NASAA Series 65 — All Questions

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.

A closed-end fund is trading at a price below its net asset value. This is described as the fund trading at:

• a.Par value
• b.A premium
• c.Its redemption value
• d.A discount✓

Closed-end fund shares trade on an exchange at a market price that can differ from net asset value; a price below NAV is a discount, and a price above NAV is a premium. Open-end (mutual) fund shares always transact at NAV, so the trap is assuming a fund must trade at NAV.

Class A mutual fund shares are typically characterized by which of the following?

• a.A front-end sales load paid at purchase, often reduced by breakpoints✓
• b.A level load with high ongoing 12b-1 fees and no breakpoints
• c.A back-end contingent deferred sales charge that declines over time
• d.No sales charge ever and the lowest possible 12b-1 fee

Class A shares charge a front-end sales load at purchase but offer breakpoint discounts for larger investments and typically carry lower ongoing 12b-1 fees. Class B shares have a back-end contingent deferred sales charge that declines over time, and Class C shares are level-load with higher 12b-1 fees; those descriptions are the traps.

A mutual fund has $500 million in net assets and annual operating expenses of $6 million. Its expense ratio is closest to:

• a.1.2%✓
• b.2.4%
• c.0.6%
• d.8.3%

The expense ratio equals annual operating expenses divided by net assets: $6 million divided by $500 million equals 0.012, or 1.2%. It represents the yearly cost of owning the fund as a percentage of assets. Reversing the fraction produces the 8.3% trap.

A mutual fund breakpoint provides which benefit to an investor?

• a.A reduction in the sales charge on purchases spread across several different fund families through the same broker
• b.A reduced front-end sales charge for investing a larger dollar amount✓
• c.A lower management fee once fund assets pass a stated size
• d.Automatic conversion of Class B shares to Class A shares once the contingent deferred sales charge period ends

A breakpoint is a discount on the front-end sales charge granted at higher investment levels within a single fund family, which an investor can reach through rights of accumulation or by signing a Letter of Intent to invest the amount within 13 months. Failing to alert a client who is near a breakpoint (a breakpoint sale) is a prohibited practice. Breakpoints do not combine purchases across unrelated fund families, they are not a cut in management fees that follows fund size, and the Class B to Class A conversion is a separate feature of back-end load shares.

A warrant differs from a preemptive right primarily because a warrant:

• a.Is a short-term right, usually expiring within weeks, issued to existing shareholders at a subscription price below the current market price
• b.Carries the voting and dividend rights of the underlying common stock from the day it is issued, as a common shareholder would have
• c.Obligates the holder to buy the underlying stock at the stated price if the stock trades above that price on the expiration date
• d.Is a long-term instrument, often attached as a sweetener, allowing purchase of stock at a set price for years✓

A warrant is a long-term right, often lasting years, to buy stock at a fixed price, frequently attached to bonds or preferred stock as a sweetener, with a strike usually above the market price at issuance. A preemptive (subscription) right is short-term, lasts weeks, and goes to existing shareholders at a price below market, which describes the first option rather than a warrant. A warrant holder has no vote or dividend until exercise, and a warrant entitles but never obligates the holder to buy.

A municipal revenue bond differs from a general obligation (GO) bond because a revenue bond is:

• a.Always exempt from federal and state tax for every investor
• b.Backed by income generated from a specific project or facility rather than by general taxes✓
• c.Guaranteed by the U.S. Treasury
• d.Backed by the full faith, credit, and taxing power of the issuer

A revenue bond is repaid from the revenues of a specific project such as tolls, utilities, or an airport, and is not backed by the issuer's taxing power. A general obligation bond is backed by the issuer's full faith, credit, and taxing power (the trap in the second option) and often requires voter approval. Municipal interest is generally federally tax-exempt but not Treasury-guaranteed.

A Government National Mortgage Association (GNMA / Ginnie Mae) pass-through security is best described as:

• a.A security representing an interest in a pool of mortgages that passes through principal and interest, backed only by the credit of the issuing agency and not by the full faith and credit of the federal government
• b.A debt security issued by a local housing authority and secured by one project's rents, paying fixed semiannual interest that is exempt from federal income tax and returning principal in full at maturity
• c.A mortgage-backed security issued by a private bank holding company from its own loans, backed by the full faith and credit of the issuing bank rather than by the federal government
• d.A security representing an interest in a pool of mortgages that passes through principal and interest, backed by the full faith and credit of the U.S. government✓

A Ginnie Mae pass-through gives investors an interest in a pool of federally insured or guaranteed mortgages, passing through monthly principal and interest, and is backed by the full faith and credit of the U.S. government. Pass-throughs issued by Fannie Mae or Freddie Mac are backed by the issuer rather than by the full faith and credit of the government, a private-label mortgage security rests on the credit of its private issuer, and a housing-authority bond is a conventional tax-exempt bond with no pass-through of principal. Ginnie Mae interest is fully taxable and carries prepayment risk.

Treasury Inflation-Protected Securities (TIPS) protect investors against inflation by:

• a.Paying a fixed coupon that automatically rises each year
• b.Guaranteeing investors a fixed 10% real return
• c.Being fully exempt from federal income tax
• d.Adjusting the principal value up or down with changes in the Consumer Price Index✓

TIPS protect against inflation by adjusting their principal with the CPI; the coupon rate is fixed but is applied to the adjusted principal, so the dollar interest paid rises with inflation. The annual increase in principal is taxable even though not received in cash, known as phantom income. TIPS are not tax-exempt and carry no guaranteed 10% return.

A negotiable (jumbo) certificate of deposit differs from an ordinary bank CD because it:

• a.Can be redeemed at the issuing bank at any time before maturity at full face value, with no early-withdrawal penalty, because it is a demand deposit
• b.Has a large face value, often $100,000 or more, and can be traded in the secondary market before maturity✓
• c.Is fully guaranteed by the U.S. Treasury no matter how large it is, so the holder bears no credit risk from the issuing bank
• d.Is a short-term unsecured promissory note that a corporation sells at a discount to face value and that is not a bank deposit at all

A negotiable (jumbo) CD carries a large denomination, typically $100,000 or more, and unlike an ordinary bank CD it can be sold in the secondary market before maturity. It is not redeemable on demand at face value, which is why a market exists for it. FDIC insurance covers deposits only up to at least $250,000 at each insured bank, so amounts above that depend on the issuing bank's credit, and the Treasury does not guarantee the CD. Commercial paper is a corporate note, not a bank deposit.

A key characteristic of a direct participation program (DPP), such as a limited partnership, is that it:

• a.Passes income, gains, losses, and deductions through directly to the investors✓
• b.Guarantees investors a fixed annual dividend
• c.Is a highly liquid, exchange-traded security
• d.Is taxed as a separate corporation before making distributions

A direct participation program such as a limited partnership is a flow-through entity: there is no tax at the entity level, and income, gains, losses, and deductions pass directly to the limited partners. DPPs offer limited liquidity and limited liability but no guaranteed return. Corporate-level taxation, the trap in the second option, is exactly what a DPP avoids.

An index mutual fund is designed primarily to:

• a.Outperform its benchmark through active security selection
• b.Replicate the performance of a specified market index at low cost✓
• c.Guarantee a positive return each year
• d.Invest only in tax-free municipal bonds

An index fund passively tracks a benchmark, aiming to match rather than beat it, with low turnover and low expenses. Active management, the trap in the first option, tries to outperform through security selection and typically costs more. No fund can guarantee a positive yearly return.

A preemptive right granted to existing common shareholders allows them to:

• a.Receive dividends ahead of preferred holders, since common holders are first in line for quarterly payments
• b.Buy the company's outstanding bonds at par before the bonds mature, ahead of other investors
• c.Purchase newly issued shares to maintain proportional ownership, usually at a subscription price below the current market price✓
• d.Require the company to buy back their shares at book value whenever they choose to sell

A preemptive (subscription) right lets existing holders buy new shares, typically below market and for a short period, so their percentage ownership is not diluted. It applies to new stock issues, not to bonds. It gives no dividend priority, since preferred holders are paid before common holders, and it gives no right to force a buyback at book value.

A cumulative preferred stock differs from straight (noncumulative) preferred because cumulative preferred:

• a.Accrues any skipped dividends, which must be paid in full before common dividends resume✓
• b.Gives holders a vote on every corporate matter, just like common stock
• c.Pays extra dividends above the stated rate whenever the company's earnings are unusually strong
• d.Can be exchanged for the issuer's common stock at the holder's option

Cumulative preferred accumulates unpaid dividends as arrears, and all arrears must be paid before common shareholders receive anything. Straight preferred does not accumulate missed dividends. Extra dividends in strong years describe participating preferred, exchange into common stock describes convertible preferred, and preferred stock generally carries no vote on ordinary corporate matters.

The distinguishing feature of participating preferred stock is that holders may:

• a.Collect any skipped dividends in full, with all arrears paid before common stockholders receive anything
• b.Exchange their shares for common stock at a fixed conversion ratio set when the preferred is issued
• c.Demand that the issuer redeem the shares at a set price on a date specified when issued
• d.Receive extra dividends beyond the stated rate when the company has strong earnings✓

Participating preferred can share in additional dividends above its fixed rate when profits are high, on top of its stated preference. Collecting skipped dividends first describes cumulative preferred, exchange into common describes convertible preferred, and redemption at a set price describes callable or putable preferred.

A callable preferred stock exposes the investor primarily to the risk that:

• a.The shares will fall in price when interest rates fall, since preferred prices move in the same direction as rates
• b.The holder will be forced to convert into common stock at a price set by the issuer
• c.The issuer will redeem the shares, often when rates fall, forcing reinvestment at lower yields✓
• d.Rising interest rates will force the issuer to raise the dividend rate on the shares

A call feature lets the issuer redeem preferred, typically after rates decline, creating reinvestment risk for the holder, the same reason issuers call bonds. The call favors the issuer, not the investor. Fixed-rate preferred rises in price, not falls, when rates fall; forced conversion describes a convertible with a call-for-conversion; and a dividend that resets upward describes adjustable-rate preferred, not callable preferred.

A convertible bond has a par of $1,000 and is convertible into common stock at $50 per share. If the common stock trades at $60, the conversion (parity) value of the bond is:

• a.$833
• b.$1,000
• c.$1,200✓
• d.$600

The conversion ratio equals par divided by the conversion price: $1,000 divided by $50 equals 20 shares. Parity value equals 20 shares times the $60 stock price, or $1,200. Because parity exceeds par, the conversion feature is in the money.

A bond's yield increases from 4.00% to 4.50%. This is a change of:

• a.0.05 basis points
• b.5 basis points
• c.500 basis points
• d.50 basis points✓

One basis point equals 0.01%, or one one-hundredth of one percent. A move of 0.50% therefore equals 50 basis points. Confusing tenths or whole percents produces the trap answers.

For a bond trading at a discount to par, which ordering of yields is correct?

• a.Coupon rate is greater than current yield, which is greater than yield to maturity
• b.Yield to maturity is greater than current yield, which is greater than the coupon rate✓
• c.Current yield is greater than yield to maturity, which is greater than the coupon rate
• d.All three yields are equal

At a discount, yield to maturity is highest because the investor also gains as the price rises toward par; current yield falls between the coupon and the YTM. The reverse ordering, with the coupon highest, applies to a premium bond.

The nominal yield of a bond refers to:

• a.The fixed coupon (interest) rate stated on the bond as a percentage of par✓
• b.The total return earned if the bond is held to maturity, combining coupon income with any gain or loss realized at final redemption
• c.The annual interest divided by the current market price
• d.The bond's yield after adjusting for inflation

Nominal yield is the stated coupon rate on par value. Annual interest divided by market price is the current yield, and total return to maturity is the yield to maturity; those are the traps. Nominal yield does not adjust for inflation.

A banker's acceptance is best described as a money-market instrument that:

• a.Pays a variable dividend tied to bank profits
• b.Represents an ownership interest in a pool of residential mortgages and passes through monthly principal and interest to its certificate holders
• c.Is a short-term time draft used to finance international trade, guaranteed by a bank✓
• d.Is a long-term unsecured corporate bond

A banker's acceptance is a short-term, bank-guaranteed time draft that facilitates import and export trade, trading at a discount in the money market. It is not a mortgage security, a long-term bond, or an equity instrument.

In a repurchase agreement (repo), a dealer:

• a.Sells securities and agrees to buy them back later at a slightly higher price, effectively a short-term collateralized loan✓
• b.Permanently sells securities with no obligation to repurchase them, transferring full title to the buyer so the dealer keeps no further claim of any kind once the initial sale settles
• c.Lends stock to a short seller for an indefinite term
• d.Issues new equity shares to the public

A repo is a short-term financing tool: the dealer sells securities and repurchases them shortly after at a higher price, and the difference is the implied interest. It is a common, collateralized money-market transaction, not a permanent sale.

Eurodollars are best defined as:

• a.Shares of European companies traded in the U.S. as dollar-denominated depositary receipts
• b.U.S. dollar-denominated deposits held in banks outside the United States✓
• c.Bonds issued in euros by U.S. corporations and sold to European investors
• d.Euro-denominated deposits held in banks inside the European Union

Eurodollars are U.S.-dollar deposits held at banks outside the United States; a Eurodollar bond is a dollar bond sold outside the U.S. The prefix denotes where the money sits, not the euro currency. Depositary receipts on foreign shares are ADRs, a bond issued in euros is a euro-denominated bond, and euro deposits in EU banks are simply euro accounts.

A U.S. Treasury note is a government security that:

• a.Has an original maturity of more than 10 years and pays interest every six months
• b.Has an original maturity of more than 1 year up to 10 years and pays semiannual interest✓
• c.Matures in one year or less and is sold at a discount, with no stated coupon
• d.Pays semiannual interest that is exempt from federal income tax but fully subject to state income tax

Treasury notes have original maturities of more than one year up to ten years and pay semiannual coupons. Maturities beyond ten years describe Treasury bonds, and maturities of one year or less sold at a discount describe T-bills. Treasury interest is the reverse of the last choice: it is federally taxable and exempt from state and local income tax.