NASAA Series 65 — All Questions

During the contraction phase of the business cycle, which of the following typically occurs?

• a.Gross domestic product rises for at least two consecutive quarters
• b.Unemployment rises while corporate profits tend to decline✓
• c.Central banks typically raise rates to cool demand
• d.Consumer spending accelerates and profits expand

A contraction is marked by falling output, rising unemployment, weakening demand and declining corporate profits. Two consecutive quarters of rising GDP describe an expansion, not a contraction, and accelerating consumer spending with expanding profits is the expansion pattern. Central banks generally cut rates during downturns to stimulate activity; raising them to cool demand is typical of the late-expansion or peak phase.

An economist states that the money supply and general price level tend to move together over time. This view is most closely associated with which school of thought?

• a.Monetarist economics✓
• b.Keynesian economics
• c.Supply-side economics
• d.Behavioral economics

Monetarists, led by Milton Friedman, argue that changes in the money supply are the primary driver of inflation and nominal output. Keynesians emphasize aggregate demand and fiscal policy. Supply-siders focus on tax and regulatory incentives to production.

Which government body sets U.S. monetary policy by adjusting the federal funds target and open market operations?

• a.The Federal Open Market Committee of the Federal Reserve✓
• b.The Council of Economic Advisers within the Executive Office of the President
• c.The Securities and Exchange Commission, through its regulation of securities markets
• d.The U.S. Treasury Department, through its management of federal debt issuance

Monetary policy is conducted by the Federal Reserve, and specifically the Federal Open Market Committee (FOMC), which sets the federal funds target and directs open market operations. The Council of Economic Advisers only advises the President and sets no rates. The Treasury manages federal debt and, with Congress, conducts fiscal policy such as taxing and spending. The SEC regulates securities markets, not the money supply.

An investor expects $10,000 in 5 years and wants its present value at a 6% annual discount rate. Which statement is correct?

• a.A higher discount rate would raise the present value
• b.The present value equals $10,000 multiplied by 1.06 raised to the fifth power
• c.The present value is greater than $10,000
• d.The present value equals $10,000 divided by 1.06 raised to the fifth power✓

Present value discounts a future amount back to today by dividing by (1 + rate) raised to the number of periods. Because money has time value, the present value is less than the future $10,000. A higher discount rate lowers, not raises, present value.

A portfolio has an expected return of 9% and a standard deviation of 12%. What does the standard deviation measure?

• a.The portfolio's sensitivity to movements in the overall market relative to a benchmark index
• b.The excess of the portfolio's 9% expected return over the return on Treasury bills
• c.The strength of the linear relationship between the portfolio's returns and those of a benchmark
• d.The dispersion or variability of the portfolio's returns around its mean✓

Standard deviation is a statistical measure of total volatility, showing how widely returns are dispersed around their average. Sensitivity to the overall market is measured by beta, not standard deviation. The excess of expected return over the risk-free rate is a risk premium, a measure of reward rather than risk. The strength of co-movement with a benchmark is correlation, a separate statistic.

Two assets have a correlation coefficient of -1.0. What is the diversification implication?

• a.The assets are unrelated and move independently, offering moderate diversification
• b.The assets move perfectly together, so combining them provides no diversification benefit
• c.The assets move exactly opposite, offering maximum diversification benefit✓
• d.The assets move exactly opposite, so the portfolio's expected return must be zero

A correlation of -1.0 means two assets move in exactly opposite directions, so losses in one can be offset by gains in the other, giving the greatest diversification benefit. Independent movement describes a correlation near zero and gives only moderate benefit. A correlation of +1.0 describes assets moving in lockstep and gives no diversification. Opposite movement does not force the expected return to zero, since each asset keeps its own expected return.

A stock's beta is 1.5. If the market rises 10%, what does beta suggest about the stock's expected move?

• a.The stock is uncorrelated with the market
• b.The stock would be expected to rise about 6.7%
• c.The stock would be expected to fall about 15%
• d.The stock would be expected to rise about 15%✓

Beta measures systematic risk relative to the market; a beta of 1.5 means the stock is expected to move 1.5 times as much as the market. A 10% market gain implies an expected 15% gain. Beta above 1.0 indicates greater volatility than the market.

Which of the following is a leading economic indicator?

• a.The unemployment rate
• b.The average duration of unemployment
• c.Corporate profits reported for the prior quarter
• d.New building permits issued for housing✓

Leading indicators, such as new building permits and stock prices, tend to change before the broader economy does. The unemployment rate and average duration of unemployment are lagging indicators. Prior-quarter corporate profits reflect activity that has already occurred.

A company's current ratio is calculated as which of the following?

• a.Net income divided by total shareholders' equity
• b.Current assets divided by current liabilities✓
• c.Earnings before interest and taxes divided by interest expense
• d.Total liabilities divided by total assets

The current ratio measures short-term liquidity by dividing current assets by current liabilities. Net income over equity is return on equity, and total liabilities over assets is a leverage ratio. EBIT over interest expense is the interest coverage ratio.

An investor earns a 12% nominal return in a year when inflation is 4%. Using the approximate method, the real return is closest to which of the following?

• a.12%
• b.16%
• c.3%
• d.8%✓

The approximate real return is the nominal return minus the inflation rate, or 12% minus 4%, which is about 8%. The nominal 12% ignores the loss of purchasing power. Adding the two rates to get 16% reverses the adjustment. Dividing the nominal return by the inflation rate to get 3% is not a real-return calculation. Real return adjusts nominal gains for lost purchasing power, which is why it matters when judging whether an investment truly grows wealth.

Which measure best captures the total percentage gain from an investment, including both price change and reinvested income?

• a.Nominal yield
• b.Total return✓
• c.Current yield
• d.Coupon rate

Total return combines price appreciation and income (such as dividends or interest), giving the complete measure of performance. Current yield reflects only annual income relative to price. Coupon rate and nominal yield reflect only a bond's stated interest, not price changes.

The Consumer Price Index (CPI) is primarily used to measure which of the following?

• a.The inflation-adjusted value of all final goods and services produced within the country
• b.Changes in the price level of a basket of consumer goods and services✓
• c.The share of the labor force without work that is actively seeking employment
• d.Changes in the prices that producers receive for their output at the wholesale level

The CPI tracks the average change over time in prices paid by consumers for a representative basket of goods and services, and is a common inflation gauge. The inflation-adjusted value of total output is real GDP. The share of the labor force without work is the unemployment rate. Producer price changes at the wholesale level are measured by the Producer Price Index, a neighboring but different gauge.

Under the time value of money, which factor increases the future value of a single deposit?

• a.A shorter investment horizon with fewer compounding periods
• b.A higher interest rate compounded over more periods✓
• c.A lower interest rate over the same period
• d.Regular withdrawals of interest during the investment period

Future value grows with higher interest rates and more compounding periods, because each period's interest earns further interest. A shorter horizon means fewer periods of growth, and a lower interest rate means slower growth, so both reduce future value. Withdrawals remove money that would otherwise keep compounding, so they also reduce the future value of the deposit.

A yield curve that slopes downward, with short-term rates higher than long-term rates, is described as which of the following?

• a.A flat yield curve
• b.A normal yield curve
• c.A humped yield curve
• d.An inverted yield curve✓

An inverted yield curve occurs when short-term interest rates exceed long-term rates and is often watched as a potential recession signal. A normal curve slopes upward. A flat curve shows little difference between short and long maturities.

Which statement about the Sharpe ratio is correct?

• a.It divides the portfolio's total return by its standard deviation, without subtracting the risk-free rate
• b.It measures excess return earned per unit of systematic risk, using the portfolio's beta
• c.A lower ratio indicates better risk-adjusted performance when comparing two portfolios
• d.It measures return earned per unit of total risk, using standard deviation✓

The Sharpe ratio divides a portfolio's excess return over the risk-free rate by its standard deviation, measuring reward per unit of total risk. The risk-free rate is subtracted, so a ratio built on total return alone is wrong. Using beta as the risk measure describes the Treynor ratio. A higher Sharpe ratio, not a lower one, indicates better risk-adjusted performance.

An analyst using fundamental analysis of a common stock would most likely focus on which of the following?

• a.Chart patterns and trading volume trends used to forecast short-term price direction
• b.The company's earnings, revenues, and competitive position✓
• c.Support and resistance price levels plotted alongside momentum indicators
• d.The stock's 200-day moving average relative to its current market price

Fundamental analysis evaluates a company's financial statements, earnings, revenues, management, and industry position to estimate intrinsic value. Chart patterns, volume trends, support and resistance levels, and moving averages are tools of technical analysis, which studies price and volume history instead.

Which feature distinguishes preferred stock from common stock?

• a.Common stock pays a stated fixed dividend that must be paid before any preferred dividend is declared
• b.Preferred dividends rise and fall with company profits in the same way that common dividends do
• c.Preferred stock typically pays a fixed dividend and has priority over common in liquidation✓
• d.Preferred stock carries the same voting rights as common and ranks behind common in liquidation

Preferred stock generally pays a fixed dividend and ranks ahead of common stock for dividends and in liquidation, though it usually lacks voting rights. Common dividends are not fixed and are paid only after preferred dividends, so the reversed description is wrong. Preferred dividends do not fluctuate with profits the way common dividends can. Preferred holders usually do not vote like common holders, and they rank ahead of common, not behind it.

A bond is trading at a premium to par. Which relationship is true?

• a.The current yield and yield to maturity are lower than the coupon rate✓
• b.The yield to maturity exceeds the coupon rate, and the current yield falls in between
• c.The coupon rate, current yield, and yield to maturity are all equal to one another
• d.The current yield is below the coupon rate, but the yield to maturity is above it

When a bond trades above par (at a premium), its yield to maturity is below its coupon rate, and the current yield falls between the two, so both yields are lower than the coupon. A yield to maturity above the coupon describes a discount bond. All three measures are equal only when the bond trades at par. A premium bond cannot have a yield to maturity above its coupon even if its current yield is below the coupon.

Duration is best described as a measure of which of the following?

• a.The credit quality of the issuer, as measured by the rating assigned to the bond
• b.A bond's price sensitivity to changes in interest rates✓
• c.The number of years remaining until the bond's stated maturity date
• d.The total coupon income a bond will pay between purchase and maturity

Duration measures how sensitive a bond's price is to interest rate changes; a longer duration means greater price movement for a given rate change. It is expressed in years but is a weighted average of cash flow timing, not simply the time to maturity. Credit quality is shown by the rating, and total coupon income is a separate figure.

If interest rates rise, what generally happens to the price of an outstanding fixed-rate bond?

• a.The bond automatically converts to a floating rate
• b.The price falls✓
• c.The price is unaffected because the coupon is fixed
• d.The price rises proportionally with rates

Bond prices move inversely to interest rates, so when rates rise, existing fixed-rate bond prices fall. This inverse relationship is a core principle of fixed income. Longer-duration bonds fall more sharply than shorter-duration bonds for the same rate increase.

A bond with a 5% coupon and $1,000 par is purchased for $800. What is its current yield?

• a.4.00%
• b.8.00%
• c.6.25%✓
• d.5.00%

Current yield equals annual coupon income divided by market price, or $50 divided by $800, which equals 6.25%. Because the bond trades at a discount, the current yield exceeds the 5% coupon rate. Current yield ignores any gain realized at maturity.

An open-end investment company (mutual fund) sells and redeems its shares at which price?

• a.The market price at the moment the order is placed, set by supply and demand on an exchange
• b.The previous day's closing net asset value, locked in at the time the order is placed
• c.The net asset value per share, calculated at the next computed valuation✓
• d.A price set by the fund's board of directors each quarter, regardless of portfolio values

Rule 22c-1(a) requires a redeemable security to be sold or redeemed at a price based on the current net asset value next computed after receipt of the order, a practice known as forward pricing. Exchange-set market prices apply to closed-end funds and ETFs, not to open-end fund shares. Using the previous day's value is backward pricing, which the rule does not permit. A price set by the board each quarter would ignore daily portfolio values.17 CFR 270.22c-1(a)

Which statement about exchange-traded funds (ETFs) is accurate?

• a.ETFs are bought and redeemed by all investors only once per day, at the closing net asset value
• b.ETFs trade throughout the day on an exchange at market prices✓
• c.ETFs cannot track an index and must be actively managed by a portfolio manager
• d.ETFs cannot be bought on margin or sold short, unlike shares of listed common stock

ETFs trade intraday on exchanges at market-determined prices, unlike open-end mutual funds that transact at end-of-day net asset value. Once-a-day pricing describes mutual funds. Many ETFs are designed to track an index. Because they trade like stocks, ETFs can generally be bought on margin and sold short.

A U.S. Treasury bond differs from a corporate bond in which key respect?

• a.Treasury interest is exempt from federal income tax but subject to state and local income tax
• b.Treasury bonds are taxed the same as corporate bonds at the federal, state, and local levels
• c.Treasury interest is exempt from state and local income tax but subject to federal tax✓
• d.Treasury bonds carry a higher default risk than investment-grade corporate bonds of similar maturity

Interest on U.S. Treasury securities is subject to federal income tax but exempt from state and local income taxes, which sets it apart from corporate bond interest that is taxable at all levels. The reverse treatment, with federal exemption only, is not how Treasuries are taxed. Treasuries are backed by the full faith and credit of the U.S. government and carry minimal default risk, not higher risk than corporates.

Interest paid on most general obligation municipal bonds is generally treated how for federal tax purposes?

• a.Subject to a mandatory 20% federal withholding
• b.Exempt from federal income tax✓
• c.Taxed at the long-term capital gains rate
• d.Fully taxable as ordinary income at the federal level

Interest on most municipal bonds is exempt from federal income tax, which makes them attractive to investors in higher tax brackets. This tax advantage means municipal yields are often compared on a taxable-equivalent basis. Capital gains on munis, however, can still be taxable.

A call option gives the holder which right?

• a.The right to buy the underlying asset at the strike price✓
• b.The right to sell the underlying asset at the strike price
• c.The obligation to buy the underlying asset at the market price
• d.The obligation to sell the underlying asset at the strike price

A call option grants its holder the right, not the obligation, to buy the underlying asset at a fixed strike price before expiration. A put option, by contrast, grants the right to sell. The option writer, not the holder, takes on an obligation.

An investor who buys a put option is generally expressing which market view?

• a.Bearish on the underlying asset✓
• b.Expecting no change in volatility
• c.Bullish on the underlying asset
• d.Neutral, seeking only income

Buying a put gives the right to sell at the strike price, which becomes valuable if the underlying asset's price falls, reflecting a bearish outlook. Puts can also hedge a long position. A call buyer, by contrast, is typically bullish.

A fixed annuity differs from a variable annuity primarily because a fixed annuity:

• a.Places investment risk on the contract owner, whose benefits vary with separate account performance
• b.Offers an accumulation unit value that is repriced each business day and may fall below premiums paid
• c.Guarantees a stated rate of return with the insurer bearing investment risk✓
• d.Is regulated as a security, so a prospectus must be delivered to every purchaser before the sale

A fixed annuity guarantees a set rate of return, and the insurance company bears the investment risk. The other descriptions fit a variable annuity: investment risk sits with the owner, accumulation unit values change with the separate account subaccounts and can fall below premiums paid, and the contract is a security requiring registration and a prospectus. That shift of investment risk is the central distinction.

Which of the following best describes a zero-coupon bond?

• a.It is issued at par and pays all of its interest in a single payment at maturity
• b.It can be issued only by the U.S. Treasury, which strips the coupons from existing bonds
• c.It is issued at a discount and pays no periodic interest, maturing at par✓
• d.It is issued at par and its interest is taxed only when the bond matures, not as it accrues

A zero-coupon bond is sold at a deep discount and makes no periodic interest payments, returning full par value at maturity, so the investor's return is the difference between the purchase price and par. It is not issued at par, and no separate interest payment is made at maturity. Corporations and municipalities issue zero-coupon bonds too, and Treasury STRIPS are just one example. The accrued discount is generally taxed each year as original issue discount, not deferred until maturity.

A hedge fund is typically offered to which type of investor and under what structure?

• a.Any investor, through a registered open-end fund that offers daily redemption and low minimums
• b.Accredited or qualified investors through a private, less-regulated structure✓
• c.Only banks and insurance companies, through a structure registered under the Investment Company Act of 1940
• d.Only government pension plans, through an offering exempt from the Securities Act of 1933

Hedge funds are generally sold through private placements to accredited or qualified investors and are subject to lighter regulation than registered funds. They often use leverage, derivatives, and limited liquidity with lock-up periods. A registered open-end fund with daily redemption describes a mutual fund. Hedge funds are not limited to banks and insurers or to pension plans, and they usually avoid registration under the Investment Company Act rather than registering.

A real estate investment trust (REIT) must generally distribute what portion of its taxable income to shareholders to maintain favorable tax treatment?

• a.At least 90%✓
• b.At least 75%
• c.At least 95%
• d.More than 50%

To keep pass-through tax treatment, a REIT must pay dividends equal to at least 90 percent of its REIT taxable income under Internal Revenue Code section 857(a)(1). The 75 percent figure belongs to other REIT qualification tests, such as the share of assets and income tied to real estate, not the payout. Ninety-five percent overstates the requirement, and a bare majority understates it. This high payout is why REITs are valued for income.IRC s.857(a)(1)

Which bond carries the greatest interest rate risk, all else equal?

• a.A 5-year bond with a high coupon
• b.A 2-year bond with a high coupon
• c.A 30-year zero-coupon bond✓
• d.A 5-year zero-coupon bond

Interest rate risk increases with longer maturity and lower coupons, both of which lengthen duration. A 30-year zero-coupon bond has the longest duration and thus the greatest price sensitivity to rate changes. Shorter maturities and higher coupons reduce that sensitivity.

A convertible bond gives the holder the right to:

• a.Sell the bond back to the issuer at par on specified dates before maturity
• b.Receive an interest rate that resets periodically with a short-term benchmark index
• c.Receive dividends alongside interest, on the same terms as common shareholders
• d.Exchange the bond for a set number of the issuer's common shares✓

A convertible bond can be exchanged for a predetermined number of the issuer's common shares, letting holders participate in stock appreciation. This feature usually lets the issuer offer a lower coupon. Selling the bond back at set dates describes a put feature, and a resetting rate describes a floating-rate note. Bondholders are creditors, so they do not receive common dividends or vote unless they convert to stock.

Commercial paper is best described as which of the following?

• a.Short-term, unsecured corporate debt used for near-term financing✓
• b.Long-term unsecured corporate debt with maturities of ten years or more
• c.A short-term obligation of a state or local government issued in anticipation of tax receipts
• d.Short-term debt issued by the U.S. Treasury at a discount and backed by its full faith and credit

Commercial paper is short-term unsecured corporate debt, typically maturing in 270 days or less, used to fund needs like payroll and inventory. Long-term unsecured corporate debt with a ten-year maturity describes a debenture. A short-term government obligation issued ahead of tax receipts is a municipal tax anticipation note, and short-term Treasury debt sold at a discount is a Treasury bill. Commercial paper is not government guaranteed and carries the issuer's credit risk.

An American Depositary Receipt (ADR) allows a U.S. investor to do which of the following?

• a.Avoid all currency risk on foreign shares because ADRs are priced in U.S. dollars
• b.Hold shares of a U.S. company that trade on foreign exchanges in local currency
• c.Hold shares of a foreign company that trade in U.S. markets and dollars✓
• d.Receive voting and dividend rights directly from the foreign company, with no depositary involved

An ADR is a negotiable certificate issued by a U.S. depositary representing shares of a foreign company, allowing U.S. investors to trade in dollars on domestic markets. Despite dollar-denominated trading, ADRs still carry currency risk from the underlying foreign shares. The structure is not the reverse arrangement of U.S. company shares trading abroad, and rights flow through the depositary rather than directly from the foreign company.

Yield to maturity (YTM) of a bond takes into account which of the following that current yield ignores?

• a.The gain or loss realized as the bond price moves toward par at maturity✓
• b.The annual coupon payment expressed as a percentage of the bond's current market price
• c.The bond's call price and the earliest date on which the issuer may redeem it
• d.The investor's tax bracket and the after-tax return on the bond's interest income

Yield to maturity reflects the total return if a bond is held to maturity, including coupon income plus any capital gain or loss as the price converges to par. Current yield considers only the annual coupon relative to the current market price, so that description is exactly what current yield already uses. The call price and first call date feed yield to call, not yield to maturity, and tax considerations belong to after-tax or tax-equivalent yield.

A unit investment trust (UIT) differs from a mutual fund primarily because a UIT:

• a.Issues a fixed number of shares in an initial offering and then lists them for trading on an exchange
• b.Holds a fixed, unmanaged portfolio with a set termination date✓
• c.Is organized as a corporation with a board of directors that hires an investment adviser to manage the portfolio
• d.Is actively managed by a portfolio manager who adjusts the holdings as market conditions change

A UIT holds a fixed, unmanaged portfolio of securities and has a set termination date. A mutual fund is a managed, continuously operating company. A UIT is organized as a trust, so it has no board of directors and no investment adviser making ongoing trades, and its units are redeemable with the sponsor or trustee. Shares listed on an exchange after a one-time offering describe a closed-end fund, and active management by a portfolio manager describes a managed fund.

Which risk is most directly associated with owning a callable bond?

• a.The holder may require the issuer to repurchase it early when rates rise, forcing a sale at a loss
• b.The issuer is more likely to call it when rates rise, leaving the holder with a lower-coupon bond
• c.Inflation risk is the main concern, because the fixed coupon buys less as prices rise over the bond's remaining life
• d.The issuer may redeem it early when rates fall, forcing reinvestment at lower yields✓

A callable bond lets the issuer redeem it before maturity, and issuers tend to call when interest rates fall so they can refinance at a lower cost. The holder then has to reinvest the proceeds at lower prevailing yields, which is reinvestment (call) risk. The right to force an early repurchase belongs to the holder of a putable bond, not a callable one. Issuers have little reason to call when rates rise, because new debt would cost more. Inflation risk affects every fixed-coupon bond and is not the risk specific to the call feature.

A money market fund seeks to maintain which of the following characteristics?

• a.Maximum long-term capital appreciation achieved by investing heavily in growth-oriented equity securities
• b.Exposure to volatile equity securities whose market prices may swing sharply from one day to the next
• c.A stable net asset value, typically $1.00 per share, with high liquidity✓
• d.A guaranteed return insured by the federal government covering both the principal and all accrued interest in full

Money market funds invest in short-term, high-quality instruments and aim to preserve a stable NAV, commonly $1.00 per share, while providing liquidity and modest income. They are not designed for capital appreciation. Although low risk, they are not federally insured like bank deposits.

A futures contract obligates the parties to do which of the following?

• a.Only the seller, who must deliver the underlying, while the buyer may decline to take delivery at expiration
• b.Both parties to exchange the underlying at the spot price on the delivery date rather than at a price fixed in advance
• c.Both parties to buy or sell the underlying at a set price on a future date✓
• d.Only the buyer to pay a premium, after which the buyer may choose whether to exercise before expiration

A futures contract is a binding agreement in which both the buyer and the seller are obligated to transact the underlying at a price agreed in advance, on a specified future date. Only the writer of an option is obligated while the holder keeps the right to walk away, and a premium paid for that right is a feature of options, not futures. A futures contract also fixes the price when it is entered, rather than leaving it to the spot price at delivery. Positions are normally closed with an offsetting trade, and futures are standardized and exchange-traded.

A high-yield (junk) bond is best characterized by which of the following?

• a.A rating of BBB- or Baa3, the lowest investment-grade rating, with a modest yield premium over Treasuries
• b.A short original maturity of under one year, sold at a discount and repaid at face value
• c.A lower coupon than investment-grade bonds, because investors accept less yield in exchange for greater safety
• d.A below-investment-grade credit rating and higher default risk✓

High-yield or junk bonds carry ratings below investment grade (below BBB- or Baa3) and must pay higher yields to compensate investors for greater default risk. A BBB- or Baa3 rating is the lowest investment-grade rating, not a junk rating. Sale at a discount with maturity under a year describes a money market instrument such as a Treasury bill. A lower coupon for greater safety is the reverse of the junk-bond trade-off: more risk, more yield.

A Guaranteed Investment Contract (GIC) issued by an insurer is most similar in risk profile to which of the following?

• a.A variable annuity subaccount, whose value rises and falls with the performance of the underlying portfolio
• b.A U.S. Treasury security, backed by the full faith and credit of the federal government
• c.A real estate investment trust, whose income depends on property rents and occupancy rates
• d.A fixed-income instrument dependent on the insurer's creditworthiness✓

A GIC promises a fixed return over a set period, and its safety rests on the claims-paying ability of the issuing insurer, so it behaves like a fixed-income instrument with the insurer's credit risk. A variable annuity subaccount carries market risk with no guaranteed return. A Treasury security is backed by the federal government, whereas a GIC has no government backing. A REIT's income depends on property performance rather than on a contractual promise from an insurer.

An investor buys a Treasury bill. How does a T-bill generate its return?

• a.Through semiannual interest payments on a coupon schedule, as with a Treasury note
• b.Through an interest rate that resets each week against the 13-week bill auction, as with a floating rate note
• c.Through semiannual adjustments to principal for inflation, with interest paid on the adjusted principal, as with TIPS
• d.By being purchased at a discount and maturing at face value✓

Treasury bills are short-term securities sold at a discount to face value that pay no periodic interest; the return is the difference between the discounted purchase price and the par value received at maturity. They mature in one year or less. Semiannual coupons are paid on Treasury notes and bonds, a rate reset against bill auctions describes a floating rate note, and principal adjusted for inflation describes TIPS.

According to Modern Portfolio Theory, an efficient portfolio is one that:

• a.Offers the lowest standard deviation of any portfolio available, regardless of the return it is expected to earn
• b.Holds only the single asset with the highest Sharpe ratio, since diversification adds cost without lowering risk
• c.Offers the highest expected return for a given level of risk✓
• d.Has a beta of exactly 1.0, so that it moves in line with the market portfolio

Modern Portfolio Theory, developed by Harry Markowitz, defines an efficient portfolio as one that provides the maximum expected return for a given level of risk, or the least risk for a target return. Such portfolios lie on the efficient frontier. The minimum-variance portfolio is only one point on that frontier, and a beta of 1.0 describes a portfolio that tracks the market, which is not what makes a portfolio efficient. Diversification across imperfectly correlated assets, not a single asset, is what lowers risk for a given return.

Diversification within a portfolio is primarily intended to reduce which type of risk?

• a.Interest rate risk on all bonds
• b.Unsystematic (company-specific) risk✓
• c.Systematic (market) risk
• d.Purchasing power risk

Diversification spreads investments across many securities and sectors to reduce unsystematic risk, which is specific to individual companies or industries. Systematic or market risk affects the entire market and cannot be diversified away. This distinction is fundamental to portfolio construction.

A strategic asset allocation approach is best described as which of the following?

• a.Setting long-term target weights across asset classes and rebalancing to them✓
• b.Shifting weights among asset classes in response to short-term market valuations or economic forecasts
• c.Concentrating in the sector that performed best over the past year and rotating into the next expected leader
• d.Selecting individual securities that appear mispriced and letting the asset class mix result from those choices

Strategic asset allocation establishes long-term target percentages for asset classes based on the investor's goals and risk tolerance, then periodically rebalances back to those targets. Tactical allocation makes shorter-term shifts to exploit perceived opportunities. Rotating into the recent or expected leading sector is a sector-rotation approach. Picking mispriced securities first and letting the asset mix fall out afterwards is bottom-up security selection, which sets no target weights.

When gathering a client profile, which factor is essential to determining suitable recommendations?

• a.The client's current account balance alone, because the size of the account determines which strategies are suitable
• b.The client's past investment returns, because a strategy that worked before should be repeated
• c.The adviser's own market outlook, because the adviser's view decides which products are recommended
• d.The client's investment objectives, time horizon, and risk tolerance✓

Suitable recommendations depend on understanding the client's investment objectives, time horizon and risk tolerance, together with the client's financial situation and liquidity needs. An account balance by itself says nothing about goals or timeline. Past returns do not show what the client needs or can tolerate, and the adviser's market outlook is not a client characteristic, so recommendations built on it ignore the client's circumstances.

A younger investor with a long time horizon and high risk tolerance saving for retirement would most appropriately hold a portfolio weighted toward which of the following?

• a.Growth-oriented equities✓
• b.Fixed annuities with guaranteed rates
• c.Long-term Treasury bonds exclusively
• d.Money market instruments and short-term CDs

A young investor with a long horizon and high risk tolerance can accept short-term volatility in exchange for higher long-term growth, making growth equities appropriate. Time allows recovery from market downturns and lets compounding work. Overly conservative holdings would likely fail to meet long-term retirement goals.

Dollar-cost averaging involves which of the following?

• a.Investing a lump sum all at once to capture the long-run upward drift of the market
• b.Buying a fixed number of shares each period regardless of the price, so the dollars invested vary
• c.Investing a fixed dollar amount at regular intervals regardless of price✓
• d.Adding to a position only when its price falls below the average cost, so the cost basis keeps dropping

Dollar-cost averaging means investing a set dollar amount on a regular schedule, which buys more shares when prices are low and fewer when high and tends to lower the average cost per share over time. Buying a fixed number of shares changes the dollars invested each period, so it is not dollar-cost averaging. A single lump sum has no schedule, and adding only on price declines is averaging down, which depends on price rather than on a fixed schedule. Dollar-cost averaging does not guarantee a profit but imposes discipline.

Which account type generally allows contributions of after-tax dollars with qualified withdrawals being tax-free in retirement?

• a.Traditional IRA
• b.401(k) with pre-tax contributions
• c.SEP IRA
• d.Roth IRA✓

A Roth IRA is funded with after-tax dollars, and qualified withdrawals in retirement, including earnings, are tax-free. Traditional IRAs, standard 401(k)s, and SEP IRAs typically use pre-tax contributions that are taxed upon withdrawal. The Roth's tax-free growth is its defining feature.