NASAA Series 66 — All Questions

Which asset is counted in the Federal Reserve's M2 money supply but not in M1?

• a.Checkable deposits at commercial banks and thrift institutions
• b.Large time deposits of $100,000 or more at commercial banks
• c.Small-denomination time deposits of less than $100,000 each✓
• d.Currency held by the public outside of bank vaults and the Fed

M2 equals M1 plus small time deposits (under $100,000) and retail money market fund balances. Currency and checkable deposits are core M1 components, so they are in both measures. Large time deposits of $100,000 or more are outside M2.

In an economy where households spend 80 cents of every additional dollar of income they receive, what is the simple spending multiplier?

• a.1.25, found by dividing 1 by the 0.80 spending share
• b.5, found by dividing 1 by (1 - 0.80)✓
• c.0.20, found by subtracting the spending share from 1
• d.4, found by dividing 0.80 by (1 - 0.80)

The simple multiplier = 1 / (1 - MPC) = 1 / 0.20 = 5, so each new dollar of spending ultimately raises income by about $5. Dividing 1 by the MPC gives 1.25, which ignores the repeated rounds of re-spending. Subtracting the MPC from 1 gives the saving share, which is the denominator and not the multiplier. Dividing the MPC by the saving share gives 4, which is the multiplier less the original dollar of spending.

During a recession, an investor wants stocks whose earnings are least sensitive to the business cycle. Which sector best fits that goal?

• a.Consumer discretionary, since spending on travel and autos stays strong
• b.Consumer staples, since households keep buying food and household basics✓
• c.Technology hardware, since firms accelerate equipment upgrades in downturns
• d.Industrials, since capital equipment orders rise when output falls

Defensive sectors such as consumer staples, utilities, and health care sell necessities whose demand holds up in downturns. Discretionary spending on travel and cars is cyclical and falls when incomes drop. Industrial orders and corporate hardware purchases are also postponed in recessions, not accelerated.

A stock trades at $60 per share. Its earnings over the last twelve months were $4 per share. What is its trailing price-to-earnings (P/E) ratio?

• a.15✓
• b.240
• c.56
• d.0.07

P/E equals price divided by earnings per share: $60 / $4 = 15. Multiplying price by earnings yields 240, which is not a ratio of price to earnings. The earnings yield, 4 / 60, is about 0.07, the inverse of the P/E. Subtracting earnings from price gives 56, a dollar difference with no valuation meaning.

A company reports net income of $12 million, pays $2 million in preferred dividends, and has a weighted average of 5 million common shares outstanding. What are its earnings per share?

• a.$1.60
• b.$2.00✓
• c.$2.40
• d.$2.80

EPS = (net income - preferred dividends) / weighted average common shares = ($12M - $2M) / 5M = $2.00. Dividing the full $12 million gives $2.40, which forgets that preferred holders are paid first. Adding the preferred dividend back gives $2.80, and subtracting it twice gives $1.60. Both move the adjustment in the wrong direction.

A company earned $4.00 per share and paid dividends of $1.00 per share. What are its dividend payout ratio and retention ratio?

• a.Payout 25% and retention 25%
• b.Payout 400% and retention 100%
• c.Payout 25% and retention 75%✓
• d.Payout 75% and retention 25%

Payout ratio = dividends / earnings = $1.00 / $4.00 = 25%, and the rest, 75%, is retained. Reversing the two numbers swaps the ratios. The two ratios must add to 100%, so 25% and 25% cannot both be right. Dividing earnings by dividends gives 4.0, not a payout percentage.

A company has net income of $8 million, total assets of $100 million, and shareholders' equity of $50 million. What is its return on equity (ROE)?

• a.16%✓
• b.8%
• c.50%
• d.6.25%

ROE = net income / shareholders' equity = $8M / $50M = 16%. Dividing by total assets gives 8%, which is return on assets. Equity as a share of assets is 50%, a capital-structure measure rather than a return. Dividing equity by net income gives 6.25 times, the inverse of the earnings ratio.

In the DuPont breakdown of return on equity, ROE equals net profit margin multiplied by asset turnover multiplied by:

• a.The equity multiplier (total assets divided by shareholders' equity)✓
• b.The current ratio (current assets divided by current liabilities)
• c.The dividend payout ratio (dividends divided by net income)
• d.The interest coverage ratio (EBIT divided by interest expense)

DuPont analysis writes ROE = (net income / sales) x (sales / assets) x (assets / equity). The last term, the equity multiplier, captures financial leverage. The current ratio measures liquidity, the payout ratio measures dividend policy, and interest coverage measures debt-service capacity; none belongs in the identity.

A company has current assets of $600,000, of which $200,000 is inventory, and current liabilities of $400,000. What is its quick (acid-test) ratio?

• a.1.5
• b.2.0
• c.0.5
• d.1.0✓

The quick ratio removes inventory from current assets: ($600,000 - $200,000) / $400,000 = 1.0. Leaving inventory in gives the current ratio of 1.5. Dividing inventory by current liabilities gives 0.5, which is not a liquidity measure. Dividing the inventory-excluded assets by the inventory is another misuse and yields 2.0.

A company has EBIT of $9 million and annual interest expense of $3 million. What is its interest coverage ratio?

• a.0.33 times
• b.3.0 times✓
• c.6.0 times
• d.12.0 times

Interest coverage = EBIT / interest expense = $9M / $3M = 3.0 times, meaning operating profit covers interest three times over. The inverse, 0.33, is the share of EBIT consumed by interest. Subtracting the interest from EBIT gives 6 and adding it gives 12, but neither is a ratio of EBIT to interest.

A company has cost of goods sold of $600 million for the year, and its average inventory was $100 million. What is its inventory turnover?

• a.7.0 times
• b.5.0 times
• c.0.17 times
• d.6.0 times✓

Inventory turnover = cost of goods sold / average inventory = $600M / $100M = 6.0 times. Inverting the fraction gives 0.17, which is not a turnover rate. Subtracting the inventory from the cost base ($500M) or adding it ($700M) before dividing gives 5.0 and 7.0, neither of which is the standard formula.

A company had revenue of $500 million and cost of goods sold of $300 million. What is its gross profit margin?

• a.40%✓
• b.60%
• c.66.7%
• d.200%

Gross margin = (revenue - COGS) / revenue = $200M / $500M = 40%. The 60% figure is the cost ratio, COGS / revenue. Dividing gross profit by COGS gives 66.7%, a markup rather than a margin. A margin on revenue cannot exceed 100%, so 200% could not be right.

Which of the following items appears on a company's income statement rather than on its balance sheet?

• a.Accounts receivable from customers
• b.Depreciation expense for the year✓
• c.Retained earnings at year-end
• d.Accumulated depreciation on equipment

Depreciation expense is a charge against revenue for the period and so belongs on the income statement. Accumulated depreciation is the running total deducted from asset values on the balance sheet. Retained earnings and accounts receivable are balance sheet items measuring cumulative equity and amounts owed by customers at a point in time.

A company reports net income of $10 million, includes $3 million of depreciation expense, and has no changes in working capital. Ignoring other adjustments, its cash flow from operations is approximately:

• a.$3 million, because only the depreciation charge itself is cash generated
• b.$10 million, since depreciation does not affect cash flow in any way
• c.$7 million, because depreciation is a cash cost that must be subtracted
• d.$13 million, because depreciation is a non-cash charge added back✓

Depreciation lowered net income but did not use cash, so it is added back: $10M + $3M = $13M. Subtracting it treats a non-cash charge as a cash outflow. Saying it has no effect ignores the add-back that reconciles net income to cash. The depreciation charge itself is not a source of cash.

A company has an equity market value of $200 million, debt of $100 million, and cash of $50 million. What is its enterprise value?

• a.$150 million
• b.$300 million
• c.$200 million
• d.$250 million✓

Enterprise value = market value of equity + debt - cash = $200M + $100M - $50M = $250M. Using equity alone leaves out the debt claims. Adding debt but ignoring cash gives $300M, which overstates the price a buyer would effectively pay. Subtracting cash from equity without adding the debt gives $150M, which leaves out the debt.

A stock trades at $45 per share. The company's book value per share is $30. What is its price-to-book (P/B) ratio?

• a.75
• b.15
• c.1.5✓
• d.0.67

P/B = market price / book value per share = $45 / $30 = 1.5. Dividing book value by price gives 0.67, the inverse. Subtracting gives $15, a dollar premium rather than a ratio. Adding the two figures gives 75, which has no meaning.

A stock is expected to pay a dividend of $2.00 next year, which is expected to grow 4% per year indefinitely. The required return is 10%. Using the constant-growth dividend discount model, the stock's value is closest to:

• a.$14.29
• b.$20.00
• c.$33.33✓
• d.$50.00

The Gordon growth model gives value = D1 / (r - g) = $2.00 / (0.10 - 0.04) = $33.33. Dividing by the required return alone ($20) ignores growth. Dividing by r + g ($2.00 / 0.14 = $14.29) adds the growth rate when it should be subtracted. Using g alone as the denominator ($50) ignores the required return.

A portfolio's annual returns have a variance of 0.0225. What is the portfolio's standard deviation?

• a.0.05%, found by squaring the variance
• b.15%, found by taking the square root of the variance✓
• c.1.1%, found by dividing the variance by two
• d.2.25%, found by restating the variance as a percentage

Standard deviation is the square root of variance: the square root of 0.0225 is 0.15, or 15%. Restating 0.0225 as 2.25% never takes the root, and dividing by two confuses the root with a half. Squaring the variance moves in the wrong direction and gives a tiny figure.

Weak-form market efficiency holds that current prices already reflect all past price and volume data. Which conclusion follows?

• a.Prices never deviate from intrinsic value, so valuation models are pointless
• b.Corporate insiders cannot earn excess returns from trading on nonpublic information
• c.Fundamental analysis of public financial statements cannot earn any excess returns
• d.Technical analysis of past prices cannot consistently earn excess returns✓

If past prices are fully reflected, chart patterns and trading rules built on historical data have no predictive edge, which defeats technical analysis. Ruling out fundamental analysis requires semi-strong efficiency, and ruling out insider profits requires strong-form efficiency. Efficiency does not claim prices equal intrinsic value in every period, only that deviations are not predictably exploitable.

Semi-strong form market efficiency holds that prices reflect all publicly available information. Which conclusion follows?

• a.Analysis of past price patterns can still consistently produce excess returns over time
• b.Analysis of published financial statements cannot consistently beat the market✓
• c.Insiders trading on material nonpublic information gain no advantage over others
• d.Price changes can be predicted from the previous day's volume and price pattern

If all public information is already in prices, studying financial statements or news cannot reliably beat the market. Semi-strong efficiency includes past prices, so chart analysis also fails to give an edge. Insiders can still profit under semi-strong efficiency, because nonpublic information is not yet reflected; only the strong form rules that out. Volume patterns are historical data and are covered as well.

On a price chart, a head-and-shoulders top is generally interpreted by technical analysts as a signal that:

• a.An uptrend is likely to continue at a faster pace
• b.A downtrend is ending and a rally is likely to begin
• c.An uptrend is likely to reverse into a sustained downtrend✓
• d.Price will remain in a narrow range with no trend

A head-and-shoulders top is a reversal pattern at the end of an advance, with a break below the neckline signaling a decline. A continuation signal would come from patterns such as flags or pennants. A downtrend ending is the job of the inverse head-and-shoulders. A narrow sideways range is a consolidation pattern.

A stock has repeatedly fallen to $40 and then rebounded, and has repeatedly rallied to $55 and then turned back. In technical analysis, $40 and $55 are called, respectively:

• a.Support and resistance✓
• b.Resistance and support
• c.Breakout and breakdown
• d.Floor and ceiling prices

Support is a price level where buying has repeatedly halted declines, and resistance is a level where selling has repeatedly stopped advances. Reversing the terms flips the roles. A breakout or breakdown happens when price moves through one of those levels. Floor and ceiling prices suggest limits imposed from outside, but these levels arise from trading behavior.

A 50-day moving average of a stock's closing prices is used mainly to:

• a.Smooth short-term fluctuations so the underlying trend is easier to see✓
• b.Measure how widely the stock's returns have varied around their mean over time
• c.Calculate the intrinsic value of the company from its projected cash flows
• d.Estimate the company's next quarterly earnings per share from sales trends

A moving average damps daily noise so analysts can judge trend direction. Earnings forecasts come from fundamental analysis of the business. Intrinsic value from cash flows comes from discounting models. The dispersion of returns around their mean is the standard deviation, a different statistic.

A savings account states a 12% annual rate, compounded semiannually. What is its effective annual yield?

• a.6.00%
• b.12.36%✓
• c.12.68%
• d.12.00%

Semiannual compounding at 6% per period gives (1.06)^2 - 1 = 12.36%. The nominal 12% ignores the interest earned on interest in the second period. 12.68% is the result of monthly compounding (1.01^12 - 1), which is not what the account does. 6% is only the rate per period.

A preferred stock pays a fixed dividend of $5 per year indefinitely. If investors require a 5% annual return, the value of one share is:

• a.$25
• b.$100✓
• c.$250
• d.$5

A perpetuity is worth its annual payment divided by the required return: $5 / 0.05 = $100. Multiplying $5 by 5 gives $25, and the payment alone ($5) ignores discounting. Dividing by 0.02 would be needed to reach $250, which does not match the stated 5% return.

Under the net present value (NPV) rule, a company should accept a project when:

• a.Its cash flows, discounted at the required return, exceed its cost✓
• b.The sum of its future cash flows, with no discounting, exceeds its cost
• c.Its payback period is longer than that of the company's other projects
• d.Its accounting profit is positive in the first full year of operation

NPV discounts future cash flows at the required return, and a positive NPV means the project adds value. Undiscounted sums ignore the time value of money. A longer payback is not a criterion for acceptance; shorter payback is preferred. First-year accounting profit does not capture the full timing or size of cash flows.

When the Federal Reserve raises its target for the federal funds rate and market interest rates rise, the prices of existing fixed-rate bonds will most likely:

• a.Rise, because investors prefer bonds when rates are higher
• b.Rise, because higher rates signal a stronger economy ahead
• c.Fall, because new bonds are issued with higher coupons✓
• d.Stay constant, because the coupon payments are fixed in dollars

Bond prices and yields move in opposite directions: existing bonds with lower coupons must trade at a discount to compete with new, higher-yielding bonds. A stronger economy does not lift the price of an existing fixed coupon. The coupon is fixed, but the price is not; it adjusts to the market yield. Investors prefer higher yields, which is exactly why older bonds drop in price.

Quantitative easing by the Federal Reserve refers to:

• a.Cutting the reserve requirement to zero so that banks can lend more freely
• b.Selling longer-term Treasuries from the Fed's portfolio to raise long-term rates
• c.Large Fed purchases of long-term Treasuries and mortgage securities✓
• d.Raising the discount rate sharply to slow bank lending and curb inflation

In quantitative easing the Fed buys large amounts of longer-dated Treasuries and mortgage-backed securities, adding reserves and pushing down long-term yields when the policy rate is already near zero. Selling long-term Treasuries from the portfolio is the reverse, quantitative tightening, and pushes long-term yields up. Cutting the reserve requirement loosens policy through a different channel and involves no asset purchases. Raising the discount rate is a tightening step.

In the expenditure approach to GDP, net exports are:

• a.Exports minus government purchases, which is added to investment
• b.Exports minus imports, which can be a negative amount✓
• c.Imports minus exports, which is added to consumption
• d.Exports plus imports, which is always a positive amount

GDP = C + I + G + (X - M). Net exports are exports less imports and turn negative when a country imports more than it exports. Adding imports and exports overstates the trade component. Reversing the subtraction flips the sign. Government purchases are a separate component, G.

Which of the following is an example of an automatic stabilizer?

• a.A Federal Reserve cut in the federal funds rate after a weak jobs report
• b.Unemployment benefits that increase on their own when layoffs rise✓
• c.A new infrastructure spending program approved by Congress after a recession begins
• d.A one-time tax rebate mailed to households after Congress passes it

Automatic stabilizers, such as unemployment benefits and progressive taxes, adjust without any new decision as the economy changes. A rebate and an infrastructure program require legislation, so they are discretionary fiscal policy. A rate cut is monetary policy made at a committee meeting.

A stock priced at $40 pays annual dividends of $1.20 per share. What is its dividend yield?

• a.33.3%
• b.3.0%✓
• c.4.8%
• d.30.0%

Dividend yield = annual dividend / price = $1.20 / $40 = 3.0%. Dividing the price by the dividend gives 33.3, a multiple of the dividend. Moving the decimal incorrectly gives 30%. A 4.8% result would need a $1.92 dividend.

An investor buys a 26-week Treasury bill at $9,800 per $10,000 of face value and holds it to maturity. How does the investor earn a return?

• a.By receiving $9,800 at maturity plus interest accrued daily
• b.By collecting a $200 coupon in the middle of the holding period
• c.By receiving the $10,000 face value, the $200 difference being the interest✓
• d.By converting the bill into a note with a fixed coupon at maturity

Treasury bills pay no coupon; they are sold at a discount and redeemed at par, so the discount is the return. A mid-period coupon is a note feature. Maturity pays par, not the purchase price. Bills cannot be converted into notes.

Treasury Inflation-Protected Securities (TIPS) protect an investor's purchasing power mainly because:

• a.Principal adjusts with the CPI, and the coupon is paid on that principal✓
• b.The principal is fixed but the maturity date extends as prices increase
• c.The coupon rate is reset each year to match the latest annual CPI reading
• d.The Treasury pays a cash bonus when inflation exceeds the Fed's 2% target

TIPS keep the coupon rate fixed but adjust the principal with the CPI, so interest is paid on a larger or smaller base. A resetting coupon describes a floating-rate note. No inflation bonus exists. Maturity dates on TIPS do not change.

A municipal bond is described as a general obligation (GO) bond. Which statement best describes the security behind it?

• a.It is backed by the issuer's taxing power and its full faith and credit✓
• b.It is backed by a pledge of the issuer's state income tax refunds only
• c.It is backed solely by the revenue from the facility the bond financed
• d.It is backed by a federal guarantee of principal and interest

General obligation bonds rely on the issuer's authority to tax and its full faith and credit. Revenue bonds rely on the income of the financed project, such as tolls or utility fees. Municipal bonds carry no federal guarantee. The sole pledge of tax refunds is not a GO structure.

A corporate bond with a $1,000 par value and a 6% coupon pays interest semiannually. Sixty days have passed since the last payment. Using 30-day months and a 360-day year, how much interest has accrued?

• a.$60, a full year of interest at the coupon rate
• b.$5, found by taking 60/360 of the $30 semiannual payment
• c.$10, found as $60 of annual interest times 60/360✓
• d.$30, the full semiannual coupon payment

Corporate bonds accrue on a 30/360 basis: $1,000 x 6% = $60 a year, and $60 x 60/360 = $10. The full $30 is owed only at the end of the six-month period, and $60 is a whole year. Taking 60/360 of the semiannual $30 applies the semiannual split twice and gives $5.

An investor owns 200 shares of 6% preferred stock with a $50 par value. If the board declares the full stated dividend, how much does the investor receive for the year?

• a.$3, the dividend on a single share rather than on 200
• b.$600, found by multiplying 6% by the $50 par value and by 200 shares✓
• c.$10,000, the combined par value of the 200 shares
• d.$1,200, found by applying 6% to a $100 par value

Preferred dividends are a percentage of par: 6% x $50 = $3 per share, and $3 x 200 shares = $600. A $100 par value is not the one stated and doubles the result. The $3 figure is correct for one share only, and $10,000 is the face amount of the holding, not the income it pays.

Interest rates rise by one percentage point. Which bond will most likely fall the most in price?

• a.A 5-year bond with a 9% coupon
• b.A 30-year bond with a 3% coupon✓
• c.A 30-year bond with a 9% coupon
• d.A 5-year bond with a 3% coupon

Price sensitivity grows with longer maturity and falls as the coupon rises, so the long-maturity, low-coupon bond has the longest duration and drops the most. A high coupon returns cash sooner and cushions the move. A 5-year maturity limits how much future value is affected by the new rate.

A $1,000 par convertible bond is convertible at $40 per share. The stock trades at $46. What is the bond's conversion value?

• a.$1,150, because it converts into 25 shares that are worth $46 each✓
• b.$1,000, because par is the floor value of any bond at maturity
• c.$870, because the conversion price is divided by the market price
• d.$1,840, because the market price is multiplied by the conversion price

Conversion ratio = $1,000 / $40 = 25 shares, and 25 x $46 = $1,150. Par value is the redemption amount, not the conversion value. Dividing $40 by $46 and applying that to par gives $870, a ratio of two prices. Multiplying the two prices gives 1,840 and has no meaning.

Which requirement must a real estate investment trust (REIT) meet to be taxed as a pass-through entity?

• a.It must distribute at least 90% of its taxable income each year✓
• b.It must distribute at least 50% of its net rental income each quarter
• c.It must limit its shareholders to fewer than 35 accredited investors
• d.It must hold at least 90% of its assets in mortgage loans, not property

Under the Internal Revenue Code, a REIT generally must distribute at least 90% of its taxable income and meet asset and income tests. A 50% quarterly distribution is not the test. A REIT may own property directly, so the loan-only rule is wrong. REITs are publicly offered and must have at least 100 shareholders.

Which of the following is a feature of an exchange-traded fund (ETF) that distinguishes it from a traditional open-end mutual fund?

• a.Shares can be purchased only through the fund's own transfer agent
• b.Shares trade all day at market prices that can differ from net asset value✓
• c.Shares are issued directly to individual investors at the net asset value
• d.Shares are redeemed only at the day's closing net asset value

ETF shares trade on an exchange all day, so the price can drift above or below NAV, with authorized participants creating and redeeming large blocks. Redemption at one daily NAV is the open-end mutual fund model. Direct issuance to individual investors at NAV is also a mutual fund feature. ETF buyers use brokers on the exchange.

An open-end investment company's total assets are $520 million, its liabilities are $20 million, and it has 10 million shares outstanding. What is the net asset value per share?

• a.$50.00✓
• b.$52.00
• c.$2.00
• d.$500.00

NAV per share = (assets - liabilities) / shares outstanding = $500M / 10M = $50. Using assets alone gives $52, which ignores what the fund owes. Dividing the liabilities by shares gives $2. Treating the $500 million of net assets as a per-share figure gives $500 and ignores the share count.

Under the Investment Company Act of 1940, an open-end fund that receives a valid redemption request must generally pay the redemption proceeds within:

• a.Seven days✓
• b.Three days
• c.Thirty days
• d.Ninety days

Section 22(e) prohibits suspending redemption rights or delaying payment more than seven days after the tender, apart from limited exceptions such as market closures or SEC orders. Shorter and longer periods do not match the statutory limit.Investment Company Act Section 22(e)

Which statement about a closed-end fund is accurate?

• a.Its shares are redeemed by the fund at net asset value whenever a holder asks
• b.Its portfolio manager must sell holdings whenever shareholders sell shares
• c.Its shares are continuously offered to the public at the net asset value
• d.Its shares trade in the secondary market at a premium or discount to NAV✓

A closed-end fund issues a fixed number of shares through an offering, after which they trade like stocks and can sit above or below NAV. Redemption on demand and continuous offering describe open-end funds. Because investors trade with each other, manager sales are not forced by shareholder selling.

Under FINRA rules, a mutual fund that pays for distribution through 12b-1 fees can describe itself as 'no-load' only if its 12b-1 and service fees total no more than:

• a.0.25% of average net assets annually✓
• b.1.00% of average net assets annually
• c.0.75% of average net assets annually
• d.2.50% of average net assets annually

FINRA Rule 2341 allows a fund to call itself no-load only if it has no front-end or deferred sales charge and its 12b-1 fees do not exceed 0.25% of average net assets. The 1.00% figure is the overall cap on asset-based sales charges plus service fees, and 0.75% is the cap on the sales charge portion. A 2.50% figure has no basis in the rule.

A client invests in a variable annuity during the accumulation phase. Which statement is correct?

• a.The insurer holds the premiums in its general account at a fixed rate
• b.The owner bears the investment risk, and values follow subaccount performance✓
• c.The insurer bears the investment risk and guarantees a fixed rate of return
• d.The contract owner is guaranteed at least the premiums paid in cash

In a variable annuity, premiums go to separate-account subaccounts and the owner takes the investment risk. A guaranteed rate describes a fixed annuity. Principal is not guaranteed on surrender. Premiums credited fixed interest from the general account describe a fixed product. Death benefits may offer minimums, but not a surrender guarantee.

A 45-year-old withdraws money from a nonqualified deferred annuity before annuitizing. What is the usual federal tax treatment of the withdrawal?

• a.The amount is tax-free because annuities grow on a tax-deferred basis
• b.The entire amount is taxed as a long-term capital gain at the lower rate
• c.Earnings come out first as ordinary income, plus a 10% additional tax before 59 1/2✓
• d.Principal comes out first and is tax-free, with the earnings taxed later

Nonqualified annuity withdrawals are taxed on a last-in, first-out basis: earnings first, as ordinary income, and the 10% additional tax applies before 59 1/2. First-in, first-out is the opposite order. Annuity gains are not capital gains. Tax-deferred is not tax-free.

A retiree annuitizes a nonqualified annuity. The investment in the contract is $100,000, and the expected return, meaning the total of all payments expected over the payout period, is $200,000. If monthly payments are $1,000, how much of each payment is excludable from income?

• a.$100, because only 10% of each payment is a return of cost
• b.$333, because the exclusion ratio is $100,000 / $300,000
• c.$1,000, because the investment in the contract is tax-free
• d.$500, because the exclusion ratio is 50% ($100,000 / $200,000)✓

The exclusion ratio = investment in the contract / expected return = $100,000 / $200,000 = 50%, so $500 of each $1,000 payment is a tax-free return of capital. Dividing by $300,000 adds the investment to an expected return that already includes it. A 10% ratio has no basis in these figures, and treating the whole payment as tax-free ignores that the growth portion is taxable. Once the full investment has been recovered, later payments are fully taxable.26 U.S.C. §72(b)(1)

An investor buys one XYZ 50 call at a premium of $3. At expiration, what is the breakeven stock price?

• a.$47
• b.$53✓
• c.$56
• d.$50

A call buyer breaks even when the stock equals strike plus premium: $50 + $3 = $53. Subtracting the premium gives $47, which is the put buyer's breakeven. The strike alone is only the point where the option starts to have intrinsic value. $56 doubles the premium.

An investor sells one ABC 40 put at a premium of $2 per share. What is the investor's maximum possible loss?

• a.$4,000
• b.$200
• c.Unlimited
• d.$3,800✓

The put seller can lose at most the strike less the premium if the stock falls to zero: ($40 - $2) x 100 = $3,800. $200 is the maximum gain. $4,000 ignores the premium received. Unlimited loss applies to an uncovered call, because a stock price has no upper limit.

An investor owns 100 shares of DEF bought at $48 and writes one DEF 50 call for a $2 premium. What is the maximum gain if the call is exercised?

• a.$600
• b.Unlimited
• c.$400✓
• d.$200

If the stock is called away at $50, the investor gains $2 on the shares plus the $2 premium: $4 x 100 = $400. The premium alone is $200. $600 double counts the premium. The upside is capped by the strike, so gains cannot be unlimited.