FINRA Series 7 — All Questions

A company reports net income of $64,000, income taxes of $22,000, interest expense of $11,000, and depreciation and amortization of $18,000. What is its EBITDA?

• a.$97,000
• b.$93,000
• c.$104,000
• d.$115,000✓

Work back up the income statement: $64,000 net income + $22,000 taxes + $11,000 interest + $18,000 depreciation and amortization = $115,000. The $97,000 figure is EBIT, which stops before adding back depreciation and amortization. The $93,000 figure leaves out the tax add-back. The $104,000 figure leaves out the interest add-back.Financial statements: EBITDA

A retailer buys 100 units at $10, later buys 100 units at $12, and then sells 100 units at $20 each. Prices are rising. Using LIFO, what is the gross profit on the sale?

• a.$900
• b.$1,200
• c.$800✓
• d.$1,000

LIFO charges the most recent cost to the units sold, so cost of goods sold is 100 x $12 = $1,200 and gross profit is $2,000 - $1,200 = $800. The $1,000 figure is the FIFO result, which charges the older $10 cost. The $900 figure uses the $11 average cost. The $1,200 figure is LIFO cost of goods sold, not gross profit. In rising prices LIFO reports the lowest profit of the three methods.Financial statements: inventory costing (LIFO vs FIFO)

Equipment costing $100,000 has a five-year life and a salvage value of $10,000. What is the annual depreciation expense under the straight-line method?

• a.$90,000
• b.$100,000
• c.$20,000
• d.$18,000✓

Straight-line depreciation spreads the depreciable base evenly: ($100,000 - $10,000) / 5 years = $18,000 per year. The $20,000 figure divides the full cost by five and ignores salvage value. The $90,000 figure is the depreciable base before it is spread over the five years. The $100,000 figure is the full cost, which is the amount recovered over the whole life and not a single year's expense.Financial statements: depreciation methods

A company pays $50 million to acquire another company whose identifiable net assets have a fair value of $38 million. How does the buyer record the $12 million difference?

• a.As an expense on the income statement in the year of purchase
• b.As a reduction of shareholders' equity at the date of purchase
• c.As a $50 million intangible asset after the purchase is closed
• d.As goodwill, an intangible asset on its balance sheet✓

The amount paid above the fair value of identifiable net assets is capitalized as goodwill and carried as an intangible asset. It is not expensed in the year of purchase and does not reduce shareholders' equity. Only the $12 million excess is goodwill; the $38 million of identifiable net assets is recorded at fair value, so labeling the whole $50 million as an intangible would overstate it.Financial statements: goodwill and intangible assets

An analyst wants to learn which inventory costing method a company uses and the schedule of its long-term debt maturities. Where in the annual report is that detail found?

• a.In the notes (footnotes) to the financial statements✓
• b.In the statement of cash flows, among the financing items
• c.In the income statement, beside the cost of goods sold line
• d.In the auditor's report, within the opinion paragraph itself

The notes to the financial statements disclose accounting policies, such as the inventory method, and details behind balance sheet items, such as debt maturities and contingent liabilities. The income statement reports amounts, not the methods behind them. The cash flow statement shows cash raised or repaid, not the maturity schedule. The auditor's report gives an opinion on the fairness of the statements and does not describe the company's policies.Financial statements: footnotes and auditor's report

A company reports common stock at par of $500,000, paid-in capital in excess of par of $4,500,000, retained earnings of $2,000,000 and treasury stock of $300,000. What is total shareholders' equity?

• a.$6,200,000
• b.$6,700,000✓
• c.$7,300,000
• d.$7,000,000

Equity is par $500,000 + paid-in capital $4,500,000 + retained earnings $2,000,000 = $7,000,000, less treasury stock of $300,000 = $6,700,000. Treasury stock is a contra-equity account because the shares were bought back. The $7,000,000 figure ignores the buyback. The $7,300,000 figure adds the treasury stock instead of subtracting it. The $6,200,000 figure omits the par value.Financial statements: shareholders' equity

During the year a company issued $5 million of bonds, paid $2 million of common dividends, repurchased $1 million of its own stock, and bought $3 million of equipment. What is its net cash from financing activities?

• a.$1 million used
• b.$5 million provided
• c.$2 million provided✓
• d.$3 million provided

Financing activities cover debt, equity and dividends: +$5 million from bonds, -$2 million dividends and -$1 million buyback, for $2 million provided. The equipment purchase is an investing activity and does not belong here; including it would produce $1 million used. The $3 million figure ignores the stock repurchase. The $5 million figure counts only the bond proceeds.Financial statements: cash flow statement

A company begins the year with retained earnings of $1,200,000, earns net income of $400,000, and pays dividends of $150,000. What are its ending retained earnings?

• a.$650,000
• b.$1,750,000
• c.$1,600,000
• d.$1,450,000✓

Ending retained earnings = beginning $1,200,000 + net income $400,000 - dividends $150,000 = $1,450,000. The $1,600,000 figure ignores the dividends paid. The $1,750,000 figure adds the dividends instead of subtracting them. The $650,000 figure subtracts net income instead of adding it.Financial statements: retained earnings

A company reports net income of $200,000, depreciation of $50,000, and an increase in accounts receivable of $30,000. Using the indirect method, what is its cash flow from operating activities?

• a.$250,000
• b.$280,000
• c.$220,000✓
• d.$120,000

Start with net income of $200,000 and add back the non-cash depreciation of $50,000. Receivables that grew by $30,000 mean sales were booked but not yet collected, so that amount is subtracted: $200,000 + $50,000 - $30,000 = $220,000. The $250,000 figure skips the receivables adjustment. The $280,000 figure adds the receivables increase. The $120,000 figure subtracts depreciation as well.Financial statements: cash flow from operations

A company has current assets of $840,000 and current liabilities of $600,000. What is its working capital?

• a.$840,000
• b.$1,440,000
• c.$600,000
• d.$240,000✓

Working capital is current assets minus current liabilities: $840,000 - $600,000 = $240,000. The $1,440,000 figure adds the two instead of subtracting. The $840,000 and $600,000 figures are single inputs, current assets and current liabilities, not the difference between them.Financial ratios: working capital

A company has current assets of $840,000 and current liabilities of $600,000, a current ratio of 1.40. It pays $100,000 of accounts payable with cash. What is its current ratio afterward?

• a.1.48 to 1✓
• b.1.4 to 1
• c.1.2 to 1
• d.1.7 to 1

Paying the payables with cash cuts current assets to $740,000 and current liabilities to $500,000, so the ratio is $740,000 / $500,000 = 1.48. Because the ratio started above 1, using equal amounts of current assets and current liabilities pushes it higher. The 1.4 figure assumes no change. The 1.2 figure (1.23 before rounding) reduces only current assets. The 1.7 figure (1.68 before rounding) reduces only current liabilities.Financial ratios: current ratio

A company has cost of goods sold of $1,200,000, sales of $1,800,000, beginning inventory of $180,000 and ending inventory of $220,000. What is its inventory turnover?

• a.9 times
• b.5.5 times
• c.6.7 times
• d.6 times✓

Inventory turnover is cost of goods sold divided by average inventory. Average inventory is ($180,000 + $220,000) / 2 = $200,000, so $1,200,000 / $200,000 = 6. The 5.5 figure uses only ending inventory. The 6.7 figure uses only beginning inventory. The 9.0 figure uses sales instead of cost of goods sold.Financial ratios: inventory turnover

A company has total assets of $5.0 million and total liabilities of $3.0 million. What is its debt-to-equity ratio, measured as total liabilities divided by shareholders' equity?

• a.0.67 to 1
• b.1.5 to 1✓
• c.0.6 to 1
• d.2.5 to 1

Equity is $5.0 million - $3.0 million = $2.0 million, so $3.0 million / $2.0 million = 1.5 to 1. The 0.6 figure divides liabilities by total assets, which is the debt ratio. The 0.67 figure flips the ratio and divides equity by liabilities. The 2.5 figure divides total assets by equity.Financial ratios: leverage (debt-to-equity)

A company reports earnings before interest and taxes (EBIT) of $3.6 million, depreciation of $1.2 million and annual bond interest of $1.2 million. What is its bond interest coverage ratio?

• a.2.0 times
• b.3.0 times✓
• c.0.33 times
• d.4.0 times

Bond interest coverage is EBIT divided by bond interest: $3.6 million / $1.2 million = 3.0 times. The 4.0 figure uses EBITDA of $4.8 million, which adds back depreciation. The 2.0 figure divides the amount left after interest by interest. The 0.33 figure turns the ratio upside down.Financial ratios: bond interest coverage

A company reports net income of $450,000 and preferred dividends of $50,000. Total shareholders' equity is $3,000,000, of which $500,000 is preferred stock. What is its return on common equity?

• a.13.3%
• b.15%
• c.18%
• d.16%✓

Return on common equity uses earnings available to common and the common equity only: ($450,000 - $50,000) / ($3,000,000 - $500,000) = $400,000 / $2,500,000 = 16%. The 15% figure ignores the preferred altogether. The 13.3% figure removes the dividends but keeps preferred in the equity base. The 18% figure keeps the dividends in earnings but removes preferred from the base.Financial ratios: return on equity

A company has sales of $2,400,000, cost of goods sold of $1,500,000, operating expenses of $500,000 and taxes of $100,000, with no interest expense. What is its net profit margin?

• a.37.5%
• b.16.7%
• c.4.2%
• d.12.5%✓

Net income is $2,400,000 - $1,500,000 - $500,000 - $100,000 = $300,000, and $300,000 / $2,400,000 = 12.5%. The 37.5% figure is the gross margin, measured before operating expenses. The 16.7% figure is the operating margin, measured before taxes. The 4.2% figure is the tax bill as a share of sales.Financial ratios: net profit margin

A company earns $3.00 per share, pays $0.75 per share in dividends and trades at $50. What is its dividend payout ratio?

• a.6%
• b.1.5%
• c.25%✓
• d.75%

The payout ratio is dividends per share divided by earnings per share: $0.75 / $3.00 = 25%. The 1.5% figure is the dividend yield, dividends over price. The 6% figure is the earnings yield, earnings over price. The 75% figure is the share of earnings retained, which is the complement of the payout.Financial ratios: dividend payout ratio

A company has net income of $3,000,000 and 1,000,000 common shares outstanding. It also has convertible bonds that would add 200,000 shares and carry after-tax interest of $300,000. What are its fully diluted earnings per share?

• a.$2.50
• b.$3.00
• c.$2.92
• d.$2.75✓

Assume conversion: add the 200,000 shares to the count and add back the after-tax interest saved. Diluted EPS = ($3,000,000 + $300,000) / 1,200,000 = $2.75. The $3.00 figure is basic EPS before any conversion. The $2.50 figure adds the shares but forgets to add back the interest. The $2.92 figure adds back $500,000 of pre-tax interest instead of the after-tax amount.Financial ratios: fully diluted earnings per share

A company has net income of $5,000,000, 100,000 preferred shares with a $50 par value paying 6%, and 2,000,000 common shares outstanding. What are its earnings per common share?

• a.$2.65
• b.$2.50
• c.$2.24
• d.$2.35✓

Preferred dividends come out first: 100,000 x $50 x 6% = $300,000. Earnings available to common are $4,700,000, and $4,700,000 / 2,000,000 = $2.35. The $2.50 figure ignores the preferred dividend. The $2.65 figure adds the dividend instead of subtracting it. The $2.24 figure divides by 2,100,000 shares, counting the preferred shares in the common share count.Financial ratios: earnings per share after preferred dividends

A company has total assets of $90 million, intangible assets of $10 million and current liabilities of $20 million. It has 40,000 bonds of $1,000 par outstanding and no other debt. What is the asset coverage per bond?

• a.$1,500✓
• b.$2,250
• c.$1,750
• d.$2,000

Net tangible assets are total assets less intangibles and current liabilities: $90 million - $10 million - $20 million = $60 million. Divided by 40,000 bonds, coverage is $1,500 per bond. The $2,250 figure uses total assets without any deduction. The $2,000 figure ignores current liabilities. The $1,750 figure ignores intangibles.Financial ratios: asset coverage per bond

A company reports net income of $7,200,000, depreciation of $2,400,000, and 3,000,000 shares outstanding. What is its cash flow per share, measured as net income plus depreciation divided by shares?

• a.$1.60
• b.$2.40
• c.$3.20✓
• d.$0.80

Cash flow adds back the non-cash depreciation charge: ($7,200,000 + $2,400,000) / 3,000,000 = $3.20. The $2.40 figure is earnings per share, with no add-back. The $1.60 figure subtracts depreciation instead of adding it. The $0.80 figure is depreciation per share alone.Financial ratios: cash flow per share

A stock has a beta of 1.5. The risk-free rate is 3% and the expected return on the market is 9%. What return does the capital asset pricing model require for this stock?

• a.12%✓
• b.13.5%
• c.9%
• d.16.5%

CAPM required return = risk-free rate + beta x (market return - risk-free rate) = 3% + 1.5 x (9% - 3%) = 12%. The 9% figure is simply the market return, which fits a beta of 1.0. The 13.5% figure multiplies beta by the whole market return and ignores the risk-free rate. The 16.5% figure adds the risk-free rate to beta times the whole market return instead of the 6% premium.Portfolio theory: capital asset pricing model

A stock with a beta of 1.2 returned 11% over the year. The risk-free rate was 2% and the market returned 8%. What was the stock's alpha?

• a.9.2%
• b.+3%
• c.-1.8%
• d.+1.8%✓

Expected return under CAPM = 2% + 1.2 x (8% - 2%) = 9.2%. Alpha is the actual return minus the expected return: 11% - 9.2% = +1.8%, so the stock beat what its risk called for. The -1.8% figure reverses the subtraction. The +3% figure compares the stock with the market return of 8% and ignores beta. The 9.2% figure is the expected return itself, not the excess over it.Portfolio theory: alpha

A portfolio has an expected annual return of 8% and a standard deviation of 12%. If returns are normally distributed, within what range will the return fall about 68% of the time?

• a.-4% to 8%
• b.-4% to 20%✓
• c.-16% to 32%
• d.8% to 20%

About 68% of outcomes fall within one standard deviation of the mean: 8% - 12% = -4% and 8% + 12% = 20%. The range of -16% to 32% is two standard deviations, which covers about 95% of outcomes. The ranges of -4% to 8% and 8% to 20% each look only one side of the mean, so neither describes the symmetric band.Portfolio theory: standard deviation

The risk-free rate is 3%. Portfolio A earned 12% with a standard deviation of 15%. Portfolio B earned 9% with a standard deviation of 8%. Which portfolio performed better on a risk-adjusted basis by the Sharpe ratio?

• a.Portfolio A, because its 12% return is higher than Portfolio B's 9% return
• b.Portfolio A, since its 9-point excess return beats B's 6 points
• c.Neither, since both portfolios beat the risk-free rate by a wide margin
• d.Portfolio B, at 0.75 of excess return per unit of risk, against A's 0.60✓

The Sharpe ratio is (return - risk-free rate) / standard deviation. Portfolio A: (12% - 3%) / 15% = 0.60. Portfolio B: (9% - 3%) / 8% = 0.75. Portfolio B earned more excess return for each unit of risk. Looking only at raw return or raw excess return ignores risk, which is what the ratio adjusts for. Both beating the risk-free rate says nothing about how efficiently each did it.Portfolio theory: Sharpe ratio

A customer holds 40 stocks spread across many industries. Which risk is NOT meaningfully reduced by adding more stocks of this kind?

• a.Business risk specific to one company's operations
• b.Management risk tied to one firm's executive team
• c.Event risk from a lawsuit against a single issuer
• d.Market risk that moves nearly all stocks together✓

Diversification removes unsystematic risk, the risk peculiar to one issuer, such as its operations, a lawsuit or its management. Systematic (market) risk affects virtually all stocks at once, so holding more of them leaves it largely intact. Only hedging, asset allocation to other asset classes or a lower beta changes exposure to it.Portfolio theory: systematic and unsystematic risk

An advisor wants to lower the volatility of a customer's all-stock portfolio by adding one more holding. Which candidate offers the greatest diversification benefit?

• a.A small-cap fund with a correlation of +0.6 to it
• b.An asset with a correlation of 0 to the portfolio
• c.A second large-cap fund with a correlation of +0.9
• d.An asset with a correlation of -0.8 to the portfolio✓

The lower the correlation, the more the new holding's swings offset those of the portfolio, so -0.8 gives the largest reduction in volatility. A correlation near +1 adds almost nothing, and +0.6 helps only a little. Zero correlation helps, but offsetting movement from a negative correlation is stronger.Portfolio theory: correlation and diversification

A customer who works for a public company has 70% of her portfolio in her employer's stock and says she wants to keep it because she knows the business well. Which recommendation best fits her suitability profile?

• a.Sell the position in stages and diversify into a broader mix✓
• b.Buy shares of the employer's top competitors to spread out the holding
• c.Keep the position, since her knowledge of the company lowers the risk
• d.Buy more through payroll deductions, building on her knowledge

A 70% position in one issuer exposes both her portfolio and her paycheck to the same company. Reducing it gradually and diversifying the proceeds addresses concentration risk while allowing for taxes and timing. Familiarity does not remove company-specific risk. Competitors in the same industry share many of the same risks, so they diversify little, and adding to the position makes the concentration worse.Portfolio construction: concentrated positions

A portfolio manager's policy target is 60% stocks and 40% bonds. Expecting stocks to outperform over the next six months, she temporarily moves to 70% stocks and 30% bonds. What is this strategy called?

• a.Strategic allocation
• b.Tactical asset allocation✓
• c.Dollar-cost averaging
• d.Constant-mix rebalancing

Tactical asset allocation makes short-term deviations from the long-term target to exploit expected market conditions. Strategic asset allocation is the long-term 60/40 mix itself. Rebalancing would move the portfolio back toward the target, not away from it. Dollar-cost averaging means investing a fixed dollar amount at regular intervals.Portfolio construction: tactical asset allocation

A portfolio plots below the efficient frontier on a risk-and-return chart. What does that tell an analyst?

• a.The portfolio's expected return is below the risk-free rate
• b.A portfolio with the same risk and a higher return exists✓
• c.The portfolio holds only market risk and no company-specific risk
• d.The portfolio has a beta below 1.0 and so is not diversified

The efficient frontier shows the highest expected return available at each level of risk. A portfolio below it is inefficient: the same return could be earned with less risk, or more return could be earned at the same risk. A position below the line says nothing about its beta, nor does it mean the return is below the risk-free rate or that only market risk remains.Portfolio theory: efficient frontier

A customer has both a traditional IRA and a taxable account. Which holding is the poorest choice to place inside the traditional IRA?

• a.A high-turnover fund that distributes short-term gains
• b.Taxable corporate bonds, whose interest is taxed each year
• c.Municipal bonds, whose tax-exempt interest gains nothing there✓
• d.REIT shares that pay large taxable dividends each year

Interest from municipal bonds is already exempt from federal income tax, so holding them in a traditional IRA wastes that benefit, and withdrawals are taxed as ordinary income anyway. Corporate bonds, REIT shares and high-turnover funds all produce income that would be taxed currently in a taxable account, so sheltering them in the IRA is the better use of the account.Portfolio construction: asset location and taxes

A portfolio is 60% invested in a stock with a beta of 1.5 and 40% in a stock with a beta of 0.5. If the market falls 10%, by about how much is the portfolio expected to decline?

• a.9%
• b.11%✓
• c.15%
• d.10%

Portfolio beta is the weighted average: 0.6 x 1.5 + 0.4 x 0.5 = 0.90 + 0.20 = 1.10. A beta of 1.10 means the portfolio moves 1.10 times the market, so a 10% decline in the market implies about an 11% decline. The 10% figure uses a simple average beta of 1.0. The 15% figure uses only the higher beta. The 9% figure uses only the 0.90 contribution of the first stock.Portfolio theory: portfolio beta

A company is soliciting proxies for an annual meeting at which directors will be elected. When must the annual report to shareholders be furnished?

• a.Only to shareholders who ask for a copy
• b.With the proxy statement or before it✓
• c.Within 30 days after the proxy statement
• d.Within 90 days after the meeting takes place

Under Rule 14a-3(b), when directors are to be elected at the meeting, the annual report must accompany or precede the proxy statement so that holders can read the financial results before they vote. It is not delivered after the meeting, and it is not limited to holders who request it.Annual reports and proxy statements: Rule 14a-3

A stock closes at $90 per share on the day before a 3-for-2 forward split takes effect. With no other news, what is the theoretical opening price after the split?

• a.$30.00
• b.$60.00✓
• c.$135.00
• d.$45.00

A 3-for-2 split gives holders three shares for every two, so total market value is unchanged and the price adjusts by the inverse ratio: $90 x 2 / 3 = $60.00. The $135.00 figure multiplies by 3/2, which is what a reverse split would do. The $30.00 figure divides by three and ignores the two. The $45.00 figure treats the event as a 2-for-1 split.Corporate actions: forward split and share price

A bidder seeks 1,000,000 shares in a partial tender offer, and 2,500,000 shares are validly tendered. If the offer is prorated, how many of a customer's 10,000 tendered shares are accepted?

• a.6,000 shares
• b.10,000 shares
• c.2,500 shares
• d.4,000 shares✓

In a partial tender offer, shares are taken up pro rata among those tendered. The proration factor is 1,000,000 / 2,500,000 = 40%, so 40% of 10,000 = 4,000 shares are accepted and the rest are returned. The 10,000-share answer assumes everything tendered is taken. The 6,000-share answer uses the 60% that is not accepted. The 2,500-share answer divides by four instead of applying 40%.Tender offers: Rule 14d-8 proration

The bidder has taken substantial steps toward a tender offer that has not been announced. An analyst at a firm that advises the bidder learns of it and buys target shares for her own account. Which statement is correct?

• a.She violates Rule 14e-3, which bars trading on tender offer information from the bidder✓
• b.She does not violate it, because the information did not come from the target
• c.She does not violate it, provided the purchase is under 5% of the target's shares
• d.She does not violate it, since she owes no duty to the target's shareholders

Rule 14e-3 makes it fraudulent to trade on material, nonpublic information about a tender offer when the trader knows it came from the bidder, the target or their agents and the bidder has taken substantial steps. No breach of duty to the target's shareholders is needed and the source need not be the target. The 5% figure is a Schedule 13D concept and creates no safe harbor.Tender offers: Rule 14e-3

A partial tender offer is made for XYZ stock. A customer owns 5,000 shares of XYZ and is short 2,000 shares. What is the most she may tender?

• a.3,000 shares✓
• b.5,000 shares
• c.2,000 shares
• d.7,000 shares

Rule 14e-4 allows a person to tender in a partial tender offer only up to the net long position, which is the long position minus the short position: 5,000 - 2,000 = 3,000 shares. The 5,000-share answer ignores the short sale. The 7,000-share answer adds the short instead of subtracting it. The 2,000-share answer is the short position alone.Tender offers: Rule 14e-4 net long position

Which of the following corporate actions requires the shareholder to decide whether to participate?

• a.A tender offer for the company's common shares✓
• b.A forward stock split declared by the board
• c.A cash dividend declared by the board
• d.A mandatory call of convertible preferred

A tender offer is voluntary: each holder chooses whether to tender, and holders who do nothing keep their shares. Splits and cash dividends happen to all holders automatically. A mandatory call forces redemption or conversion on the terms of the security, so no decision is needed for it to take effect.Corporate actions: voluntary vs mandatory

A parent company distributes shares of its subsidiary Spinco at a ratio of one Spinco share for every five parent shares. How many Spinco shares does a customer who owns 500 parent shares receive?

• a.2,500 shares
• b.500 shares
• c.100 shares✓
• d.5 shares

In a spin-off, holders receive shares of the subsidiary in proportion to their parent shares: 500 / 5 = 100 Spinco shares, and the parent shares stay in the account. The 2,500-share answer multiplies by five instead of dividing. The 500-share answer assumes one-for-one. The 5-share answer divides by 100.Corporate actions: spin-offs

A customer owns a 7% bond callable at 103, and market rates for similar bonds have fallen to 4%. Which risk is most directly threatening her income stream?

• a.Interest rate risk, since the bond's price will fall as market rates fall
• b.Call risk, since the issuer may redeem it early and she must reinvest at 4%✓
• c.Credit risk, since the issuer's ability to pay weakens as rates fall
• d.Purchasing power risk, since lower rates reduce her income's real value

When rates fall well below a bond's coupon, an issuer has an incentive to call the bond and refinance at the lower rate. The holder is left with the call price and must reinvest at about 4%, which cuts her income. A bond's price rises, not falls, when market rates fall. Falling rates do not impair the issuer's credit, and the threat here is a lost coupon, not inflation.Investment risk: call risk

A retiree who planned to hold her actively traded blue-chip stocks for ten years must sell them to pay a medical bill, during a bear market that has cut their price by a third. The shares sell instantly. Which risk does this describe?

• a.Credit risk
• b.Timing risk✓
• c.Liquidity risk
• d.Reinvestment risk

Timing risk is the risk of being forced to buy or sell at an unfavorable moment. Here the need for cash forced a sale at a depressed price. Liquidity risk is the difficulty of selling without a large price concession, and these shares sell instantly. Credit risk concerns an issuer's ability to pay, and reinvestment risk concerns where interest and principal can be reinvested.Investment risk: timing risk

A U.S. investor buys a stock listed in euros. Over the year its euro price rises 10%, but the euro falls 10% against the dollar. What is the investor's approximate return in dollars?

• a.No net change
• b.A loss of 1%✓
• c.A loss of 10%
• d.A gain of 10%

The dollar value changes by the product of the two moves: 1.10 x 0.90 = 0.99, a loss of 1%. A gain of 10% counts the local price rise and ignores the currency. A loss of 10% counts the currency and ignores the local gain. Simply netting 10% against 10% to get no change overlooks that the percentages compound.Investment risk: currency risk

A customer owns a thinly traded corporate bond. When she tries to sell, the best bid is far below the last reported trade, and few dealers will quote it. Which risk is she facing?

• a.Legislative risk
• b.Liquidity risk✓
• c.Prepayment risk
• d.Reinvestment risk

Liquidity risk is the risk that an investment cannot be sold quickly without accepting a substantial price concession. The wide bid-ask gap and the lack of dealers are the signs. Prepayment risk applies to mortgage-backed securities, reinvestment risk concerns the rate earned on cash received, and legislative risk concerns changes in law.Investment risk: liquidity risk

A customer plans to invest $500,000 in a fund family and hold it for at least 15 years. Which share class generally fits best?

• a.Class C, because its contingent deferred charge ends after one year
• b.Class C, because there is no front-end charge and nothing is paid up front
• c.Class A, since breakpoints cut the sales charge and its 12b-1 fee is lower✓
• d.Either class, because the total cost over a long hold is the same

At $500,000 a Class A purchase earns breakpoint discounts on the front-end load, and Class A carries a lower annual 12b-1 fee than the level-load Class C. Over a long holding period the higher ongoing fee in Class C compounds, so Class C usually costs more. Avoiding a charge up front or after a year does not make up for paying the higher fee every year.Costs and fees: mutual fund share classes

A client has a $400,000 portfolio and makes four trades a year with a commission of $275 each. A fee-based account would charge 1.25% of assets a year. How much more would the client pay each year in the fee-based account?

• a.$6,100 more
• b.$1,100 more
• c.$5,000 more
• d.$3,900 more✓

The fee-based account costs 1.25% x $400,000 = $5,000. The commission account costs 4 x $275 = $1,100. The difference is $5,000 - $1,100 = $3,900. The $5,000 figure is the fee alone, and the $1,100 figure is the commissions alone. The $6,100 figure adds the two instead of comparing them. For a low-trading client the fee-based account may not be suitable.Costs and fees: fee-based vs commission accounts

A variable annuity's surrender charge is 7% in contract year 1 and falls by one percentage point each year. During contract year 4 the owner withdraws $30,000 in excess of any free amount. What surrender charge applies?

• a.$1,200✓
• b.$1,500
• c.$2,100
• d.$900

The charge in year 4 is 7% - 3 points = 4%, so 4% x $30,000 = $1,200. The $1,500 figure applies the 5% rate of year 3. The $900 figure applies the 3% rate of year 5. The $2,100 figure applies the 7% first-year rate to the withdrawal.Costs and fees: annuity surrender charges

An adviser with discretion pays a broker a commission higher than another broker would have charged, in return for research. Under the Section 28(e) safe harbor, what must the adviser have determined in good faith?

• a.The broker charged the lowest commission available for that particular transaction in the market
• b.The commission was reasonable in relation to the value of the brokerage and research received✓
• c.Every client whose commissions paid for the research benefited from that particular research
• d.The client approved in writing the use of its commissions to pay for the research on each trade

Section 28(e) of the Exchange Act protects a money manager from a claim of breach of fiduciary duty for paying more than the lowest available commission if the manager determined in good faith that the amount was reasonable in relation to the value of the brokerage and research services provided, judged by either the particular transaction or the manager's overall responsibilities. It does not require the lowest rate, a per-client benefit or written approval of every trade.Costs and fees: soft dollars (Section 28(e))

A customer holds $80,000 in a fund whose total annual expense ratio is 0.85%, which includes a 0.25% 12b-1 fee. About how much does the fund cost her each year?

• a.$200
• b.$480
• c.$680✓
• d.$880

The expense ratio already includes the 12b-1 fee, so the annual cost is 0.85% x $80,000 = $680. The $880 figure adds the 12b-1 fee a second time (1.10%). The $480 figure leaves the 12b-1 fee out (0.60%). The $200 figure is the 12b-1 fee alone.Costs and fees: expense ratio and 12b-1 fees

A stock closed at $54, $51, $55, $53 and $56 over the last five trading days. What is its five-day simple moving average?

• a.$56.00
• b.$53.80✓
• c.$54.00
• d.$53.75

A simple moving average adds the closing prices and divides by the number of days: ($54 + $51 + $55 + $53 + $56) / 5 = $269 / 5 = $53.80. The $53.75 figure leaves out one of the days and divides by four. The $54.00 figure is the median close, not the average. The $56.00 figure is just the latest close.Technical analysis: moving averages

A chart shows three troughs with the middle one the deepest. Price then breaks up through the neckline on rising volume. How do technicians read this?

• a.As a bearish reversal of the earlier advance
• b.As a bullish reversal of the earlier decline✓
• c.As a trading range that carries no signal
• d.As a continuation of the earlier decline

Three troughs with a lower middle trough form an inverted head and shoulders, a bottoming pattern. A breakout above the neckline on rising volume confirms a reversal of the downtrend. A bearish reversal of an advance is the signal from the regular head and shoulders top. A continuation signal would come from a flag or pennant, not a rounded bottom with a breakout.Technical analysis: chart patterns (inverted head and shoulders)