is obligated to pay interest on all of the following except
- Adjustment bonds
- Variable-rate bonds
- Nonconvertible bonds
- Convertible bonds
Correct answer: Adjustment bonds
Even if a corporation reports a loss, the corporation is obligated to pay interest on all of its outstanding debt except for income (adjustment) bonds. Income—or adjustment bonds—require interest to be paid only if declared by the board of directors.
- An investor viewing a stock market video is particularly interested in the discussion of convertible debt securities. Those are issued by
- Municipalities
- Foreign governments
- Corporations
- The U.S. Treasury.
Correct answer: Corporations
Convertible securities (debt or preferred stock) are always convertible into common stock. Therefore, they can be issued only by an entity that also issues common stock: a corporation.
- Which of the following best describes a debenture?
- A long-term corporate debt obligation with a claim against securities rather than against physical assets
- Unsecured corporate debt
- A corporate debt obligation that allows the holder to purchase shares of the company's common stock at specified dates before maturity
- An investment in the debt of another corporate party
Correct answer: Unsecured corporate debt
A debenture is unsecured corporate debt.
- Each of the following would be disclosed to potential municipal bond buyers in the official statement of a new municipal bond issue except
- The issue's purpose
- The creditworthiness of the issue
- The source from which interest and principal will be paid
- The disclosure that it was prepared by the underwriters
Correct answer: The disclosure that it was prepared by the underwriters
Although a broker-dealer acting in an advisory capacity may assist in preparing the official statement (OS), it is considered to be the responsibility of, and prepared by, the issuer. If qualifying for an exception (such as receiving no compensation other than the advisory fee), a BD acting in an advisory capacity may assist with preparing the OS and other similar duties normally associated with underwriting.The official statement identifies the issue's purpose, the source from which the interest and principal will be repaid, information regarding the issuer's financial and economic background, and information relating to the issue's creditworthiness.
- Your new client lists income as the primary investment objective for an account with your broker-dealer. Which of the following investments would not be suitable?
- Corporate preferred shares
- Ginnie Mae government securities
- Zero-coupon bonds
- Corporate debt securities
Correct answer: Zero-coupon bonds
Zero-coupon bonds make no payments until maturity, and therefore, would not be suitable investments for those with an income objective. Typically, preferred shares (because of the fixed dividend they pay) and corporate or government securities, which make interest payments, would be suitable investments to meet an income objective.
- A convertible bond callable at 101 is trading at 105. The bond is a 4% bond convertible at $25. The common stock is trading at $27. If an investor bought the bond and converted, her profit would be
Correct answer: $30.
First, calculate the number of shares each bond will convert to: $1,000 (par) divided by $25 per share equals 40 shares per bond. With market value at 105, each bond costs $1,050. What is the stock parity price? $1,050 divided by 40 shares equals $26.25 per share. Current market value of the stock minus stock parity price equals profit (or loss). $27.00 − $26.25 = $0.75 per share × 40 shares = $30.
- In active trading, a bond of standard size rises in price from 9885 to 10143. This represents a dollar change of
- $0.3125.
- $31.25.
- $312.50.
- $3.125.
Correct answer: $31.25.
Let's take this step by step remembering that every point in a bond quote equals $10 and every 81 of a point equals $1.25 ($10/8 = $1.25). Method #1 1) The increase is 381 points (10143 minus 9885 = 10186 minus 9885 = 381 2) 381 = $30 (3 times $10 per point) + $1.25 which equals $31.25 Method #2 1) 10143 = 101 x $10 = $1,010 + 43 of $10 = $7.50, total price is $1,017.50. 2) 9885 = 98 x $10 = $980 + 85 of $10 = $6.25. total price is $986.25. 3) The difference between the two prices is $1,017.50 minus $986.25 which = $31.25.
- KLM Company has 10 million convertible bonds outstanding that are convertible at $25. The bonds contain an antidilution feature. If KLM declares a 10% stock dividend, the new conversion price will be
- $22.50.
- $45.45.
- $22.73.
- $50.00.
Correct answer: $22.73.
Before the stock dividend, an investor would have received 40 shares of stock for each $1,000 bond ($1,000 / $25). A 10% stock dividend would now give an investor 44 shares on conversion (40 shares + 10% = 4 shares more). $1,000 / 44 shares = $22.73 per share for the new conversion price.
- An institutional investor is seeking a quote on $2 million of term bonds issued by the City Water Authority. These are the 3s of 2050 and would be quoted
- As a dollar price, expressed as a percentage of stated par
- On a yield basis, the way serial bond offerings are quoted
- At the dealer's bid price for that entire block being sold
- In thirty-seconds of a point, as a Treasury bond is quoted
Correct answer: As a dollar price, expressed as a percentage of stated par
Term bonds of a single maturity are called dollar bonds because they are quoted as a dollar price, and that price is expressed as a percentage of par. The 3s of 2050 tells you the coupon is 3% and the maturity is 2050. Serial bonds, whose maturities are staggered, are the ones quoted on a yield, or basis, instead. A buyer would be quoted the dealer's ask price; the bid is the side used when the customer is selling. Quotes in thirty-seconds belong to Treasury securities rather than to municipal term bonds.
- Who attests to the legality of a bond issue and issues a legal opinion on a proposed new municipal bond issue?
- Syndicate manager
- Case attorney
- State administrator
- Bond counsel
Correct answer: Bond counsel
The issuer hires a firm or an individual to act on its behalf as bond counsel.
- 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?
- The investor will receive 10 shares of the common stock.
- The investor will receive 1 share of the common stock.
- The conversion price will be adjusted to $9.09.
- The conversion price will be adjusted to $11.00.
Correct answer: The conversion price will be adjusted to $9.09.
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.
- An investor purchased a new issue corporate zero-coupon bond for $600. The bond has a maturity of 20 years. Six years later, the investor sells the bond for $700. For tax purposes, this would result in
- A capital loss of $280
- A capital gain of $100
- A capital loss of $20
- A capital gain of $20
Correct answer: A capital loss of $20
The $400 discount is accreted over the 20 years to maturity. That is an annual accretion of $20. After 6 years, that is $120, making the tax basis of the bond $720. Because the sale at $700 is $20 less than the basis, the investor has a long-term capital loss.
- An investor purchases a newly issued convertible bond at par. The bond is convertible at $40. Three years later, the underlying common stock is trading at $50 per share. If the investor sells the bond at a $50 premium over the parity price, there is
- A long-term capital gain of $1,050
- A long-term capital gain of $10 per share
- A long-term capital gain of $200
- A long-term capital gain of $300
Correct answer: A long-term capital gain of $300
This question involves several steps. The first is to determine the conversion ratio in shares. A bond convertible at $40 per share has a share conversion rate of 25 shares ($1,000 ÷ $40). The second step is to compute the parity price. That is, what are those 25 shares worth? Multiply 25 shares times $50 per share and that equals $1,250. When the bondholder sells the bonds at parity plus a $50 premium, $1,300 is received. The $300 profit over the $1,000 initial cost is a long-term capital gain. An alternative that might be easier for some is to look at the appreciation of the stock. It is $10 per share higher than the conversion price of $40. That represents an increase of 25% (10 ÷ 40). If the bond is at parity with the stock, its price must be 25% higher and that brings us again to the $1,250 parity price. Add the $50 premium to get to $1,300, $300 above the initial cost.
- Municipal bonds—known as dollar bonds—are generally quoted
- On a yield to maturity basis
- As a discount from par value
- As a percentage of par value
- On a yield to first call
Correct answer: As a percentage of par value
Most municipal bonds are quoted on a yield basis, but the actively traded term issues known as dollar bonds are the exception: they are quoted as a price, and that price is expressed as a percentage of par value. The name comes from the quote being given in dollars, and a percentage of the 1,000 dollar par value converts directly into a dollar price. Yield to call and yield to maturity are yield quotations rather than the price the question describes, and a bond is never quoted as a discount FROM par; the quote is the price itself, stated as a percentage OF par.
- ABC Corporation has outstanding a 7.75% convertible debenture currently trading at 102. The bond is convertible into common stock at $40. ABC stock is trading $45 per share. Which of the following statements is true?
- To profit in this situation, the investor should buy the bonds and short the stock.
- An arbitrage opportunity does not exist in this situation.
- To profit in this situation, the investor should buy the stock and short the bonds.
- The bond is at parity with the stock.
Correct answer: To profit in this situation, the investor should buy the bonds and short the stock.
With a conversion price of $40, the bond is convertible into 25 shares of ABC common stock ($1,000 / $40 = 25 shares). As the common stock is currently trading at $45 per share, the value of the stock as converted would be $1,125 (25 shares × $45 = $1,125), which is greater than the current price of the bond ($1,020). Therefore, the bond and the stock are not at parity. An investor could profit in this situation by shorting the stock and buying an equivalent number of bonds. A bond could be purchased for $1,020 and immediately converted into stock worth $1,125—a risk-free profit opportunity.
- DMF Company has $50 million of convertible bonds (convertible at $50) outstanding. The current market value of DMF's stock is $42. The bond indenture contains a nondilution feature. If DMF declares a 10% stock dividend, the new conversion price will be
- The stock's current market price
- Lower than $50
- $50.
- Higher than $50
Correct answer: Lower than $50
With an antidilution feature, the issuer will increase the number of shares available upon conversion if the company declares a stock split or stock dividend. This means the bondholder must be able to convert it to more shares, which requires a lower conversion price.
- All of the following statements regarding convertible bonds are true except
- The issuer pays a lower interest rate
- Holders receive a fixed interest rate
- Holders may share in the growth of the common stock
- Holders receive a higher interest rate
Correct answer: Holders receive a higher interest rate
Because of the possibility of participating in the growth of the common stock through an increase in the market price of the common, the convertible can be issued with a lower interest rate. The interest rate on a convertible, just as with any other fixed-income security, does not change.
- Expressed as a percentage of par, one basis point equals
- One-one hundredth of 1%
- One-one thousandth of 1%
- 10%.
- One-tenth of 1%
Correct answer: One-one hundredth of 1%
One basis point equals one-one hundredth of 1% of par. One percent of par ($1,000) equals $10; therefore, 1 basis point equals one-one hundredth of $10, or $0.10 (10 cents).
- All of the following statements regarding a market not-held order are true except
- The order ticket must be marked, not held
- It is given to a specialist (designated market maker)
- It gives the floor broker discretion over the price or time of execution
- A small portion may be filled at a time
Correct answer: It is given to a specialist (designated market maker)
In a market not-held order, the client agrees not to hold the broker responsible if she cannot fill the complete order. Such an order allows the floor broker to use her judgment on the best execution strategy. Specialists (designated market makers) cannot accept market not-held orders.
- If a customer wishes to change a day order to a good-til-canceled (GTC) order in the middle of the day, the registered representative should
- Enter the new order right now and cancel the resting day order at once
- Let the day order run until the close and enter the new order tomorrow
- Enter the new order right away and simply let that old day order lapse
- Send in a change notice so the order desk converts the day order today
Correct answer: Let the day order run until the close and enter the new order tomorrow
A good-til-canceled instruction cannot be grafted onto an order that is already working, because it is treated as a new order. If the representative enters it during the session, the original order loses the time priority it earned that day, and for a stretch of the session the customer has two live orders in the same stock. The correct handling is to let the day order run out at the close and then enter the good-til-canceled order before the next session opens. There is no change notice that converts a resting day order, and leaving both orders live invites a double execution.
- An investor submits an immediate-or-cancel order to sell 800 shares of stock at 32.15. When the order reaches the trading floor, the quote is 32.18 – 32.26, 6×8. The investor
- Sold 600 shares at 32.18
- Sold 600 shares at 32.15
- Did not sell any shares
- Sold 600 shares at 32.26
Correct answer: Sold 600 shares at 32.18
An immediate-or-cancel order (IOC) is a limit order requiring immediate execution or cancellation. Unlike its cousin, the fill-or-kill (FOK) order, a partial fill is permitted with an immediate-or-cancel order. An IOC order to sell 800 shares at 32.15 means that the investor will accept the sale of anything up to and including 800 shares as long as the sale price is at least $32.15 per share. Sellers receive the highest bid price (the most an investor is willing to pay for the stock). At the time this order is presented, the highest bid was 32.18. Because the buyer was willing to take only 600 shares (the quote size was for 600), and the sale price exceed the limit, 600 shares are sold, and the balance of the order is canceled.
- Which of the following would accelerate a decline in a bear market?
- Sell stop
- Sell limit
- Buy limit
- Buy stop
Correct answer: Sell stop
Sell stops, placed below the current market, become market orders to sell when the stock trades at or through (below) the stop price. Market sell orders can accelerate declines in the price of the stock.
- Earlier in the day, you entered a customer order to buy 300 XYZ at 26.45 good til canceled (GTC). By late afternoon, you notice that XYZ is trading at your customer's limit price. At the close of trading, you contact the order desk and get a Nothing Done report because
- The order was canceled at the close of trading
- Of the small size of the order
- Of the normal time delay between execution and execution reports
- Of stock ahead
Correct answer: Of stock ahead
All limit orders stand in time priority.
- Last week one of your customers placed a good-til-canceled order to sell 200 shares of ABC with an 18 stop when the stock was trading at $18.85. It is now the ex-date for a $0.55 dividend and the order has not yet been executed. What has happened to your customer's stop order?
- It is increased to $18.55.
- It is reduced to $17.45.
- It is canceled.
- It remains at $18.
Correct answer: It is reduced to $17.45.
Unless the customer has given DNR (do not reduce) instructions, open buy limit orders and open sell stop orders are reduced on the ex-dividend date by the amount of the dividend.
- Your client has entered a limit order to buy 600 shares of DMF at $50 per share. DMF declares a 10% stock dividend. How would this order be adjusted on the ex-date?
- 600 shares at $50
- 660 shares at $46.50
- 600 shares at $45.45
- 660 shares at $46.37
Correct answer: 600 shares at $45.45
In this example, adjust only the share price: $50 ÷ (1 + 0.10) = $45.45. The number of shares in the order is not adjusted unless the shares can be increased by a full round lot (100 shares).
- An order to sell at 38.65 stop limit is entered before the opening. The subsequent trades are 38.85, 38.50, and 38.35. The order
- Was executed at 38.50 right after the stop was elected
- Was executed at 38.35 when the market kept moving down
- Was not triggered since 38.85 was the only trade above
- Was triggered at 38.50 but has still not been executed
Correct answer: Was triggered at 38.50 but has still not been executed
A sell stop limit becomes a limit order once the stop price is touched. The stop here is 38.65, so the print at 38.50 elects the order; it was certainly triggered. From that moment it is a limit order to sell at 38.65 or better, and the only prints after the election are 38.50 and 38.35, both below the limit. No execution is possible at those prices, so the order was elected but is still working, and it was filled neither at 38.50 nor at 38.35.
- The writer of an in-the-money put will receive the upcoming dividend from the underlying issuer if the contract is exercised
- After the ex-date
- On or after the ex-date
- On the ex-date
- Before the ex-date
Correct answer: Before the ex-date
When assigned, the put writer is obligated to purchase the stock. Provided the stock is purchased before the ex-date, its buyer becomes the owner of record on or before the record date and is therefore entitled to the dividend. This is no different from anyone else purchasing before the ex-date.
- You receive a not-held order from a customer who wants you to buy 1,000 shares of ABC when the price is right. Under NYSE rules, this order is
- A good-til-canceled order
- A day order
- A limit order
- A fill-or-kill order
Correct answer: A day order
Unless the customer instructs you otherwise, not-held orders must be executed on the day received.
- A customer enters an order to buy 1,000 ABC at 50, good for the week only. How will this order appear on the order book?
- Buy 1,000 ABC 50 Day
- Buy 1,000 ABC 50 GTC
- Buy 1,000 ABC 50 GTW
- Buy 1,000 ABC 50 GTM
Correct answer: Buy 1,000 ABC 50 GTC
Limit orders and stop orders are entered on the order book as either good til canceled (GTC) or day orders. Orders that are good for only a particular time frame (good for the week) will appear as GTC. It is the responsibility of the broker-dealer that entered the order to cancel it at the end of the week, if unexecuted.
- Which of the following orders on the order book would be reduced for a cash dividend on the ex-date?
- Buy 100 XYZ at 50 DNR
- Sell 100 XYZ at 50 stop
- Sell 100 XYZ at 60
- Buy 100 XYZ at 60 stop
Correct answer: Sell 100 XYZ at 50 stop
Orders on the book adjusted on the ex-date for a cash dividend are those below the current market: buy limits and sell stops. The buy limit at 50 is marked DNR (do not reduce), so the only order reduced is the sell stop at 50.
- A customer has sold short 100 GM at 70. GM is selling for 81. The customer had previously placed a good-til canceled buy stop order at 83. GM announces a stock split and an increase in the dividend. The stock starts to move up and the customer decides to cover the short sale at a loss and instructs his broker to buy 100 shares of GM at the market. The registered representative will
- Buy the entire position at market and leave the stop order alone
- Enter a market sell order for the shares and cancel nothing else
- Execute the resting stop order at 83 to close the short position
- Buy the shares at market and cancel the resting stop order today
Correct answer: Buy the shares at market and cancel the resting stop order today
Covering a short sale means buying the stock back, so the market order to buy 100 shares is executed. That leaves the old good-til-canceled buy stop at 83 sitting in the book with nothing left to protect, and if the stock reached 83 it would create a long position the customer never wanted. The representative therefore has two jobs: execute the buy, and cancel the stale stop order. Selling would add to the short rather than cover it, and the stop at 83 cannot be used to close the position, since it has not been elected.
- A customer tells a broker to buy 1,500 shares of ABC at 33.60 immediately for the full 1,500 shares. This is
- A good-til-canceled order
- An all-or-none (AON) order
- A fill-or-kill (FOK) order
- An immediate-or-cancel (IOC) order
Correct answer: A fill-or-kill (FOK) order
In an FOK order, the instruction is to fill the entire order immediately at the limit price or better. If this cannot be done, the order will be canceled (killed). An IOC order is similar, except that partial execution is acceptable. An AON order must be filled in its entirety. However, it can be filled over time; it does not require immediate execution.
- At 2:00 pm ET, a customer enters an order to buy GGZ at the close on the NYSE. GGZ traded between 70 and 71 all day. Then, after a last-minute rally, it closed up 4 points at 74. The customer should expect to pay
- The price as near to the close as possible, at the floor broker's discretion
- The closing price
- The average price calculated for the entire day
- The opening price the next morning
Correct answer: The closing price
When an order is placed market at the close on an exchange, a customer should expect execution at the closing price.
- An order designated fill-or-kill (FOK) means that the order must be executed
- At the opening of trading
- Immediately but not necessarily entirely
- In its entirety but not immediately
- Immediately and in its entirety
Correct answer: Immediately and in its entirety
FOK orders must be executed immediately in their entirety or they are canceled.
- One of your clients has a profit in STV common stock. The purchase price was $40 per share and is now $60 per share. The client is looking to take the profit and feels the stock still has a bit more growth. The client's strategy is to enter a sell limit order at $62. It is critical that the client understand that
- If the stock never reaches $62, the order will never be executed
- Entering this order erases the holding period of the stock
- The order becomes a market order when the price of $62 is reached
- The sell limit order should be entered below the current market price
Correct answer: If the stock never reaches $62, the order will never be executed
One of the risks with a limit order, buy or sell, is that the stock may never reach the price limit. In that case, the order is never executed. For this client, if the stock climbs to $61.99 and then plunges, the client has lost out on much or maybe all of the profit. Because the order can never be executed below the price limit, it never becomes a market order. It is purchasing a put option on stock held less than 12 months and one day where the holding period is erased.
- All open orders must be confirmed to the order book
- Once a year on the anniversary of the order
- The last business days of April and October
- April 1 and October 1.
- Every six months after the order has been entered
Correct answer: The last business days of April and October
All open orders must be confirmed the last business day of April and the last business day of October.
- All of the following orders could be placed on the designated market maker's order display book except
- Stop orders
- Market orders
- Limit orders
- Stop limit orders
Correct answer: Market orders
Market orders are executed immediately. The order display book is for orders that are away from the current market, such as stop and limit orders.
- A customer sold 100 shares of QRS short when the stock was trading at 19. If QRS is now trading at $14, and she wants to protect her gain, which of the following orders should she place?
- Sell limit at 14
- Buy limit at 14
- Sell stop at 13.75
- Buy stop at 14.25
Correct answer: Buy stop at 14.25
A buy limit order is used to buy at a lower price (when the market moves down). A buy stop order is used to buy in a short position at a higher price (when the market moves up). To protect the gain, a buy stop order would be placed just above where the stock is currently trading.
- KLP common stock has been trading at or near $25 per share all day. Your client would like to buy 500 shares of KLP at 25, but he is willing to accept fewer shares at that price. Which of the following orders fulfills his intentions?
- Market order to buy 500 shares of KLP
- Limit order to buy 500 shares of KLP at 25 IOC (immediate-or-cancel)
- Limit order to buy 500 shares of KLP at 25 FOK (fill-or-kill)
- Limit order to buy 500 shares of KLP at 25 AON (all-or-none)
Correct answer: Limit order to buy 500 shares of KLP at 25 IOC (immediate-or-cancel)
Partial execution is permissible on an IOC order.
- One of your clients has a profit in STV common stock. The purchase price was $40 per share and is now $60 per share. The client is concerned that the stock might backtrack and some of the profit might be lost. One way to protect that profit would be to
- Enter a sell limit order at $55
- Enter a sell limit order at $62
- Enter a sell stop order at $62
- Enter a sell stop order at $55
Correct answer: Enter a sell stop order at $55
Stop orders, frequently called stop-loss orders, are used to protect an existing profit or prevent a loss. In the case of a client owning stock, the fear is that the stock will decline in price. Sell stop orders are always placed below the current market, never above. In this question, should the stock's price fall to 55 (or lower), the stop order will be triggered and a market order entered. This will preserve at least some of the profit. Sell limit orders are placed above the market, but that will never be executed unless the stock rises to at least $62. A sell limit order placed below the current market is, in effect, a market order and is immediately executed.
- Under NYSE rules, a not-held order
- Requires discretionary authority from the customer
- Is good for the day only
- Is good til canceled
- Is a limit order
Correct answer: Is good for the day only
Under NYSE rules, a not-held order where a customer gives you authority over the price or timing of the order is good for that day only.
- If a customer gives his broker-dealer an order to sell his stock if it falls to or below 69 and will not accept a price below 69, the order is
- A stop limit order
- A sell limit order
- A stop order
- A buy limit order
Correct answer: A stop limit order
When an order is entered this way, the client has specified that it should not be triggered until the stock is at or below 69, a stop order. Because the client will not accept an execution below 69, it is a stop limit order.
- For a client to get immediate execution on an order, it should be placed as which of the following?
- All-or-none
- Market
- Good-til-canceled
- Stop
Correct answer: Market
A market order is executed immediately at the best available market price.
- A significant increase in which of the following types of orders may cause a bull market to accelerate?
- Buy stops
- Short sales
- Sell stops
- Buy limits
Correct answer: Buy stops
If the market is rising, only those orders on the order book above the current market will be executed. Buy stops and sell limits are both entered above the prevailing market price. Of these two, only buy orders (in this case buy stops) will accelerate a rise in the market.
- Stop orders may be used for each of the following except
- To guarantee an exact price when closing out a large position
- To establish a new long position above a key resistance level
- To protect an unrealized profit on a long position being held
- To limit the potential losses on a short position sold before
Correct answer: To guarantee an exact price when closing out a large position
A stop order is contingent: it does nothing until the stock trades at or through the stop price, and it then becomes a market order. Because it turns into a market order, the execution can occur away from the stop price, so it can never guarantee a specific price. What it does well is trigger action at a chosen level, which is why technicians use it to establish positions as a stock breaks through resistance or support, and why it is the standard tool for protecting an existing profit on a long position or capping the loss on a short one.
- One of your customers submits a market on close (MOC) order to sell 300 shares of IYH common stock, traded on the NYSE. The order is entered just before noon ET. At 3:00 pm, trading in IYH is halted for the remainder of the day. What does this do to the customer's order?
- The order is cancelled.
- The customer receives the price of the last trade before the halt.
- The order is carried over to the following business day.
- The order is carried over to the next day that IYH stock is traded.
Correct answer: The order is cancelled.
Market on close (MOC) orders are cancelled if there is a halt in trading of the stock before the market close. ** This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- A buy stop order is elected (triggered) when the underlying stock trades
- Anywhere below the stop price
- At or below the stop price
- Through the stop price only
- At or above the stop price
Correct answer: At or above the stop price
A buy stop order is placed above the prevailing market price and is elected (triggered), becoming a market order to buy when the stock trades at or through (above) the stop price.
- On the morning of the ex-date for a cash dividend, which of the following orders on the order book will not be reduced?
- Buy limit
- Sell stop limit
- Sell limit
- Sell stop
Correct answer: Sell limit
It is sell limit and buy stop orders that are placed above the market and are not reduced. Orders entered below the prevailing market [unless marked DNR (do not reduce)] are reduced on the morning of the ex-date by the amount of the cash dividend. Those orders are buy limits and sell stops, including sell stop limits.
- A client enters a buy stop order for 100 shares of XYZ at 40. Trades then occur at 38, 39, 39.90, 40.05, 40.10, and 39.78. At what price is the order triggered?
Correct answer: $40.05
The order is triggered as soon as the price gets to 40 or higher. That would be the trade at 40.05. A typical use of a buy stop order is to protect a short stock position. Because the short stock position has unlimited potential loss, the short seller can gain protection by entering a buy stop order. That order is entered at a price above the current market (the short seller is hoping the price will fall), but if the price reaches or exceeds the stop price, the stop will be triggered. At that time, a market order is entered and the client pays the next price (which could be more or less than 40). In this case, the next price is 40.10, and although not the answer to our question, that is the likely price per share paid by the client.
- A market order to purchase 100 shares of XYZ common stock is
- Executed at the market close
- Executed at the lowest price of the day
- Good for that day only
- Valid at the stipulated price only
Correct answer: Good for that day only
A market order is executed at the best price in the market at the time the order is entered. Because these orders have guaranteed execution (there is always a "best" price), there would be no practical reason for the order to be carried over to another day. There is a market on close order, but that would have to be specified in the order. A stipulated price is a limit order.
- At 2:15 pm ET, a customer gives his registered representative a market order to buy 100 shares of ABC at the close. What should the registered representative do with the order?
- Hold it at his desk until just before market close.
- Send the order to the floor immediately.
- Execute the order at the closing price first thing next morning.
- Send in the order after the close to ensure he receives the closing price.
Correct answer: Send the order to the floor immediately.
The registered representative should mark the order ticket at close. His firm's floor broker will take on the responsibility for proper execution.
- If a customer with an unrealized gain on a short stock position wishes to protect her profit, she should enter
- A sell stop order
- A buy limit order
- A sell limit order
- A buy stop order
Correct answer: A buy stop order
A buy stop order can be placed above the current market to protect the short stock position. If the stock trades at or above the stop price, the order is elected and becomes a market order to buy the stock, which will be used to cover the short position.
- A customer entered an order to sell short 100 shares of ABC. The stock closed on Friday at $48. The stock will trade ex-dividend $0.50 on Monday. At what price can the order be executed at the opening?
- At 47.51 or higher, one cent above the adjusted opening price
- At 47.50 or higher, right at the adjusted opening price level
- At any price, above or below the 47.50 adjusted opening price
- At 47.49 or higher, one cent below the adjusted opening price
Correct answer: At any price, above or below the 47.50 adjusted opening price
The stock is reduced by the 50-cent dividend at Monday's opening, so the reference price becomes 47.50. That adjustment changes where the stock opens; it says nothing about where a short sale may print. The requirement that a short sale on an exchange or on Nasdaq be made on a plus or zero-plus tick was eliminated in 2008, so no price test stands between this order and an execution. The short sale can therefore be executed at any price, whether above or below the adjusted 47.50 opening.
- An investor sold 100 shares of MAS short when the stock was trading at 21. If MAS is now trading at 16, and the investor wants to protect her gain, which of the following orders should she place?
- Sell limit at $16
- Buy limit at $16
- Sell stop at $16.25
- Buy stop at $16.10
Correct answer: Buy stop at $16.10
A buy stop order is used to buy in a short position at a higher price (when the market moves up). To protect the gain, a buy stop order would be placed just above where the stock is currently trading. In this case with the stock trading at 16, a buy stop of 16.10 is the best choice.
- An investor submits an immediate-or-cancel order to buy 500 shares of stock at 32.20. When the order reaches the trading floor, the quote is 32.18 – 32.26, 6×6. The investor
- Bought 500 shares at 32.20
- Bought 500 shares at 32.18
- Did not buy any shares
- Bought 500 shares at 32.26
Correct answer: Did not buy any shares
An immediate-or-cancel order (IOC) is a limit order requiring immediate execution or cancellation. Unlike its cousin, the fill-or-kill (FOK) order, a partial fill is permitted with an immediate-or-cancel order. An IOC order to buy 500 shares at 32.20 means that the investor will buy up to and including 500 shares as long as the purchase price is at no higher than $32.20 per share. Buyers pay the lowest ask price (the least a seller is willing to accept for the stock). At the time this order is presented, the lowest ask was 32.26. Even though the seller was willing to sell all 500 shares (the quote size was for 600), the price is not low enough, so the order is canceled.
- A customer, concerned about a possible pull-back in XYZ stock, instructs her broker to "Sell my XYZ stock if it falls to 40, but I don't want less than 39.75 for my shares." The broker should enter
- A sell limit order
- A market order to sell
- A sell stop order
- A sell stop limit order
Correct answer: A sell stop limit order
A sell stop limit order would be appropriate (sell 100 XYZ 40 stop 39.75). Once the price of XYZ trades at or through (below) 40, the order is elected and becomes a limit order to sell at 39.75 or better (higher).
- When a major decline occurs within a few minutes of the close, trading is halted on all markets for the remainder of the trading day. Under the market-wide circuit breaker (MWCB) rules, market-on-close (MOC) orders pending at the time trading is halted
- Should be held for execution on the following trading day unless canceled by the customer
- Are converted to market orders and executed at the opening on the following trading day
- Should be held for execution on the following trading day
- Must be canceled
Correct answer: Must be canceled
During shorter market-wide trading halts that will allow trading to resume on that same trading day, pending and new incoming orders should be forwarded to the appropriate market for execution upon the resumption of trading. If a halt closes the market for the remainder of the trading day, MOC orders pending at the time trading is halted should be canceled. MOC orders received after trading is halted should be declined.
- Each of the following statements concerning fill-or-kill (FOK) orders and all-or-none (AON) orders are true except
- An AON order must be canceled if the whole order cannot be executed immediately
- An AON order must be filled in its entirety
- An FOK order must be canceled if the whole order cannot be executed immediately
- An FOK order must be filled in its entirety
Correct answer: An AON order must be canceled if the whole order cannot be executed immediately
An FOK order must be executed immediately in its entirety or else it is canceled. An AON order must be executed in its entirety but is not canceled if the whole order cannot be executed immediately.
- An investor submits an immediate-or-cancel order to sell 500 shares of stock at 32.20. When the order reaches the trading floor, the quote is 32.18 – 32.26, 6×6. The investor
- Sold 500 shares at 32.18
- Sold 500 shares at 32.26
- Sold 600 shares at 32.26
- Did not sell any shares
Correct answer: Did not sell any shares
An immediate-or-cancel order (IOC) is a limit order requiring immediate execution or cancellation. Unlike its cousin, the fill-or-kill (FOK) order, a partial fill is permitted with an immediate or cancel order. An IOC order to sell 500 shares at 32.20 means that the investor will accept the sale of anything up to and including 500 shares as long as the sale price is at least $32.20 per share. Sellers receive the highest bid price (the most an investor is willing to pay for the stock). At the time this order is presented, the highest bid was 32.18. Even though the buyer was willing to take all 500 shares (the quote size was for 600), the price is not high enough, so the order is canceled.
- Which of the following orders on the order book will not be filled if the stock rises?
- Buy stops
- Sell stop
- Sell limit
- Buy stop limit
Correct answer: Sell stop
Those orders on the book which are above the current market will be executed if the stock rises. Those open orders above the current market are buy stops (including buy stop limits) and sell limits.
- A technical analyst has been charting XYZ stock and notes that it fluctuates between $36 and $41. The last trade was at $39. If the analyst expects a breakout through resistance, which of the following orders should be placed?
- Buy XYZ 35 Stop GTC
- Buy XYZ 35 GTC
- Buy XYZ 42 Stop GTC
- Buy XYZ 42 GTC
Correct answer: Buy XYZ 42 Stop GTC
A breakout through the resistance ($41) signifies, at least to a technical analyst, that the stock will continue to increase in price. This is a bullish sign. A buy stop order is placed above a resistance level. It is triggered if and when the stock trades at or above the stop price. This allows an investor to participate in a bullish breakout through the resistance. Why not enter "Buy XYZ 42 GTC"? That order calls for the stock to be purchased at a price of 42 or better (lower). With the current price at $39 per share, this is, in essence, a market order, and the stock is bought at the best price in the market. That defeats the purpose of not buying until the breakout is confirmed.
- A buy stop order may be used for all of the following except
- To protect a profit in a long position
- To protect against loss in a short position
- To acquire a long position as a stock breaks through resistance
- To protect a profit in a short position
Correct answer: To protect a profit in a long position
Buying can only protect short positions, not long positions.
- A technical analyst has been charting ABC stock and notes that the support/resistance levels are $20 and $30, respectively. If the analyst expects ABC to fall through support, which of the following orders should he enter?
- Buy 100 ABC 20.50 stop
- Sell 100 ABC 19.50 stop
- Sell 100 ABC 29.75 stop
- Buy 100 ABC 30.25 stop
Correct answer: Sell 100 ABC 19.50 stop
An analyst who expects a stock to fall through support is anticipating that the stock will decline. He can take advantage of this trend by establishing a short position at the top of the decline. He will enter a sell stop order just below the support price.
- A client enters a buy stop order for 100 shares of XYZ at 40. Trades then occur at 38, 39, 39.90, 40.05, 40.10, and 39.78. What is the likely price the client paid for the stock?
Correct answer: $40.10
The order is triggered as soon as the price gets to 40 or higher. That would be the trade at 40.05. A typical use of a buy stop order is protecting a short stock position. Because the short stock position has unlimited potential loss, the short seller can gain protection by entering a buy stop order. That order is entered at a price above the current market (the short seller is hoping the price will fall), but if the price rises, the stop will be triggered. At that time, a market order is entered and the client pays the next price (which could be more or less than 40). In this case, the next price is 40.10 and that is the likely price per share paid by the client.
- Which of the following order types is permitted in Nasdaq and NYSE equity markets?
- Stop orders.
- Fill or kill (FOK)
- Good til canceled (GTC)
- Market
Correct answer: Market
Market orders are permitted on both of these major trading markets. Fill or kill, GTC, and stop orders may no longer be entered in the Nasdaq and NYSE equity markets. Most large broker-dealers provide the service of handling these orders.
- Each of the following is true about stop orders except
- They can accelerate the advance or decline of a stock's price if executed
- They become market orders when there is a trade at, or the market passes through, a specific price
- They are the same as limit orders
- They can limit a loss in a declining stock
Correct answer: They are the same as limit orders
A stop order becomes a market order once the market price reaches or passes through the stop price. An investor in a long position can use the sell stop order for protection against a market decline. When a large number of stop orders are triggered at a particular price, the advance or decline of the market at that point can be magnified.
- Which of the following orders is reduced on the order book on the ex-dividend date for a cash dividend?
- Buy stop order
- Sell limit order
- Buy stop limit order
- Limit order to buy
Correct answer: Limit order to buy
Only orders placed below the market price are reduced for cash dividends on the order book. Buy limits and sell stops are entered below the market price.
- A customer has an order to buy 400 ABC at 60. ABC declares a 25% stock dividend. On the ex-date, the order on the order book will read
- Buy 500 shares at 30
- Buy 425 shares at 50
- Buy 500 shares at 48
- Buy 400 shares at 60
Correct answer: Buy 500 shares at 48
For stock dividends, all buy limit orders on the book are adjusted and the order value must be the same before and after the adjustment. Before the adjustment, 400 ABC at 60 stop = $24,000 total value. After the adjustment, total shares on the buy order will be 500 (400×25%=100 new shares, 400+100=500). To arrive at the new price, divide the total order value by the new number of shares ($24,000 ÷ 500 shares = 48). After the adjustment the new order will read; buy 500 shares at 48.
- All of the following kinds of orders may be turned over to the specialist (designated market maker) for execution except
- Not-held orders
- Limit orders
- Stop orders
- Market orders
Correct answer: Not-held orders
A not-held order is a market order in which the investor has given the authority to choose the price and time to the floor broker to achieve the best possible execution.
- A representative enters a customer's immediate-or-cancel (IOC) order to sell 1,000 shares at $12. If only 500 shares can be sold at $12, which of the following will occur?
- Because 500 shares can be sold, the balance of the order will remain as a sell limit order for 500 shares at $12.
- None of these.
- Because the entire order cannot be filled, the entire order will be canceled unexecuted.
- The 500 shares will be sold at $12; the remainder of the order will be canceled unexecuted.
Correct answer: The 500 shares will be sold at $12; the remainder of the order will be canceled unexecuted.
An IOC order will take a partial fill. Time is the limiting factor in an IOC.
- There are a number of different types of orders that a registered representative can enter for a client. Of the following, which one has the greatest assurance of being executed?
- A limit order
- A buy stop order
- A market order
- A sell stop order
Correct answer: A market order
Market orders are executed immediately at the best available price in the market. The other choices all have a specified price. There is no assurance that price will ever be reached.
- Each of the following types of orders will remain open (working orders) until certain conditions are met, except
- Market orders
- Stop orders
- Good-till-canceled orders
- Stop limit orders
Correct answer: Market orders
A market order is executed immediately at the prevailing market price. A stop, or stop limit, order is not triggered until a set price is hit or passed through. A good-til-canceled order remains open until executed or canceled.
- An order ticket is marked as follows: Buy 10 GGZ 9% debentures at 95 AON good til canceled (GTC). All of the following statements regarding this order are true except
- The order will expire at the end of the day
- This is a buy limit order
- If executed, the customer will pay $9,500 or less for the bonds
- The trade will be filled in its entirety or not at all
Correct answer: The order will expire at the end of the day
The customer has placed a limit order to buy 9% debentures issued by GGZ. The limit the customer is willing to pay is 95% of $10,000 worth of bonds, or $9,500 or lower. AON means all-or-none (either fill the order in its entirety or do not execute the order). GTC is a good-til-canceled order, not a day order.
- AMZ Corporation has declared a cash dividend of $1.10. On the ex-dividend date, an open order to buy AMZ at 52 stop would
- Remain at 52 stop
- Be automatically adjusted to 53.10 stop
- Be automatically adjusted to 51.90 stop
- Be automatically adjusted to 52.10 stop
Correct answer: Remain at 52 stop
When a stock goes ex-dividend, the price of the stock falls by the amount of the dividend. This would require an adjustment in the amount of the dividend to orders placed below the market. This is a buy stop order and those are placed above the market so there is no adjustment to the price. Remember the SLoBS, where the Sell Limits and Buy Stops are above the market, and BLiSS, the Buy Limits and Sell Stops are below the market
- A designated market maker is permitted to do all of the following except
- Accept a not-held order
- Represent a bid and offer simultaneously
- Buy and sell for a proprietary account
- Accept a limit order
Correct answer: Accept a not-held order
A specialist (designated market maker) on the floor does not deal directly with the public. Therefore, a designated market maker cannot accept any order that requires the exercise of discretion. A not-held order is one in which the floor broker can choose the price or time of execution.
- A customer sells short 100 shares of XYZ Corporation at $78 per share. The support and resistance levels for XYZ are at $70 and $80, respectively. If he wishes to protect his position, which of the following is the best place to put in a buy stop order?
Correct answer: $80.10
The client will want to place a buy stop a little above the resistance level to protect himself against an upside breakout. Entering a buy stop order too close to the purchase price (78.10) would not afford the client an opportunity for gain.
- An investor sold 100 shares of RAN common stock short at $50 per share. The RAN is now at $38. The investor is still bearish on the stock but would like to protect that gain. What would you recommend if this were your client?
- Enter a buy stop order at $55
- Enter a sell order at $40
- Enter a buy stop order at $40
- Enter a sell stop order at $40
Correct answer: Enter a buy stop order at $40
Buy stop orders are used as a protective tool for short sellers. In this case, if the stock should begin to rise from its current price of $38, once it reaches or exceeds $40, a buy order at the market is entered. The stock purchased is used to cover the short position, and the investor's profit is the $50 sale price minus the cost of the purchase. Buy stops are always placed above the current market. Because the investor is short, the only protective order would be a buy, not a sell (you buy protection)..
- A broker-dealer informs a customer that her order was not executed because of stock ahead. The order was most likely
- A margin purchase
- A market order
- A limit order
- A short sale
Correct answer: A limit order
When there are a number of limit orders entered at the same price, they are filled in the order in which they have been received. It is possible that those orders received later could not be executed because the execution of the earlier orders has caused the market price to move away from the limit price. Market orders are always executed at the best price in the market (even though that might be far away from what the investor expected). If the investor wants immediate execution—turn in a market order. If the client wants a specific price—turn in a limit order but give the warning that it might never be executed.
- A customer places an order to buy 300 DWQ at 140 stop, but not over 140.25. This is
- A buy stop order
- A buy limit order
- A market not-held order
- A buy stop limit order
Correct answer: A buy stop limit order
The customer has entered a stop limit order. If the stock rises to the stop price of $140, the order is elected and then becomes a buy limit order at 140.25, meaning an order to buy at 140.25 or lower.
- What type of order provides that market activity can cause activation, but it is possible that the trade itself may or may not be executed?
- A market order
- An open buy order
- A stop order.
- A stop limit order
Correct answer: A stop limit order
With a stop limit order, if the stock price trades at or through the specified stop price, the order will be triggered or activated and become a limit order. But remember, a limit order may not be executed because the limit price may never be reached.
- There are a number of different types of orders that a registered representative can enter for a client. Of the following, which one would be most appropriate for a client wishing to protect a profit on a short stock position?
- A buy stop order.
- A buy limit order.
- A sell limit order.
- A sell stop order
Correct answer: A buy stop order.
Protecting a profit on a short position means covering (buying back) the stock before its price increases above the original sale price. That means buying the stock. The investor would enter the buy stop order with a stop price above the current market, but below the original sale price. A buy limit order is placed below the market, and that is of no help if the price increases. A market order is executed at once, and selling the stock is not appropriate when the investor has already sold it.
- A day order is entered to buy 500 LMN at 24.35. By the close of the trading day the firm has been able to purchase 100 shares at 24.25 and 200 shares at 24.35. If the remainder of the order is unfilled, what is the outcome?
- The customer must accept the execution for 300 shares, and the remainder of the order is canceled after the close.
- The customer may reject the incomplete order unless the remainder can be filled within three business days.
- The customer may demand that the firm deliver the remaining shares at 24.35.
- The customer may reject the incomplete order unless the broker-dealer can guarantee filling the remainder by the end of the day.
Correct answer: The customer must accept the execution for 300 shares, and the remainder of the order is canceled after the close.
The customer must accept the order for 300 shares. The representative cannot guarantee that the order will be filled by the end of day.
- All of the following statements about trading index options on the Chicago Board Options Exchange are true except
- Market makers may trade in index options for their house accounts
- Orders entered by a market maker have priority over public orders
- Floor brokers may execute orders for others on a commission basis
- Public limit orders are held inside the order official's own book
Correct answer: Orders entered by a market maker have priority over public orders
Public orders come first. A member trading for its own account never takes precedence over a customer order at the same price, and that holds for stock, for bonds, and for options of every kind, so the statement that market maker orders have priority is the false one. The other three describe the exchange accurately: market makers do trade for their own accounts, floor brokers do execute orders for others and are paid a commission for doing it, and public limit orders on index options are maintained in the order official's book.
- There are a number of different types of orders that a registered representative can enter for a client. Of the following, which one would be most appropriate for a client wishing to protect a profit on a long stock position?
- A sell limit order.
- A sell stop order
- A buy stop order
- A market order
Correct answer: A sell stop order
Protecting a profit on a long position means getting out of the stock before its price declines below the original purchase price. That means selling the stock. The investor would enter the sell stop order with a stop price below the current market, but above the original cost. A sell limit order is placed above the market and that is of no help if the price drops. A market order is executed at once and buying the stock is not appropriate when the investor already owns it.
- When referring to a stock, the term spread refers to
- The range between the high and low price for a particular year
- The dealer's markup
- The difference between the bid and asked prices
- The range between the high and low price for a particular trading day
Correct answer: The difference between the bid and asked prices
The term spread refers to the difference between the bid and asked prices.
- XYZ Corporation has set Friday, January 23, as the record date for its next quarterly dividend distribution. To receive the dividend, a customer, long 1 XYZ Feb 40 call, must issue exercise instructions on or before
- Monday, January 19.
- Wednesday, January 21.
- Tuesday, January 20.
- Friday, January 23.
Correct answer: Wednesday, January 21.
Dividends are paid to investors who are owners of record as of the close of business on the record date. When a call option is exercised, money and stock are exchanged (settlement) on the first business day after notice is given to the Options Clearing Corporation (T+1). To be an owner of record by the record date (Friday, January 23), the stock must be acquired no later than the business day before the ex-date. With T+1 settlement, the ex-date is one business day before the record date (Thursday, January 22), so the customer must exercise the call no later than Wednesday, January 21. This is no different from anyone else purchasing stock before the ex-date.
- A customer has his broker enter an order to buy GHI stock at the opening. Though transmitted promptly, the order does not reach GHI's trading post in time to be filled at the opening. How is the order handled?
- The order is handled as a market order.
- The order is executed in the day, at a price as close to the opening price as possible.
- The order is canceled.
- The order automatically becomes an at-the-open order in the following trading session.
Correct answer: The order is canceled.
An at-the-open order is to be filled at the opening price or not at all. An at-the-open order arriving later must be canceled.
- Your client feels that GGZ, currently trading around 39, would be a good buy at 38. Therefore, she places an order to buy 200 GGZ at 38 GTC. On the ex-date, when the stock splits 2:1, the order is still on the order book. How is the order adjusted on the ex-date?
- Buy 400 GGZ at 19 GTC
- Buy 200 GGZ at 19 GTC
- Buy 100 GGZ at 76 GTC
- Buy 400 GGZ at 38 GTC
Correct answer: Buy 400 GGZ at 19 GTC
In a stock split, the number of shares is increased and the price is reduced proportionately on the ex-date (200 shares×2=400 shares; the new price is 38×0.5, or 19).
- If a Nasdaq market maker is selling stock to a customer from inventory and the firm has held the shares to be sold for several months, what price should the dealer use as a basis for a markup?
- Price at which it purchased the securities
- Best offering price quoted in the interdealer market
- Broker/dealer's own current offer price
- Offer price shown in the electronic OTC Pink on the day of the current sale
Correct answer: Best offering price quoted in the interdealer market
FINRA rules require that a dealer's markup to a customer be based on the current market rather than the dealer's cost in an active, competitive market. The dealer's potential loss on inventory is considered to be a risk of making a market.
- Last-sale information is always available for all of the following securities except
- Convertible bonds quoted on the Nasdaq Global Market
- Equity securities traded over the counter off Nasdaq
- Preferred stock listed on the New York exchange
- Option contracts listed on a national options market
Correct answer: Equity securities traded over the counter off Nasdaq
Last-sale reporting is a feature of the organized markets. Every exchange-listed security and every Nasdaq security has last-sale information disseminated as trades occur, and listed option contracts are reported the same way. An equity that trades over the counter without a Nasdaq quotation is the exception: it carries no comparable last-sale reporting obligation, so a current last-sale price may simply not be available for it.
- To fill a customer buy order for 800 WXYZ shares, your firm requests a quote from a market maker for 800 shares. The response is "bid 15, ask 15.25." If the order is placed, the market maker must sell
- 100 shares at $15.25 per share.
- 800 shares at $15 per share.
- 800 shares at no more than $15 per share.
- 800 shares at $15.25 per share.
Correct answer: 800 shares at $15.25 per share.
A market maker is responsible for honoring a firm quote. If no size is requested by the inquiring trader, a quote is firm for 100 shares. In this example, the trader requested an 800-share quote, so the market maker is responsible for selling eight round lots of 100 shares at the ask price of $15.25 per share.
- An over-the-counter (OTC) quote that must be reconfirmed with the OTC trading room before a broker-dealer takes action is
- Third party
- Subject
- Representative
- Firm
Correct answer: Subject
Before a trade can take place, a subject quote always must be reconfirmed with the OTC trader or market maker that provided it. Subject quotes are typically used in conjunction with thinly traded securities or before filling large block orders.
- A client of yours wishes to sell 400 shares of LMNO common stock. You contact your trading desk and receive the following quote: "We are currently quoting LMNO at 42-42.15, 6 by 4." You report this to the client who says, "Do it." The customer will receive
- $4,200.
- $16,800.
- $16,860.
- $4,215.
Correct answer: $16,800.
The statement from the trading desk indicates a firm quote. When the client is selling, the price received is the dealer's bid price. This quote indicates that the firm is willing to buy up to 600 shares at the bid price. Multiply 400 shares times the bid of $42 per share to arrive at $16,800. If the client was a buyer, the cost would be the ask price of $42.15 ($16,860). The other two choices are for students who didn't notice the client had 400 shares.
- A financial intermediary that offers to buy an asset at a bid price and to sell the same asset at an ask price is best described as
- An investment adviser
- A market maker
- A broker
- An arbitrageur
Correct answer: A market maker
Market makers maintain an inventory of securities and profit from a bid-ask spread. They are acting in a principal (dealer) capacity as either the buyer or the seller. Brokers locate counterparties for buyers and sellers. They act in an agency capacity. Arbitrageurs seek to earn a riskless profit by buying an asset in one market and simultaneously selling the same asset for a higher price in another market. The function of investment advisers is rendering advice. They do not maintain quotes to buy and sell a security.
- In performing their natural job functions, all of the following may act in a principal capacity in a transaction with customers except
- Broker-dealers
- OTC market makers.
- Designated market makers (DMM) on the NYSE
- Branch managers of FINRA member firms
Correct answer: Branch managers of FINRA member firms
When acting as a principal in a transaction, you are buying for or selling from inventory. Although branch managers of member firms are generally required to be registered as principals, that is different from acting in a principal capacity in a transaction. DMMs facilitate trading on the floor of the NYSE. Doing that sometimes requires them to buy or sell as principals. OTC market makers, by definition, act as principals. The term broker-dealer means that the firm can act either as a broker or a dealer. There are a number of words used in this exam than can have multiple meanings. Principal is one of those.
- An over-the-counter (OTC) trader's quote of "60 to 63, work out," in response to a broker holding a customer order to sell a block of stock, indicates which of the following?
- The quote is firm and the customer can sell an unlimited amount of stock at 60 or buy at 63.
- The quote is tentative (nominal), merely suggesting a range in which the order is likely to be filled.
- The quote is firm but the market maker must be given discretion over when the transaction will take place.
- The market maker guarantees that a customer buy order can be filled no higher than 60.
Correct answer: The quote is firm and the customer can sell an unlimited amount of stock at 60 or buy at 63.
The term work out means that the quote is approximate, or nominal. As with a subject quote, the OTC trader that supplied the quote will most likely negotiate with a number of market makers to get the customer's securities sold or bought.
- FINRA considers all of the following as prohibited conduct except
- Backing away from firm quotations
- Interpositioning a third party broker
- Shredding an order into fragments
- Honoring a firm's published quote
Correct answer: Honoring a firm's published quote
A member that publishes a firm quote is obligated to trade at it, so honoring that quote is simply doing what the rules require and is not prohibited conduct. Backing away is the refusal to honor a published firm quote, and it is prohibited. Interpositioning inserts a third broker between the firm and the best available market, which almost always leaves the customer with a worse execution. Trade shredding breaks one order into many small pieces to collect extra per-trade credits or fees. Those three are all prohibited.
- Failure to honor a firm quote is called
- Trading ahead
- Backing away
- Interpositioning
- Front running
Correct answer: Backing away
Failure to honor a stated quote is a rules violation called backing away.
- Sell order tickets must be
- Marked only if they are short sales
- Marked as either long or short
- Executed in accordance with the appropriate rules, but not necessarily marked
- Marked only if they are long sales
Correct answer: Marked as either long or short
Every sell order must be marked as either a long sale or a short sale.
- Establishing short positions is typical for all of the following except
- Preferred stock
- Municipal bonds
- Listed stock
- Over-the-counter common stock
Correct answer: Municipal bonds
Even though there is no regulation that prohibits short sales of municipal bonds, this is rarely done. To short a security, it must be borrowed and later covered. The general illiquidity of the municipal market makes this difficult.
- The locate requirement of Regulation SHO for short sales does not apply to
- Over-the-counter equity securities
- American depositary receipts traded on the Nasdaq Stock Market
- Preferred stock traded on the NYSE
- Nonconvertible bonds traded on the NYSE
Correct answer: Nonconvertible bonds traded on the NYSE
The locate requirement is applicable to all short sales of equity securities. It is unlikely to be tested, but, just in case, for purposes of this rule, convertible bonds are considered equity securities.
- An investor places an order to sell short ABC at the open. The opening bid of $15.25 is the same as the prior day's close. At what price may the investor sell short at the open?
- $15.26
- $15.24
- $15.25
- The investor is prohibited from selling short at the open
Correct answer: $15.25
Short sales can occur any time during the trading day, including the opening and the close. In this case, the sale would take place at the best bid, which is $15.25.
- An investor places a market order to sell short 200 shares of ABC stock. The order is filled at $23.45 per share. Assuming the investor can cover the short by purchasing the shares at $20 per share, calculate the gain or loss.
- Gain of $690
- Loss of $690
- Loss of $345
- Gain of $850
Correct answer: Gain of $690
A short seller makes a profit when the stock sold short can be purchased at a price below the sale price. The investor sold the shares for $23.45 and was able to cover the short at $20 per share. That is a profit of $3.45 per share. Because there are 200 shares, the total gain is $690 (200 times $3.45).
- An investor believes that ICBS, a Nasdaq security, is overpriced at 40. She can sell ICBS short in the over-the-counter (OTC) market under which of the following circumstances?
- Under no circumstances
- With no restrictions
- Only if she has an outstanding long position
- Only at a price higher than the current inside bid
Correct answer: With no restrictions
As on exchanges, short sales on the Nasdaq Stock Market can occur at any time in the trade sequence.
- One of your customers with an existing margin account turns in an order to sell short 500 shares of LMN common stock. Before entering the order, you must
- Verify that the account has sufficient equity
- Update the customer’s account profile
- Determine if the trade is suitable for the customer
- Be sure the firm can locate the stock
Correct answer: Be sure the firm can locate the stock
Regulation SHO mandates a locate requirement for short sales. Before entering a short sale order, members are required to locate the security to be ensured that delivery can be made on settlement date. The locate requirement applies to short sales in all equity securities. The margin call on a short sale should be met by settlement date (T+2) and must be met by the Regulation T deadline (S+2). Therefore, the money does not have to be in the account before the sale. Because this is an unsolicited order (the customer initiated the order), Regulation Best Interest on suitability does not apply (Regulation Best Interest only applies to your recommendations). Customer account profiles should be updated no less frequently than every 36 months, not with each order.
- Municipal bonds are not normally sold short because
- The municipal bond market is illiquid
- The transaction is expensive to execute
- Short sales are prohibited by municipal statute
- Short sales are prohibited by Municipal Securities Rulemaking Board rules
Correct answer: The municipal bond market is illiquid
While there is no law or industry rule prohibiting short sale of municipal bonds, it is not a common practice. To short a security, it must be borrowed, and because most municipal securities are thinly traded, it is often difficult to locate the specific issue needed to cover the short position.
- The practice of naked short selling is prohibited by
- Regulation T.
- The Options Clearing Corporation
- Regulation SHO.
- FINRA.
Correct answer: Regulation SHO.
Naked short selling is when the broker-dealer accepts an order to sell stock short but is not able to ascertain the location of stock to deliver.
- Your customer asks you to borrow shares of stock from another investor's account and then sell the borrowed stock in the open market. Sometime later, the customer repurchases the stock in the open market and replaces, or covers, the borrowed stock. Identify the type of transaction that was used in this account.
- Wash sale
- Zero-cost collar
- Protective put
- Short sale
Correct answer: Short sale
This type of transaction is known as a short sale. A short sale allows an investor to take advantage of falling stock prices. The mechanics involve borrowing shares, selling them at a high price, and then returning those shares by buying them at a lower price. Collars and puts are options that can be used in the face of a potential decline in the price of the underlying stock. A wash sale occurs when an investor sells a security at a loss and then repurchases the same security (or one substantially identical) within 30 days before or after the sale at a loss.
- Insiders (control persons or affiliates) of a company are prohibited from
- Buying call options on the company's stock
- Engaging in any short sales on stock of competing issuers
- Selling short their own company's stock
- Buying shares of affiliated issuers
Correct answer: Selling short their own company's stock
What a conflict of interest it would be for insiders to sell their own company's stock short! Wanting the shares to decline in price, then mismanaging the company into a loss to profit in their personal account at the expense of all the other stockholders? We don't think so and neither does the SEC. There are no restrictions on insiders buying call options on their company's stock nor buying shares of affiliated companies. The short sale restrictions apply only to the insider's company, not any others.
- Regulation SHO prohibits
- Short selling in cash accounts
- Naked short selling
- Short sales on an uptick
- Unsuitable short selling
Correct answer: Naked short selling
Regulation SHO mandates a locate requirement with regard to short sales. Before entering a short sale order, members are required to locate the security to be ensured that delivery can be made on settlement date. The locate requirement applies to short sales in all equity securities. Failure to positively locate the stock before making the short sale is the prohibited practice of naked short selling. Although one can sell short only in a margin account, the prohibition against doing so in a cash account is part of Regulation T, not SHO. Short selling, just as with any activity in customer's accounts, must be suitable. That is part of the suitability requirements, not Regulation SHO. Short sales can be made on any tick: up, down, or the same.
- Sell orders for equity securities
- Do not need to be marked, only executed in accordance with the appropriate rules
- Must be marked long or short
- Must be marked only if they are short sales
- Must be marked only if they are long sales
Correct answer: Must be marked long or short
Every sell order in an equity security must be marked as either a long sale or a short sale.
- Typically, general obligation bonds are not sold short because
- Thin markets may make it difficult to cover a short municipal position
- They are backed by the full faith and credit of the issuing authority
- Municipal Securities Rulemaking Board regulations prohibit short selling.
- They trade over the counter
Correct answer: Thin markets may make it difficult to cover a short municipal position
Because the municipal trading market is thin, it is often difficult to cover (buy back) a municipal security that has been sold short. It is easy to short 100 shares of GM (borrow the stock), for example, because an equivalent 100 shares of GM can be purchased on the NYSE at any time.
- The requirement for a broker-dealer to locate a security to be sold short before executing the order is found in
- Regulation T.
- TRACE.
- Regulation SHO.
- The FINRA Uniform Practice Code
Correct answer: Regulation SHO.
Regulation SHO mandates a locate requirement for short sales. Before entering a short sale order, members are required to locate the security to ensure that delivery can be made on settlement date. The locate requirement applies to short sales in all equity securities. Failure to positively locate the stock before making the short sale is the prohibited practice of naked short selling. Regulation T mandates that short sales be made in margin accounts. The Trade Reporting and Compliance Engine (TRACE) is the FINRA-approved trade reporting system for corporate and government agency bonds trading in the OTC secondary market. FINRA's Uniform Practice Code tangentially deals with this issue because the location requirements enable delivery of stock sold short to be made according to its rules on good delivery.
- When an investor sells stock short on the ex-dividend date, the dividend belongs to
- The lender of the borrowed shares
- The short seller of those shares
- The buyer on the ex-dividend date
- The issuer that paid the dividend
Correct answer: The lender of the borrowed shares
Selling on the ex-dividend date means the buyer bought without the dividend, so the dividend stays on the sell side of the trade. In an ordinary sale that would be the seller, but a short seller does not own the stock, because the shares were borrowed. The owner of record, the one whose name is on the books when the dividend is paid, is the party that lent the stock, and the dividend belongs to that lender. A due bill is sometimes needed to route the payment to the proper party. The issuer merely pays the dividend out.
- Under Regulation T, action by the broker-dealer is not required when
- The total amount of the transaction does not exceed $1,000
- The amount due does not exceed $100
- The amount due does not exceed $200
- The amount due does not exceed $1,000
Correct answer: The amount due does not exceed $1,000
Regulation T permits a broker-dealer to disregard any amounts due less than $1,000.
- In a new margin account, a customer sells short 1,000 shares of XYZ at $30 per share and deposits the required margin. If the stock subsequently falls to $25 per share, the equity in the account is
- $20,000.
- $25,000.
- $10,000.
- $15,000.
Correct answer: $20,000.
When selling short, the initial credit balance is the sum of the proceeds of the sale ($30,000) plus the 50% Regulation T margin requirement ($15,000) or $45,000. The beginning equity is $15,000 (CR − SMV = EQ, or $45,000 − $30,000 = $15,000). If the market value falls to $25,000, equity is determined as $45,000 minus $25,000 equals $20,000.
- Toby Jensen originally purchased 400 shares of CSC stock on margin at a price of $60 per share. The initial margin requirement is 50%, and the maintenance margin is 25%. CSC stock price has fallen dramatically in recent months, and it closed today with a sharp decline, bringing the closing price to $40 per share. Based on FINRA requirements, will Jensen receive a maintenance margin call?
- Yes, because the account is below the house maintenance requirement.
- Yes, the account does not meet the minimum maintenance margin requirement.
- No, the account meets the minimum maintenance margin requirement.
- No, the account meets the minimum initial margin requirement.
Correct answer: No, the account meets the minimum maintenance margin requirement.
Minimum maintenance requires equity equal to 25% of the current market value. If the price per share is $40, then the value of the 400 shares is $16,000. That would make the minimum equity requirement $4,000 ($16,000 times 25%). The initial purchase was $24,000 resulting in a debit balance of 50%, or $12,000. If the LMV is $16,000 and the debit balance is $12,000, the account is right at the minimum maintenance level of $4,000. Toby might be below the house maintenance, but because that is not given in the question, there is no way to tell.
- In a customer's margin account, a broker-dealer must segregate
- The whole amount permitted up to 140% of the debit balance
- The entire market value of the long shares in this account
- The excess above 140% of the debit balance in this account
- Half of the equity the customer has in this margin account
Correct answer: The excess above 140% of the debit balance in this account
A broker-dealer may hypothecate, or pledge, customer securities worth up to 140% of the customer's debit balance in order to finance the margin loan. Anything the customer owns beyond that 140% is not needed as collateral, so it must be physically segregated and held for the customer. The 140% figure itself is the amount that may be pledged rather than the amount segregated, and neither the full long market value nor a share of the customer's equity is the measure the rule uses.
- Issued and outstanding stock is the authorized stock of a corporation that has been purchased by investors. The remaining authorized but unissued stock may be used for all of the following except
- Paying a stock dividend to all existing common shareholders
- Raising more capital in a second registered public offering
- Paying the corporation's federal income taxes for this year
- Meeting the conversion rights of buyers of convertible debt
Correct answer: Paying the corporation's federal income taxes for this year
Authorized but unissued shares are a reserve the corporation can draw on whenever it needs to issue stock. It can sell them to raise capital in a later offering, distribute them as a stock dividend, and deliver them when holders of convertible bonds or convertible preferred exercise the conversion privilege. What it cannot do is hand them to the Internal Revenue Service. A corporation is taxed like any other taxpayer, and its tax has to be paid in money rather than in its own shares.
- Which of the following is true regarding a 5-for-4 stock split?
- The declared par value of each share stays exactly the same
- The share of equity each holder owns stays exactly the same
- The market price of one single share stays exactly the same
- The number of shares in each account stays exactly the same
Correct answer: The share of equity each holder owns stays exactly the same
A forward split multiplies the shares outstanding without changing the size of the company, so every holder ends up with more shares that each represent less. Because everyone is multiplied by the same 5-for-4 factor, each holder's percentage of the company is exactly what it was, and that proportionate equity is what remains unchanged. Par value moves the other way, reduced so that total par stays constant; the market price is adjusted downward for the same reason; and the number of shares each holder owns rises by a quarter.
- Due to a sudden drop in earnings, the board of directors of Amalgamated Metal Industries (AMI) has voted to suspend all dividend payments this year. This would have the least effect on holders of AMI's
- Cumulative preferred stock
- Common stock
- Adjustable-rate preferred stock
- Callable preferred stock
Correct answer: Cumulative preferred stock
The notable feature of cumulative preferred stock is that it carries any skipped dividends on its books. They appear as dividends in arrears. This arrearage must be paid before any dividend can ever be paid on the company's common shares. There is no guarantee that the company will ever be able to make up those dividends, but in none of the other choices is there any concept of arrearage.
- An investment banker purchasing what is left unsold from a rights offering is engaging in
- Firm commitment underwriting
- Preemptive rights underwriting
- Standby underwriting
- All or none underwriting
Correct answer: Standby underwriting
In many cases, when a corporation is issuing new shares, existing shareholders receive preemptive or stock rights to buy these new shares to maintain their current proportionate ownership. In the event some of the rights are not used, the standby underwriter agrees to purchase those unsubscribed for shares.
- The rate on an adjustable preferred stock may be indexed to
- The Consumer Price Index
- The Dow Jones Industrial Average
- The Treasury bill rate
- The Producer Price Index
Correct answer: The Treasury bill rate
The dividend on an adjustable rate preferred stock is tied to a particular interest rate, and the Treasury bill rate is a common benchmark.
- Nickelplate Manufacturing Corporation (NMC) is capitalized with 1 million shares of a 6% $50 par callable, cumulative preferred stock and 10 million shares of $1 par common stock. NMC has not paid any dividends at all for the past five quarters. The current quarter's earnings are excellent and the company would like to pay a dividend to its common shareholders. Doing so would require
- An affirmative vote of the common shareholders
- Paying the preferred shareholders a dividend of $3.75 per share
- Paying the preferred shareholders a dividend of $0.75 per share
- Paying the preferred shareholders a dividend of $4.50 per share
Correct answer: Paying the preferred shareholders a dividend of $4.50 per share
A corporation cannot pay a dividend to its common shareholders without satisfying the dividend requirements of any outstanding preferred stock. NMC has a 6% $50 par preferred. The annual dividend requirement (if declared) is $3 per share. That is $0.75 per quarter. On the exam, all dividends are paid quarterly unless stated otherwise. Once that dividend is paid to the preferred, the declared dividend can be paid to the common. But, the question tells us that NMC has not paid preferred dividends for more than one year (five quarters). What about those skipped dividends? This preferred stock is cumulative. That means the five skipped quarters ($0.75 times 5 = $3.75) plus the current quarter ($0.75) must be paid. Be careful to read the question. Shareholders do not vote on cash dividend payments. That decision is made by the company's board of directors.
- Which of the following are characteristics of both stock rights and warrants?
- One must be a current stockholder to receive them.
- They are frequently used as a sweetener to attract purchasers to another security.
- They offer the holder an opportunity to purchase stock at a fixed price.
- When initially offered, neither one has intrinsic value.
Correct answer: They offer the holder an opportunity to purchase stock at a fixed price.
Rights and warrants are equity securities granting the holders the ability to purchase shares of the issuer at a pre-determined price. In the case of a rights offering, the price is always below the current market price. In the case of warrants, the exercise price is always above the current market price. That means only the rights have intrinsic value when initially offered. It is the warrants that are frequently attached to a new issue to make the offering more attractive. It is only the rights where one must be a current stockholder to initially obtain them. After that, they trade in the secondary market.
- Which of the following statements regarding warrants is true?
- Warrants are considered safer than the bonds of the issuing company
- Warrants give the holder a never-ending claim on the issuer's stock
- Warrants have shorter lives than the preemptive rights of an issuer
- Warrants are attached to other issues to sweeten the whole offering
Correct answer: Warrants are attached to other issues to sweeten the whole offering
Warrants are long-term options to buy stock at a set price, and issuers most often attach them to a bond or preferred offering to make that offering more attractive, which lets the issuer borrow at a lower rate. As equity securities with no claim on assets or income, warrants sit below bonds in safety rather than above them. They are long-lived but not perpetual, since every warrant carries an expiration date. And their lives are far longer than those of stock rights, which typically expire within weeks.
- Cement Mixer Corporation has 1 million shares of convertible preferred stock and 2 million shares of common outstanding. Each share of preferred can be converted into half a share of common. The preferred stock is selling at $17.50, and the common stock is selling at $35.75. If all preferred shares were converted, how many shares of common stock would be outstanding after conversion?
- 3,000,000
- 2,000,000
- 2,500,000
- 500,000
Correct answer: 2,500,000
One million shares of preferred, each converted to half a share of common, is 500,000 common shares, and 500,000 shares after conversion, added to 2 million shares of common previously outstanding, equals 2.5 million common shares.
- When comparing preemptive rights and warrants, one similarity is
- The method by which the issuer distributes them to shareholders
- Their exercise price relative to the market price of the underlying stock
- The length of time before they expire
- Their voting privilege
Correct answer: Their voting privilege
In an odd play on words, the only similarity here is that neither of them have voting rights. Warrants are long-term while rights are short-term. The exercise price of a right is below the current market while that of a warrant is above. Only rights are distributed to existing shareholders in proportion to the investor's current stock ownership. Warrants are not sent to shareholders; they are most often part of another issue.
- Which of the following securities typically carries the highest dividend rate?
- Callable preferred issues
- Straight preferred issues
- Cumulative preferred issues
- Convertible preferred issues
Correct answer: Callable preferred issues
Straight preferred sets the benchmark rate, because it carries no extra feature at all. Anything that hands the investor something additional lets the issuer pay less: a conversion privilege into the common, or the right to collect skipped dividends later, are each worth something, so convertible and cumulative issues carry lower rates than the straight benchmark. A call provision runs the other way, since it is a right the ISSUER holds and the investor bears the reinvestment risk. Callable preferred therefore has to pay the highest rate of the group.
- Many investors diversify by adding foreign securities to their portfolios. Those who do so with ADRs are least likely to be concerned with
- Currency risk
- Market risk
- Political risk
- Liquidity risk
Correct answer: Liquidity risk
Most ADRs actively trade on the exchanges or OTC market. As such, their liquidity is generally quite good. Because the investment is in a foreign corporation, there is foreign currency risk. Market risk is universal anytime you are investing in something traded in "the market." Political risk is always a concern when investing overseas. It is true that it is not very high in most developed markets, but it is still there and more prevalent than liquidity risk.
- Your customer wishes to invest in a security that will pay a specific level of dividends, but may also receive additional dividend amounts, should the underlying company have outstanding performance. Which of the following securities would best match this customer's objectives?
- Participating preferred stock
- Floating-rate preferred stock
- Cumulative preferred stock
- Convertible preferred stock
Correct answer: Participating preferred stock
Participating preferred pays its stated dividend, expressed as a percentage of par, and then lets the holder share in additional distributions when the company's results are strong enough to meet the conditions written into the issue. That is exactly the pattern the customer described. A floating-rate issue moves its rate with an index rather than with company performance. A cumulative issue only carries skipped dividends forward. A convertible issue offers appreciation through the common stock, but the conversion feature does nothing for the dividend.
- Corporations issue equity securities. One category of equity is preferred stock. A number of different adjectives can apply to preferred stock issues. Which of the following preferred stock issues would likely offer the greatest protection against interest rate risk?
- Participating
- Cumulative
- Callable
- Convertible
Correct answer: Convertible
Owners of convertible preferred stock have the ability to convert the preferred into common stock. This offers growth potential not otherwise available to a preferred stockholder. This feature causes the stock's price to track that of the common. That results in convertible preferred stock having less interest rate risk than the others do.
- It would be correct to describe a warrant in all of the following ways except
- The holder gets no vote at the annual meeting of shareholders
- The exercise price is set just below the current market price
- The remaining life of a warrant exceeds any stock right's life
- The warrant sweetens a bond issue for the eventual bond buyer
Correct answer: The exercise price is set just below the current market price
A warrant is issued with an exercise price ABOVE the market price of the underlying stock at the time, so the description of an exercise price below the market is the one that does not fit. That out-of-the-money starting point is what makes the warrant a long-term speculation on the stock rising. Warrants carry no vote, because they are not yet shares. They run for years, often five or more, while a stock right expires in weeks. And the upside they offer is precisely why issuers attach them to bond offerings as a sweetener.
- One of the primary differences between rights and warrants is
- Rights may be sold in the secondary market
- Warrants have a life before expiration that is much longer than rights
- Warrants provide the ability to purchase shares of common stock at a specified price
- The exercise of rights will result in a decline in the issuer's earnings per share
Correct answer: Warrants have a life before expiration that is much longer than rights
Warrants have an expiration date that often runs as long as 5 years. In fact, there is no legal maximum, but it is rare to see one with an expiration date longer than 10 years from issuance. On the other hand, most rights expire within 30-45 days and it is rare to see one with a life exceeding 60 days. Both rights and warrants provide the holder with the ability to acquire shares of common stock at a specified price. The exercise of each will result in additional shares outstanding and will cause earnings per share to decline. Both instruments are marketable and may trade in the secondary market.
- Which of the following is not an advantage of purchasing American depositary receipts (ADRs)?
- They eliminate exchange rate risk.
- They allow U.S. investors to buy foreign country stock denominated in dollars.
- Foreign taxes withheld can be claimed as a credit to offset income taxes on dividends received.
- Transactions are done on an organized exchange in the U.S.
Correct answer: They eliminate exchange rate risk.
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.
- A company that has issued cumulative preferred stock
- Pays the current dividends on the preferred, but not the past dividends on the preferred, before paying a dividend on the common
- Pays past and current preferred dividends before paying dividends on common stock
- Pays the preferred dividend before paying the coupons due on its outstanding bonds
- Forces conversion of the preferred that is trading at a discount to par, thereby eliminating the need to pay past-due dividends
Correct answer: Pays past and current preferred dividends before paying dividends on common stock
Current and unpaid past dividends on cumulative preferred stock must be paid before common stockholders can receive a dividend. Bond interest is always paid before dividends. Dividends in arrears on cumulative preferred have the highest priority of dividends to be paid.
- American depositary receipts (ADRs) are used to facilitate
- The foreign trading of domestic securities
- The domestic trading of foreign securities
- The domestic trading of U.S. government securities.
- The foreign trading of U.S. government securities.
Correct answer: The domestic trading of foreign securities
An ADR is a negotiable security that represents an ownership interest in a non-U.S. company. Because they trade in the U.S. marketplace, ADRs allow investors convenient access to foreign securities.
- A corporation is having a rights offering. The terms of the offering require four rights plus $40 to purchase one share. With the stock's current market price at $50 per share, the theoretical value of one right before the ex-rights date is
Correct answer: $2.00.
Because the question is asking about the value before ex-rights, it means we use the cum-rights (with rights) formula. That is, the (market price minus the subscription price) divided by the (number of rights it takes to buy one share plus one). Plugging in the numbers gives us ($50 − $40) ÷ (4+1) = $10 ÷ 5 = $2.00
- GIN Corporation is offering shareholders the right to subscribe to a new issue of stock at $30 per share. The current market price of the GIN stock is $44 per share, and it takes 20 rights plus the subscription price to purchase one share. The theoretical value of a single right, prior to the ex-rights date, is approximately
Correct answer: $0.67.
Because this is cum rights (before the ex-rights date), the formula is N+1M−S. Thus, ($44 − $30) ÷ (20 + 1) = 14 ÷ 21 = $0.67
- Aenical Corporation issued $100 million of $100 par value preferred stock a number of years ago. The stock pays quarterly dividends of $1.25. Recent issues of comparable preferred stock carry a dividend yield of 10%. One could expect the market price of the Aenical preferred stock to be closest to
Correct answer: $50.
As with other fixed-income securities, as market yields increase, the price of previously issued securities declines. The logic is that investors will purchase fixed income securities only if they can receive a return comparable to the current market rate. This stock is paying an annual dividend of $5 ($1.25 per quarter times four). Investors will be most interested in this stock if their return will be approximately 10%, the current rate being paid in the market. The math here needs to first answer "$5 is 10% of what number?" Divide $5 by 10% and the answer is $50. At $50 per share, Aenical stock paying a $5 annual dividend is offering a 10% return on investment.
- Aenical Corporation issued $100 million of $100 par value preferred stock a number of years ago. The stock pays semiannual dividends of $1.25. Recent issues of comparable preferred stock carry a dividend yield of 10%. One could expect the market price of the Aenical preferred stock to be closest to
Correct answer: $25.
As with other fixed-income securities, as market yields change, the price of previously issued securities increase or decrease to offer a comparable return. The logic is that investors will purchase fixed-income securities only if they can receive a return comparable to the current market rate. This stock is paying an annual dividend of $2.50 ($1.25 every six months). If not stated, dividends are always paid quarterly. This question specifically states the dividends are semiannual; do not get tripped up with something like this on the exam. Investors will be most interested in this stock if their return will be approximately 10%, the current rate being paid in the market. The math here must first answer "$2.50 is 10% of what number?" Divide $2.50 by 10% and the answer is $25. At $25 per share, Aenical stock paying a $2.50 annual dividend is offering a 10% return on investment.
- Corporate stocks trade in all of the following locations except
- The over-the-counter (OTC) market
- The commodities market
- The third market
- Stock exchanges
Correct answer: The commodities market
Corporate securities issues do not trade in the commodities market. That is where physical assets such as agricultural products, industrial metals, and precious metals trade. Listed stocks are the ones that have qualified for listing on exchanges. Unlisted stocks are traded OTC. The third market is the trading of listed stocks in the OTC market.
- Stock prices in the over-the-counter (OTC) market are determined by
- The 5% markup policy
- Buyers and sellers bidding directly against each other in a double auction market
- Open outcry for the securities at a central marketplace
- Negotiation between buyers and sellers
Correct answer: Negotiation between buyers and sellers
The OTC market is a negotiated market (not an auction market as is the case with an exchange) in which dealers negotiate stock trades with each other.
- A Nasdaq market maker buys 1,000 shares of stock from a customer at its bid to satisfy a customer order. This is an example of
- A principal trade
- A riskless principal trade
- A block trade
- An agency trade
Correct answer: A principal trade
The market maker is acting in a principal (dealer) capacity.
- The KPL Corporation is considering having its stock listed on the New York Stock Exchange (NYSE). Who will make the final decision as to whether it will be listed?
- The NYSE
- FINRA
- The SEC
- The Board of Directors of KPL
Correct answer: The NYSE
The NYSE has certain requirements that a company must meet before its stock can be considered for listing. Because the NYSE sets the requirements, it must make the final decision.
- The Nasdaq Stock Market permits listing for all of the following except
- Convertible debt offerings
- American depositary shares
- Limited partnership units
- Nonconvertible debt issues
Correct answer: Nonconvertible debt issues
Nasdaq is an equity and equity-equivalent market. Common and preferred stock, warrants, limited partnership units, American depositary shares and receipts, and convertible debt all qualify for listing, because each one is either equity or convertible into equity. Straight, nonconvertible corporate debt has no equity component and is therefore not eligible for listing on the Nasdaq Stock Market; it trades in the over-the-counter bond market instead.
- A portion of the OTC market where companies that have been delisted for regulatory reasons are usually traded is
- The fourth market
- The grey market
- The ""pink"" market
- The third market
Correct answer: The grey market
The grey market is sometimes called the "dumping ground" for stocks that cannot trade on the organized markets for regulatory reasons or have such little investor interest that broker-dealers are unwilling to quote them. The third market is the trading of listed securities OTC, and the fourth market is institution-to-institution trading to avoid the use of broker-dealers. The "pink" market is part of the OTC Markets Group and does not handle issues with regulatory problems. **This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- The over-the-counter (OTC) market is
- The first market
- A negotiated market
- All of these
- An auction market
Correct answer: A negotiated market
The OTC market is a negotiated market. Registered market makers compete among themselves to post the best bid and ask prices.
- A recommendation to purchase a security traded in which of the following venues would most likely result in the greatest scrutiny by your manager?
- The Nasdaq Stock Market
- The New York Stock Exchange
- The OTC Bulletin Board
- The grey market
Correct answer: The grey market
Securities trading on the "grey market" are not quoted on any U.S. quotation system. Broker-dealers are not willing or able to publicly quote these securities because of a lack of investor interest, company information availability, or regulatory compliance. **This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- The Securities Exchange Act of 1934 applies to all of the following except
- Regulation of new issues
- The extension of credit on purchase of securities
- Registration of broker-dealers
- Secondary market trading
Correct answer: Regulation of new issues
The Securities Act of 1933 deals with new issues. The Securities Exchange Act of 1934 created the SEC, required the registration of broker-dealers, empowered the Federal Reserve to control the extension of credit on securities transactions, and created rules dealing with secondary market trading.
- A network of market makers that offers to trade securities not listed on an exchange is called
- The over-the-counter (OTC) market
- NYSE Arca.
- National Daily Quotation Service.
- National Association of Securities Dealers Automated Quotations.
Correct answer: The over-the-counter (OTC) market
This best describes the OTC market which is an interdealer market linked by computer terminals to FINRA member firms across the country.
- Stocks that are listed on the NYSE can also traded in all of the following except
- The third market
- The fourth market
- The CBOE (Chicago Board Options Exchange)
- An electronic communications network (ECN)
Correct answer: The CBOE (Chicago Board Options Exchange)
NYSE-listed stocks would never be listed on an options exchange such as the CBOE; those are strictly for trading options, not stock. The third market is the trading of listed securities in the over--the-counter market. The fourth market is the use of ECNs for institutions to trade without the "middleman," a broker-dealer.
- The Securities Exchange Act of 1934 regulates or mandates all of the following except
- Creation of the Securities and Exchange Commission
- Extension of credit for customer margin accounts
- Full and fair disclosure in registered offerings
- Policing of manipulation in the secondary market
Correct answer: Full and fair disclosure in registered offerings
The Securities Exchange Act of 1934 is the secondary market statute. It created the Securities and Exchange Commission, gave the Federal Reserve authority over the extension of credit for securities purchases, and outlawed manipulation of trading in the secondary market. Full and fair disclosure of a new offering belongs to the Securities Act of 1933, the primary market statute that requires registration and a prospectus, so that is the one item the 1934 Act does not address.
- When you hear your firm's traders talking about institutions trading with a lack of transparency, they are probably referring to
- The over-the-counter market
- The OTC Bulletin Board
- The third market
- Dark pools
Correct answer: Dark pools
Dark pools, sometimes referred to as dark pools of liquidity, is trading volume that occurs that is not openly available to the public. The bulk of this volume represents large trades engaged in by institutional traders and trading desks away from the exchange markets. Trading in the other choices is relatively transparent.
- All of the following securities trade in the over-the-counter (OTC) market except
- Government and agency securities
- Open-end investment companies
- Nasdaq securities.
- American depositary receipts.
Correct answer: Open-end investment companies
Municipal bonds, government and agency securities, and corporate securities (listed and unlisted) all trade in the OTC market. Foreign securities trade in the United States if the companies comply with SEC registration and disclosure requirements. Mutual fund shares (open-end companies) do not trade.
- All of the following statements regarding the over-the-counter (OTC) market are true except
- It trades listed securities
- More issues trade OTC than on the exchanges
- It trades unlisted securities
- It is an auction market
Correct answer: It is an auction market
The OTC market is a negotiated market. The exchanges are auction markets.
- All of the following statements regarding over-the-counter (OTC) markets are true except
- An offer is the lowest price a dealer will accept when selling
- A bid is the highest price a dealer will pay when buying
- The OTC market is an auction market
- Securities traded OTC include American depositary receipts (ADRs) and municipal bonds
Correct answer: The OTC market is an auction market
The OTC market is a negotiated market in which market makers post their quotes to facilitate negotiating price. A bid is the highest price a buyer is willing to pay, and an offer is the lowest price a seller is willing to accept. Among the securities traded OTC, both ADRs and municipal securities would be included.
- The RJN Corporation has issued warrants where each warrant offers the holder the right to purchase one share of RJN's common stock for $20 per share. The warrants are exercisable anytime within the next five years. Chelsea purchases 80 warrants for $2 each. If three years after the purchase, the market price of RJN common stock has risen to $25 per share and Chelsea sells the warrants for their intrinsic value, she has realized
- A long-term capital gain of $400
- A long-term capital gain of $240
- A short-term capital gain of $240
- A short-term capital gain of $400
Correct answer: A long-term capital gain of $240
The intrinsic value of a warrant is the difference between the exercise price and the current market price. Being able to purchase stock at $20 per share when the market price is $25 per share means the warrant is intrinsically worth $5. With 80 warrants, the sale proceeds are $400 (80 times $5 each). Don't forget that Chelsea paid $2 for each warrant, a cost of $160 (80 times $2). That makes her net gain $240 ($400 proceeds minus $160 cost). The gain is long-term because she held the warrants longer than 12 months.
- The RJN Corporation has issued warrants where each warrant offers the holder the right to purchase one share of RJN's common stock for $20 per share. The warrants are exercisable anytime within the next five years. Chelsea purchases 80 warrants for $2 each. Three years after the purchase, the market price of RJN common stock has risen to $25 per share. Chelsea exercises the warrants and immediately sells the RJN stock at the market price. The result of these transactions is that Chelsea has realized
- A net short-term capital gain of $400
- A net long-term capital gain of $240
- A net long-term capital gain of $400
- A net short-term capital gain of $240
Correct answer: A net short-term capital gain of $240
Exercising the warrants means that Chelsea purchases 80 shares at $20 each. That is a cost of $1,600 (80 times $20). She then sells those 80 shares immediately at the current market price of $25 generating proceeds of $2,000 (80 times $25). The difference between the proceeds and the cost is $400 ($2,000 minus $1,600). Don't forget that Chelsea paid $2 for each warrant adding $160 to her cost (80 times $2). That makes the net realized gain $240 ($400 minus the $160 cost of the warrants). The net gain is short-term because she did not hold the stock for more than 12 months.
- For tax-reporting purposes, qualified dividends are considered to be what type of income?
- Earned
- Phantom
- Passive
- Portfolio
Correct answer: Portfolio
Portfolio income includes dividends, interest, and net capital gains derived from the sale of securities.
- The DCAV corporation has declared a 10% stock dividend. Which of the following is true regarding the shareholders receiving the stock dividend?
- The stock dividend would not be taxable upon receipt by the shareholder.
- The stock dividend would increase the cost basis per share.
- The stock dividend would decrease their percentage of ownership within the corporation.
- The stock dividend would increase their percentage of ownership within the corporation.
Correct answer: The stock dividend would not be taxable upon receipt by the shareholder.
When a stock dividend is paid, the shareholders receive a dividend of additional shares instead of cash. The effect of this is an increase in the number of share with a reduction in the cost basis of each share. Because there is no monetary impact, there is no current taxation. The stock dividend would decrease their original cost basis. Although the stock dividend is not taxable upon receipt, it would be taxable upon the sale of the shares if sold for more than the adjusted cost basis. Stock dividends have no effect on a shareholder's proportionate ownership of the corporation.
- If a customer buys $28,000 of ABC stock in April 20XXand at year end, the stock is worth $23,000, how much may the customer deduct on his 20XX tax return?
Correct answer: $0
Until the customer realizes the loss by selling, there is no tax deduction.
- A customer has $12,000 of capital gains, $15,000 of capital losses, and $50,000 adjusted gross income. How much unused loss is carried forward to the following tax year?
Correct answer: $0
After netting capital gain and losses, the customer has a net capital loss of $3,000. Because $3,000 of net losses can be deducted from income in any single tax year, there is no carryforward.
- An investor who purchased 100 shares of PERD common stock on June 30, 2020, would receive long-term capital gain treatment if the stock is sold at a profit starting
- July 1, 2021.
- June 31, 2021.
- December 31, 2021.
- June 30, 2021.
Correct answer: July 1, 2021.
Investors must own a security for more than 12 months before it becomes long term for tax purposes. The first day after June 30, 2020, is July 1, 2020. Twelve months later is July 1, 2021. Remember, there is no June 31.
- At year's end, your client reports $12,000 in capital gains and $20,000 in capital losses. The net effect of this on his taxes would be
- A $4,000 deduction from ordinary income with a $4,000 loss carryforward
- An $8,000 deduction from ordinary income
- A $3,000 deduction from ordinary income with a $2,500 loss carryforward
- A $3,000 deduction from ordinary income with a $5,000 loss carryforward
Correct answer: A $3,000 deduction from ordinary income with a $5,000 loss carryforward
The customer may offset all of the gains with the losses. This leaves a new loss of $8,000. Because the maximum net capital loss that may be deducted against ordinary income is $3,000 per year, we take off the $3,000 and have a carryforward of the balance ($5,000).
- 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?
- None of these.
- $4,500
- $2,500
- $5,500
Correct answer: $2,500
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.
- Four years ago, you declared a net capital loss of $23,000 on your tax return. You have had no further capital gains or losses since then. For that year and the next two, you took the maximum allowable income deduction. How much may you deduct from your income this year, and how much loss will you have to carry forward?
- $2,000/$11,000.
- $3,000/$12,000.
- $2,000/$12,000.
- $3,000/$11,000.
Correct answer: $3,000/$11,000.
The maximum allowable deduction against income is $3,000. You will have taken four such deductions against $23,000, which leaves you with $11,000 to carry forward ($23,000 – $12,000).
- A married couple who files jointly has a $5,000 long-term capital loss with no offsetting capital gains. Regarding the tax treatment of this loss, all of the following statements are true except
- The maximum they can deduct this year is $3,000
- Capital losses can be deducted dollar for dollar against capital gains
- They can carry forward $2,000 to future years
- Capital losses can be used to offset capital gains only
Correct answer: Capital losses can be used to offset capital gains only
Capital losses are deducted from ordinary income, and therefore, reduce tax liability. The maximum that individuals or married couples can deduct is $3,000 annually. If the long-term capital loss exceeds the maximum, the excess is carried forward to future years until the loss is exhausted. Under current IRS regulations, $1 in losses results in $1 in deductions.
- An investor had a $20,000 capital loss, a $15,000 capital gain, and $50,000 in income for the year. How much of the income is taxable?
- $20,000
- $47,000
- $50,000
- $30,000
Correct answer: $47,000
Capital losses may be used to reduce taxable income. The first step is to net the gains and the losses. This investor has a net loss of $5,000. Of that net loss, a maximum of $3,000 can be written off against the income for the year. That reduces the investor's taxable income to $47,000. The unused $2,000 of the net loss is carried forward to subsequent tax years until utilized.
- All of the following corporate transactions are nontaxable to investors when received except
- Cash dividends
- Reverse stock splits
- Stock dividends
- Stock splits
Correct answer: Cash dividends
The receipt of a cash dividend is a taxable event. Stock splits are nontaxable because although the number of shares owned changes, the cost basis of the shares is adjusted to keep the total investment unchanged. Stock dividends are adjusted in the same way as stock splits, so they are also nontaxable events. It is not until shares received as part of a stock split or stock dividend are sold that there is a taxable event (gain or loss).
- If your client has a $21,000 net capital loss this year, and he plans to apply the maximum deduction toward his ordinary income for the year, after this year, he may
- Deduct $3,000 each year for no longer than five tax years
- Deduct no part of it but offset just future capital gains
- Deduct $3,000 a year until the entire loss is written off
- Deduct $3,000 in total and carry none of the losses along
Correct answer: Deduct $3,000 a year until the entire loss is written off
Capital losses first offset capital gains. Once the gains are used up, as much as 3,000oftheremainingnetlossmaybedeductedagainstordinaryincomeinayear.Witha21,000 net loss, 3,000istakenthisyearandtheother18,000 is carried forward, where the same treatment repeats each year until the loss is exhausted. The carryforward is not capped at five years, it is not limited to $3,000 in total, and it is not restricted to offsetting capital gains alone.
- The following dividends were received by a husband, his spouse, and both of them jointly: husband, $160; spouse, $160; joint, $100. What amount of dividends that would be subject to taxation if they filed a joint tax return?
Correct answer: $420
$160 + $160 + $100 = $420. This would all be taxable as ordinary income.
- If a customer has $9,000 of capital losses and $2,000 of capital gains in a tax year, that year's consequences are
- A $9,000 loss deduction
- A $7,000 loss deduction with no carryforward
- A $3,000 loss deduction with no carryforward
- A $3,000 loss deduction with $4,000 carryforward
Correct answer: A $3,000 loss deduction with $4,000 carryforward
For tax purposes, the customer can net gains with losses. In this case, the customer's net losses are $7,000. However, there is an annual capital loss deduction limit of $3,000. Therefore, the investor can deduct $3,000 this year and carry forward $4,000 to the following tax year.
- One of your customers owns 100 shares of GTS common stock. The purchase was made two years ago at a price of $51 per share. GTS has recently declared a 3:2 stock split. At the customer's request, as soon as the new shares are in the account, you sell them and $2,000 from the proceeds of the sale is credited to the customer's account. Based on this information, the tax impact of this transaction is
- A long-term capital loss of $1,400
- A short-term capital gain of $300
- A long-term capital loss of $1,333 and a short-term capital loss of $667
- A long-term capital gain of $300
Correct answer: A long-term capital gain of $300
Immediately after the stock split, the total investment of the initial position remains unchanged at $5,100 (100 shares at $51 per share). After the stock split, the customer owns 150 shares (3/2 times 100 = 150 shares). Therefore, the adjusted cost basis per share is $34 ($5,100 divided by 150 shares). Those 50 shares were sold for $2,000 and have a cost basis of $1,700 ($34 times 50). That is a profit of $300. Alternatively, you could say that 50 shares sold for $2,000 represents a selling price of $40 per share ($2,000 divided by 50 shares), which is a $6 per-share profit ($40 minus the $34 cost basis). Fifty shares times $6 equals a profit of $300. The gain is long-term because the holding period of securities received through a stock split (or stock dividend) is that of the original purchase. If you have to guess, or are running out of time, when you see two identical numbers with the only difference being short- or long-term gain, in almost all questions, one of those two is the correct answer. Now you have a 50% change of guessing correctly and, if you remember that the holding period always begins with the initial purchase, then the odds are 100% in your favor.
- SEC rules require that customers be given a copy of the risk disclosure document before their first transaction in a penny stock. The member firm must receive a signed and dated acknowledgment from the customer that the document has been received. In addition to obtaining the client's signature, the SEC requires the firm to wait at least
- Two business days after sending the statement before executing the first trade
- Two business days after receiving the statement before executing the first trade
- Five business days after receiving the statement before executing the first trade
- Five business days after sending the statement before executing the first trade
Correct answer: Two business days after sending the statement before executing the first trade
It is SEC Rule 15g-2 that requires the firm wait at least two business days after sending the risk disclosure document before executing the first penny stock trade for a new customer.
- The 5% markup policy would apply to all of the following equity transactions except
- A proceeds transaction
- A riskless principal transaction
- An agency trade done on an exchange
- A primary market transaction
Correct answer: A primary market transaction
The 5% markup policy applies to secondary market transactions in nonexempt securities.
- A customer sells securities and uses the proceeds to buy more securities at the same cost. Under the 5% markup policy, the markup is calculated on
- The sell side of the proceeds transaction alone
- The buying side of that transaction taken alone
- The larger of the two compensation amounts paid
- The two sides of the transaction taken together
Correct answer: The two sides of the transaction taken together
Selling one position and using the money to buy another is a proceeds transaction, and the 5% policy treats it as a single transaction rather than as two. The firm adds the compensation it earned on the sale to the compensation it earned on the purchase and measures the combined figure. Looking only at the sale, only at the purchase, or at whichever leg happened to pay the firm more all understate what the customer actually paid for the round trip. The measure is the total of the two.
- All of the following considerations apply to the 5% markup policy except
- The cost of executing the transaction
- The availability of the security
- The customer's ability to pay
- The services rendered by the broker-dealer
Correct answer: The customer's ability to pay
The 5% policy is a guideline for markups and commissions for exchange and over-the-counter trades. A firm cannot charge a higher commission or markup to a customer on the basis of the customer's ability to pay. Factors relevant in determining the fairness of a commission or markup include the type of security, the services rendered by the firm, and the expenses and difficulty of executing a particular trade.
- When an investor's account contains penny stocks,
- The account must maintain minimum equity of $25,000
- Account statements must be sent monthly
- Account statements must be sent weekly
- Orders must be approved before being submitted
Correct answer: Account statements must be sent monthly
One of the aspects in which accounts containing penny stocks differ from those that do not is the requirement to send monthly rather than quarterly account statements. As with all other orders, principal approval is done after the execution report is received. The $25,000 minimum equity is for pattern day trader accounts.
- Which of the following transactions would not be subject to the 5% markup policy?
- Your client enters trades to purchase two different mutual funds in the same fund family. The combined purchases do not qualify for any breakpoints. The client is charged a sales charge of 6.5%.
- A client enters an order to purchase one share of a stock to be put in the name of her grandchild. You charge the client the minimum commission for your firm ($15) even though the stock is currently trading at $26 per share.
- A client sells shares of an over-the-counter stock and uses the proceeds to purchase shares from your firm's inventory account.
- Your firm agrees to do an agency cross-transaction between two of your clients. Each client has been charged a commission.
Correct answer: Your client enters trades to purchase two different mutual funds in the same fund family. The combined purchases do not qualify for any breakpoints. The client is charged a sales charge of 6.5%.
It is important to understand that the FINRA Markup Policy is a guide, not a rule. The policy describes the various factors that a member firm should consider when determining the markup, markdown, or commission to charge in any given transaction. Because securities sold by prospectus have a stated offering price per share, a guide is unnecessary; the price is the price. In the case of mutual funds, which are always sold by prospectus, the formula for computing the price (NAV plus the sales charge, if any) is clearly listed in that prospectus. Once again, member firms do not need a guide; the price is the price. The policy is frequently referred to as the five percent policy, but that number is simply a guideline, and the broker-dealer's charge can exceed that percentage, especially in the case of a small transaction, such as one share at $26.
- For purposes of the SEC Rule 15g-9 dealing with penny stocks, the term established customer does not include a person who has
- Both a cash and a margin account with the firm
- Purchased the securities of three different penny stocks on three different days involving three different issuers
- Effected a securities transaction in an account more than one year before the proposed penny stock transaction
- Deposited funds or securities in an account more than one year before the proposed penny stock transaction
Correct answer: Both a cash and a margin account with the firm
Rule 15(g)9 deals with sales practices relating to penny stocks. If a member is soliciting new customers to buy penny stocks, the member must prepare a suitability statement showing why the proposed penny stock trade is suitable for that customer. A suitability statement is not required if the member is soliciting an established customer. The type of account or the number of accounts is not part of the definition. An established customer is one who has effected a securities transaction, made a deposit of funds or securities in an account at least 1 year before the proposed penny trade, or made 3 purchases of penny stocks on 3 separate days involving 3 different issuers.
- All of the following statements regarding the 5% markup policy are true except
- The markup policy does not apply to securities sold at a specific price and with a prospectus
- The type of security is a factor to consider
- A riskless transaction is not generally covered by the 5% markup policy
- A transaction in common stock customarily has a higher percentage markup than a bond transaction of the same size
Correct answer: A riskless transaction is not generally covered by the 5% markup policy
Riskless transactions are covered by the 5% markup policy.
- Which of the following customer accounts requires the sending of monthly customer statements?
- An account leveraged by margin borrowing
- An account that trades uncovered options
- An account containing penny stock shares
- An account that grants broker discretion
Correct answer: An account containing penny stock shares
Monthly statements are required for an account that holds penny stocks. SEC Rule 15g-6 obliges the broker-dealer to send that customer a monthly account statement showing the market value of each penny stock position, because those securities trade in a thin, quote-driven market where a customer cannot easily price the position for himself. Every other customer account is on the general FINRA cycle of at least quarterly, with a monthly statement only when there was activity in the month. Margin credit, options approval and discretionary authority each add paperwork, approval and supervisory review, but none of them shortens the statement cycle.
- One of your customers has asked you about trading penny stocks. After discussing the risks, the customer decides to go ahead. The firm sends the individual a copy of the special penny stock risk disclosure document. The firm needs the customer's signed and dated acknowledgment of receipt of the document. Trading in penny stocks may not begin in that account until
- At least two business days after sending the statement
- At least two business days after receiving the statement
- The day the signed acknowledgment has been received
- At least $25,000 in equity is in the account
Correct answer: At least two business days after sending the statement
It is SEC Rule 15g-2 that requires the firm to wait at least two business days after sending the risk disclosure document before executing the first penny stock trade for a new customer. The $25,000 is the minimum equity in a pattern day trading account.
- One of your clients frequently enters unsolicited orders to purchase penny stocks. This means
- The client must sign and return the penny stock suitability statement
- As an unsolicited order, the client is exempt from the compensation disclosure requirements
- The client must be given a copy of the risk disclosure document prior to each trade
- The client receives monthly statements
Correct answer: The client receives monthly statements
Once a client's account contains penny stocks, monthly account statements are required. The penny stock suitability statement is not required when the order is unsolicited. That statement is required only when a penny stock purchase is due to a recommendation. The risk disclosure document is required before the first trade only. Even when the order is unsolicited, the compensation earned by the member firm and the registered representative must be disclosed.
- ABC Corporation offers statutory voting. At the upcoming annual meeting, it is announced that six people are running for the four available open seats on the board. An investor with 100 shares would be able to cast
- 600 votes on one of the individuals.
- 400 votes on one of the individuals.
- 100 votes for each of four individuals.
- 100 votes for each of six individuals.
Correct answer: 100 votes for each of four individuals.
With statutory voting, the shareholder has one vote for each share and can use those votes for each open seat on the board. It is cumulative voting where the shareholder can lump votes to place on a single seat. Any of the other choices could be correct for cumulative voting.
- 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
- Now own 150 shares and the market price will be approximately $440 per share
- Now own 600 shares and the market price will be approximately $220 per share
- Now own 600 shares and the market price will be approximately $110 per share
- Still own 300 shares and the market price will be approximately $440 per share
Correct answer: Now own 600 shares and the market price will be approximately $110 per share
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.
- ZYX Corporation has 100 million shares of common stock authorized in its charter, with 80 million shares outstanding. The board of directors of ZYX could vote to take which of the following actions?
- Announce an additional public offering of 40 million shares of common stock
- Declare a stock dividend of 10%
- Issue 20 million shares of a 4%, $100 par preferred stock, convertible at $50
- Declare a 2:1 stock split
Correct answer: Declare a stock dividend of 10%
A corporation cannot issue more shares than authorized. True, there could be a vote to amend the charter, but be careful not to read anything into the question that is not given. A 10% stock dividend will require issuing 8 million more shares. That will bring the total outstanding to 88 million. A 2:1 stock split would need an additional 80 million shares and ZYX has only 20 million left. With only 20 million authorized, but unissued shares remaining, where is ZYX going to get 40 million shares for the additional public offering? Likewise, the convertible preferred is convertible into two shares each ($100 par divided by the $50 conversion price). That would also require 40 million shares to be available if everyone elected to convert. As mentioned in the beginning, if Company ZYX wished to conduct a 2:1 stock split, or offer 40 million additional shares, either through a public offering or the issuance of convertible preferred stock, an amendment to the corporate charter, approved by the board of directors and the shareholders, would be necessary.
- ABC, Inc., has 1 million shares of common stock outstanding ($10 par value), paid-in surplus of $10 million, and retained earnings of $20 million. If ABC stock is trading at $20 per share, what would be the effect of a 2-for-1 stock split?
- The retained earnings would be decreased by $10 million
- The number of shares outstanding would decrease by 50%.
- The par value would decrease to $5 per share.
- The market price of the stock would double.
Correct answer: The par value would decrease to $5 per share.
A stock split results in more outstanding shares at a lower par value per share. In the case of a 2-for-1 split, there are twice as many shares (2 million) and the par value is cut in half ($10 ÷ 2 = $5) The total par value of stock outstanding is unchanged ($2 million × $5 = the same $10 million in total par value). Remember, a 2:1 split is the same as changing a $10 bill for two $5 bills. Retained earnings are not affected by a stock split. Although not part of this question, the market value of the stock would be approximately $10 per share (half of the $20 per share before the split).
- Your client owns 100 shares of CCC at $25. CCC declares a 25% stock dividend. After the ex-date, what will she own?
- 125 shares at $20
- 100 shares at $31.25
- 100 shares at $25
- 125 shares at $18.75
Correct answer: 125 shares at $20
Stock dividends make the number of shares owned increase and the cost per share decrease. The overall value should remain unchanged before and after the adjustment: 125 shares × $20 = $2,500, and 100 shares × $25 = $2,500.
- ABC has 1 million shares of common stock outstanding. Mr. Chen owns 100,000 shares of ABC common stock. If ABC issues an additional 500,000 shares, and assuming ABC's charter calls for preemptive rights, Chen will receive enough rights to purchase
- 15,000 additional shares.
- 20,000 additional shares.
- 10,000 additional shares.
- 50,000 additional shares.
Correct answer: 50,000 additional shares.
Mr. Chen has a 10% ownership position in ABC (100,000 divided by 1,000,000). Therefore, if an additional 500,000 shares are issued, Mr. Chen has a preemptive right to maintain his 10% position. Ten percent of 500,000 = 50,000 additional shares.
- A corporation must have stockholder approval to
- Declare a cash dividend
- Issue convertible bonds
- Declare a 15% stock dividend
- Repurchase 100,000 shares of stock for its Treasury
Correct answer: Issue convertible bonds
Stockholders are entitled to vote on the issuance of additional securities that would dilute shareholders' equity (the shareholders' proportionate interest). Conversion of the bonds would cause more shares to be outstanding, thus reducing the proportionate interest of current stockholders. Decisions that are made by the board of directors and do not require a stockholder vote include the repurchase of stock for its Treasury, declaration of a stock dividend, and declaration of a cash dividend.
- JDX Corporation's charter has authorized 10,000,000 shares of common stock. It has issued 5,000,000 shares and has 1,000,000 shares in its treasury. JDX decides to use all of the treasury stock to pay a dividend to shareholders. As a result, the number of outstanding shares is
- 5,000,000.
- 4,000,000.
- 6,000,000.
- 10,000,000.
Correct answer: 5,000,000.
Treasury stock is stock that has been issued and reacquired by the company. At that point, it is no longer outstanding in the hands of the public. Sending those shares out as a dividend puts them back in the hands of the investing public. Now, all of the five million issued shares are outstanding.
- 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
- 80 million.
- 30 million.
- 20 million.
- 10 million.
Correct answer: 20 million.
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.
- A share of common stock in the hands of a stockholder carries with it certain rights. Among those rights is
- Entitlement to receive profits through dividends when distributed but not the right to vote for who will serve on the board of directors
- Entitlement to receive profits through dividends when distributed and the right to vote for the amount of that dividend
- A claim on the assets of the corporation second only to that of the company's secured creditors
- Entitlement to receive profits through dividends when distributed and the right to vote for who will serve on the board of directors
Correct answer: Entitlement to receive profits through dividends when distributed and the right to vote for who will serve on the board of directors
Each share of common stock entitles its owner to a portion of the company's earnings through dividends when distributed and a proportionate vote in major management decisions such as electing individuals to the board of directors (BOD). It is the board that determines the amount and frequency of dividend payments. The common stockholders' claim is behind everyone—they are last in line.
- ADJ Corporation's charter has authorized 10,000,000 shares of common stock. It has issued 5,000,000 shares and has 1,000,000 shares in its treasury. How many shares of common stock are currently outstanding?
- 5,000,000 shares
- 4,000,000 shares
- 6,000,000 shares
- 9,000,000 shares
Correct answer: 4,000,000 shares
Shares outstanding are those that are in the hands of the public. To determine the number of outstanding shares, take the number issued minus the number in the treasury. In this question, that is 5 million minus 1 million = 4 million. If, at a later time, ADJ should decide to issue some of the authorized, but unissued shares, the number of outstanding shares will obviously increase. The same would happen if the company sold some of the treasury stock in the open market or used it to pay stock dividends to current shareholders.
- JEG Corporation common stock is currently trading at $25 per share. The par value of JEG stock
- Has nothing to do with the current market price
- Sets the annual dividends the issuer has to pay
- Marks the price the public paid at the offering
- Fixes a floor beneath the price of these shares
Correct answer: Has nothing to do with the current market price
Par value on common stock is an arbitrary bookkeeping figure carried in the issuer's capital accounts. It is not a price, and it tells an investor nothing about what the stock is worth: JEG's $25 market price is set by supply and demand and may sit above par, below par, or on it. Par does fix a dividend, but on PREFERRED stock, where the stated rate is applied to par; a common dividend is whatever the board declares. The price at which shares are first sold to the public is the offering price, which is a market-driven number unrelated to par. And nothing stops common stock from trading below par once it is in the secondary market, so par is no floor.
- If a company splits its stock 3 for 2, how many additional shares will be issued to an investor who owns 200 shares?
Correct answer: 100
The investor will receive an additional 100 shares from a 3-for-2 stock split. To calculate the additional shares as a result of a split, multiply the existing number of shares by the split rates (200 shares×3/2=300 shares). Because the investor owned 200 shares, she will be issued 100 additional shares, bringing ownership to 300 shares.
- A client has 100 shares of GHI when the stock undergoes a split. After the split, the client has
- Greater exposure
- A proportionately decreased interest in the company
- A proportionately increased interest in the company
- No effective change in the value of the position
Correct answer: No effective change in the value of the position
When a stock splits, the number of shares each stockholder has either increases or decreases (in the case of a reverse split). The customer experiences no effective change in position because the proportionate interest in the company remains the same.
- An investor purchased 100 shares of ABC common stock valued at $6,000. What is the adjusted cost basis per share of this position after the company pays a 20% stock dividend?
Correct answer: $50.00
The total value of the initial position is unchanged, remaining at $6,000. After the stock dividend, the investor owns 120 shares (100×20%=20+100=120). Therefore, the adjusted cost basis is $50 per share ($6,000 divided by 120 = $50). 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.
- By regular or statutory voting procedures, a shareholder with 100 shares would be able to vote to fill seats for six directors in which of the following ways?
- 600 votes for any one director, no votes for the others
- 100 votes for each of the six candidates
- 300 votes for any two, none for the other four
- 150 votes for any four candidates
Correct answer: 100 votes for each of the six candidates
With regulatory or statutory voting, the investor has one per share per vacant seat. In this case, this is 100 shares for each of the six open seats. Any of the choices would work for cumulative voting.
- Reasons why a corporation might engage in a stock buy-back program would include all of these except
- Having stock available for future acquisitions
- Using the stock for employee stock options
- Increasing earnings per share
- Reducing annual interest expense
Correct answer: Reducing annual interest expense
There is no interest expense with stock. When a company buys back its stock, it becomes treasury stock. That stock is no longer outstanding. Buying back the stock should cause the earnings per share to increase (there are now fewer shares outstanding). Many times one company will acquire another one by paying for the purchase with its treasury stock rather than cash. Many companies offer employees ownership opportunities through employee stock options. This is a way to ensure that the company has enough stock to meet the needs.
- 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?
- 600 votes for any one director, no votes for the others
- 100 votes for each of six directors.
- 200 votes for each of three directors
- 300 votes for each of two directors.
Correct answer: 200 votes for each of three directors
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.
- An investor owns 300 shares of XYZ common stock, currently selling for $50 per share. The investor also owns 100 shares of XYZ's 5% $100 par preferred stock currently trading at $90 per share. A 2:1 stock split is declared. After the payment date, the investor will own
- 150 shares of common at $100 per share and 100 shares of the preferred at $90 per share.
- 600 shares of common at $25 per share and 100 shares of the preferred at $90 per share.
- 600 shares of common at $25 per share and 200 shares of the preferred at $45 per share.
- 300 shares of common at $50 per share and 200 shares of the preferred at $45 per share.
Correct answer: 600 shares of common at $25 per share and 100 shares of the preferred at $90 per share.
A stock split is always of common stock. In a 2:1 split, the number of shares doubles, and the price is 50% of the presplit price, which means 600 shares at $25 per share. The stock split has no effect on the preferred stock.
- Common stock that has no voting power, no rights to receive dividends, that has been authorized and issued but is not outstanding is known as
- Subordinated shares
- Class B common shares.
- Unissued stock
- Treasury stock
Correct answer: Treasury stock
This is the definition of treasury stock.
- An investor holds 3,000 shares of a stock with a current market value of $12 per share. After a 1:6 stock split, the investor's position will be
- 15,000 shares with a market value of $12 per share.
- 500 shares with a market value of $2.40 per share.
- 15,000 shares with a market value of $2.40 per share.
- 500 shares with a market value of $72 per share.
Correct answer: 500 shares with a market value of $72 per share.
This is an example of a reverse split. For each share owned, the investor will now have 1/6 of a share. That turns 3,000 shares into 500. At the same time, the market price per share will increase approximately by a factor of six. The key to any stock split question is that the total value of the account remains the same. Presplit, it was 3,000 × $12 = $36,000 and postsplit it is 500 × $72 = $36,000.
- A corporation has gone out of business and the assets are being liquidated. Investors of the corporation have claim to those assets, including common stockholders. All the following terms apply to the common stockholders' claim except
Correct answer: Senior
Creditors, such as bondholders and general creditors, as well as preferred stockholders of the corporation, would have a prior or senior claim to corporate assets in liquidation. Common stockholders have the last claim to assets in liquidation. This also known as the most junior or residual claim.
- Treasury stock is
- Authorized but unissued stock owned by the company
- Preferred stock
- Issued by the U.S. Treasury Department.
- Stock repurchased by the issuer
Correct answer: Stock repurchased by the issuer
A company may, from time to time, go into the market and buy some of its own outstanding stock, which is then placed in the Treasury and called Treasury stock. Treasury stock has no voting rights and does not receive dividends. Treasury stock is not included when calculating shareholders' equity or net worth.
- A company's dividend on its common stock is
- Mandatory if the company is profitable
- Voted on by shareholders
- Specified in the company charter
- Determined by its board of directors
Correct answer: Determined by its board of directors
A common stock's dividend payment and amount are determined by the company's board of directors.
- A company has reverse split its common stock. The effect on the earnings per share will be
- None of these
- An increase
- No effect
- A decrease
Correct answer: An increase
When a reverse split takes place, the number of outstanding shares is reduced. Because the split has no effect on earnings of the company, dividing those earnings by fewer shares will cause an increase to the earnings per share.
- A corporation's corporate charter allows for cumulative voting. A shareholder with 300 shares would be able to vote in an election for three open seats in any of the following ways except
- 900 votes for any one open seat.
- 300 votes for each open seat.
- 450 votes for any two open seats.
- 900 votes for each open seat.
Correct answer: 900 votes for each open seat.
With cumulative voting, the shareholder multiplies the number of shares owned by the number of seats being contested. With 300 shares and three seats, the shareholder has 900 shares to be invested in any manner desired. But, that is a total of 900, not 900 times 3.
- Which of the following securities is considered the most junior?
- Common stock
- Debenture
- Prior lien preferred stock
- Mortgage bond
Correct answer: Common stock
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.
- Minority stockholders are more likely to be able to elect directors through which form of voting?
- Statutory
- Cumulative
- Regular
- Progressive
Correct answer: Cumulative
Minority stockholders are more likely to be able to elect representatives to the board of directors through cumulative voting. Small stockholders may cast all of their votes on one position rather than spread them out, and thus dilute them over two or three positions.
- The board of directors of DMF, Inc., announces a 5, for-4 stock split. The market price of DMF after the split should decrease in value by
Correct answer: 20%.
The easy way to handle questions about stock splits is to turn the split into a fraction. You know that after a split, which increases the number of shares outstanding, the market price per share will be reduced. With a 5-for-4 stock split, the new price should be about four-fifths of the old price. A one-fifth change equals 20% (100% / 5 = 20%).
- 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?
Correct answer: $100
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.
- Elisha purchased 100 shares of RMBN common stock on June 6, 2019, at $60 per share. On February 11, 2020, RMBN paid shareholders a 20% stock dividend. Elisha sells the shares received as the stock dividend on December 5, 2020, at $55 per share. What are the tax consequences of this trade?
- $100 short-term capital loss
- $100 long-term capital gain
- $100 short-term capital gain
- $100 long-term capital loss
Correct answer: $100 long-term capital gain
When a stock dividend is paid, the cost basis of the shares is adjusted. In this case, Elisha now owns 120 shares and the total cost is still the original $6,000. That makes the adjusted cost basis per share $50 ($6,000 ÷ 120). With the new cost basis of $50 per share, when the sale of those 20 shares takes place at $55 per share, the result is a gain of $100 ($5 per share profit times 20 shares. Alternatively, $1,100 total proceeds [20 shares x $55 per shares] minus $1,000 cost basis [20 shares x $50 per share adjusted cost per share)). Even though these shares were acquired less than 12 months before the sale, their holding period is based on the original purchase date and that is clearly more than 12 months before the sale. That is why it is long term.
- Common stockholders have certain voting rights. Those rights do not include voting on
- Determining the annual dividend rate
- Declaring stock splits
- Issuing convertible products or additional common stock
- Important corporate decisions such as mergers and acquisitions
Correct answer: Determining the annual dividend rate
Common stockholders cannot determine the annual dividend rate. Only the board of directors can declare dividends. Common stockholders do have the right to vote for or against conversions, substantial corporate decisions, and the declaration of stock splits.
- Synapse Communication Corporation (SCC) is growing. To finance the expansion, the company has a $100 million debenture offering. Attached to the offering are five-year warrants to purchase SCC common shares. Each warrant allows for the purchase of two SCC shares at a price of $53 per share. Three years after the issue date, SCC stock is trading at $63 per share. Each warrant has
- An intrinsic value of $10
- An intrinsic value of $20
- No intrinsic value, only time value
- An intrinsic value of $5
Correct answer: An intrinsic value of $20
A warrant has intrinsic value when the exercise price is lower than the stock's current market price. In this question, each warrant allows the holder to purchase two shares of a $63 stock for $53 per share. That is a $10 per share value times two. Therefore, intrinsically, the warrant is worth $20. With two years to go, it also has time value, but the question is not dealing with that. ** This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- QED Corporation, whose common stock is currently selling for $90 per share, is having a rights offering. The terms of the offering require seven rights plus $83 to subscribe to one share of stock. Compute the theoretical value of a right on the ex-rights date.
Correct answer: $1.00
Because this is ex-rights (without the rights), the formula does not include the "+1." The formula is (M − S) N. Plugging the numbers in, we have ($90 − $83) 7 = $7.00 7 = $1.00.
- Which of the following is an advantage of owning American depositary receipts (ADRs)?
- The holder is spared the currency risk of foreign issues
- The holder is handed preemptive rights on a new offering
- The holder may vote the underlying shares at the meeting
- The holder is paid its dividend directly in U.S. dollars
Correct answer: The holder is paid its dividend directly in U.S. dollars
The convenience an ADR buys is a dollar convenience. The receipt is created by a U.S. depositary bank against foreign shares held on deposit abroad; it trades in U.S. markets, settles through U.S. systems, and the depositary converts the foreign dividend and pays the holder in dollars. That is a currency CONVENIENCE, not a currency HEDGE: the dollar amount the holder receives still rises and falls with the exchange rate, so currency risk is not removed. Because the receipt is not the underlying share, it carries neither the vote at the foreign issuer's meetings nor the preemptive right to subscribe to a new offering; the depositary holds the shares that carry those rights.
- Investing in ADRs presents certain risks that do not apply to investing in domestic stocks. One specific risk that applies only to ADRs is
- Business risk
- Currency risk
- Market risk
- Financial risk
Correct answer: Currency risk
Because the ultimate value of the ADR is based on the underlying stock's value in its local currency, ADRs have currency risk. Both have market risk. You may not know business or financial risk, but you should know that currency risk is part of investing in ADRs.
- Dividends may be paid to holders of
- Repurchased treasury shares
- American depositary receipts
- Unexercised stock warrants
- Preemptive stock rights
Correct answer: American depositary receipts
An ADR holder gets nearly everything a common shareholder gets except the vote, and that includes the dividend: the depositary bank collects the foreign issuer's dividend on the shares it holds and passes it through to the receipt holders in dollars. Warrants and preemptive rights are only the right to BUY stock at a set price for a set period. Until they are exercised their holder owns no shares, so there is nothing on which a dividend could be paid. Treasury shares are shares the corporation has issued and then bought back; they are no longer outstanding, and a corporation does not declare a dividend to itself.
- A tombstone ad for a new bond issue announces that warrants to purchase shares of the issuer's common stock at $75 per share are attached to the bonds. The common stock is currently traded at $45 per share and the warrants expire in five years. What is the most likely reason the issuer attached the warrants to the bonds?
- To decrease the dilution of the current shareholders
- To improve the marketability of the bond issue
- To make the bonds convertible into the issuer's common stock
- To increase the dilution of the current shareholders
Correct answer: To improve the marketability of the bond issue
Warrants are often issued as a bonus (or sweetener) to entice investors to purchase new bond issues. Dilution may occur at the time the warrants are exercised (if ever), but this would not be a reason for their issuance. A warrant has nothing to do with the bond's convertibility into the underlying common stock.
- The DERP Corporation has a rights offering. The common stock is currently selling at $45.50. DERP is issuing one new share of stock at $40 per share for each 10 shares owned. What is the theoretical value of one right when the stock is traded ex-rights?
Correct answer: $0.55
The formula for the theoretical value of a right when it is ex-rights (the buyer doesn't get the rights) is (M−S)÷N where M = market price of the stock, S = the subscription price, and N = number of rights needed. Plug in the numbers and you have ($45.50 ‒ $40) divided by 10. That is $5.50 divided by 10 or $0.55 each
- A corporation has 1 million shares of common stock outstanding. There is also a $100 par 6% cumulative convertible preferred issue with 100,000 shares outstanding. If the corporation wishes to use a rights offering to raise additional capital by selling 500,000 new shares of common, which of the following statements is true?
- It will require five rights granted to the preferred stockholders to buy one new share.
- Each common share will receive half of a right.
- It will require two rights to buy one new share.
- Each preferred share would receive five rights.
Correct answer: It will require two rights to buy one new share.
The number of rights necessary to acquire one new share is computed by dividing the number of outstanding shares of common stock by the number of new shares being issued. In this question, that is 1,000,000÷500,000=2.
- A convertible preferred stock issue (par value $100) is selling at $125 and is convertible into five shares of common stock. The conversion price of the common stock is
Correct answer: $20.
Par value divided by conversion price equals the number of shares into which the security is convertible. If this security is convertible into five shares, we need to know what number goes into $100 five times. That number is $20. The current market value of the preferred stock is unnecessary information.
- Nickelplate Manufacturing Corporation (NMC) is capitalized with 1 million shares of a 6% $50 par callable preferred stock and 10 million shares of $1 par common stock. NMC has not paid any dividends at all for the past five quarters. The current quarter's earnings are excellent and the company would like to pay a dividend to its common shareholders. Doing so would require
- Paying the preferred shareholders a dividend of $3.75 per share
- Paying the preferred shareholders a dividend of $0.75 per share
- Paying the preferred shareholders a dividend of $4.50 per share
- An affirmative vote of the common shareholders
Correct answer: Paying the preferred shareholders a dividend of $0.75 per share
A corporation cannot pay a dividend to its common shareholders without satisfying the dividend requirements of any outstanding preferred stock. NMC has a 6% $50 par preferred. The annual dividend requirement (if declared) is $3 per share. That is $0.75 per quarter. On the exam, all dividends are paid quarterly unless stated otherwise. Once that dividend is paid to the preferred, the declared dividend can be paid to the common. But, the question tells us that NMC has not paid preferred dividends for more than one year (five quarters). What about those skipped dividends? This preferred stock is callable, not cumulative. Be careful to read the question. Shareholders do not vote on cash dividend payments. That decision is made by the company's board of directors.
- American depositary receipt (ADR) owners have all the following rights except
- The right to sell the ADR in the foreign market
- The right to receive dividends in U.S. dollars.
- The right to sell in the secondary market
- The right to receive the underlying foreign security
Correct answer: The right to sell the ADR in the foreign market
The purpose of the ADR is to facilitate trading in U.S. markets. The ADR can only be traded in the United States. If the owner exercises the right to obtain the actual foreign security, it may be sold overseas.
- A registered representative has a customer looking to invest in stock for income. The customer is looking for the highest fixed rate of return available based on her risk profile. Which of the following would be least suitable?
- Callable preferred
- Convertible preferred
- Cumulative preferred
- Straight preferred
Correct answer: Convertible preferred
Convertible preferred stock is convertible into the issuer's common stock. This conversion feature has value if the market price of the underlying stock should increase. Because of that feature, issuers are able to attract investor interest with a lower dividend on this preferred stock compared with preferred stock that has no conversion feature. Therefore, it would be the least suitable investment for this client.
- Sagacious Publishing Company (SPC) has issued a $25 par 4% preferred stock. If current market interest rates should rise, it is probable that
- SPC will lower the par value of the stock.
- SPC will increase the dividends to match market returns.
- The market price of this stock will decline
- Investors holding shares of this stock will vote to increase the dividends
Correct answer: The market price of this stock will decline
Because preferred stock is a fixed-income investment, its market price moves inversely to changes in interest rates. As interest rates in the market go up, the price of preferred stock goes down. The dividend rate and par value of a preferred stock is fixed at issuance and do not change. It is rare to find a preferred stock with voting powers. Even then, they would never be voting on changing the dividend rate on a preferred stock. That is one of the benefits of adjustable-rate preferred stock. Because the dividend rate adjusts in response to changes in the market interest rate, the price generally remains relatively stable. How do we know this is not adjustable-rate preferred? Because the question would have to state that fact.
- New offering: 800,000 units at $6 per unit. Each unit has two shares of common stock and one warrant. Each warrant is to purchase half a share of common stock. Based on this information, how many shares of stock will be sold, and how many warrants will be sold?
- 800,000 shares and 200,000 warrants
- 1.6 million shares and 400,000 warrants
- 1.6 million shares and 800,000 warrants
- 800,000 shares and 400,000 warrants
Correct answer: 1.6 million shares and 800,000 warrants
Warrants may be distributed to stockholders in an underwriting as part of a unit. The warrant is a form of bonus to entice investors to purchase the unit. As each unit contains two shares, 1.6 million shares are being distributed. As each unit also includes one warrant, 800,000 warrants are being distributed.
- A convertible preferred stock with a par value of $100 is currently trading at $125 per share. The conversion ratio is 5:1. If the common stock is trading at $30 per share, what must the preferred stock's price be to be at parity?
Correct answer: $150
The math is 5 × $30 = $150. The logic is, you can convert the preferred stock into five shares of the common. If the common is trading at $30 per share, to be equal, the preferred stock must be selling for five times that price.
- One of your clients asks about a recent purchase of a preferred stock. When looking at online information about the stock, the client notices that no par value is assigned. How does the company determine the amount of dividend to be paid?
- On a no-par preferred stock, the company has the flexibility to increase or decrease the dividend as earnings warrant.
- The board of directors determines the amount each quarter based on current interest rates.
- On a no-par preferred stock, the dividend is paid as a percentage of the common stock dividend.
- On a no-par preferred stock, the dividend is a stated rate.
Correct answer: On a no-par preferred stock, the dividend is a stated rate.
When a preferred stock is issued without a stated or par value, the dividend rate is stated in dollars. For example, it could be a $2 preferred. That would mean quarterly dividends of $0.50; $2 per year. Although the company is under no obligation to pay a preferred dividend (unless it plans to pay a dividend on its common stock), and the board of directors can pay a partial dividend, that does not mean the dividend can be increased over the stated rate.
- XYZ Corporation, whose common stock is currently selling for $40 per share, is having a rights offering. The terms of the offering require 10 rights plus $35 to subscribe to one share of stock. Compute the theoretical value of a right before the ex-rights date.
Correct answer: $0.45
Because the stock is trading with rights (before the ex-rights date), the formula is (M − S) ÷ (N + 1), where M is the market price, S is the subscription price, and N is the number of rights needed. Plugging the numbers in, we have ($40 − $35) ÷ (10 + 1) = $5.00 ÷ 11 = $0.45.
- A company is offering investors the opportunity to purchase shares for the next five years at a fixed price slightly above today's market price. The company is issuing
- Warrants
- A letter of intent
- Futures
- Call options
Correct answer: Warrants
A warrant is a security that allows the holder to purchase shares of the underlying issue at a fixed price (above the current market price when issued) for an extended period (typically two years or longer). Call options are similar, except they are short-term securities (nine months at issue).
- Dividends from American depositary receipts (ADRs) held by U.S. investors are declared in
- U.S dollars but paid in the foreign currency.
- U.S. dollars and paid in U.S. dollars.
- The foreign currency and paid in the foreign currency
- The foreign currency but paid in U.S. dollars.
Correct answer: The foreign currency but paid in U.S. dollars.
Although the dividends paid by ADRs held by U.S. investors are declared in the foreign currency, they are paid in U.S. dollars. This is one reason currency risk is a factor for ADR holders.
- A sophisticated investor wants to purchase stock of a foreign company or an American depositary receipt (ADR) representing the shares of that company. The purchase would align with the investor's goal of growth and income, but he makes several statements about the potential purchase, and only one of them is accurate. You feel it is important to point out and discuss from a suitability perspective which statements were and were not accurate. Which of the following is the accurate statement?
- The direct purchase of the foreign stock shares eliminates currency risk.
- With the ADRs, I'll have voting rights just like I would if I purchased the shares directly.
- I can trade the foreign shares right here on U.S. exchanges.
- The purchase of ADRs representing the shares exposes me to currency risk.
Correct answer: The purchase of ADRs representing the shares exposes me to currency risk.
From a suitability perspective, correcting any inaccuracies about an investment that an investor might have is important. Currency risk cannot be avoided when investing in foreign companies, either directly or using ADRs. While ADRs trade on U.S. exchanges, foreign shares do not, and ADR issuers generally do not pass on voting rights to the ADR holders.
- Certificates issued by U.S. domestic banks and trust companies against the deposit of shares of foreign securities are known as
- American share receipts.
- Certificates of deposit
- Foreign depositary receipts
- American depositary receipts.
Correct answer: American depositary receipts.
This is the definition of the ADR – the simplest way to trade foreign securities in the United States.
- All of the following statements describe stock rights except
- They are usually issued to the existing common holders
- They are usually attached to debentures as a sweetener
- They are usually traded in the secondary equity market
- They usually expire worthless after a handful of weeks
Correct answer: They are usually attached to debentures as a sweetener
It is WARRANTS, not rights, that an issuer attaches to a debenture offering to make the bonds easier to sell. Warrants are long-term, are handed to the bond buyers, and are struck above the current market. A right is the opposite animal: it goes to the EXISTING common shareholders so they can subscribe to the new shares at a discount to market and hold their proportionate ownership steady. Rights run only a few weeks and expire worthless if they are neither exercised nor sold, and a shareholder who does not want to subscribe may sell them in the secondary market, where they trade until they expire.
- A participating preferred stock
- Has a senior claim in liquidation over holders of debentures
- Participates in voting along with the common shareholders
- Receives both a fixed dividend plus a share of the common dividend
- Must be paid any dividend arrearage before dividends may be paid on the common stock
Correct answer: Receives both a fixed dividend plus a share of the common dividend
In addition to the stated fixed dividend, participating preferred stock is eligible to receive a percentage of the common dividend. The participation has nothing to do with voting. Any preferred stock, although senior to common, has a junior claim to any debt security. It is the cumulative preferred where there is the obligation to clear up the arrearage before paying dividends on the common stock.
- A corporate offering of 200,000 additional shares to existing stockholders may be made through
- A warrant
- A tender offer
- A rights offering
- A secondary offering
Correct answer: A rights offering
A rights offering is an offering of additional shares of stock to existing shareholders.
- Which of the following securities cannot pay a dividend?
- Class B common stock
- Warrants.
- Convertible preferred stock.
- American depositary receipts.
Correct answer: Warrants.
Warrants represent long-term options to buy stock at a fixed price, and, like options, cannot pay dividends.
- An investor has purchased 100 shares of common stock of the UOM Corporation. UOM Corporation is a Japanese company. Rather than receiving a UOM stock certificate, the investor receives an American depositary receipt (ADR). The investor calls his registered representative and wants to know why he did not receive the stock certificate. The registered representative tells the client that
- The shares are held in the broker-dealer's street name
- The transfer agent would send a certificate on request
- Ownership of the shares is recorded in book-entry form
- The receipt he holds evidences ownership of the shares
Correct answer: The receipt he holds evidences ownership of the shares
The ADR is not a substitute for the client's certificate in the sense of a stand-in; it IS his evidence of ownership. A U.S. depositary bank holds the actual UOM shares through a foreign branch or custodian and issues receipts against them, and the receipt in the client's hands represents his interest in that deposited stock. Street name registration and book-entry recording are both real ways a U.S. investor comes to hold securities without a paper certificate, but neither is the reason here: they describe how domestic shares registered in the United States are held, while UOM stock sits abroad. A transfer agent will still produce a certificate on request for a domestic issue, but no U.S. investor can obtain a UOM certificate at all.
- An American depositary receipt (ADR) is used to
- Let a U.S. investor buy foreign shares in a home market
- Let a U.S. citizen abroad sell his U.S. stock out there
- Let a foreign investor buy U.S. shares on a local board
- Let a U.S. importer pay a foreign shipper for the goods
Correct answer: Let a U.S. investor buy foreign shares in a home market
An ADR exists so an American can own a foreign company's stock without leaving the U.S. market. A U.S. depositary bank takes delivery of the foreign shares abroad and issues receipts that trade, settle and pay dividends in dollars on a U.S. exchange or over the counter. The mirror arrangement is a real instrument but a different one: a receipt that lets an investor outside the United States hold American shares on his own exchange is a global or foreign depositary receipt. No depositary receipt is built so that a U.S. citizen living abroad can trade U.S. stock overseas. And financing an importer's purchase from a foreign seller is the work of a banker's acceptance, not an ADR.
- A new bond issue will include warrants to
- Increase the price of the issue to the public
- Increase the attractiveness of the issue to the public
- Increase the capital raised by the issuer through the bond offering
- Increase the spread to the underwriter
Correct answer: Increase the attractiveness of the issue to the public
By including warrants with debt issues, issuers increase the marketability of bonds. The warrants offer a long-term opportunity to buy the underlying stock at a fixed price. In addition to increasing the marketability of the issue, the issuer can offer the bonds with a lower coupon rate and, as a result, reduce fixed costs.
- GC, Inc., is proposing an additional public offering of common stock. It conducts a rights offering to its current shareholders at $55 per share, plus five rights. If the market price of GCI is $70 after the ex-rights date passes, what is the value of one right?
Correct answer: 3
Because the stock is selling ex (after ex-rights), the formula is ($70 − $55) / 5. ($70 − $55 = $15) ($15 / 5 = $3).
- Many investors diversify by adding foreign securities to their portfolios. Those who do so by purchasing foreign stock mutual funds are least likely to be concerned with
- Liquidity risk
- Market risk
- Political risk
- Currency risk
Correct answer: Liquidity risk
Because federal law requires mutual funds to offer redemption at net asset value within seven days of the request (in the real world, it is much quicker), liquidity risk is not a concern to this investor. Although the fund is trading in dollars and all distributions in the U.S. currency, the income to the fund comes through the foreign currency. That makes investors in the fund subject to the same currency risk as if they bought the stock directly. The foreign securities in the portfolio of the fund are subject to market risk and that directly affects the value of the fund shares. Political risk is always a concern when making foreign investments. Certainly, it is of less concern in the major developed countries, but we cannot compare that with the absence of liquidity risk.
- Which of the following statements is true regarding dividend payments on common stock?
- Dividends on common stock are paid at the discretion of the board of directors and may be paid ahead of preferred stock when necessary to allow the company to remain listed on the exchange.
- Dividends on common stock are paid at the discretion of the board of directors and may be paid even where there are no earnings.
- Dividends on common stock are paid at the discretion of the board of directors and are paid as a stated percentage of the corporation's net income.
- Dividends on common stock are paid at the discretion of the board of directors and can be paid only when there are sufficient earnings.
Correct answer: Dividends on common stock are paid at the discretion of the board of directors and may be paid even where there are no earnings.
Dividends on common stock are paid at the discretion of the corporation's board of directors. Although each stockholder receives an amount proportionate to their holdings, the dividend can be any proportion of the company's earnings. In fact, a corporation can pay a dividend even when there are no earnings. However, no dividend on common stock can ever be paid before payment of the dividends due on preferred stock.
- Which of the following features of preferred stock allows the holder to reduce the risk of inflation?
- Noncumulative
- Convertible
- Callable
- Cumulative
Correct answer: Convertible
Fixed-dollar investments, such as bonds and preferred stock, are subject to inflation risk, which is the risk that the fixed interest or dividend payments will be worth less over time in terms of purchasing power. The ability to convert to common stock, which tends to keep pace with inflation, offsets this risk.
- Owners of a corporation's common stock who are unable to attend the corporation's annual meeting are
- Sent proxies to cast their votes
- Unable to change their vote if they should be able to attend the meeting
- Forfeiting their right to vote
- Required to give voting instructions to the broker-dealer handling the account
Correct answer: Sent proxies to cast their votes
A proxy is this industry's version of an absentee ballot. Most are handled electronically now. Should the situation change and the individual be able to make the meeting, the vote can be changed at that time if desired. The broker-dealer handling the account is frequently the one who solicits the proxy on behalf of the issuer. There is no action taken against a client who ignores the proxy, just as nothing happens to a citizen who decides not to vote in an election.
- All of the following would be included in a penny stock risk disclosure statement except
- A description of penny stock investing risk
- A definition covering the term penny stocks
- A guarantee of the customer's own principal
- A summary of the customer's lawful remedies
Correct answer: A guarantee of the customer's own principal
A member firm may never guarantee a customer against loss in a security, so a broker-dealer's statement of guarantee is the one item that could never appear in the document. Everything else is required content. SEC Rule 15g-2 obliges the firm to deliver a standardised risk disclosure document before the customer's first penny stock trade, and that document defines what a penny stock is, describes the risks of a thin quote-driven market in low-priced securities, sets out the customer's legal rights and remedies if the rules are broken, and states the broker-dealer's own duties to the customer.
- Which of the following provisions of a new corporate debt issue would be least attractive to a potential investor?
- A high nominal yield
- A sinking fund
- A low call price
- Significant collateral
Correct answer: A low call price
Investors can be wary when it comes to callable bonds. When interest rates decline and the investors are smiling over the higher than market rates they are earning, along comes the issuer and calls that bond in. The lower the call price, the more attractive it is for the issuer, not the investor. A sinking fund is like the escrow account on a home mortgage. Money is being put aside to make sure that when it is due, it is there. Obviously the investor would prefer a higher coupon (nominal) yield than a lower one and collateral always adds to the security of the debt.
- Which of the following is a money market instrument?
- Long-term debt
- Short-term debt
- Preferred stock
- Common stock.
Correct answer: Short-term debt
A money market instrument is short-term debt with one year or less to maturity.
- DERF Corporation has a significant amount of cash on hand. The chief financial officer (CFO) has suggested to the chief executive officer (CEO) that it might be wise to pay off $10 million of the company's outstanding debt. There are four bond issues outstanding, and your broker-dealer is approached for advice on determining which issue to repay. Which of these four issues would the firm recommend?
- $15 million @8% due in 10 years, callable at 101
- $10 million @6% due in 20 years, callable at par
- $25 million @5% due in 5 years, callable at 104
- $30 million @12% due in 15 years, non-callable
Correct answer: $15 million @8% due in 10 years, callable at 101
Anytime we have extra cash, it can make sense to pay off debt. Corporations feel the same way. When it comes to deciding which debt to repay, the wisest move is to pay down the debt with the highest interest cost. In this case, that would be the 12% bond. However, that bond is non-callable. Based on the inverse relationship between interest rates and bond prices, the 12% bond is going to be selling at a higher price than any of the others. Any savings in interest payments would be more than offset by the price the company would have to pay to buy the bond in the open market. The next highest interest rate is 8% and that bond will cost us a slight premium of $10 per bond to call. Although the 6% bond is callable at par, the company would be far better off removing an 8% debt than one at 6%. In fact, the 1 point call premium is saved after the first semiannual interest payment. A partial call, calling in $10 million of the 8% bond, should be the recommendation.
- An investor sells 10 5% bonds at a profit and buys another 10 bonds with a 5.25% coupon rate. The investor's yearly return will increase by
- $2.50 per bond.
- $2.00 per bond.
- $1.00 per bond.
- $1.50 per bond.
Correct answer: $2.50 per bond.
The first bonds are 5% and pay $50 per year per bond. The new bonds are 5.25% and pay $52.50 per year per bond, for a difference of $2.50 per bond.
- A corporation plans to make a public tender for 50% of its outstanding bonds. The price of the tender will be set by
- The trustee
- The issuer
- The transfer agent
- The paying agent
Correct answer: The issuer
In a tender offer, the issuer is offering to buy back all or a portion of the issue at a stated price. The price of the tender is set by the issuer although the issuer may engage an underwriter to help it set the price. This could happen when interest rates have gone up, causing the price of the outstanding bonds to fall. From a practical standpoint, this would mean the corporation paying off debt at a price below face value.
- When a corporation issues a debt security, the terms of the loan are expressed in a document known as the bond's indenture. The indenture is sometimes referred to as
- The debenture
- The bond resolution
- The deed of trust
- The loan agreement
Correct answer: The deed of trust
The indenture, sometimes also referred to as the deed of trust, states the issuer's obligation to pay back a specific amount of money on a specific date. A debenture is a debt security containing an indenture. The bond resolution is a term used for municipal bonds not corporate debt.
- A bond you are recommending to a customer has call protection. What does that mean?
- It is the number of years into the issue before the issuer may exercise the call privilege.
- The issuer has set up a sinking fund to provide funds for the call.
- The issuer records the phone number of investors and puts it on the do-not-call list.
- It is the number of years into the issue before the investor may exercise the call privilege.
Correct answer: It is the number of years into the issue before the issuer may exercise the call privilege.
The definition of call protection is the length of time an investor is protected against the issuer exercising the right to call the bonds in. What is the maximum possible call protection? A noncallable bond. In many cases, the issuer sets up a sinking fund to use for the call, but that is not the definition of call protection.
- An investor might expect to receive the greatest gain on an investment in a corporate bond by purchasing
- Long-term bonds when interest rates are low
- Short-term bonds when interest rates are high
- Long-term bonds when interest rates are high
- Short-term bonds when interest rates are low
Correct answer: Long-term bonds when interest rates are high
If an investor purchases bonds when market interest rates are high, a drop in interest rates will lead to a corresponding increase in bond value. Long-term debt instruments will fluctuate to a greater degree than those with short-term interest rates. Thus, long-term debt offers the greater chance of gain.
- The legal contract stating the issuer's obligation to pay back a specific amount of money on a specific date to its bondholders is best described as
- The prospectus
- The official notice of sale
- The official statement
- The trust indenture
Correct answer: The trust indenture
A trust indenture delineates the covenants or promises made by an issuer to its bondholders. Those would include the amount of the debt, the maturity date, and the rate of interest. A trustee would also be identified in the indenture who would act on behalf of the bondholders in the event of default on any of the indenture's provisions.
- What happens to outstanding fixed-income securities when market interest rates drop?
- Short-term fixed-income securities are affected most.
- The coupon rates increase.
- The yields increase.
- The prices increase.
Correct answer: The prices increase.
When interest rates drop, the price of outstanding bonds rises to adjust to the lower yields on bonds of comparable quality.
- A corporation is likely to call eligible debt when interest rates are
- Stable
- Rising
- Declining
- Volatile
Correct answer: Declining
A corporation generally calls in its debt when interest rates are declining to replace old, higher interest rate debt with new, lower interest rate issues.
- A convertible corporate bond with an 8% coupon yielding 7.1% is available but may be called sometime this year. Which feature of this bond would probably be least attractive to your client?
- Coupon yield
- Near-term call
- Current yield
- Convertibility
Correct answer: Near-term call
The near-term call would mean that no matter how attractive the bond's other features, the client may not have very long to enjoy them.
- If a fund has a fixed portfolio of municipal bonds with long maturities, how will substantial changes in general interest rates affect the fund's portfolio?
- The market value will swing while the income sits still
- The interest paid will vary while the price stays fixed
- Both the price and the interest paid will swing sharply
- Neither the price nor the interest paid will shift much
Correct answer: The market value will swing while the income sits still
The portfolio is FIXED, so nothing is bought or sold and each bond keeps paying the coupon it was issued with. The dollar income the fund collects therefore does not move when market rates move. What moves is market value: a bond with a fixed coupon must reprice so its yield matches the market, and the longer the maturity the further it has to travel, which is why a portfolio of long-term municipals swings sharply on a substantial rate change, down as rates rise and up as they fall. Income would only fluctuate if the manager were reinvesting maturities or trading the portfolio, and a long-maturity portfolio cannot sit still through a large rate move.
- Corporate bonds are considered safer than common stock issued by the same company because
- If there is a shortage of cash, dividends are paid before interest
- Bonds and similar fixed-rate securities are guaranteed by SIPC
- The par value of bonds is generally higher than that of stock
- Bonds place the issuer under an obligation but stock does not
Correct answer: Bonds place the issuer under an obligation but stock does not
A bond represents a legal obligation to repay principal and interest by the company. Common stock carries no such obligation.
- The XYZ Corporation has issued some 4% callable bonds maturing in 20 years. The bonds are callable at 102 commencing in 10 years. Regarding these bonds, which of the following statements is not correct?
- These bonds will appreciate faster in declining interest rate markets than comparable bonds without a call feature.
- The call premium generally will not compensate the bondholder for the loss of interest if the bond is called.
- The bonds will likely be called in a declining interest rate market, forcing the bondholders to reinvest at lower rates.
- XYZ will most probably call these bonds when it can refund the issuer at a lower interest rate.
Correct answer: These bonds will appreciate faster in declining interest rate markets than comparable bonds without a call feature.
All things being equal, callable bonds will not show as much appreciation in a declining interest rate market as bonds without a call feature. Logically, as interest rates fall, those bonds will be called making them less attractive than bonds where the higher interest rate payments will continue until maturity. It is correct that the premium ($20 in this question) is generally not going to equal the amount of interest that the investor would have been able to earn on the bond. It is some compensation, but not full. The bonds will be called when interest rates have declined, and the investor will now have the cash but faces the reinvestment risk of having to put the money to work at those lower interest rates.
- Your customer is interested in long-term corporate bonds. Which of the following interest rate environments makes a call protection feature most valuable to your customer?
- Volatile interest rates
- Rising interest rates
- Stable interest rates
- Declining interest rates
Correct answer: Declining interest rates
A call protection feature is an advantage to bondholders in periods of declining interest rates. When interest rates are falling, issuers are more likely to call in bonds previously issued at higher interest rates. For bondholders, calling bonds creates reinvestment risk, as they are unlikely to be able to reinvest at the rate they had been earning. Call protection gives the bond holder a specified length of time during which the bond cannot be called.
- A corporate bond is quoted at 102⅝. A customer buying 10 bonds would pay
- $10,262.50.
- $10,025.80.
- $10,258.00.
- $10,285.00.
Correct answer: $10,262.50.
Par ($1,000) × 102% = $1,020. Five-eighths of one bond point ($10) equals 0.625 × $10 = $6.25. Therefore, the quote reading 10285 equals $1,026.25 per bond ($1,020 + $6.25). Because we are told the customer is buying 10 bonds, we multiply $1,026.25 by 10 bonds, which equals the amount the customer will need to pay to make the entire purchase: $10,262.50.
- A bond investor who is looking for capital gains should invest in bonds when interest rates are
- High and expected to rise
- High and expected to decline
- Low and expected to rise
- Low and expected to decline
Correct answer: High and expected to decline
This is about the inverse relationship between interest rates and bond prices. As interest rates rise, bond prices fall. Conversely, when interest rates decline, bond prices increase. If an investor buys bonds when the current interest rates are high, a future decline in those interest rates will cause the price of the bonds to increase.
- An investor would most likely purchase money market instruments for their
- Liquidity
- Yields
- Inflation protection
- Appreciation potential
Correct answer: Liquidity
Money market instruments are frequently referred to as cash equivalents. That is largely due to their high liquidity. Yields on these instruments are very low, and as fixed-income instruments, they offer no appreciation potential or inflation protection.
- A respected analyst reports that last week's T-bill rate at 1% is lower than the rate for the preceding week and lower than the average for the past month. Which of the following is true?
- The general level of interest rates is increasing.
- Investors are paying more for T-bills.
- Prices are descending.
- Investors are paying less for T-bills.
Correct answer: Investors are paying more for T-bills.
When the rate is lower, the price has gone up. This means investors are paying more as interest rates are going down.
- All of the following are money market instruments except
- Commercial paper
- Bankers' acceptances
- Options
- Reverse repurchase agreements
Correct answer: Options
Money market instruments are short-term (one year or less to maturity) liquid debt instruments. Reverse repurchase agreements, repurchase agreements, commercial paper, CDs, and bankers' acceptances are examples. Options are not money market instruments.
- The Union Fidelity Bank of Highville has issued jumbo CDs with a term of three years and a fixed interest rate of 3.5%. The minimum denomination of the CDs is $100,000, and the CDs are callable at 101% of face value beginning on the first anniversary of the issue date. Under which of the following circumstances is it most likely that the bank would exercise the call feature on that anniversary date?
- Five-year jumbo CDs are currently being issued with a fixed interest rate of 2.7%.
- One-year jumbo CDs are currently being issued with a fixed interest rate of 4%.
- Three-year jumbo CDs are currently being issued with a fixed interest rate of 3.5%.
- Three-year jumbo CDs are currently being issued with a fixed interest rate of 4%.
Correct answer: Five-year jumbo CDs are currently being issued with a fixed interest rate of 2.7%.
As is the case with other fixed payment callable issues, whenever interest rates decline, it is generally beneficial to call in the older issue. In this case, the bank would pay an extra 1% to redeem but could refinance at a rate that is at least .8% lower and extend the maturity. We say at least .8% lower because with the new five-year CDs paying 2.7%, if the bank wanted to keep to the same final maturity date (two more years), it is expected that the rate on two-year CDs would be lower than that of CDs with a five-year maturity.
- Which of the following instruments is essentially a letter of credit?
- Trade acceptances
- Repurchase agreements
- Bankers' acceptances
- Eurodollar deposits
Correct answer: Bankers' acceptances
A banker's acceptance is a time draft drawn on a bank; once the bank stamps it accepted, the bank itself is on the hook to pay the face amount at maturity. That is precisely what a letter of credit does, substituting a bank's credit for a commercial buyer's, and importers and exporters use the two for the same purpose. A trade acceptance looks identical on its face but is accepted by the buying COMPANY, so no bank stands behind it and no bank credit is substituted. A repurchase agreement is a collateralised short-term loan between dealers, and a Eurodollar deposit is a dollar-denominated time deposit at a bank outside the United States; neither involves a bank guaranteeing a third party's obligation.
- All of the following statements regarding negotiable jumbo certificates of deposit are true except
- They are fully insured in any denomination by the FDIC
- They are usually issued in denominations of $100,000 to $1,000,000
- They are readily marketable
- They usually have maturities of less than one year
Correct answer: They are fully insured in any denomination by the FDIC
The FDIC insures only up to $250,000.
- Which of the following does not issue commercial paper?
- Corporations
- Broker-dealers
- Finance companies
- U.S. Treasury
Correct answer: U.S. Treasury
The U.S. Treasury does not issue commercial paper. Its short-term borrowing is done with Treasury bills. Commercial paper is unsecured, short-term corporate debt most commonly issued by finance companies but also by industrial corporations and broker-dealers.
- Which of the following is a short-term money market instrument with a bank guarantee that is used to provide capital for exporters to foreign countries?
- Commercial paper.
- Bankers' acceptances.
- American depositary receipts (ADRs).
- World Bank drawing rights
Correct answer: Bankers' acceptances.
Bankers' acceptances are money market instruments used to finance international trade. A banker's acceptance is a time draft drawn on a bank by an importer or exporter of goods, and it represents the bank's conditional promise to pay the face amount of the note at maturity (normally less than three months).
- All of the following statements regarding commercial paper are correct except
- Interest is received at maturity
- It is quoted on a discount yield basis
- It is quoted as a percentage of par
- It is unsecured
Correct answer: It is quoted as a percentage of par
Commercial paper is short-term, unsecured corporate debt. It is issued and traded at a discount of face value and does not pay periodic interest. Like all zeroes, it is quoted on a discounted yield basis.
- It is most accurate to state that commercial paper is
- Sold at a discount
- Secured
- Traded on the NYSE
- Interest bearing
Correct answer: Sold at a discount
Commercial paper (CP) is short-term unsecured paper issued by corporations (especially finance companies), primarily to raise working capital. These are always issued at a discount from the face value. The minimum denomination is usually $100,000, making them unsuitable for small investors.
- Debt normally issued by big corporations with reliable credit ratings that seek to finance short-term needs best describes
- Certificates of deposit
- Commercial paper
- Revenue anticipation notes
- T-bills.
Correct answer: Commercial paper
This is the definition of commercial paper, as known as promissory notes. They are short-term corporate-issued instruments sold at a discount and maturing at par.
- When a well-established corporation needs short-term borrowing for working capital needs, it will most likely issue
- A letter of credit
- A jumbo CD
- Commercial paper
- Preemptive rights
Correct answer: Commercial paper
Commercial paper is the most common tool for corporations to raise short-term funds. A letter of credit is issued by a bank. On the exam, this would usually take the form of bankers' acceptances for those in the import/export business. Banks issue CDs, and preemptive rights are used for the sale of common stock. Stock is long-term capital.
- The minimum face amount of a negotiable CD is
- $50,000.
- $100,000.
- $25,000.
- $10,000.
Correct answer: $100,000.
Negotiable CDs are issued in the minimum face amount of $100,000. These are called jumbo CDs and are traded in blocks of $1 million.
- Which of the following is not a characteristic of certificates of deposit (CDs)?
- A jumbo CD is issued in amounts above $100,000
- A CD is FDIC insured to $500,000 per depositor
- A CD may be issued in bearer or registered form
- A CD may be negotiable or nonnegotiable in form
Correct answer: A CD is FDIC insured to $500,000 per depositor
FDIC insurance on deposits, certificates of deposit included, is limited to $250,000 per depositor per insured bank for each ownership category, so a statement of $500,000 of coverage is the one that does not describe a CD. The rest are accurate. Negotiable jumbo CDs are issued in denominations above $100,000 and are the form that trades in the money market. A CD may be drawn in bearer form or registered in the investor's name. And CDs come both negotiable, meaning the holder can sell the instrument before maturity, and nonnegotiable, meaning it can only be redeemed at the issuing bank, usually with an early-withdrawal penalty.
- Transactions in all of the following are affected in the money market, as opposed to the capital market, except
- Prime commercial paper
- U.S. Treasury bills
- Jumbo negotiable CDs
- Municipal revenue bonds
Correct answer: Municipal revenue bonds
The money market trades debt with a year or less left to run; the capital market is where long-term capital is raised. Commercial paper is unsecured corporate promissory paper maturing in 270 days or less, Treasury bills are issued with maturities out to one year, and jumbo negotiable CDs are short-term bank obligations that trade among institutions. All three are money market instruments. A municipal revenue bond is long-term debt sold to build a facility and retired out of that facility's earnings over many years, which places it in the capital market.
- Interest and principal on a Eurodollar bond issued in Germany are paid
- In U.S. dollars.
- In German deutsche marks
- In European Union euros
- In German euros
Correct answer: In U.S. dollars.
It is always the final part of the word that describes the currency of a eurobond. A Eurodollar bond pays in U.S. dollars, while a Euroyen bond would pay in Japanese yen.
- One of your individual customers would like to add some foreign debt securities to their portfolio. When told that the investment would be $2,500, the best suggestion would be to
- Contact a broker-dealer in the foreign country of choice and open an account there
- Invest in a mutual fund concentrating in foreign debt securities
- Tell the customer that $2,500 is below the minimum purchase quantity of foreign bonds
- Use one of the overseas branches of your firm to suggest the appropriate issues
Correct answer: Invest in a mutual fund concentrating in foreign debt securities
For small investments, a mutual fund or exchange-traded fund (ETF) is usually going to be the most suitable choice. Most countries do not allow nonresident noncitizens to open local brokerage accounts, and that is a pretty impractical idea anyway. If your firm has an overseas office, it could be a source of information, but when only $2,500 is involved, purchasing individual bonds issued by a foreign nation is usually not reasonable.
- When a bond is issued by a national government, it is called
- Sovereign debt
- High-quality debt
- National debt
- Treasury debt
Correct answer: Sovereign debt
The term sovereign debt applies to securities issued by national governments. U.S. Treasuries are an example of sovereign debt issued here. Other countries have their versions. Not all are considered high quality, especially those issued by emerging economies.
- In the United Kingdom, they are called gilts. In Germany, they are called Bunds. In France, they are called OATS. To investors, they are known as
- Sovereign debt
- Commodities
- Stock exchanges
- Eurobonds
Correct answer: Sovereign debt
Although it is highly unlikely that you would ever see any of these terms on the exam, you might need to know what sovereign debt is. For the United States, the sovereign debt (the debt issued by the sovereign nation) is Treasury securities. The safety of sovereign debt depends on the economy of the specific nation. You would probably not recommend the debt of a third-world country to a customer wishing to avoid risk.
- A bond issued by a Swiss company, sold outside the United States and the issuer's country, but for which the principal and interest are stated and paid in U.S. dollars, is the definition of a
- Francodollar bond.
- Eurodollar bond.
- Eurobond.
- Matterhornbond.
Correct answer: Eurodollar bond.
The key to a Eurodollar bond is that everything is in U.S. dollars. The issuer is either a non-U.S. corporation or government, and the security is not issued in the United States.
- Many investors, especially institutions, diversify their fixed-income portfolios by purchasing bonds issued outside of the United States. When a French corporation issues a bond denominated in Swiss francs, it is known as
- A euroswiss bond
- A eurobond
- A eurodollar bond
- Sovereign debt
Correct answer: A eurobond
The term eurobond is the generic name given to a long-term debt instrument issued and sold outside the country of the currency in which it is denominated. An example would be eurosterling bonds where a non-U.K. entity issues a debt denominated in British pounds. In our question, the French company is borrowing in Swiss francs instead of the domestic currency (the euro). Sovereign is issued by the sovereign government, e.g., U.S. Treasury bonds.
- A customer buys a 5% bond at par. The bond is callable in five years at par and matures in 10 years. Which of the following statements is true?
- Nominal yield is higher than either YTM or YTC.
- YTC is higher than YTM.
- YTC is lower than YTM.
- YTC is the same as YTM.
Correct answer: YTC is the same as YTM.
If a bond is trading at par, the nominal yield (coupon rate) equals current yield equals yield to maturity (YTM) equals yield to call (YTC). YTC is higher than YTM if the bond is trading at a discount to par. YTC is lower than YTM if the bond is trading at a premium over par. Nominal yield is higher than either YTM or YTC if the bond is trading at a premium over par.
- When a bond is selling at a premium
- The nominal yield will always be lower than the yield to call
- The yield maturity will always be higher than the nominal yield
- The current yield will always be higher than the yield to maturity
- The current yield will always be higher than the nominal yield
Correct answer: The current yield will always be higher than the yield to maturity
When a bond is selling at a premium, all of the yields are lower than the nominal (coupon) yield. The sequence in descending order of yield is NY, CY, YTM, YTC.
- If interest rates increase, the interest payable on outstanding corporate bonds will
- Increase
- Decrease
- Change according to the inverse payout theory
- Remain unchanged
Correct answer: Remain unchanged
The interest payable is the nominal yield, which is stated on the face of the bond. It is the percentage of face value the bond will pay each year, regardless of the prevailing interest rates in the market. It is the market price of bonds—not the interest payable—that responds inversely to changes in interest rates.
- The LLAW Manufacturing Company issued a 6.25% debenture 5 years ago. The bond is callable in seven years at 102 and matures in 15 years. The bond's current yield is 4.23%. If one of your customers decided to purchase this bond, they would have to understand they would be
- Required to pay the call price
- Receiving a yield to maturity in excess of 4.23%
- Paying a premium for the bond
- Buying the bond at a price below par
Correct answer: Paying a premium for the bond
The first thing to notice is that the current yield is below the nominal (coupon) rate. That automatically tell us the bond is selling at a premium. Whenever a bond is selling at a premium, in increasing order, the order of the yields is yield to call, yield to maturity, current yield, and nominal yield. Therefore, if the current yield is 4.23%, the yield to mature cannot be higher than that; it must be less. As we say in the study materials, "if you pay more, you get less" and "if you pay less, you get more." The issuer pays the call price when, and if, the bond is called.
- A callable municipal bond maturing in 30 years is purchased at 102. The bond is callable at par in 15 years. If the bond is called at the first call date, the effective yield earned on the bond is
- Not determinable
- Higher than the yield to maturity
- Lower than the yield to maturity
- The same as the yield to maturity
Correct answer: Lower than the yield to maturity
When a bond is purchased at a premium ($1,020) and called for redemption, the investor's effective yield is the yield to that call date. That will be lower than the bond's yield to maturity because the premium is lost sooner.
- An investor is looking to add some fixed-income securities to their portfolio. A registered representative suggests either the ABC 6s of 2050, or the XYZ 6s of 2043. Should there be an increase to market interest rates,
- The XYZ bonds will enjoy a price increase greater than the ABC bonds
- The ABC bonds will enjoy a price increase greater than the XYZ bonds
- The ABC bonds will suffer a price decline greater than the XYZ bonds
- The XYZ bonds will suffer a price decline greater than the ABC bonds
Correct answer: The ABC bonds will suffer a price decline greater than the XYZ bonds
This is a basic duration problem. When interest rates change, the bond with the longest duration will have the greatest price change. When there are two bonds with the same coupon rate (6%), the bond maturing latest has the longest duration. That tells us that the ABC bonds will fluctuate more than the XYZ bonds. Then, we need to remember that when interest rates increase, bond prices fall. That means that while both bonds will decline in price, the decline of the ABC bonds will be greater.
- Two bonds currently quoted at a 5.50 basis mature in exactly 15 years. Their coupons are 6% and 7%, respectively. Which bond would experience the greatest appreciation in value if the yields dropped to a 5.20 basis?
- Neither because both would decline in value
- The 7% bond
- The 6% bond
- Both would appreciate the same amount
Correct answer: The 7% bond
These bonds are selling at a premium (their coupons are above their yield to maturity, or basis). If the YTM declines to 5.20, it means that the prices of the bonds went up. Without getting too deep into the mathematics, in order for both bonds to have the same basis (5.20), the one with the 7% coupon must have a higher price because the $10 per year additional interest has to be offset by a larger annual "loss." Here is a general rule that will apply to your exam questions. When interest rates are falling, bonds with higher coupon rates are going to appreciate in price at a greater rate than bonds with lower coupon rates. Conversely, when interest rates are rising, those bonds with higher coupons will decrease in price at a slower rate than bonds with lower coupons. In our specific question, the 7% bond will have a greater price increase than the 6% bond. If, however, our question showed the bond selling at a discount, e.g., the basis (YTM) is 8%, the 7% bond would be selling closer to par value than the 6% bond.
- The current yield on a bond with a coupon rate of 7.5% currently selling at 10521 is approximately
Correct answer: 7.1%.
A bond with a coupon rate of 7.5% pays $75 of interest annually. Current yield equals annual interest amount divided by bond market price, or $75 / $1,055 = 7.109% or approximately 7.1%.
- A bond offered at par has a coupon rate
- Greater than its yield to maturity
- Less than its yield to maturity
- Equal to its current yield
- Less than its current yield
Correct answer: Equal to its current yield
When a bond is selling at par, its coupon or nominal rate, current yield, and yield to maturity are all the same.
- In which of the following will a change in interest rates cause the greatest price fluctuation?
- 7% 30-year U.S. Treasury bond
- Series EE bond
- 7% AA-rated one-year municipal note
- 7% AAA-rated corporate bond with eight years until maturity
Correct answer: 7% 30-year U.S. Treasury bond
Price fluctuations are the greatest in bonds with the longest terms to maturity. The riskier the instrument, the more price volatility. Long-term bonds have greater risk than short-term bonds.
- Which of the following statements regarding a $1,000 corporate 8.50% bond offered at 110 is true?
- The bond is a discount bond.
- To determine the bond's current yield, its stated rate must be compared against other fixed-rate investments in the client's portfolio.
- The bond's current yield is calculated by dividing its annual interest by its market price.
- The bond's current yield is lower than its yield to maturity.
Correct answer: The bond's current yield is calculated by dividing its annual interest by its market price.
A bond's current yield is calculated by dividing its annual interest by its current (market) price. The current yield will be higher than its yield to maturity, which will include the premium return. The determination of a bond's yield is unrelated to other bonds. In addition, this is a premium bond, not a discount bond.
- Nickelplate Manufacturing Corporation (NMC) is capitalized with 1 million shares of a 6% $50 par callable preferred stock and 10 million shares of $1 par common stock. Your customer's required rate of return on fixed income investments is 8%. The NMC preferred stock would be an appropriate addition to this customer's portfolio only if the stock was not priced in excess of
- $75.00.
- $66.66.
- $37.50.
- $40.00.
Correct answer: $37.50.
How does a 6% preferred stock return 8%? Remember the inverse relationship between interest rates and fixed income security prices. As one goes up, the other goes down. An increased return results from a decreased price. The math is basic algebra. We know the annual dividend is $3 per share (6% of $50 = $3); that is fixed. What number results in a payment of $3 providing an 8% return? Divide 3.00 by $8 and the answer is $37.50. You could also do this question by working backwards. Multiply each of the choices by 8% and the one where the product is $3 is correct.
- A 5% bond is trading at a premium. Which of the following would be the bond's highest yield?
- Yield to maturity
- Current yield
- Dividend yield
- Coupon yield
Correct answer: Coupon yield
If a bond is trading at a premium, its coupon rate will represent the highest of its yields. Bonds do not have a dividend yield.
- Nickelplate Manufacturing Corporation (NMC) is capitalized with 1 million shares of a 6% $50 par callable preferred stock and 10 million shares of $1 par common stock. With the preferred stock currently selling at $75 per share and the common stock at $60 per share, the current yield of the preferred stock is closest to
Correct answer: 4%.
Current yield on any security, stock or bond, is the annual income (dividend on stock, interest on bond) divided by the current market price per share (or per bond). The math in this question is the dividend of $3 (a 6% $50 par preferred stock is paying an annual dividend of 6% of $50, or $3 per share) divided by the current market price of the preferred stock ($75). The quotient is .04 or 4%. What about the common stock? All of that information is just to distract you. We cannot compute the current yield of the common stock because we do not have any information about its dividend.
- 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?
- 1-year bond selling at a premium
- 20-year bond selling at a discount
- 1-year bond selling at a discount
- 20-year bond selling at a premium
Correct answer: 20-year bond selling at a discount
In general, prices of long-term bonds are more volatile than prices of short-term bonds. 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. 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.
- When a bond is selling at a discount
- The nominal yield will always be lower than the current yield
- The current yield will always be higher than the yield to call
- The yield to maturity will always be lower than the current yield
- The yield to call will always be lower than the yield to maturity
Correct answer: The nominal yield will always be lower than the current yield
When a bond is selling at a discount, all of the yields are higher than the nominal (coupon) yield. The sequence in ascending order of yield is NY, CY, YTM, YTC.
- The following is taken from the S&P Bond Guide: FLB Zr 37 87 8721. What is the coupon rate on this bond?
Correct answer: 0%
FLB is the issuer, Zr means zero coupon, 37 indicates the year of maturity (2037), 87 is the bid price ($870), and 8721 is the asked price ($875).
- The price of which of the following will fluctuate most with a change in interest rates?
- Money market instruments
- Common stock.
- Short-term bonds
- Long-term bonds
Correct answer: Long-term bonds
Long-term debt prices fluctuate more than short-term debt prices as interest rates rise and fall.
- The price of which of the following will fluctuate most with fluctuating interest rates?
- Short-term bonds
- Long-term bonds
- Money market instruments
- Common stock
Correct answer: Long-term bonds
Long-term debt prices will fluctuate more than short-term debt prices as interest rates rise and fall. When buying a debt instrument, a person is really buying the interest payments and final principal payment. Money has a time value: the longer it takes to receive the money, the less it is worth today.
- The coupon on a bond can be described as its
- Basis
- Yield to call
- Current yield
- Nominal yield
Correct answer: Nominal yield
The coupon on a bond is also known as the nominal yield, and it indicates the annual interest paid. For example, a 4% bond pays $40 of interest per year.
- The basis of a bond with a 5% nominal yield maturing in twenty years and selling at 115 is approximately
Correct answer: 3.95%.
A bond's basis is its yield to maturity (YTM). It is not necessary to do the YTM calculation because it could only be one choice. We can easily compute the current yield by dividing the $50 annual interest by the $1,150 current market price. That is about 4.35%. The YTM must be lower than that because it includes the eventual loss realized when the bond matures at par. There is only one selection that is lower than 4.35%. The calculation would follow our formula of: Annual interest − (premium ÷ number of years to maturity), all ÷ [(Current market price + par) ÷ 2] Plugging in the numbers, we have: ($50 - $7.50) divided by $1,075. That is 3.95%
- The basis of a bond with a 5% nominal yield maturing in twenty years and selling at 85 is approximately
Correct answer: 6.22%.
A bond's basis is its yield to maturity (YTM). It is not necessary to do the YTM calculation because it could only be one choice. We can easily compute the current yield by dividing the $50 annual interest by the $850 current market price. That is about 5.88%. The YTM must be higher than that because it includes the eventual profit realized when the bond matures at par. There is only one selection that is higher than 5.88%. The calculation would follow our formula of: Annual interest + (discount ÷ number of years to maturity), all ÷ [(Current market price + par) ÷ 2] Plugging in the numbers, we have: ($50 + [$150 ÷ 20 years]) = ($50 + $7.50) divided by ([$850 + $1,000] ÷ 2) = $57.50 ÷ ($1,850 ÷ 2) = $57.50 ÷ $925 = 6.22%
- Six percent XYZ debentures are trading for $1,200. Other similarly rated bonds are offered at 4.5%. What is the current yield on the 6% XYZ debentures?
Correct answer: 5%
Current yield is defined as the annual income (or coupon rate) from a bond divided by the bond's current market price. Accordingly, $60 / $1,200 = 0.05×100=5%. The current yield will be lower than the coupon rate when the bond is trading at a premium.
- The market price of fixed-income securities, especially bonds, are highly sensitive to changes in market interest rates. Based on that knowledge, which of the following bonds will have the greatest price change when market interest rates decrease?
- 10-year maturity, 4% coupon
- 10-year maturity, 6% coupon
- 20-year maturity, 6% coupon
- 20-year maturity, 4% coupon
Correct answer: 20-year maturity, 4% coupon
Without getting into complicated math, assume that market interest rates fell to 2%. Those investors holding a bond with a 4% coupon are going to be earning twice the going rate while those with the 6% coupon are earning three times the going rate of 2%. Presented with that information, what would be worth more to an investor: the 4% bond or the 6% bond? I think most would rather earn 6% and would pay a higher price for that bond. The next step is thinking about how long the investor will be receiving that higher-than-market rate. Would you rather receive three times the going rate for 10 years or for 20 years? Clearly, the longer you can get those higher interest payments, the more attractive the bond. That makes the 6% bond with a 20-year maturity the most attractive investment, and its price will increase more than the others. Remember, there is an inverse relationship between bond market prices and changes to market interest rates. As interest rates decrease, the value of older bonds (with their higher coupons) increases. The higher the coupon, the greater the increase. When their coupons are the same, the longer the time to maturity, the more valuable that higher coupon rate.
- The market price of fixed-income securities, especially bonds, is highly sensitive to changes in market interest rates. Based on that knowledge, which of the following bonds will have the greatest price change when market interest rates increase?
- 20-year maturity, 6% coupon
- 20-year maturity, 4% coupon
- 10-year maturity, 6% coupon
- 10-year maturity, 4% coupon
Correct answer: 20-year maturity, 4% coupon
The longer the duration, the greater the decrease in price when interest rates go up. The bond with the longest duration will have the longest term to maturity and lowest coupon. Without getting into complicated math, assume that interest rates rose to 8%. Those investors holding a bond with a 4% coupon are going to be earning half of the going rate while those with the 6% coupon are earning 75% of the going rate of 8%. Presented with that information, you can ask what would be worth more to an investor: the 4% bond or the 6% bond? I think most would rather earn 6% and would pay a higher price for that bond. The next step is thinking about how long the investor will be stuck with that lower-than-market rate. Would you rather receive half the going rate for 10 years or for 20 years? Clearly, the sooner you can get your principal back and reinvest at the higher rates, the more attractive the bond. That makes the 4% bond with a 20-year maturity the least attractive investment, and its price will decline more than the others. That relates to our first two statements: the longer the duration, the more the price decline, and the longest term to maturity with the lowest coupon rate will have the longest duration.
- An analyst is comparing the yields of U.S. Treasury bonds and AAA-rated corporate bonds with similar maturities. This measurement would indicate an improving economy when
- The yield spread is remaining stable
- The yield spread is narrowing
- The yield spread is widening
- The yields on the Treasury bonds are lower than those on the corporate bonds
Correct answer: The yield spread is narrowing
You should understand that the greater the risk, the higher the yield on the bond. Many analysts compare the difference between yields on bonds with the same maturity but different quality (rating) to get a sense of the market sentiment. One common measurement is the difference in yields between Treasuries and corporate bonds. This difference is called the yield or credit spread and tends to widen when economic conditions sour and narrow when they get better. You will never see (at least on the exam and probably in the real world as well) the yield on a corporate bond lower than a Treasury bond when the maturities are similar. It is the spread, the difference in yields, that is important. ** This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- A bond would be considered speculative below which of the following Standard & Poor's (S&P) ratings?
- A rating of AAA
- A rating of AA
- A rating of A
- A rating of BBB
Correct answer: A rating of BBB
S&P's investment-grade band runs AAA, AA, A and BBB. The first rating under that band is BB, and BB and everything below it is speculative, the tier the market calls high yield or junk. The dividing line therefore sits at BBB: a bond rated below BBB is speculative. It is not below AAA, AA or A. Each of those sits well inside the investment-grade band, and the ratings immediately beneath them are AA, A and BBB, all three of which are still investment grade and none of which a rating service would call speculative.
- When part of an issue of speculative bonds with a 25-year maturity are called, the effect on the remaining bonds will be to
- Improve their quality
- Increase their coupon rate
- Decrease their coupon rate
- Decrease their quality
Correct answer: Improve their quality
Speculative bonds are those with lower ratings. They are considered to be of lower quality because the risk of timely payment and principal are higher than investment-grade bonds. When a company shows its determination to honor its debt by paying off some of it in advance, the rating associations take note of that and invariably increase the rating. Compare this to your personal credit score. Your score might be relatively low because you have a lot of outstanding debt. As you pay down that debt, your credit score is likely to increase. It is the same logic here.
- Most rating services rate which of the following?
- Reinvestment risk
- Marketability
- Quality
- Durability
Correct answer: Quality
The rating services are concerned with quality, which is defined as the ability of the issuer or guarantor to pay (default risk).
- The SEC recognizes all of the following under the Credit Rating Agency Reform Act as being registered with the commission to rate debt instruments. Which of them historically has specialized in ratings for the insurance sector?
- Moody's
- Fitch Ratings
- A.M. Best
- Standard & Poor's
Correct answer: A.M. Best
A.M. Best historically has specialized exclusively on the insurance marketplace. They issue financial strength ratings measuring insurance companies' ability to pay claims and rate financial instruments issued by insurance companies, such as bonds and notes. They can issue debt and financial strength ratings for other sectors as well under the Credit Rating Agency Reform Act.
- A bond analyst plots the yields of AAA corporate bonds and compares them to the yields of U.S. Treasury bonds with similar maturities. This is known as
- Inverse yield analysis
- Yield comparison analysis
- Yield curve analysis
- Yield plot analysis
Correct answer: Yield curve analysis
The plotting of bond yields results in a curve, usually one where the longer the time to maturity, the higher the yield. The term yield curve analysis is the proper way to describe comparing the yields of highly-rated corporate bonds to those of Treasury bonds. When the spread between the yields is narrow, economic conditions in the United States are generally favorable. If the spread (sometimes called the credit spread) widens, it is generally a sign of a worsening economy. ** This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- One of your customers calls and asks you about a security with an S&P rating of SP-2. The customer is most likely asking about which of the following?
- Your firm's privacy notice
- A municipal note
- Commercial paper
- A municipal bond
Correct answer: A municipal note
The three major rating services each have their own rating system for short-term municipal debt (notes). In the case of Standard and Poor's, the ratings are SP-1, SP-2, and SP-3 in declining order of quality. Regulation S-P (with the hyphen between the S and P) deals with privacy notices. Although it is unlikely to be tested, commercial paper is rated A-1, A-2, A-3, and then into the "Bs."
- The industry term "junk bond" applies to a bond with a Standard and Poor's rating no higher than
Correct answer: BB.
Once a bond's rating has fallen below the top four grades (AAA, AA, A, and BBB), it is no longer considered investment grade. At that point, BB (or Moody's Ba) or lower, it is considered a high-yield or junk bond.
- Which of the following choices is least similar to the others?
- Standard & Poor's Ratings
- Financial Guaranty Insurance
- Fitch Ratings Incorporated
- Moody's Investors Service
Correct answer: Financial Guaranty Insurance
Standard & Poor's, Fitch and Moody's are credit RATING agencies. Each analyses an issuer and publishes an opinion of its creditworthiness, and each is paid for that opinion without taking any financial risk on the securities it rates. Financial Guaranty Insurance is a bond INSURER: it sells a municipality a guarantee of principal and interest, and the issuer buys that guarantee so the insurer's own rating can be substituted for its own. It is therefore the entity in the list that assumes the credit risk rather than measuring it, and that is what makes it least similar to the other three.
- Which of the following debt instruments would likely be suitable for sophisticated investors only?
- Debentures
- Equity-linked notes
- Jumbo CDs
- First mortgage bonds
Correct answer: Equity-linked notes
Despite the misleading name, ELNs are debt instruments. When traded on an exchange, they are exchange-traded notes (ETNs). In either case, these are considered alternative products with unique risks, and therefore, not suitable for most investors. Although debentures are corporate debt without any pledged collateral, some of the financially strongest companies in the country issue them and receive high ratings. Even though Jumbo CDs require a minimum of $100,000, it does not require any sophistication to understand the product.
- All of the following are characteristics associated with equity-linked notes (ELNs) except
- They have final payments at maturity linked to the return of an underlying stock or basket of stocks
- They are considered to be nonconventional structured investments
- They can be exchange traded or traded over-the-counter (OTC)
- They are equity securities
Correct answer: They are equity securities
Despite their name, ELNs are debt instruments, not equity instruments. They have a partial fixed return, as well as a final payment linked to the performance of a single stock or equity index. Some are exchange traded, while others trade OTC. FINRA, who considers ELNs to be nonconventional structured investments, has expressed concerns that investors might not fully understand ELNs or the risks associated with them.
- A term used to define certain alternative forms of debt financing, such as equity-linked notes (ELNs) and exchange-traded notes (ETNs), is
- Combination products
- Principal protected products
- Structured products
- High-risk investments
Correct answer: Structured products
In Notice to Members 05-59, FINRA defined a structured product as "securities derived from or based on a single security, a basket of securities, an index, a commodity, a debt issuance and/or a foreign currency." The most important thing for you to know for the exam is that these generally carry higher risk than other debt securities. These should be recommended only when the registered representative has a thorough understanding of the product and believes it is suitable for the specific investor. Yes, these are high-risk investments, but that is not the term used to describe them.
- Which of the following would be considered an equity security?
- A collateralized mortgage obligation
- A prior lien preferred stock
- An exchange-traded note
- An equity-linked note
Correct answer: A prior lien preferred stock
Stock means equity. Prior lien means that this preferred has priority over other preferred stock the company has issued. The other three are alternative forms of debt financing. Do not fall into the equity-linked note trap; it is a debt security.
- In recent years, much publicity has surrounded the rapid growth of start-up businesses. In most cases, the early financing was done privately. When private debt is used at the intermediate stage of a company's development, it is called
- Middle-risk debt
- Mid-term debt
- Intermediate debt
- Mezzanine debt
Correct answer: Mezzanine debt
Just as the mezzanine in a theater is between the balcony and the orchestra levels, mezzanine debt represents financing supplied at the intermediate point in a new company's development. The funds are provided on a private basis and the investment carries a high degree of risk. As an alternative investment, it will be suitable for a very narrow range of customers. **This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- During a period of sustained low interest rates, many investors, particularly institutions, look to increase their return through alternative debt investments. Examples of those would include all of the following except
- Exchange-traded notes
- Leveraged ETFs
- Equity-linked notes
- Private placement debt
Correct answer: Leveraged ETFs
Although leveraged ETFs (exchange-traded funds) are certainly an alternative investment, they represent an equity investment rather than debt. Despite the misleading name, equity-linked notes are, in fact, debt instruments.
- Which of the following would be most likely to issue an equipment trust certificate?
- A social media company installing new servers
- A company using specialized equipment on an oil drilling rig
- A user of farming equipment
- An airline company
Correct answer: An airline company
When you see "equipment trust certificate," think transportation companies such as airlines and railroads.
- You have a client who is about to retire and wants to rearrange his portfolio to have predictable income. Which of the following would not be a good investment vehicle?
- U.S. Treasury note
- AA-rated debenture
- AA-rated IDB
- Income bonds
Correct answer: Income bonds
Income bonds, also known as adjustment bonds, are issued when a company is reorganizing and coming out of bankruptcy. Income bonds pay interest only if the company has enough income to meet the interest payment. As a result, these bonds normally trade flat without accrued interest. Therefore, they are not suitable for customers seeking income.
- Which of the following corporate bonds is backed by other securities?
- Debentures
- Mortgage bond
- Collateral trust bond
- Equipment trust certificate
Correct answer: Collateral trust bond
Collateral trust bonds are backed by a portfolio of other securities, while mortgage bonds are backed by real estate. Equipment trust certificates are backed by equipment, while debentures are backed only by the company's promise to pay.
- An investor seeking income combined with a conservative level of risk would purchase
- AA-rated mortgage bonds.
- Junk bonds
- AAA-rated convertible debentures.
- Unrated income bonds
Correct answer: AA-rated mortgage bonds.
The conservative level of risk eliminates the income bonds and the junk bonds. Income bonds pay interest only if the issuer has the funds to do so. Junk bonds are named such because of their high risk. Even though the convertible debentures have a higher rating than the mortgage bonds, the difference is relatively insignificant at that level and either would be suitable for the conservative investor. However, because of the convertible feature, it is always true on the exam that the income return is lower than non-convertible issues. Therefore, the most suitable for this investor would be the mortgage bonds.
- Which of the following debt instruments is unsecured?
- Collateral trust certificates
- Equipment trust certificates
- AAA/AAA-rated debentures
- Junior lien mortgage bonds
Correct answer: AAA/AAA-rated debentures
Corporate debentures are unsecured bonds backed by the credit of the issuing corporation; they are not secured by underlying collateral. Mortgage bonds are secured with real estate serving as collateral. Collateral trust bonds are secured by securities that a corporation owns in other companies or bonds. Equipment trust certificates are secured by transportation equipment owned by the corporation.
- If a mutual fund's objective is income, it would not hold which of the following securities in its portfolio?
- Preferred stock
- U.S. T-notes
- Income bonds
- Corporate bonds
Correct answer: Income bonds
A fund designed to generate current income for its shareholders would not hold an income bond, also known as an adjustment bond. Income bonds pay interest only if the issuer has enough earnings to do so. They are often issued by companies coming out of bankruptcy. As a result, these bonds tend to trade like zeroes.
- Which of the following would be the most likely unsuitable recommendation for a client whose objective is steady income?
- A U.S. Treasury bond
- A bank CD
- A subordinated debenture
- An income bond
Correct answer: An income bond
Income (or adjustment) bonds carry the unique characteristic of requiring payment of interest only when the issuer's income is sufficient. They are used primarily for companies undergoing a financial restructuring, usually after a bankruptcy filing. Don't be fooled by the subordinated debenture. Although it stands last in line of the creditors in the event of a liquidation, that does not mean the investor is not going to get regular interest payments, especially when the debenture is investment grade. Bank CDs typically pay interest quarterly.
- An investor wants to maximize income using debt securities. Which of the following lists rank securities from the least suitable to the most suitable recommendation if income is the investment objective?
- Convertible bond, income bond, nonconvertible bond
- Treasury bills, convertible bond, income bond
- Income bond, convertible bond, nonconvertible bond
- Nonconvertible bond, convertible bond, income bond
Correct answer: Income bond, convertible bond, nonconvertible bond
The income (or adjustment) bond is the least suitable because it is issued by companies coming out of bankruptcy with interest payable only if the money is available. Therefore, it is not suitable given the objective. A convertible bond has a lower coupon than a nonconvertible bond because of the convertibility feature. Therefore, if seeking to maximize income, the corporate bond would be the most suitable of the three choices (from least to most: income bond, convertible bond, and nonconvertible bond).
- A corporation coming out of a bankruptcy proceeding would probably find it most attractive to issue
- A subordinated debenture
- A collateral trust certificate
- A promissory note
- An income bond
Correct answer: An income bond
Income (or adjustment) bonds carry the unique characteristic of requiring payment of interest only when the issuer's income is sufficient. They are used primarily for companies undergoing a financial restructuring, usually after a bankruptcy filing. Each of the other choices would require timely payment, and failure to do so could result in the company's failure.
- Bondholders may not take action against the corporation if it fails to make interest payments for
- Subordinated debentures
- Income bonds
- Convertible bonds
- Debentures
Correct answer: Income bonds
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).
- Equipment trust certificates are commonly issued by
- Investor-owned utilities
- Manufacturing corporations
- Transportation companies
- Political subdivisions
Correct answer: Transportation companies
An equipment trust certificate finances rolling stock. The trustee takes legal title to the equipment, leases it back to the issuer, and releases title only when the certificates are retired, so the debt is secured by a specific, movable, easily resold asset. That structure fits a company whose principal assets are vehicles, which is why railroads, airlines and truckers are the classic issuers. An investor-owned utility pledges plant and real property under a first mortgage bond; a manufacturer raises money with debentures or mortgage bonds against its factories; and a political subdivision issues municipal securities, not corporate equipment trust certificates.
- Libby sees a tombstone advertisement for a new issue of Southwest Barge subordinated convertible debentures. The bonds will carry an 1141% coupon, are convertible into common stock at $10.50, and are being issued to the public at 100. The proceeds of the issue will be used specifically for purchasing new Southwest barges. Libby's concerns about the issue could include which of the following?
- The new barges might sink, and the collateral would be gone.
- She should not be concerned, as the bonds will be first in liquidation.
- The issue may have a junior claim to another security issue.
- The company might demand that she accept common stock for her bond.
Correct answer: The issue may have a junior claim to another security issue.
The word subordinated is the key to the question. A subordinated bond has other debt holders ahead of it in the event of liquidation. The barges do not serve as collateral, as the bonds are identified as debentures, and having to convert to common stock is not a threat because she is the one that will, if she desires, exercise the conversion privilege.
- One of your customers owns 10 HBH Creations 4.5% convertible callable debentures. The conversion price into HBH common stock is $40. With the current market price of the HBH Creations stock at $44, the company publishes a notice that all of the debentures will be called in thirty days at a price of 104. When the customer calls for your advice, you would probably recommend
- Converting the bonds into the common stock
- Accepting the call and redeeming the bonds
- Selling the debentures at the market price
- Selling the common shares at market prices
Correct answer: Converting the bonds into the common stock
Work out parity first. A $1,000 debenture with a $40 conversion price converts into 25 shares, and 25 shares at $44 are worth $1,100, so the debentures are worth 110 while the issuer is offering only 104, or $1,040. Converting captures the $60 per bond difference, which is the whole point of a call priced below parity: it forces conversion and relieves the issuer of the debt. Accepting the call takes the lower $1,040. Selling the debentures is no better, because once a call at 104 is announced the debentures trade down toward the call price. And selling the common stock is impossible: the customer owns no shares until he converts.
- A customer purchases 600 shares of the $100 par ABC 6.5% convertible preferred stock at $80. The conversion price is $20. If the common stock is trading two points below parity, the price of ABC common is
Correct answer: $14.
The conversion ratio is computed by dividing par value by the conversion price ($100 par / $20 = 5). Parity price of the common stock is computed by dividing the market price of the convertible by the conversion ratio ($80 / 5 = $16). $16 − 2 = $14. Alternatively, with the preferred stock selling 20% below its par value, the parity price will be 20% less than the conversion price. That would make the parity price $16 (20% of $20 = $4 and $20 minus $4 = $16). The question states that the common stock is two points below parity which would, once again, be $16 minus $2 or $14.
- ABC Corporation has issued a convertible preferred stock with a par value of $100. The stock is convertible at $40. The current market price of the stock is $80. It would be correct to state that the conversion ratio is
Correct answer: 2.5:1.
When a $100 par preferred has a conversion price of $40, the stockholder can convert into 2.5 shares. That is a 2.5:1 ratio. The current market price of the stock is only relevant if the question asks about the parity price (which is $32).
- An investor owns ten ABC 6s of 2045. The debentures have a conversion price of $50 with an anti-dilution provision. After ABC distributes a 20% stock dividend, the investor's position will be
- Ten ABC 6s of 2045 convertible into 16.67 shares
- Twelve ABC 6s of 2045 with conversion price of $50
- Ten ABC 6s of 2045 convertible into 20 shares plus forty additional shares
- Ten ABC 6s of 2045 with a conversion price of $41.67
Correct answer: Ten ABC 6s of 2045 with a conversion price of $41.67
This question deals with the anti-dilution provisions of a convertible security. When there is a stock dividend or a stock split, the holder of the convertible maintains the same equity proportion as before. With a conversion price of $50, the debenture is convertible into 20 shares ($1,000 ÷ $50). After a 20% stock dividend, the holder should be able to acquire 20% more shares. That makes the security convertible into 24 shares. Divide the $1,000 par value by 24 shares and the conversion price is now $41.67.
- The market price of a convertible bond depends on all of the following except
- The conversion prices of bonds from similar companies
- The value of the underlying stock into which the bond can be converted
- Current interest rates
- The rating of the bond
Correct answer: The conversion prices of bonds from similar companies
A convertible bond's current market price will be impacted by the value of the underlying stock into which the bond can be converted, current interest rates, and the rating of the bond. Conversion prices are not set in competition; therefore, the conversion prices of similar bonds would be of no concern regarding price.
- A 7% convertible debenture is selling at 101. It is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. If the stock were trading at parity with the debenture, the price of the stock would be
- $40.00.
- $25.25.
- $25.00.
- $43.91.
Correct answer: $25.25.
To determine the parity price of the common, first find the number of shares the debenture is convertible into (conversion ratio) by dividing par value by the conversion price ($1,000 / $25 = 40 shares). Next, divide the current price of the bond by the conversion ratio. The result is the parity price of the common stock. (1,010 / 40 = $25.25).
- An investor purchases a PQR convertible bond at 98 on June 18, 1994. The bond is convertible at $25, and on June 19, 1995, when the common stock is trading at $26 per share, the investor converts his bond into the stock. For tax purposes, these transactions will result in
- A $40 capital gain
- A $60 capital gain
- Neither gain nor loss
- A $40 capital loss
Correct answer: Neither gain nor loss
The process of converting a convertible bond into common stock is not a taxable event. When the stock is sold, the taxable event occurs.
- An investor interested in acquiring a convertible bond as part of her investment portfolio would
- Want the safety of a fixed-income investment along with potential capital appreciation
- Want the assurance of a guaranteed dividend on the underlying common stock
- Seek to minimize changes in the bond price during periods of steady interest rates
- Be interested in tax advantages available to convertible debt securities
Correct answer: Want the safety of a fixed-income investment along with potential capital appreciation
An investor who wants the safety of a fixed-income investment with the potential for capital gains would be most interested in purchasing a convertible bond. However, because convertible bonds can be exchanged for common stock, their market price tends to be more volatile during times of steady interest rates than other fixed-income securities.
- An investor owns 100 shares of the 4% $80 par convertible, callable, cumulative preferred stock issued by HBH Creations. With a conversion price of $20 and a current market price of $84, HBH issues a call of all of the outstanding preferred shares at $82. If the HBH Creations common stock is currently selling at $18 per share, what is likely the wisest choice for the investor?
- Hold on to the preferred stock
- Sell the preferred stock
- Convert the preferred into the common at the stated conversion rate
- Accept the call at $82
Correct answer: Accept the call at $82
Although issuers generally exercise the call privilege when the common stock's price is above the conversion price, there are cases when the call is exercised with the hope of eliminating some of the preferred shares with their preferred dividend payout. Let's go through the math of this question. With a par value of $80 and a conversion price of $20, each share of the preferred stock is convertible into 4 shares of the HBH Creations common stock. If the investor converts, those 4 shares are currently worth $18 each or a total of $72 for each share of preferred converted. That being the case, the investor's decision is, "Do I convert and have stock worth $7,200 (remember, there are 100 shares of the preferred, each convertible into 4 shares of the common), or do I accept the call at $82 per share of preferred totaling $8,200?" Why not sell the preferred stock at $84? Because the moment the call is announced, the price of the preferred will fall. Holding on to the preferred stock doesn't make sense because after the call date, the preferred will no longer receive dividends.
- Under what circumstances will a dilution of equity occur?
- The declaration of a semiannual stock dividend
- The refunding of debentures with mortgage debt
- The conversion of debentures into common stock
- The declaration of a three-for-one stock split
Correct answer: The conversion of debentures into common stock
Dilution means each existing share comes to represent a smaller slice of the company. When convertible bonds are converted the issuer creates brand-new shares and delivers them to the former bondholders, who were not shareholders before, so every existing holder's percentage of the company falls. A stock dividend and a stock split also increase the number of shares outstanding, but they distribute the new shares to the SAME owners in proportion to what each already holds, so no one's percentage changes. Refunding debentures with mortgage debt replaces one obligation with another and never touches the equity accounts.
- A 7% convertible debenture is selling at 101, and it is convertible into the common stock of the same corporation at $25. The common stock is currently trading at $23. What is the parity price of the debenture?
Correct answer: $920
To determine the parity price of the bond, first find the number of shares the debenture is convertible into (conversion ratio) by dividing par value by the conversion price ($1,000 / $25 = 40 shares). Next, multiply the current price of the common by the conversion ratio. The result is the parity price of the bond (40 shares × $23 = $920).
- ABC Company issues a 10% bond due in 10 years. The bond is convertible into ABC common stock at a conversion price of $25 per share. The ABC bond is quoted at 90. Parity of the common stock is
- $100.00.
- $36.00.
- $25.00.
- $22.50.
Correct answer: $22.50.
The bond is quoted at 90, so it is selling for $900. The parity price of the common stock is $22.50, calculated as follows: the bondholder could convert the bond into 40 shares of stock ($1,000 face amount / $25 per share = 40 shares). Because the bond has a current price of $900, divide $900 by 40 to get the underlying parity price (90% × $25 = $22.50).
- A DMF convertible bond (convertible into 25 shares) has increased 20% above par in market value. Which of the following would you expect the price of the DMF's common stock to be?
Correct answer: $48
$1,000 (par) + 20% = $1,200 / 25 shares = $48. Alternatively, it is ordinarily the 20% increase in the value of the common stock that has caused the bond to increase 20% in value. $1,000 divided by 25 shares equals $40 plus 20% equals $48.
- A customer owns a 7.5% ABC convertible bond currently trading at 115. The conversion price is $40. What is the parity price of the common?
Correct answer: $46.00
What does parity price mean? Here is what it says in the study materials: Calculating Conversion Parity Parity means that two securities are of equal dollar value (in this case, a convertible bond and the common stock into which it can be converted). The question is looking for the parity price of the common stock. That is the market price per share, where the total value of the stock received upon conversion equals the market price of the bond. There are two ways to do this. The first is generally the easiest to understand. We are told that the bond has a conversion price of $40. That means you can get 25 shares if you wish to convert. That is because the issuer is basically saying, "We owe you $1,000 and will let you spend it on our stock at $40 per share." Now that we know we can get 25 shares, what does each share have to be worth to equal $1,150? If you divide $1,150 by 25 shares, the result is $46. The other method to do this is as follows: The bond is selling at a 15% premium. To be equal to that, the stock must be selling at a 15% premium over the conversion price. $40 times 115% equals $46. If that makes sense to you, it is much faster than the first method.
- A bond convertible at $50 is selling at 105% of parity, while the common stock has a current market value of $45. What is the market value of the bond?
Correct answer: $945
When a bond is convertible at $50, it means the holder can exchange each $1,000 par value bond for the company's common stock at a rate of $50 per share. Dividing $1,000 (always use the par value, not the market value) by $50 results in a conversion rate of 20 shares per bond. With the bond convertible into 20 shares and the market price of each share currently $45, the parity price, the price at which the value of the stock and the bond are the same, is $900, (20 x $45). The question tells us that the bond is selling for 105% of the parity price. That would be $900 x 105% = $945. An alternative method is to recognize that the stock is selling for 10% below its conversion price ($45 is $5 less than $50 and $5 ÷ $50 = 10%). That means the parity price of the bond must be 10% below the par value, or $900 (which is 10% less than $1,000). Once you have the $900, multiply by 105% to arrive at the correct answer of $945.
- A customer purchased 10 ABC 9s of 2045 convertible debentures at 99. The debentures are callable at 101. The conversion ratio is 40. Some time later, the debentures are called while the common is trading at $24 and the debenture is trading at 98. Which of the following options would be most beneficial to the customer?
- Tender the bonds to the corporation
- Convert the bonds and sell the common stock
- Wait for a better offer from the corporation
- Sell the bonds
Correct answer: Tender the bonds to the corporation
First of all, recognize that the investor purchased 10 of the debentures. They have a coupon of 9% and mature in 2045. None of that is relevant to answering the question, but we want to be sure you understand the terminology.The option most beneficial to the investor is tendering the debentures to the corporation for $10,100 (10 times $1,010). If the debentures were sold on the market, the investor would receive $9,800 (10 times $980). If the debentures were converted into common, the investor would receive 400 common shares (40 shares per debenture times 10) that could be sold for their current price of $24, for a total of $9,600.
- One of your customers owns five JLO 5s of 2042. The debentures have a conversion price of $15. When the market price of the convertible is 80, the parity price of the stock is
- $18.00.
- $12.00.
- $15.00.
- $5.33.
Correct answer: $12.00.
A debenture with a conversion price of $15 is convertible into 66.66 shares ($1,000 ÷ $15). It is always the par value that is used, not the market price. To determine the parity price of the stock, divide the current market price of $800 by 66.66 and the answer rounds off to $12. Some students find it easier to recognize that the bond is 20% below its par value. To be equal (and that is what parity means), the stock must be 20% below the $15 conversion price (or 80% of it). Reducing $15 by 20% is a $3 reduction to $12 or taking 80% of $15 equals $12.
- What action could a corporation take that would result in the forced conversion of an outstanding convertible debt security?
- Exercise the call feature when the debt security’s conversion value exceeds the call price
- Reduce the dividends on the common stock to a rate lower than the interest on the debt security
- Exercise the conversion feature when the debt security’s conversion value exceeds the call price
- Reduce the coupon rate below the dividend rate on the common stock
Correct answer: Exercise the call feature when the debt security’s conversion value exceeds the call price
One of the investor benefits of a convertible security is that an increase in the market price of the underlying common stock will lead to a comparable increase in the price of the convertible. For example, when the market price of the common stock is $25 per share, a $1,000 convertible debenture with a conversion ratio of 50 shares per bond has a conversion value of $1,250 (50 shares time $25 per share). Because most convertibles are also callable, by calling the bonds at the stated call price (perhaps 102 or 103) the company can force the bond holders to convert the bonds. Using our example, why would investors hold onto the bonds knowing that, within about 30 days, they're going to get a check for $1,020 or so for each bond when they could convert and own shares worth $1,250 per bond. This is known as forced conversion. The coupon rate is fixed, and an investor would not want to convert to the stock just because the dividends on the stock are lower than the interest on the bond. ** This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- With a bearish outlook on the market, an investor would like to purchase something that will generate income now during current bearish conditions but would also be able to take advantage of capital appreciation should market sentiment turn bullish. Which of the following would be a suitable purchase recommendation that puts the investor in a position to do both?
- Nonconvertible bonds
- Cumulative preferred stocks
- Convertible bonds.
- Common stock
Correct answer: Convertible bonds.
A convertible bond would generate income from interest payments during the bear market, but if market sentiment becomes bullish, the bond can be converted into common stock, taking advantage of the change in market conditions. None of the remaining choices could fulfill both of these investment objectives.
- Convertible debentures offer which of the following benefits to investors?
- A coupon larger than similar straight debt pays
- A claim on assets ranking above secured lenders
- A forced conversion when the stock price climbs
- A common stockholder's upside with a debt floor
Correct answer: A common stockholder's upside with a debt floor
A convertible debenture can be exchanged for a fixed number of common shares, so when the stock rises the holder participates in the gain exactly as a stockholder would. When the stock falls the security still pays its coupon and still matures at par, and that stream of interest puts a floor under its price, so the downside is smaller than owning the stock outright. Investors pay for that combination by accepting a LOWER coupon than a comparable straight bond, never a higher one. A debenture is unsecured, so it ranks behind every secured creditor rather than ahead of them. And forced conversion is not a benefit at all: it is the issuer calling the bond to push the holder out of the debt security and into stock, taking the choice away from him.
- A corporation with an outstanding convertible debenture issue could force conversion by
- Publishing an announcement that the debenture holders have thirty days to tender their bonds at the call price
- Soliciting proxies from the common shareholders asking them to vote for mandatory conversion
- Decreasing the coupon rate on the debenture to a level where the dividend on the common stock provides a higher return
- Issuing new debentures with a higher coupon rate
Correct answer: Publishing an announcement that the debenture holders have thirty days to tender their bonds at the call price
Most convertible debt securities are callable, usually at a price slightly above the par value. When the price of the underlying common stock rises to a point where the converted value of the bond is worth more than the par value, issuers will frequently exercise their call privilege. Because the call price is usually significantly less than the converted value, it is only common sense that the debenture holders will exercise their conversion privilege. For example, when the market price of the common stock is $25 per share, a $1,000 convertible debenture with a conversion ratio of 50 shares per bond, has a conversion value of $1,250 (50 shares time $25 per share). By calling the bonds at the stated call price, perhaps 102 or 103, the company can force the bond holders to convert the bonds. Using our example, why would investors hold on to the bonds knowing that, within about 30 days, they're going to get a check for $1,020 or so for each bond when they could convert and own shares worth $1,250 per bond. This is known as forced conversion. Shareholders do note vote on a management decision to call in debt. The coupon rate on the debenture is fixed; the issuer doesn't have the ability to change it. ** This question deals with material not covered in your study materials, but it relates to recent rule changes and/or student feedback.
- Reggie owns a convertible bond that converts into 20 shares of common stock. The current market value of the bond was 11821 at the close on Friday, April 1. A 30-day call is announced before the opening on Monday, April 4, at a price of 102. The stock is trading at $57.75. What should Reggie do?
- Sell the bond
- Convert the bond into the stock
- Redeem the bond at the call price
- Hold the bond to maturity
Correct answer: Convert the bond into the stock
Reggie will not be allowed to hold the bond to maturity because it is being called. The real question is whether he should sell the bond, allow it to be called, or convert it to the underlying stock. Now that the call has been announced, the market value of the bond will fall to meet the call price. This occurs as a result of declining demand. (Who wants to buy a bond that is about to be called at a lower price?) Thus, redeeming the bond at the call price and selling the bond would both yield the same results: $1,000 times 102% equals $1,020. If he converts the bond, he will get the following results: 20 shares times $57.75 equals $1,155. Therefore, it makes the most sense to convert the bond.
- Which of the following statements regarding convertible bonds is not true?
- Coupon rates are usually lower than nonconvertible bond rates of the same issuer.
- Convertible bondholders are creditors of the corporation.
- If there is no advantage to converting the bonds into common stock, they would sell at a price based on their market value without the convertible feature.
- Coupon rates are usually higher than nonconvertible bond rates of the same issuer.
Correct answer: Coupon rates are usually higher than nonconvertible bond rates of the same issuer.
Coupon rates are not higher; they are lower because of the value of the conversion feature. The bondholders are creditors. If the stock price falls, the conversion feature will not influence the bond's price.
- XYZ Corporation has outstanding a 7% convertible bond currently trading at 102. The bond, which has a conversion price of $50, was issued with an antidilution covenant. If XYZ declares a 10% stock dividend, the new conversion price, as of the ex-date, will be
- $55.55.
- $45.45.
- $45.00.
- $55.00.
Correct answer: $45.45.
To compute a new conversion price, divide the current conversion price by 100% plus the percent increase in shares. $50 / 110% = $45.45.
- PDQ Corporation has a 6.25% $100 par value convertible preferred stock (conversion ratio of 4) outstanding. The stock has an antidilution covenant. If PDQ declares a 10% stock dividend, the antidilution covenant will adjust
- The par to $90
- The conversion price to approximately $27.50
- The conversion price to approximately $22.73
- The par to $110
Correct answer: The conversion price to approximately $22.73
When a $100 par value preferred stock is convertible into four shares of common stock, the conversion price is $25 per share, ($100 ÷ 4 = $25). The antidilution covenant means the investors will have the same conversion rights after a stock split or stock dividend as they had before. After a 10% stock dividend, each share of preferred stock will be convertible into 4.4 shares (4 shares x 110% = 4.4). The par value of the preferred stock does not change. Divide that $100 par value by the new number of shares to get the new conversion price. It looks like this: $100 ÷ 4.4 = 22.73. Alternatively, you can divide the original conversion price of $25 by 110% arrive at the same answer.
- A convertible corporate bond with a conversion price of $20 is trading at 115. The parity price of the common stock is
Correct answer: $23.
A conversion price of $20 means the conversion ratio is 50 (i.e., each bond can be converted into 50 shares of common stock). $1,150 / 50 = $23 parity price.
- A corporation has an outstanding issue of 8% convertible debentures with a conversion price of $25. The bond indenture contains an antidilutive clause guaranteeing the debt holders the right to maintain proportionate equity conversion in the corporation. If the company pays a 10% stock dividend to its common shareholders, how will that affect the debenture holders?
- Each debenture holder will receive a check for $100.
- The interest rate on the debentures will increase to 8.8%.
- The bonds will now be convertible at approximately 22.73.
- They will receive four shares of the common stock.
Correct answer: The bonds will now be convertible at approximately 22.73.
The antidilutive provision means the debenture holders will be able to convert into an equivalent share value as before. With a conversion price of $25, the bond is convertible into 40 shares ($1,000 ÷ $25). After the 10% stock dividend, they should be able to have 10% more shares, or 44 shares. That means the conversion price must be reduced. Divide $1,000 by 44 shares and the result is $22.73. Remember, anytime there is a stock dividend, prices go down.
- ABC Corporation has an outstanding 8% convertible bond that is callable at 102. Currently, the bond is trading at 101. The conversion price is $40, and the common stock is currently trading at $39.50. ABC announces a call at 102. To realize the greatest profit, a bondholder should
- Sell the bonds at the current market price
- Convert the bonds into common and sell the converted shares
- Continue to hold the bonds and receive interest payments
- Tender the bonds
Correct answer: Tender the bonds
The investor would realize the greatest sales proceeds by tendering the bond to the corporation for 102. Selling the bond at its current market value of 101 is not an attractive option. Converting the bond to common stock would result in 25 shares ($1,000 par converted at $40 = 25 shares) sold at $39.50 per share ($39.50 × 25 = $987.50). Once the call date passes, the issuer ceases interest payments making it unattractive to continue to hold the bonds.
- Phantom income is a characteristic of
- Zero-coupon bonds
- Convertible bonds
- American depositary receipts.
- Preferred stock
Correct answer: Zero-coupon bonds
Phantom income is the term describing income that is not received, but it is taxed. With zero-coupon bonds, the principal payoff at maturity represents receipt of the discount in lieu of periodic interest. However, each year, a portion of that discount is reported to the IRS on Form 1099 OID and is taxed as ordinary income unless the security is a municipal bond.
- An investor purchased a new issue corporate zero-coupon bond for $600. The bond has a maturity of 20 years. Six years later, the investor sells the bond for $740. For tax purposes, this would result in
- A capital gain of $100
- A capital loss of $280
- A capital gain of $20
- A capital loss of $20
Correct answer: A capital gain of $20
The $400 discount is accreted over the 20 years to maturity. That is an annual accretion of $20. After 6 years, that is $120, making the tax basis of the bond $720. Because the sale at $740 is $20 more than the basis, the investor has a long-term capital gain.
- An investor purchases a newly issued convertible bond at par. The bond is convertible at $25. Three years later, the underlying common stock is trading at $33 per share. If the investor sells the bond at the parity price,
- There is a long-term capital gain of $8 per share
- There is a long-term capital loss of $175
- There is a long-term capital gain of $320
- The investor has no gain and no loss
Correct answer: There is a long-term capital gain of $320
This question involves several steps. The first is to determine the conversion ratio in shares. A bond convertible at $25 per share has a share conversion rate of 40 shares ($1,000 ÷ $25). The second step is to compute the parity price. That is, what are those 40 shares worth? Multiply 40 shares by $33 per share and that equals $1,320. When the bondholder sells the bonds at parity, that $1,320 is received. The $320 profit over the $1,000 initial cost is a long-term capital gain. An alternative that might be easier for some is to look at the appreciation of the stock. It is $8 per share higher than the conversion price of $25. That represents an increase of 32% (8÷25). If the bond is at parity with the stock, its price must be 32% higher and that brings us again to the $1,320 price.
- An investor purchases a zero coupon bond at a price of 64. The bond matures in nine years. Five years later, the investor sells the bond at a price of 80. This would result in
- No gain and no loss
- A long-term capital gain of $160
- A long-term capital loss of $200
- A long-term capital loss of $40
Correct answer: A long-term capital loss of $40
This question deals with accretion of the discount. The discount here is $360 (the difference between the $640 paid and the $1,000 maturity value). With nine years until maturity, the annual accretion is $360 divided by nine, or $40 per year. After five years, the bond's basis has increased by $200 ($40 times 5 years) to $840. The sale at $800 represents a long-term loss of $40.
- If a customer sells a zero coupon bond before maturity, gain or loss will be the difference between sales proceeds and
- Accreted value
- Original cost
- Discounted value
- Par value
Correct answer: Accreted value
Zero coupon bonds must be accreted for tax purposes. Each year, the annual accretion is taxable to the holder. In addition, the customer may adjust the cost basis of the zero upward by the amount of the annual accretion.
- An issuer may be able to diversify a single municipal bond issue by maturity because
- Every state issues municipal bonds
- Many municipal securities are very marketable
- Municipal securities are mostly long term
- Many municipal bonds are serial issues
Correct answer: Many municipal bonds are serial issues
Serial maturity means that within a single issue, portions of the issue mature at intervals. Municipal bonds typically mature serially.
- All of the following would be found in a bond resolution for a new municipal issue except
- The costs of the offering borne by this issuer
- The covenants restricting what the issuer does
- The maturity and call terms set for this issue
- The duties the issuer owes to the bond holders
Correct answer: The costs of the offering borne by this issuer
The bond resolution, or bond contract, is the issuer's authorising document and its contract with the bondholders. It describes the issue itself, including maturities, denominations and call provisions; it states the issuer's obligations to the bondholders; and it imposes the protective covenants the issuer promises to observe, such as rate, insurance and maintenance covenants. What it does not contain is the issuer's cost of doing the deal. Underwriting spread, bond counsel's fee and printing costs are settled between the issuer and its underwriters, have no effect on a bondholder's security, and are disclosed in the official statement rather than in the resolution.
- The unqualified legal opinion on a municipal bond states that
- The issue has cleared the additional bonds test
- The issuer has the power to bind itself legally
- The issuer has the money to service these debts
- The issue will find a ready market among buyers
Correct answer: The issuer has the power to bind itself legally
An unqualified legal opinion is bond counsel's flat conclusion, with no reservation attached, that the issuer was legally empowered to authorise and sell the securities and that the bonds are legal, valid and enforceable obligations of that issuer, and on a tax-exempt issue that the interest is exempt from federal income tax. That is a legal conclusion and nothing more. Counsel does not pronounce on whether the issuer can afford the debt, which is credit analysis and the rating agencies' work; does not certify that an additional bonds test has been met, which is an accounting and engineering question under the trust indenture; and says nothing about how well the bonds will sell.
- The bond resolution includes all covenants between
- The issuer and the trustee acting for the bondholders
- The issuer and the bond counsel
- The bond counsel and the bondholders
- The issuer and the Municipal Securities Rulemaking Board
Correct answer: The issuer and the trustee acting for the bondholders
The bond resolution describes not only the characteristics of the proposed offering, but also the obligations the issuer has to its bondholders.
- Which of the following documents would include information about the issuer's financial condition?
- Bond resolution
- Official statement
- Trust indenture
- Notice of sale
Correct answer: Official statement
The official statement is used to disclose all material information about the issuer that an investor would need to know to make a decision regarding issue purchase.
- A municipal bond dealer is making a bona fide quote. Which of the following statements regarding such a quote is true?
- The quote cannot represent an offer to sell bonds that the dealer does not currently own.
- The quote may not take into consideration any anticipated market movement.
- The quote need not be one that the dealer is prepared to act upon (buy or sell).
- The quote must have a reasonable relationship to fair market value.
Correct answer: The quote must have a reasonable relationship to fair market value.
A bona fide quote must have a reasonable relationship to fair market value and can be made in consideration of any anticipated market movement. A bona fide quote is one the dealer is prepared to buy or sell on, as opposed to a workable, nominal, or subject quote. On the offer side of a bona fide quote, a dealer may make an offer to sell bonds that it does not hold in its own inventory, but it must know where to obtain the bonds if they are needed to complete the transaction.
- Investor information about the financial condition of a municipal issuer is most likely found in
- The official notice of sale
- The Bond Buyer.
- The official statement
- The legal opinion
Correct answer: The official statement
The official statement, which is the disclosure document used in new municipal offerings, will describe the issue's financial condition in detail.
- A legal opinion that has restrictions placed on it by the municipality's bond counsel is called
- A restricted opinion
- An unqualified opinion
- A qualified opinion
- A contingent opinion
Correct answer: A qualified opinion
A qualified opinion is one where the bond counsel to the municipality places certain legal restrictions (qualifications) on the issue that must be disclosed to purchasers. An unqualified opinion has no restrictions.
- In most cases, new municipal bond issues are accompanied by a legal opinion. That legal opinion is drafted by bond counsel hired by
- The MSRB
- The municipal issuer
- The syndicate
- The managing underwriter
Correct answer: The municipal issuer
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.
- A municipal securities principal must approve all of the following except
- Legal opinions
- Each transaction in municipal securities
- The handling of written customer complaints
- The opening of new customer accounts
Correct answer: Legal opinions
Municipal securities principals are required to approve all new customer accounts, all municipal transactions, and the handling of customer complaints. Legal opinions are prepared by bond counsel to determine the authority of an issuer and tax treatment of new municipal issues.
- Which of the following would be most likely to require a mandatory sinking or surplus fund?
- A regional public housing bond
- A municipal water revenue bond
- A county tax anticipation note
- A general obligation city bond
Correct answer: A municipal water revenue bond
A sinking or surplus fund is a covenant written into a revenue bond's trust indenture. Because no taxing power stands behind the debt, the issuer promises to divert a stated portion of the facility's net revenue each period into a fund reserved for retiring the bonds, and a water and sewer system is the classic self-supporting enterprise that carries it. A tax anticipation note is short-term borrowing repaid in one lump from taxes about to be collected, so there is nothing to sink. General obligation bonds, a city's included, are serviced from the general fund and secured by the taxing power. Public housing bonds rest on federal contributions rather than on a revenue pledge.
- All of the following statements regarding municipal bond official statements are true except
- All retail purchasers of a new municipal bond issue must receive a final official statement
- A retail customer must receive an official statement no later than the settlement date
- An official statement must be delivered only upon request of a retail customer
- A municipal securities broker-dealer may satisfy the delivery requirements by providing a notice advising the customer how to obtain the official statement from Electronic Municipal Market Access (EMMA)
Correct answer: An official statement must be delivered only upon request of a retail customer
A final official statement must be delivered to retail buyers of a new issue on or before the settlement date. With today's technology, most investors receive their official statement through EMMA.
- Your broker-dealer has prepared an advertising piece for general distribution to all of its retail customers regarding numerous option strategies. Filing the piece with FINRA is
- Required within 10 business days of the time it is first used or published
- Required at least 10 business days before first use or publication
- Required to occur no later than the end of the month during which it was used
- Not required
Correct answer: Required at least 10 business days before first use or publication
Filing with FINRA is required at least 10 business days before first use or publication for retail communications having to do with options.
- An unqualified legal opinion means that
- The issue is legal, but certain contingencies may limit the flow of funds in the future
- The underwriter has failed to disclose sufficient information to qualify the issue
- The bond counsel has rendered an opinion without any qualifying limitations
- The interest is not exempt from state or local taxes
Correct answer: The bond counsel has rendered an opinion without any qualifying limitations
An unqualified legal opinion means that the bond counsel found no problems with the issue. A qualified opinion means that the issue is legal, but certain contingencies exist. For example, the bond counsel might render a qualified opinion because authority to tax is in question or the issuer does not have clear title to the property.
- A municipal bond dealer gives your firm's trading desk an estimate of a municipal security's market value. This is
- A workable indication
- Holding a quote
- A nominal quote
- A firm quote
Correct answer: A nominal quote
A nominal, or subject, quotation indicates a dealer's estimate of a security's market value. Nominal quotations are provided for informational purposes only and are permitted if the quotes are clearly labeled as such. A workable indication is usually a firm bid price from a dealer and holding a quote is one that is firm for a specified time.
- A qualified legal opinion issued for a municipal bond underwriting means that
- The bond counsel is considered competent
- The legal opinion is qualified with restrictions and conditions
- The bond attorney is qualified to express her opinion on the bond
- The revenue bond issue has certain debt limitations
Correct answer: The legal opinion is qualified with restrictions and conditions
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.
- A municipal revenue issue's flow of funds statement is contained in
- The notice of sale
- The bond contract
- The legal opinion
- The agreement among underwriters
Correct answer: The bond contract
The bond contract describes the nature of the contract and the issuers' duties to bondholders. The bond contract is a more expansive document than a bond resolution. The contract is comprised of the bond resolution (or trust indenture) and other security agreements and laws in force at the time of bond issuance.
- Your FINRA member firm takes 100 GO bonds from a municipal bond dealer out-firm for one hour. This means that
- After one hour, your firm owns the bonds
- Your firm controls the bonds for one hour
- The municipal bond dealer has one hour to sell these bonds to another member at a greater price
- The municipal bond dealer has one hour to change the quoted price
Correct answer: Your firm controls the bonds for one hour
A municipal securities dealer may quote a bond price that is firm for a certain time. This is called an out-firm with recall quote. Generally, these quotes are firm for an hour (or half hour) with a five-minute recall period. During this time, the municipal dealer cannot offer those bonds to anyone else—they are under the control of your firm.
- A quotation on a municipal security between dealers is assumed to be
- A workable quote
- An indication of interest
- A bona fide quote
- A nominal quote
Correct answer: A bona fide quote
Municipal bond quotations between dealers are required to be bona fide, or firm, quotes. They are required to be fair and reasonably related to the current market.
- One of the benefits of adding a sinking fund provision to a municipal bond issue is that the bond will generally
- Receive a higher rating
- Have a longer maturity
- Receive more favorable tax treatment
- Carry a higher coupon
Correct answer: Receive a higher rating
Adding a sinking fund provision to a bond issue invariably results in a higher rating for the security. The fact that money is put aside to repay the principal on a regular basis offers greater safety. A higher rating results in a lower coupon, not a higher one. After all, the higher the rating, the lower the risk, and that means the issuer is able to borrow at a lower cost. Although the sinking fund itself does not change the maturity date, having a sinking fund enables the issuer to use partial calls to redeem the bond ahead of the final maturity date. A sinking fund has nothing to do with tax treatment.
- Which of the following quotes represents a municipal dollar bond quote?
- A quote of 85.50 - 86.00
- A quote of 8.200 - 8.000
- A quote of 0.085 - 0.086
- A quote of $850 - $870
Correct answer: A quote of 85.50 - 86.00
A dollar bond is a municipal term bond quoted as a price rather than as a yield, and bond prices are always stated as a percentage of the $1,000 par amount. A market of 85.50 bid, 86.00 offered therefore means 85.5% of par, or $855, bid and 86.0% of par, or $860, offered. A quotation running 8.200 to 8.000 is a basis, or yield, quote, the normal form for serial bonds, where the bid side carries the higher yield because a higher yield is a lower price. A quote of 0.085 to 0.086 is simply a yield written as a decimal. And $850 to $870 states actual dollars per bond, which is not how any bond quotation is expressed.
- All of the following municipal securities are quoted on a yield basis except
- Serial bonds
- Tax anticipation notes
- Term bonds
- Secured bonds
Correct answer: Term bonds
Term bonds, or dollar bonds, are quoted like corporate bonds as a percentage of par. All other municipals are quoted in basis.
- All of the following are allowable municipal dealer quotes except
- A bid wanted circulated to fellow dealers
- An offer wanted sent out to other dealers
- A bona fide bid good for an instant trade
- A nominal quote put out without any label
Correct answer: A nominal quote put out without any label
MSRB Rule G-13 requires that a quote a municipal dealer disseminates be bona fide, that is, a bid or offer at which the dealer is actually prepared to trade. The rule also permits requests for quotations from other dealers, the familiar bid wanted and offer wanted, because those solicit a market rather than state one. A nominal quote, given for informational purposes only, is likewise permitted, but only on the condition that it is identified as nominal when it is given. An unidentified nominal quote is indistinguishable from a firm quote to the dealer receiving it, and that is the form of quotation the rule prohibits.
- Which of the following securities is typically sold with the legal opinion attached?
- Municipal bonds
- Participating preferred stock
- U.S. Treasury issues
- Corporate bonds sold under the Trust Indenture Act of 1939
Correct answer: Municipal bonds
The legal opinion is supplied by bond counsel, an attorney specializing in securities law. The opinion states that the municipal bond is legal and binding on the issuer. If the bond's interest is tax-exempt, that opinion is stated as well. Legal opinions are exclusive to municipal securities.
- A 4% municipal bond maturing in 2040 has a current yield of 4.4% with a yield to maturity of 4.7%. What is the basis of this bond?
Correct answer: 4.7%
The basis of a municipal bond is its yield to maturity (YTM). The terms are used interchangeably. Therefore, in this question, the basis is the 4.7% stated as the YTM. There will be some questions on the exam similar to this where no math is involved. Just be sure to know your definitions.
- In a new municipal offering, who is responsible for hiring bond counsel?
- The syndicate manager
- The issuer
- Syndicate members
- The Municipal Securities Rulemaking Board
Correct answer: The issuer
The issuer hires a bond attorney to render an opinion on the prospective municipal offering.
- The call provisions of a municipal issue would be detailed most completely in
- The bond resolution
- The Bond Buyer.
- The legal opinion
- The official notice of sale
Correct answer: The bond resolution
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.
- Whether funds should be allocated to support the debt service on a moral obligation bond in default is usually determined by
- The state comptroller
- The indenture trustee
- The state legislature
- The governor's office
Correct answer: The state legislature
A moral obligation bond carries no legal pledge of state money. The statute authorising it typically permits, but never requires, the state legislature to appropriate funds to replenish a depleted debt service reserve, a step known as legislative apportionment. Because only the legislature can appropriate state money, only the legislature can decide whether the shortfall is made good. The governor may request or recommend such an appropriation but cannot enact one. The indenture trustee administers whatever funds it is given and has no power to create them. And the comptroller merely disburses money the legislature has already appropriated.
- You have a high-income client who wishes to maximize his after-tax interest income. Which of the following investments might not meet your client's objective?
- An AA-rated general obligation bond
- An AA-rated municipal turnpike bond
- An AA-rated grant anticipation note
- An AA-rated industrial revenue bond
Correct answer: An AA-rated industrial revenue bond
All four pay interest exempt from federal income tax, but an industrial revenue bond is a PRIVATE ACTIVITY bond: the municipality issues it and a private corporation occupies and pays for the facility. Interest on most private activity bonds issued after August 1986 is a tax preference item that must be added back when the alternative minimum tax is computed, so a high-income client may find part of that interest taxed after all and his after-tax income short of what he expected. A general obligation bond, a turnpike revenue bond financing a public facility, and a short-term grant anticipation note are all public-purpose issues and carry no AMT preference.
- All of the following municipal bonds would be defined as revenue bonds except
- New housing authority bonds
- General obligation bonds
- Special tax bonds
- Special assessment bonds
Correct answer: General obligation bonds
A general obligation bond (GO) is not a revenue bond because it is backed by something other than a revenue-producing project. In general, the backing for GO bonds is the taxing ability of the issuer. That ability to tax is why they are frequently referred to as "full faith and credit" bonds. Revenue bonds include industrial development revenue bonds, special tax bonds, special assessment bonds, new housing authority bonds, and moral obligation bonds.
- A city's day-to-day operational expenses may be met by the issuance of
- Grant anticipation notes (GANs)
- Bond anticipation notes (BANs)
- Credit-linked notes (CLNs)
- Tax anticipation notes (TANs)
Correct answer: Tax anticipation notes (TANs)
When a city needs short-term cash flow to meet ordinary operating expenses (e.g., to meet the payroll for city employees), it issues TANs. These notes are paid off when the city collects the expected tax revenues.
- Which of the following are funded by general tax receipts?
- Bond anticipation notes (BANs)
- Hospital revenue bonds
- Tax anticipation notes (TANs)
- Revenue anticipation notes (RANs)
Correct answer: Tax anticipation notes (TANs)
Municipalities issue TANs to raise funds immediately. The community expects general tax revenues to generate the necessary funds to pay off the notes. RANs are eventually funded by revenues other than tax receipts, and BANs are eventually funded through the sale of bonds.
- All of the following characteristics regarding industrial development bonds (IDBs) are true except
- Funds from the lease are used to pay the principal and interest on the bonds
- The bonds are normally backed by the full faith and credit of the municipality
- The funds are used to construct a facility for a private corporation
- The bonds are issued by municipalities or other governmental units
Correct answer: The bonds are normally backed by the full faith and credit of the municipality
IDBs are issued by a municipality, and the proceeds are used to construct facilities or purchase equipment for a private corporation. The corporation leases the facilities or equipment, and funds from the lease are used to repay investors. In addition to a first mortgage on the property, IDBs are backed by the full faith and credit of the corporation (not the municipality).
- It is not uncommon for municipal revenue bonds to have a catastrophe call provision. Another term that might be used for this provision is
- Unplanned call
- Unexpected call
- Extraordinary call
- Premium call
Correct answer: Extraordinary call
An extraordinary call can occur at an unknown point in time prior to maturity. The issuer has the right to call the bonds, generally at par, when a certain event occurs, typically a catastrophe. Although catastrophe calls are unplanned or unexpected, the term that will be used for this type of call is extraordinary.
- All of the following would be considered when evaluating a municipal revenue bond's creditworthiness except
- Competing facilities
- Management expense
- Collection ratio
- Coverage ratio
Correct answer: Collection ratio
The collection ratio shows the percentage of property taxes that are collected. This would be relevant in evaluating general obligation bonds, which are backed by the taxing authority of the issuer. Revenue bonds, however, are backed by user fees, not taxes.
- Which of the following governmental bodies receive the least amount of their revenues from property taxes?
- County governments
- School districts
- State governments
- Municipalities
Correct answer: State governments
State governments generally do not assess property (ad valorem) taxes. These are assessed by local governments. Generally, state governments receive most of their income from sales and income taxes.
- A city has issued bonds to construct a new sewage treatment facility. If the bonds are not backed by the full taxing authority of the city, all of the following statements about the bond issue are true except
- If earnings fall short of the amount needed to make principal and interest payments, the debt service reserve can be used
- The disbursement of principal and interest payments must be approved semiannually by the state public service commission
- There is no debt limitation on the issue
- The interest on these bonds is not considered a preference item for the alternative minimum tax
Correct answer: The disbursement of principal and interest payments must be approved semiannually by the state public service commission
As an exclusion question, we are looking for the false statement. The public service commission would have no approval power over revenue bond interest and principal payments. Because the bond is not backed by the taxing authority of the city, it is a revenue bond rather than a general obligation bond. The funds for payment of interest and repayment of principal are generated through the fees paid by those using the city's water and sewage facilities. Being a public, rather than private, facility, these would not be alternative minimum tax bonds.
- Which of the following investment vehicles has the highest credit risk?
- General obligation bonds
- Industrial revenue bonds
- New Housing Authority bonds
- Ginnie Mae pass-through certificates
Correct answer: Industrial revenue bonds
The industrial revenue bonds would have the highest risk because debt service is the responsibility of the corporation leasing the facility rather than the issuing municipality.
- In safety of principal, general obligation municipal bonds are considered second only to
- AAA-rated finance notes and debentures
- Public utility and railroad debentures
- Direct Treasury and agency obligations
- First-mortgage and rolling stock bonds
Correct answer: Direct Treasury and agency obligations
Nothing in the domestic market is regarded as safer than direct obligations of the U.S. Treasury and the securities of federal agencies, which carry either the full faith and credit of the federal government or its sponsorship. General obligation municipal bonds, backed by a state or local government's power to tax, rank immediately behind them. Every corporate obligation listed depends on the credit of a private company that can fail, and a rating or a pledge of collateral does not change that: a AAA-rated note, a utility or railroad debenture, and a bond secured by a first mortgage or by equipment held in trust all rank below governmental credit.
- If industrial development bonds are called because of condemnation, this would be covered under which of the following clauses in the bond indenture?
- Catastrophe
- Refunding
- Refinancing
- Defeasance
Correct answer: Catastrophe
Condemnation is considered a catastrophe and only applies to revenue bonds.
- Which of the following types of municipal bond issues is associated with a flow of funds?
- Tax anticipation notes (TANs)
- General obligation (GO) bonds
- Revenue bonds
- School district bond
Correct answer: Revenue bonds
The flow of funds only relates to municipal revenue bonds. It describes the priority of disbursing revenues from the project. TANs are backed by taxes to be collected, while GO bonds are backed by the issuer's taxing authority. School districts are funded by GO bonds.
- Which of the following bonds may be secured by a leaseback arrangement?
- Lease-rental bonds
- Variable-rate demand obligations
- Toll-bridge bonds
- Housing authority bonds
Correct answer: Lease-rental bonds
Certain revenue bonds—called lease-rental bonds—are secured by a leaseback arrangement. For example, the state may set up an agency to construct a new office complex to house all state agencies. This authority issued the bonds. Once the facility is built, the state leases the complex from that authority. The bonds are backed by the lease payments.
- Long-term securities issued by municipalities that use a Dutch auction method to reset short-term interest rates known as clearing rates are
- Real estate investment trusts (REITs)
- American depositary receipts (ADRs).
- Auction rate securities (ARS)
- Collateralized mortgage obligations (CMOs)
Correct answer: Auction rate securities (ARS)
ARS are long-term securities issued by municipalities that use a Dutch auction to reset interest rates at short-term intervals. The reset rate is known as the clearing rate and establishes the rate paid during the period following the auction.
- An investor anticipating a rise in interest rates would likely purchase
- Long-term zero-coupon bonds
- Variable-rate demand notes
- High-coupon callable bonds
- Long-maturity Treasury bonds
Correct answer: Variable-rate demand notes
When market rates rise, a bond with a fixed coupon must fall in price until its yield matches the market, and the longer the maturity and the lower the coupon the further it falls, which makes a long-term zero the worst thing to hold into rising rates. A variable-rate demand note behaves the other way: its coupon is reset periodically against a market index, so as rates climb the income climbs with them and the price stays anchored near par. A call feature serves the issuer and it serves him when rates FALL, not when they rise. And a long Treasury bond, whatever its credit, carries the same interest rate risk as any other long fixed-coupon obligation.
- A calamity (catastrophe) call may be made by a municipal issuer if
- The issuer has accumulated excess money in its surplus account
- The issuer must call outstanding bonds on a predetermined schedule as outlined in the bond contract
- A building constructed with revenue bond financing has been condemned
- Interest rates have fallen
Correct answer: A building constructed with revenue bond financing has been condemned
A calamity call is also known as a catastrophe call. If a facility built with revenue bond financing is destroyed or condemned, the issuer must call the bonds with the bulk of the funds provided by insurance proceeds.
- Which of the following would not be found in a municipal revenue bond resolution?
- Reporting requirements regarding revenues collected
- Conditions of the maintenance covenant
- Underwriting agreement
- Terms of the rate covenant
Correct answer: Underwriting agreement
The bond resolution, which is also referred to as the bond contract, contains the requirement for the municipality to properly keep the facilities books, reporting requirements regarding revenues collected, conditions of the maintenance covenant, and terms of the rate covenant. The underwriting agreement is between the municipality and underwriters, and it spells out the terms agreed to for the underwriting of a new issue.
- All of the following are characteristics of Section 8 bonds except
- They are also known as Public Housing Authority (PHA) and New Housing Authority (NHA) bonds
- They are backed by the U.S. government.
- They are a type of general obligation bond
- They are used to finance subsidized housing
Correct answer: They are a type of general obligation bond
Section 8 bonds are municipal revenue bonds backed by the U.S. government to help finance low- and moderate-income public housing. They are also known as PHA or NHA bonds.
- Municipal bonds that are backed by the income from specific projects are known as
- Income bonds
- Revenue bonds
- General obligation bonds
- Debenture bonds
Correct answer: Revenue bonds
Principal and interest on municipal revenue bonds are paid from revenues of a particular project, whereas general obligation bonds are backed by the full taxing authority of the municipality.
- A municipal bond, issued with a covenant that states, "If revenue collections are not sufficient to meet debt service requirements, the issue will be backed by the full faith and credit of the municipality," is known as
- A moral obligation bond
- A Section 8 bond
- A double-barreled bond
- A contingent liability bond
Correct answer: A double-barreled bond
When a municipal bond is backed by both a source of revenue and the taxing ability of the issuer, this is referred to as a double-barreled bond.
- An investor has purchased a municipal certificate of participation (COP). COPs can be characterized by all of the following except
- They would require voter approval before a municipality could issue them
- The holder of a COP could foreclose on the asset generating the revenue in the case of default
- The holder of the COP participates in lease or loan payments from a specific piece of equipment or facility purchased or built by the municipality
- They are a form of municipal revenue bond
Correct answer: They would require voter approval before a municipality could issue them
COPs are considered revenue issues and, therefore, do not require voter approval. They are a form of lease revenue bond that allow the holders of the certificates to participate in some revenue stream (lease or loan payments) associated with land, equipment, or facilities purchased or built by the municipality. They are unique in that in the case of default, the holders of the COPs could foreclose on the asset associated with the certificate.
- A customer purchased a full faith and credit bond. This bond would be known as
- A sinking or surplus fund bond
- A general obligation bond
- A revenue bond
- A moral obligation bond
Correct answer: A general obligation bond
General obligation bonds are also known as full faith and credit bonds.
- If a municipal bond rated BBB is prerefunded, all of the following statements are true except
- The marketability of the issue will decrease
- Funds required to meet debt servicing have been set aside in escrow
- The rating of the issue will increase
- The issue is now backed by U.S. government securities.
Correct answer: The marketability of the issue will decrease
When funds are escrowed to call in a bond at a predetermined call date, the bond is said to be prerefunded. The money set aside is invested in government securities, which makes the issue very safe and highly marketable. The rating of prerefunded bonds is AAA, as they are now backed by U.S. government securities.
- All of the following statements regarding municipal revenue bonds are true except
- The bonds usually outlive the facility they financed
- The issuer usually faces no statutory debt limit now
- The bonds may be sold by an interstate authority too
- The debt service usually comes from facility revenue
Correct answer: The bonds usually outlive the facility they financed
A revenue issue is scheduled so that it is retired while the facility is still earning. The maturity is set SHORTER than the useful life of the project, because once the asset is worn out there is no revenue left to pay debt service, so a maturity that outran the facility's life would be the false statement. The other three are true of revenue bonds. Because they are not secured by taxes, they generally fall outside the statutory debt limits that constrain general obligation borrowing and need no voter approval. They may be issued by authorities operating within one state or across state lines. And both interest and principal are paid out of the revenue the financed facility produces.
- When a securities professional refers to a bond as a full faith and credit issue, it is
- A moral obligation bond
- A general obligation bond
- A special tax bond
- A revenue bond
Correct answer: A general obligation bond
General obligation bonds are payable from general funds, including taxes, and are often referred to as backed by the "full faith and credit" of the governmental entity.
- All of the following may be used to service special tax bond issues except
- Gasoline taxes
- Business license taxes
- Excise taxes
- Real estate taxes
Correct answer: Real estate taxes
Special tax bonds are sometimes included in the larger and more general category of revenue bonds. Bonds supported from the proceeds of specified income generators, such as gasoline, cigarettes, liquor, and business licenses, are special tax bonds. Ad valorem (real estate) taxes never service special tax bonds.
- If an investor purchases a bond anticipation note (BAN) that matures in one year, when will the investor collect the interest?
- At maturity
- Semiannually
- Quarterly
- Monthly
Correct answer: At maturity
BANs are short-term money market instruments. Interest is paid at maturity.
- All of the following might affect the credit rating of a municipal revenue issue except
- The quality of the facilities management
- The rate covenants set forth in the indenture
- The tax rates of nearby municipalities
- The debt service coverage ratio
Correct answer: The tax rates of nearby municipalities
The credit rating of a revenue issue would not be affected by tax rates in surrounding municipalities.
- Which of the following secures an industrial revenue bond (IDR)?
- Net lease payments made by the corporate lessee
- Ad valorem taxes levied by the state government
- The full faith and credit pledge of this issuer
- A special assessment against the benefited land
Correct answer: Net lease payments made by the corporate lessee
An industrial revenue bond is issued by a municipality or an authority it creates, but the municipality pledges none of its own money and none of its assets. The proceeds build a facility that is leased to a corporation under a net lease, and the corporation's lease payments are the only money available for debt service, which is why the issue is analysed and rated on the corporation's credit rather than the municipality's. No tax revenue is pledged, so neither ad valorem taxes nor the issuer's full faith and credit stands behind the bonds, and a special assessment against the properties benefited by an improvement secures a special assessment bond, a different structure altogether.
- A moral obligation bond is one where
- The governing legislature is empowered, but not obligated to appropriate funds to prevent the bond from going into default
- The board of directors of the entity is empowered, but not obligated to appropriate funds to prevent the bond from going into default
- The U.S. government is empowered, but not obligated to appropriate funds to prevent the bond from going into default.
- The bondholders are empowered, but not obligated to appropriate funds to prevent the bond from going into default
Correct answer: The governing legislature is empowered, but not obligated to appropriate funds to prevent the bond from going into default
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."
- Which of the following may not lead to an industrial development bond being called?
- The municipality is approaching a statutory debt limit.
- Interest rates are falling.
- Funds are available in the surplus account to call the bond.
- The facility is destroyed by a storm.
Correct answer: The municipality is approaching a statutory debt limit.
An issuer of industrial development revenue bonds is likely to call bonds to reduce interest costs when interest rates are falling, discontinue interest payments if the facility is destroyed by a natural disaster, or reduce debt if funds are available in a surplus account. Industrial development revenue bonds are not affected by the issuer's statutory debt limits, as they affect the issuance of general obligation bonds only.
- Another term for municipal overlapping debt is
- Refunded debt
- Double-barreled debt
- Coterminous debt
- Defeased debt
Correct answer: Coterminous debt
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.
- A variable-rate municipal bond investment's main advantage is that
- Its price should climb steadily as rates rise
- Its price should stay anchored near par value
- Its interest should escape both levels of tax
- Its terms should rule out an early redemption
Correct answer: Its price should stay anchored near par value
A variable-rate bond has no fixed coupon. At each reset date the coupon is adjusted to whatever the market rate then is, so the income the bond pays always reflects current rates. Because a buyer never has to be compensated with a discount or bid up with a premium, the price stays anchored near par whichever way rates move, and that price stability is the whole reason the structure exists. The price does not climb as rates rise; it stays put while the coupon does the moving. Exemption from federal and often home-state tax belongs to fixed-rate municipals just as much, so it is not this bond's particular advantage. And a variable coupon says nothing about redemption: many of these issues are callable, and many carry a put or demand feature instead.
- Which of the following would not be found within the protective covenants for a municipal revenue bond issue?
- The issue's rating
- Catastrophe clause
- Additional bonds test
- Flow of funds
Correct answer: The issue's rating
There are different sources for bond ratings, but they would not be found within the revenue issue's protective covenants. The municipality agrees to abide by the covenants, and a trustee appointed in the bond indenture supervises the issuer's compliance with them. Some common covenants include rate or fee (promise to maintain user fees high enough to pay expense and debt service) maintenance, insurance, additional bonds test, sinking fund, catastrophe, flow of funds, books and records, and call or put features.
- All of the following sources of revenue could be used to service general obligation debt except
- Ad valorem taxes
- Fines
- Sales taxes
- User charges
Correct answer: User charges
Historically, municipalities get most of their revenues from property taxes (ad valorem taxes). Other sources of revenue include sales taxes, income taxes, gasoline taxes, license fees, fines, and assessments. User charges would be used to service revenue bonds.
- All of the following are examples of short-term municipal obligations except
- Bond anticipation notes (BAN)
- State and local government securities (SLGS)
- Tax and revenue anticipation note (TRAN)
- Tax anticipation note (TAN)
Correct answer: State and local government securities (SLGS)
SLGS are issued not by a municipality, but by the U.S. Treasury Department to assist local governments in complying with arbitrage restrictions imposed by the IRS. The other choices are examples of short-term funding used by municipalities.
- A project that was funded with a revenue issue has been condemned by the state under an eminent domain proceeding. The outstanding bonds would be subject to which of the following call provisions?
- Catastrophe call
- Prerefunding call
- Defeasance call
- Refunding call
Correct answer: Catastrophe call
If a revenue project was condemned under eminent domain, the bonds would be subject to a catastrophe call.
- Which of the following details would not be found on the bond resolution for a revenue bond?
- The insurance covenant
- The maintenance covenant
- The rate covenant
- The tax covenant
Correct answer: The tax covenant
Unless something in the question refers to special taxes, revenue bonds do not have tax backing. The other items are included in the bond resolution (or trust indenture). The rate covenant is a promise to maintain rates sufficient to pay expenses and debt service. The maintenance covenant is a promise to maintain the equipment and facility/facilities. The insurance covenant is a promise to insure any facility.
- New Housing Authority (NHA) bonds are a relatively safe investment because
- Rental income provides a hedge against inflation
- Banks buy these bonds
- They are backed by the full faith and credit of the issuing municipalities
- The U.S. government guarantees a contribution to secure the bonds.
Correct answer: The U.S. government guarantees a contribution to secure the bonds.
NHAs are considered safe because, in addition to the backing of rental income, they are secured by a subsidy from an agency of the U.S. government. Thus, they are rated AAA.
- A municipal bond rating service would consider all of the following when evaluating a revenue bond except
- The engineer's feasibility study of the project
- The net operating revenue the facility produces
- The public's recorded attitude toward more debt
- The debt service coverage ratio of this project
Correct answer: The public's recorded attitude toward more debt
A revenue bond is repaid out of one enterprise's earnings, so the rating analysis is economic. The analyst asks whether the consulting engineer's feasibility study supports the projected demand, what net operating revenue the facility is actually producing, and how many times that revenue covers annual debt service. A community's attitude toward debt is a general obligation consideration: where the security IS the taxing power, voters who resist tax increases or defeat bond referendums weaken the credit. It has no bearing on whether a toll road or a water system earns enough to pay its own bonds.
- Each of the following choices are potential sources of funds associated with the backing of a revenue bond issue except
- Lease payments
- Ticket revenues
- Concessions
- Fines
Correct answer: Fines
Fines received by a municipality or a state may be used to service the debt of a general obligation bond. Often fines are levied for reasons that include parking tickets, traffic violations, and the late payments of taxes. Concessions and lease payments are sources of funds commonly associated with airport revenue bond issues. Ticket revenue is another term for user fees, as would be the case for the ridership revenue of a municipal bus service.
- In rating a general obligation (GO) bond, all of the following factors would be considered by an analyst except
- The tax collection ratio
- The total outstanding debt
- The flow of funds
- The public's attitude toward debt
Correct answer: The flow of funds
GO bonds are backed by the full faith and credit of a municipal issuer, which is based on its ability to levy and collect taxes. Therefore, among the considerations for an analyst, total outstanding debt, the tax collection ratio, and the public's attitude toward more municipal debt are prominent. The flow of funds is one of the protective covenants associated with municipal revenue bonds.
- A municipal revenue bond has a catastrophe call feature, but otherwise, is not callable. Which of the following statements regarding the features of this bond that must be described on a customer's confirmation is true?\
- It must be designated as callable.
- It must be designated as callable in the event of an act of God.
- It need not be designated as callable.
- It must be designated as subject to eminent domain.
Correct answer: It need not be designated as callable.
Catastrophe call provisions associated with municipal revenue bond issues are not included on customer confirmations. Only call provisions with specific dates are included on confirmations.
- The trust indenture of a revenue bond will show all of the following except
- The rate covenant
- The reoffering yields
- The revenue pledge
- The application of flow of funds
Correct answer: The reoffering yields
Reoffering yields are unrelated to trust indentures. However, the trust indenture for a revenue bond issue does include covenants (or promises) between the issuer and the trustee for the bondholders' benefit. Among these covenants are the flow of funds and the rate covenant.
- Revenue bond rate covenants require the user fees to be high enough to cover all of the following obligations of the issuing authority except
- The operations and maintenance
- The optional call provisions
- The debt service reserve fund
- The debt service
Correct answer: The optional call provisions
Optional call provisions are at the option of the issuer. Rate covenants of an issue will not require enough to be collected to cover a call on the bonds.
- You are having a discussion with one of your clients regarding suitable investments. The client is in a high-income tax bracket and has a high net worth as well. During the conversation, your client mentions several investments that he is thinking about that might be beneficial to him now. Of those listed, which would be the best recommendation?
- Noninvestment-grade corporate bonds
- A real estate investment trust (REIT)
- Municipal bonds
- A corporate blue-chip balanced mutual fund
Correct answer: Municipal bonds
Of the choices listed, only municipal bonds offer a tax consequence suitable for high-income, high-net-worth investors in the form of tax-free interest payments. Corporate bond interest, mutual fund dividends, and income earned from REITs are all taxable.
- Variable-rate municipal bonds are subject to all of the following risks except
- Issuer credit default
- Coupon reinvestment rates
- Secondary market liquidity
- Interest rate changes
Correct answer: Interest rate changes
The coupon on a variable-rate bond is reset periodically to the prevailing market rate, so a change in rates is absorbed by the income stream instead of by the price. The bond keeps trading at or near par whether rates rise or fall, and the holder therefore carries essentially no interest rate risk. That protection does not extend to anything else about the security. The issuer can still fail to pay, so credit risk is untouched. Because the coupon is cut when rates fall, interest received has to be put back to work at whatever the market then offers, so reinvestment risk is real. And these are municipal issues traded over the counter, where a holder who must sell can still meet a thin secondary market.
- Which of the following is considered a source of debt service for a city-issued general obligation (GO) bond?
- Revenue generated by a hospital
- Sales taxes
- Real estate taxes
- Tolls on roads
Correct answer: Real estate taxes
General revenues of a city municipality, such as real estate taxes or licensing fees, may be used to pay the debt service on a GO bond. State-issued GO bonds will also include sales taxes as a source of money. Usage revenue, such as that generated from toll roads or hospitals, would be associated with funding revenue bonds.
- Which of the following is a double-barreled bond?
- General obligation bond to construct a new grade school
- Hospital bond backed by revenues and taxes
- Anticipation note
- New Housing Authority (NHA) bond
Correct answer: Hospital bond backed by revenues and taxes
A double-barreled bond is backed by a defined source of revenue other than property taxes, as well as the full faith and credit of an issuer with taxing authority. NHA bonds are not double-barreled. If rental income from the housing cannot meet servicing costs, the shortfall is covered by the federal government. To be double-barreled, the issue must be backed by more than one municipal source.
- Which of the following is not a source of revenue for a municipal revenue bond issue?
- Tolls collected from motorists on a road
- User fees paid by the facility's patrons
- Ad valorem taxes levied on real property
- Special assessments on nearby landowners
Correct answer: Ad valorem taxes levied on real property
A revenue bond is serviced only by money the financed project itself produces. Tolls charged to motorists on a bridge or highway, user fees and charges paid by the people who use the facility, and in some structures special assessments levied on the specific properties an improvement benefits are all fund generators of that kind. Ad valorem property taxes are the general taxing power of the municipality, and that taxing power is exactly what backs a GENERAL OBLIGATION bond. If ad valorem taxes were pledged to the debt service, the issue would not be a revenue bond at all.
- All of the following items of information must be included in a municipal securities confirmation except
- The date of maturity that has been fixed by a call notice
- Whether the securities are fully registered or book entry
- An extraordinary call provision
- The capacity in which the broker-dealer acted
Correct answer: An extraordinary call provision
Municipal Securities Rulemaking Board rules require that certain information be included on all municipal confirmations, including the capacity in which the firm acted in filling the order, whether the bonds are in registered or book entry form, and any relevant call provisions. Information on catastrophe or extraordinary call provisions is not included on a confirmation because catastrophes have no planned dates of occurrence.
- It is not uncommon for municipal revenue bonds to have a catastrophe call provision. Another term that might be used to refer to this provision is
- An unplanned call
- A premium call
- An extraordinary call
- An unexpected call
Correct answer: An extraordinary call
An extraordinary call can occur at an unknown point in time prior to maturity. The issuer has the right to call the bonds, generally at par, when a certain event occurs, typically a catastrophe. Because catastrophe calls are unplanned or unexpected, the term that will often be used is extraordinary.
- A double-barreled bond would be defined as
- A bond that is exempt from both federal and state taxes
- A bond of a foreign issuer that is backed by the U.S. government, with the interest payable either in dollars or in foreign currency.
- A bond that has its principal and interest backed by revenues of a facility and the general taxing authority of a municipality
- A corporate bond that pays interest from ordinary income and revenue received from operating a facility for a municipality
Correct answer: A bond that has its principal and interest backed by revenues of a facility and the general taxing authority of a municipality
Double-barreled bonds have two sources of revenue to support them. They are municipal bonds.
- Which of the following bonds is issued to finance the construction of subsidized housing and is backed by rents and the taxing authority of the U.S. government?
- Special tax
- Section 8
- Special assessment
- Moral obligation
Correct answer: Section 8
Section 8 bonds, also known as Public Housing Authority bonds and New Housing Authority bonds, are used to finance subsidized housing. These bonds are backed by rental income. If this income is insufficient to service the debt, the U.S. government makes up the difference. Essentially, these are revenue bonds backed by the U.S. government, and are therefore AAA rated.
- 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
- Via grants from the federal government
- From both tax and other anticipated revenue
- Through the issue of long-term bonds
- From future tax revenue
Correct answer: Via grants from the federal government
GANs are short-term municipal notes issued in anticipation of funds via grants that the municipality is expecting from the federal government.
- With bonds subject to a gross revenue pledge, the first priority will be to pay
- The sinking or surplus fund
- Operation and maintenance
- Bond interest and principal
- The first lien on the property
Correct answer: Bond interest and principal
Bonds subject to a gross revenue pledge (gross lien revenue bonds) are backed by the gross revenues of the facility (meaning revenues before expenses). In this case, the first money disbursed is for payment of interest and principal. However, most revenue bonds only pledge net revenues to pay off revenue bonds. In the more common net revenue pledge, the first priority is operation and maintenance; the second priority is interest and principal.
- A bond resolution would most likely be found in an offering of
- Corporate bonds
- U.S. Treasury bonds.
- Unrated bonds
- Municipal bonds
Correct answer: Municipal bonds
Bond resolutions are most commonly found as part of the offering documents of a municipal bond issue. The bond resolution represents an official action taken by a state or local issuer with regard to the bonds.
- If a moral obligation bond goes into default, the only way bondholders can be repaid is
- By waiting for the issuer to become solvent again
- A court order
- Through legislative apportionment
- Through an asset liquidation
Correct answer: Through legislative apportionment
A moral obligation bondis a state- or local-issued, or state- or local-agency issued, bond. If revenues or tax collections backing the bond are not sufficient to pay the debt service, the state legislature has the authority to appropriate funds to make payments. That is the only way the bondholders can be repaid. The legislature rarely reneges on its moral obligation.
- All of the following information is included in a municipal bond resolution except
- Compensation paid to the underwriters
- An authorization to sell the securities
- Restrictive covenants that are binding on the issuer
- Any call provisions that allow the issuer to redeem the bonds before their scheduled maturity
Correct answer: Compensation paid to the underwriters
The bond resolution is the document in which the issuer authorizes the issuance of municipal securities. Among other things, the resolution describes the characteristics of the proposed issue and the issuer's duties to the bondholders. Compensation paid to the underwriters would be found in the official statement.
- In addition to their tax advantages, municipal bonds are often purchased for their safety. Your client wishing to purchase municipal bonds with the utmost in safety should buy
- New Housing Authority bonds
- Double-barreled revenue bonds
- Unlimited tax obligation bonds
- Self-supporting toll bonds
Correct answer: New Housing Authority bonds
New Housing Authority bonds, also called Public Housing Authority or PHA bonds, are secured by contributions the federal government contracts to make, so behind them stands the full faith and credit of the United States. That federal backing makes them the safest municipal security available and the right answer for a client whose first concern is safety. A double-barreled bond is strong because it adds a taxing-power pledge to a revenue pledge, and an unlimited tax bond rests on a state or local government's whole taxing power, but both depend on a municipal issuer rather than on the federal government. A self-supporting revenue bond depends on nothing but the earnings of one facility.
- Debt service on an industrial revenue bond is secured by
- Special assessments upon the benefited land
- Cigarette tax receipts pledged by the state
- Ad valorem taxes levied by the county board
- Net rental payments from the corporate user
Correct answer: Net rental payments from the corporate user
In an industrial revenue bond the municipality issues the paper but pledges no money of its own. A corporation occupies the financed facility under a net lease, and its rental payments are the sole source of debt service, which is why the credit of the bond is only as good as the credit of the corporation that signed the lease. No municipal tax revenue is available to the bondholders. Ad valorem taxes back a general obligation bond, a dedicated sales or excise tax backs a special tax bond, and an assessment charged to the properties that benefit from an improvement backs a special assessment bond.
- Revenue bonds may be called for all of the following reasons except
- Interest rates have fallen
- A provision in a sinking fund agreement is calling for a partial call
- The facility has been destroyed
- The issuer has reached a statutory debt limit
Correct answer: The issuer has reached a statutory debt limit
Statutory debt limits only apply to general obligation bonds.
- All of the following statements regarding a municipality's collection ratio are true except
- A high ratio is generally preferable to a weaker one
- A poor ratio may signal trouble on its revenue bonds
- The ratio may be taxes collected over taxes assessed
- The ratio generally follows property tax collections
Correct answer: A poor ratio may signal trouble on its revenue bonds
The collection ratio is taxes collected divided by taxes assessed, and it measures how much of the property tax a municipality levies it actually manages to bring in, so a high ratio is plainly better than a low one. It is a GENERAL OBLIGATION analysis tool, because it speaks to the strength of the taxing power that backs a GO bond. Revenue bonds are not paid from taxes at all; they are paid from the user fees, tolls and charges the financed facility collects. A municipality could collect a poor share of its assessed taxes while its revenue bonds continued to be paid on time, so linking a weak collection ratio to a revenue bond default is the statement that is false.
- Which of the following is limited in the case of a limited tax municipal bond?
- The total debt the issuer has now outstanding
- The kind of taxes pledged to service the debt
- The projects the bond proceeds may go towards
- The years the issuer may take to pay the debt
Correct answer: The kind of taxes pledged to service the debt
A limited tax bond is a general obligation whose backing has been narrowed. The issuer has pledged only a particular tax, a sales tax or a gasoline tax for instance, rather than its full and unlimited taxing power, so debt service can be paid from that named source and from nothing else. Because the security is narrower, such an issue comes to market at a higher yield than a conventional general obligation. The limitation is on the SOURCE of the money. How much debt an issuer may have outstanding is set by its statutory debt limit, the purposes proceeds may serve come from the authorising ordinance, and the time allowed to retire the debt is fixed by the maturity schedule.
- If an indenture has a closed-end provision, this means
- Additional issues have no lien on the revenue stream
- A sinking or surplus fund must be established
- Additional issues will have junior liens
- The bonds must be called before maturity
Correct answer: Additional issues will have junior liens
These additional issues are also known as junior lien bonds. Under a closed-end indenture, additional bonds issued against the same stream of revenues have a junior (subordinate) claim to those already outstanding unless the funds are required to complete construction of the facility.
- Special tax bonds are
- Backed by the ad valorem property levies
- Backed by the issuer's full taxing power
- Backed by the project's fees and charges
- Backed by gasoline or sales tax receipts
Correct answer: Backed by gasoline or sales tax receipts
A special tax bond is serviced by one or more designated taxes other than the property tax. Excise taxes on sales, cigarettes, fuel or alcohol are the usual pledges, and the tax chosen need not have anything to do with the project being financed. It is not backed by ad valorem property taxes, which are what secure a general obligation bond, and it is not backed by the issuer's full taxing power, since narrowing that power to one designated tax is exactly what makes the issue special. Nor is it self-supporting debt: a self-supporting revenue bond is paid from the fees and charges the financed project collects from its own users, while a special tax bond is paid from a tax levied on the community at large.
- An example of a taxable bond issued by a municipal government is
- A general obligation bond (GO)
- Series EE bonds.
- A Build America Bond (BAB)
- A tax anticipation note (TAN)
Correct answer: A Build America Bond (BAB)
BABs are municipal issues created under the Economic Recovery and Reinvestment Act of 2009 to assist in reducing the cost of issuing municipalities and to stimulate the economy. Bonds to fund municipal projects have traditionally been sold in the tax-exempt arena, but BABs are taxable obligations.
- Each of the following are generally used to service state general obligation bond issues except
- Motor vehicle license fees
- Real estate taxes
- Income taxes
- Sales taxes
Correct answer: Real estate taxes
State-issued municipals are backed by state revenues, including sales and income taxes, as well as fees for state-issued licenses and permits. States do not normally levy property (real estate) taxes. Real estate taxes—known as ad valorem taxes—are typically levied by local municipalities such as cities and counties.
