FINRA Series 7 — All Questions

A normal (positive) yield curve exists when:

• a.Short-term interest rates are higher than long-term rates all along the maturity spectrum of the curve
• b.Municipal yields exceed corporate yields
• c.All maturities yield the same amount
• d.Longer maturities carry higher yields than shorter maturities✓

A normal yield curve slopes upward because investors demand higher yields to lend for longer periods, compensating for greater interest-rate and inflation risk. An inverted curve (short rates above long) is the opposite and can signal an expected slowdown.

Which of the following are considered leading economic indicators?

• a.Building permits, new manufacturing orders, and stock prices, which tend to change before the broad economy✓
• b.The prime rate and the average duration of unemployment, both lagging
• c.Corporate profits and GDP, which are coincident measures
• d.The unemployment rate, a lagging figure

Leading indicators, such as building permits, new orders, stock prices, and initial jobless claims, tend to move ahead of the overall economy. GDP and corporate profits are coincident, while unemployment duration and the prime rate are lagging indicators.

M2 is best described as:

• a.A broad measure of the money supply including currency, checking and savings deposits, and retail money-market funds✓
• b.The monetary base: currency in circulation plus bank reserve balances at the Federal Reserve
• c.The reserves that banks are required to hold against their checking deposits, a ratio the Federal Reserve now sets at zero percent
• d.M1 alone: currency, demand deposits, and other liquid deposits, with no time deposits or retail funds

M2 is a broad monetary aggregate: it consists of M1 (currency, demand deposits and other liquid deposits) plus small-denomination time deposits and balances in retail money market funds, as the Federal Reserve defines it in the H.6 release. The monetary base is a narrower measure of currency in circulation plus bank reserve balances. Required reserves are a regulatory ratio, not a measure of the money supply. M1 by itself leaves out the small time deposits and retail money market funds that make up the rest of M2.Federal Reserve Statistical Release H.6 (Money Stock Measures)

Demand-pull inflation occurs when:

• a.Aggregate demand outpaces the economy's productive capacity, pushing prices up✓
• b.Prices broadly fall because the supply of goods persistently exceeds total consumer demand in the economy
• c.A one-time tax increase reduces spending
• d.Unemployment rises while prices fall

Demand-pull inflation results from total demand for goods and services exceeding the economy's ability to produce them, bidding prices upward. It contrasts with cost-push inflation, which stems from rising input costs such as wages or raw materials.

Purchasing power (inflation) risk most seriously affects:

• a.A basket of physical commodities
• b.Long-term fixed-income securities with level payments, whose real value erodes as prices rise✓
• c.A broadly diversified portfolio of common stocks whose earnings and dividends tend to rise along with the general price level
• d.Directly owned real estate

Inflation risk is the danger that rising prices erode the real value of fixed cash flows. Long-term bonds and fixed annuities are most exposed because their payments do not increase with inflation, while equities, real estate, and commodities may adjust with price levels.

A mutual fund share has a net asset value (NAV) of $19.05, and the maximum sales charge is 5% of the public offering price. What is the public offering price?

• a.$20.00, found by adding 5% of the NAV to the NAV
• b.$19.05, the NAV itself with no sales charge added
• c.$20.05✓
• d.$18.10, found by subtracting 5% of the NAV from the NAV

Sales charges are expressed as a percentage of the offering price (FINRA Rule 2341), so POP = NAV / (1 - 0.05) = $19.05 / 0.95 = $20.05. The $1.00 sales charge is about 5% of the $20.05 offering price. Adding 5% of the NAV treats the charge as a markup on NAV and gives only $20.00, which is just 4.76% of the price the customer actually pays. The NAV alone is the price of a no-load share, and subtracting 5% of the NAV moves the price the wrong way.FINRA Rule 2341(d)

An investor is bullish on a stock but wants to cap both the premium paid and the maximum possible loss. Which position fits best?

• a.Debit call spread (buy a lower-strike call, sell a higher-strike call)✓
• b.Long straddle (buy a call and a put at the same strike and expiration)
• c.A bearish credit call spread that is established for a net premium credit received
• d.Long put spread (buy a higher-strike put, sell a lower-strike put) for a net debit

A debit call spread (bull call spread) buys a call and sells a higher-strike call for a net debit. The net debit is the most the investor can lose, and the gain is capped at the strike difference less the debit, so it is a cheaper bullish position than buying the call outright. A long straddle profits from a large move in either direction and costs more, not less. A credit call spread is bearish and gains when the stock stays below the short strike. A long put spread also has capped cost and loss but profits when the stock falls.

A callable bond is purchased at a discount, and its call price is at or above par. Of the four measures, which yield is the highest?

• a.Current yield (annual interest divided by the price paid)
• b.Yield to maturity (return if held to the maturity date)
• c.Yield to call✓
• d.Nominal yield (the stated coupon rate on par)

For a bond bought at a discount the ranking from lowest to highest is nominal yield, current yield, yield to maturity, then yield to call. A call returns par or more, which is above the discounted purchase price, sooner than maturity does, so the same gain is earned over a shorter period and the annualized yield is higher. Nominal yield ignores the discount and the price paid, current yield counts only the interest, and yield to maturity spreads the gain over the longest period. On a discount bond yield to maturity is the yield to worst; on a premium bond the order reverses and yield to call is the lowest.

A company reports current assets of $600,000, of which $200,000 is inventory, and current liabilities of $250,000. What is its acid-test (quick) ratio?

• a.1.6 to 1✓
• b.1.2 to 1
• c.2.4 to 1
• d.0.8 to 1

Quick assets exclude inventory: $600,000 less $200,000 is $400,000, and $400,000 divided by $250,000 is 1.6. A ratio of 2.4 is the current ratio, which leaves inventory in. A ratio of 0.8 divides inventory alone by current liabilities. A ratio of 1.2 removes far more than the inventory.Financial statement analysis (liquidity ratios)

A stock trades at $50 per share and pays a quarterly dividend of $0.40. What is its current dividend yield?

• a.3.2%✓
• b.6.4%
• c.0.8%
• d.1.6%

Annual dividends are $0.40 x 4 = $1.60, and $1.60 / $50 = 3.2%. A yield of 0.8% divides a single quarterly payment by the price. A yield of 1.6% is the annual dollar dividend, not a percentage. A yield of 6.4% doubles the correct result.Fundamental analysis (dividend yield)

A company earned net income of $10 million, paid $2 million of preferred dividends, and has 4 million common shares outstanding. The common stock trades at $45. What is its price-earnings ratio?

• a.90.0
• b.18.0
• c.22.5✓
• d.11.25

Earnings available to common are $10 million - $2 million = $8 million, so EPS is $2.00 and the P/E is $45 / $2.00 = 22.5. A ratio of 18.0 ignores the preferred dividends (EPS of $2.50). A ratio of 11.25 divides price by shares outstanding. A ratio of 90.0 treats the preferred dividend as the earnings figure.Fundamental analysis (price-earnings ratio)

A company has total assets of $120 million, of which $10 million is intangible, total liabilities of $50 million, preferred stock of $10 million at par, and 5 million common shares outstanding. Using the standard method that excludes intangible assets, what is its book value per common share?

• a.$12.00
• b.$14.00
• c.$10.00✓
• d.$8.00

Book value per share = (total assets - intangibles - liabilities - preferred) / common shares = ($120M - $10M - $50M - $10M) / 5M = $10.00. A figure of $12.00 forgets to subtract the preferred stock. A figure of $14.00 also ignores the intangibles. A figure of $8.00 deducts the preferred stock twice.Fundamental analysis (book value per share)

A corporation has $40 million of bonds outstanding, $15 million of preferred stock, and $45 million of common equity, for total capitalization of $100 million. What is its bond ratio?

• a.55%
• b.66.7%
• c.40%✓
• d.88.9%

The bond ratio is bonds divided by total capitalization: $40M / $100M = 40%. A ratio of 55% adds the preferred stock to the debt. A ratio of 66.7% divides bonds by the equity accounts without the preferred, which is not total capitalization. A ratio of 88.9% divides bonds by common equity alone.Fundamental analysis (bond ratio)

An investor buys 1 ABC 40 call for 3 and exercises it when ABC trades at 55. What is the investor's cost basis per share in the stock acquired?

• a.$55
• b.$43✓
• c.$40
• d.$52

On exercise of a long call, the premium is added to the strike price: $40 + $3 = $43 per share. A basis of $40 ignores the premium paid. A basis of $52 subtracts the premium from the market price. A basis of $55 uses the market price on the exercise date, which is not what the investor paid.Options tax and cost basis

An investor sells 1 DEF 60 put for 4 and is assigned when DEF trades at 52. What is the investor's net cost per share, counting the premium received?

• a.$56✓
• b.$52
• c.$64
• d.$60

The writer must buy at the 60 strike but keeps the 4 premium, so the net cost is $60 - $4 = $56. A cost of $60 ignores the premium received. A cost of $52 uses the market price, but the assigned writer pays the strike. A cost of $64 adds the premium instead of subtracting it.Options tax and cost basis

An investor owns 100 shares of GHI bought at $50. The investor buys 1 GHI 45 put for 1.50 and sells 1 GHI 55 call for 2.00. What is the maximum loss on the position?

• a.$500
• b.$550
• c.$450✓
• d.$150

The put costs $1.50 and the call brings in $2.00, a net credit of $0.50. The most the stock can lose below the 45 put strike is $5.00, reduced by the credit, so the maximum loss is $4.50 x 100 = $450. A loss of $500 ignores the credit. A figure of $550 is the maximum gain. A figure of $150 is the put premium alone and ignores the fall in the stock.Options strategies (collar)

An investor buys 1 JKL 50 call for 8, sells 2 JKL 55 calls for 5 each, and buys 1 JKL 60 call for 3. What is the maximum gain?

• a.$100
• b.$400✓
• c.$500
• d.$1,000

The net cost is 8 + 3 - 10 = a 1 point debit. The position peaks if JKL closes at 55: the 50 call is worth 5, so the gain is 5 - 1 = 4 points, or $400. A gain of $500 ignores the debit. A figure of $100 is the maximum loss. A figure of $1,000 is the premium collected on the short calls.Options strategies (butterfly spread)

An investor buys 1 MNO 55 call for 2 and buys 1 MNO 45 put for 1. At expiration, at which two stock prices does the position break even?

• a.$42 and $58✓
• b.$47 and $53
• c.$45 and $55
• d.$43 and $57

The combined premium is 3 points. The put side breaks even at 45 - 3 = 42, and the call side at 55 + 3 = 58. Breakevens at the strike prices ($45 and $55) ignore the cost of the premiums. The $43 and $57 pair uses only the larger premium. The $47 and $53 pair moves the breakevens inside the strikes, where the position still loses money.Options strategies (long strangle)

An investor sells short 100 shares of PQR at $40 and buys 1 PQR 45 call for 2. What is the investor's maximum loss?

• a.$200
• b.$700✓
• c.$500
• d.Unlimited

If PQR rises above 45 the call offsets further loss, so the most the investor can lose is the 5-point rise to the strike plus the 2-point premium: 7 points, or $700. A loss of $500 leaves out the premium. A loss of $200 counts only the premium. A short sale without a hedge has unlimited risk, but the purchased call caps it.Options strategies (protective call)

A TIPS has a $1,000 par value, a 2% coupon, and an inflation-adjusted principal of $1,050. What is each semiannual interest payment?

• a.$21.00
• b.$10.00
• c.$5.25
• d.$10.50✓

TIPS pay the coupon rate on the adjusted principal: 2% x $1,050 = $21.00 a year, or $10.50 each half year. A payment of $10.00 applies the coupon to the original par. A payment of $21.00 is the full annual amount. A payment of $5.25 divides the semiannual amount a second time.Treasury inflation-protected securities

Which of the following debt securities is backed by the full faith and credit of the U.S. government?

• a.Freddie Mac (FHLMC) participation certificates
• b.Federal Home Loan Bank consolidated obligations
• c.Fannie Mae (FNMA) mortgage-backed securities
• d.Ginnie Mae (GNMA) pass-through certificates✓

GNMA certificates carry the explicit full faith and credit guarantee of the U.S. government. Fannie Mae and Freddie Mac are government-sponsored enterprises whose securities are not backed by the government's full faith and credit. Federal Home Loan Bank obligations are likewise debts of a government-sponsored system, not direct obligations of the Treasury.Government agency securities

A fund meets the 75-5-10 diversification test for 75% of its assets. On that portion, what are the limits on one issuer?

• a.No more than 10% of total assets and no more than 5% of its voting shares
• b.No more than 10% of total assets and no more than 10% of its voting securities
• c.No more than 5% of total assets and no more than 10% of its voting stock✓
• d.No more than 5% of total assets and no more than 5% of the issuer's voting stock

For at least 75% of its assets, a diversified fund may hold no more than 5% of its total assets in any one issuer and no more than 10% of that issuer's outstanding voting securities. The other pairings reverse the two limits or set them to the same percentage, which is not what the statute provides.Investment Company Act of 1940, Section 5(b)(1)

Apart from narrow emergency exceptions, what is the longest period an open-end fund may postpone paying redemption proceeds after a shareholder tenders shares?

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

Section 22(e) of the Investment Company Act bars a fund from postponing payment of redemption proceeds for more than seven days after tender, except in specified cases such as an exchange closing or an emergency affecting valuation. Three, fifteen and thirty days do not match the statutory limit.Investment Company Act of 1940, Section 22(e)

Which parties create and redeem exchange-traded fund shares in large blocks called creation units?

• a.The exchange specialist assigned to the fund
• b.Authorized participants, usually large broker-dealers✓
• c.The fund's custodian, using cash from shareholders
• d.Individual investors who buy shares on an exchange

ETF shares are created and redeemed in creation units by authorized participants, typically large institutional broker-dealers that deliver or receive baskets of securities. Individual investors trade existing shares in the secondary market. The custodian holds assets but does not create units, and an exchange market maker does not issue shares.Exchange-traded funds

Commercial paper issued to finance current transactions is exempt from Securities Act registration only if its maturity at issuance does not exceed:

• a.Nine months✓
• b.Six months
• c.One year
• d.Two months

Section 3(a)(3) exempts notes and similar paper arising from current transactions with a maturity at issuance of not more than nine months. Six months and two months are shorter than the statute allows, and one year is longer, which would take the paper outside the exemption.Securities Act of 1933, Section 3(a)(3)

An investor buys an 8% preferred stock with a $25 par value at a market price of $20. What is the current yield?

• a.12.5%
• b.10%✓
• c.6.4%
• d.8%

The annual dividend is 8% of the $25 par, or $2.00, and $2.00 / $20 = 10%. A yield of 8% is the stated rate on par, not the yield on the lower market price. A yield of 6.4% applies the 8% to the market price and then divides by par. A yield of 12.5% uses a $2.50 dividend, which is not 8% of par.Preferred stock yield

A customer can sell an interest in a thinly traded limited partnership only at a steep discount, if at all. Which risk does this describe?

• a.Reinvestment risk
• b.Purchasing power risk
• c.Credit risk
• d.Liquidity risk✓

Liquidity risk is the difficulty of selling an asset quickly without a large price concession, which is typical of partnership interests with no active market. Reinvestment risk concerns falling rates on reinvested income, purchasing power risk concerns inflation, and credit risk concerns an issuer's ability to pay.Investment risks (liquidity risk)

A stock has a beta of 1.4. If the overall market rises 10%, the stock's expected change is approximately:

• a.A 10% gain
• b.A 1.4% gain
• c.A 7% gain
• d.A 14% gain✓

Beta measures sensitivity to the market, so a beta of 1.4 implies about 1.4 x 10% = 14%. A 10% gain would be a beta of 1.0. A 7% gain divides by the beta instead of multiplying. A 1.4% gain confuses the beta with a percentage move.Investment risks (beta)

A corporate bond has an 8% coupon and $1,000 par. Interest was last paid on March 1, and the trade settles on May 16. Using the corporate 30/360 day count, how much accrued interest does the buyer pay?

• a.$16.67✓
• b.$6.67
• c.$20.00
• d.$13.33

From March 1 to May 16 is 75 days on a 30-day-month basis. Accrued interest is $1,000 x 8% x 75/360 = $16.67. A figure of $13.33 counts only 60 days, and $20.00 counts 90 days. A figure of $6.67 counts only 30 days.Corporate bond accrued interest

A retiree paid $60,000 of after-tax money for an annuity with an expected return of $100,000. How is each $1,000 monthly payment taxed under the exclusion ratio?

• a.$600 is a tax-free return of investment and $400 is taxable✓
• b.$400 is a tax-free return of investment and $600 is taxable
• c.All $1,000 is tax-free because the contract was bought with after-tax dollars
• d.All $1,000 is taxable as capital gains

The exclusion ratio is the investment in the contract divided by the expected return: $60,000 / $100,000 = 60%. So $600 of each payment is excluded and $400 is taxed as ordinary income. Reversing the split gets the ratio backwards. Annuity earnings are ordinary income, not capital gains, and buying with after-tax dollars exempts only the return of basis.Annuity taxation (exclusion ratio)

An investor buys one XYZ 40 call for a premium of $2.50. What is the breakeven price at expiration?

• a.$42.50, strike plus the premium paid✓
• b.$37.50, the strike less the premium paid
• c.$45.00, the strike plus twice the premium paid
• d.$40.00, the strike price with no premium added

A call buyer needs the stock to rise far enough to recover the premium, so breakeven is the $40 strike plus the $2.50 premium, or $42.50. Subtracting the premium is the breakeven formula for a put buyer. The strike alone ignores the cost of the option, and doubling the premium has no basis in the contract.OCC Options Disclosure Document

A customer sells one ABC 60 put for a premium of $4. What is the customer's maximum possible loss, ignoring commissions?

• a.$6,000, the strike times 100, no premium credit
• b.Unlimited, because the stock has no upper price limit
• c.$5,600, the strike less the premium, all times 100✓
• d.$400, the premium collected on the contract

A put writer may have to buy 100 shares at $60 if the stock falls to zero, a $6,000 outlay, but the $400 premium collected offsets part of it, so the worst case is $5,600. Ignoring the premium overstates the loss. The premium is the writer's maximum gain, not the loss. Unlimited loss belongs to an uncovered call writer, because a stock can fall only to zero.OCC Options Disclosure Document

An investor owns 100 shares bought at $48 and sells one 50 call for $3. What is the maximum gain on this position?

• a.$200, the stock gain up to the strike only
• b.Unlimited, as the stock can rise without any limit
• c.$300, the premium collected with no stock gain
• d.$500, the $3 premium plus the $2 gain up to the strike✓

If the stock finishes at or above $50 the shares are called away at $50, giving a $2 gain per share plus the $3 premium, or $500 in total. The premium alone ignores the stock gain, and the stock gain alone ignores the premium. The upside is capped at the strike because the shares are delivered at $50 however high the price rises.OCC Options Disclosure Document

An investor buys one ABC 50 call for 3 and one ABC 50 put for 2. At expiration, at what stock prices does the position break even?

• a.$50 only, since the call and the put offset each other
• b.$47 and $52, the strike less the call premium and plus the put premium
• c.$45 and $55, the strike less and plus the $5 combined premium✓
• d.$48 and $53, the strike less the put premium and plus the call premium

A long straddle must recover both premiums, so the stock must move $5 either way: $45 on the downside and $55 on the upside. Applying only one premium to each side mixes the legs and gives the wrong prices. At $50 both options expire worthless and the investor loses the full $5, so the strike itself is the point of maximum loss.OCC Options Disclosure Document

A bond pays a fixed 5% coupon. Market rates on new comparable bonds then rise to 6%. How will the existing bond trade?

• a.At a premium until the first call date, then at par
• b.At a premium, because higher rates lift the price of older bonds
• c.At a discount, since its coupon is below the new market rate✓
• d.At par, since the coupon is fixed for the life of the bond

Buyers will not pay full price for a 5% coupon when 6% is available, so the price falls until the yield to a new buyer matches the market, which means a discount. A fixed coupon does not keep the price at par; it is why the price must move. Prices of existing bonds move opposite to rates, so a premium would require falling rates.Fixed income pricing

A $1,000 par bond with a 6% coupon trades at $800. What is its current yield?

• a.6.7%, the annual interest divided by the average of price and par
• b.25.0%, the $200 discount divided by the $800 price
• c.7.5%, the $60 annual interest divided by the $800 price✓
• d.6.0%, the stated coupon rate printed on the face of the bond

Current yield is annual interest divided by current market price: $60 over $800 is 7.5%. The coupon rate is measured against par, not the price paid. Averaging price and par does not produce current yield. The $200 discount is a one-time gain at maturity, not annual income.Fixed income pricing

Rates are expected to rise. Which bond would lose the most value?

• a.A 30-year bond with an 8% coupon, since a higher coupon raises risk
• b.A 5-year Treasury note, since Treasuries lose value fastest
• c.A 30-year zero-coupon bond, paying nothing until maturity✓
• d.A 2-year zero-coupon bond, since zeros are always the most volatile

Interest rate risk grows with the time until cash is received. A 30-year zero pays nothing until maturity, so its present value falls the most. The coupon on the 30-year bond returns cash along the way and shortens its effective life, and the 5-year note and 2-year zero have far shorter lives. A zero is most volatile only when maturities are comparable.Fixed income pricing

What backs a general obligation municipal bond?

• a.The issuer's taxing power, together with its full faith and credit✓
• b.Only the revenues of the facility the bond financed
• c.A federal government guarantee of principal and interest
• d.A pledge of a single excise tax such as the state fuel tax

General obligation bonds are repaid from the issuer's ability to tax, usually property taxes, backed by full faith and credit. Repayment from a facility's revenues describes a revenue bond. Municipal bonds carry no federal guarantee, and a pledge of one dedicated tax describes a special tax bond.Municipal securities

An investor in the 28% federal bracket is comparing a 4.5% municipal bond to a taxable bond. What taxable yield equals the municipal yield?

• a.6.25%, found by dividing the 4.5% yield by 0.72✓
• b.4.50%, since municipal interest is free of federal tax
• c.5.76%, found by multiplying 4.5% by 1.28
• d.3.24%, found by multiplying 4.5% by 0.72

Tax-equivalent yield is the tax-free yield divided by one minus the tax rate: 4.5% over 0.72 is 6.25%. Multiplying by 1.28 understates it, and multiplying by 0.72 gives the after-tax yield of a taxable bond, not the equivalent. A tax-free 4.5% is worth more than 4.5% to someone paying 28%, so the nominal figure is not equivalent.Municipal securities

How is interest on U.S. Treasury notes taxed?

• a.No income tax applies when the note is held to maturity
• b.State and local income tax applies, but federal income tax does not
• c.Federal income tax applies, but state and local income taxes do not apply✓
• d.Federal, state and local income taxes all apply to the interest

Treasury interest is taxed by the federal government and exempt from state and local income tax. The reverse describes no federal obligation. Taxing at every level would defeat the state exemption, and holding to maturity does not remove the federal tax on interest.IRC and Treasury securities

A fund has $52 million in assets, $2 million in liabilities and 2.5 million shares outstanding. What is its net asset value per share?

• a.$20.00, $50 million of net assets over the shares✓
• b.$19.20, with liabilities subtracted from assets twice
• c.$20.80, total assets divided by the shares outstanding
• d.$21.60, with the liabilities added to total assets

NAV is assets minus liabilities, divided by shares: $50 million over 2.5 million is $20. Dividing total assets ignores what the fund owes. Subtracting liabilities twice or adding them both misstate net assets.Investment company mathematics

A mutual fund quotes a net asset value of $19.00 and charges a 5% sales charge, expressed as a percent of the public offering price. What is the public offering price?

• a.$19.95, found by adding 5% of the NAV to the NAV
• b.$18.05, the NAV less 5% of the NAV
• c.$20.00, found by dividing the NAV by 0.95✓
• d.$19.00, since the NAV is what every buyer pays

A sales charge stated as a percent of the offering price means NAV equals 95% of that price, so $19.00 over 0.95 is $20.00. Adding 5% to the NAV treats the charge as a percent of NAV. Subtracting it would give a price below NAV. Paying only NAV applies to no-load funds.FINRA Rule 2341

What is the highest sales charge an open-end investment company may impose under FINRA's sales charge rule?

• a.10% of the public offering price
• b.5.75% of the public offering price
• c.8.5% of the offering price✓
• d.7.0% of the total amount invested

FINRA caps the sales charge on open-end fund shares at 8.5% of the offering price, and lower caps apply when the fund lacks certain features such as breakpoints. The 5.75% figure is a common front-end load in practice, not the cap. The other figures are not limits in the rule.FINRA Rule 2341

Which statement describes a closed-end investment company's shares?

• a.They trade in the secondary market at supply-and-demand prices✓
• b.They are offered continuously by the fund at the public offering price
• c.They are redeemed by the issuing fund at net asset value on request
• d.They are priced once per day at the close of the market

Closed-end funds issue a fixed number of shares that then trade on an exchange or over the counter, often at a premium or discount to NAV. Redemption at NAV, continuous offering and once-a-day pricing all describe open-end funds.Investment Company Act of 1940

To avoid tax at the corporate level, a real estate investment trust must distribute at least what share of its taxable income?

• a.50%, with the balance kept as retained earnings
• b.75%, after deducting property depreciation
• c.90%, distributed to shareholders as dividends each year✓
• d.100%, with no income retained by the trust at all

A REIT that distributes at least 90% of its taxable income receives a dividends-paid deduction and avoids corporate tax on that income. Lower figures do not qualify, and the law does not require a full 100% payout. Depreciation is already part of figuring taxable income.Internal Revenue Code Section 857

During the accumulation period of a variable annuity, who bears the investment risk of the separate account?

• a.The state guaranty fund, up to the owner's cost basis
• b.The contract owner, as accumulation units rise and fall✓
• c.The insurer, which guarantees the value of each unit it issues
• d.The selling broker-dealer, which holds the units

A variable annuity passes investment performance directly to the owner through accumulation units in a separate account. An insurer guaranteeing unit value describes a fixed annuity. Guaranty associations cover insurer failure, not market losses, and a broker-dealer does not bear contract performance.Variable annuity regulation

A 50-year-old owner paid $50,000 into a nonqualified annuity now worth $70,000 and withdraws $10,000. How is the withdrawal taxed?

• a.All $10,000 is taxed at long-term capital gains rates
• b.All $10,000 is ordinary income, since earnings come out first✓
• c.Only $2,857 is taxable, the earnings fraction of each withdrawal
• d.None is taxable, since $10,000 is below the $50,000 cost basis

Withdrawals from a nonqualified annuity are treated as earnings first, and earnings are ordinary income, so the entire $10,000 is taxable. An owner under 59 and a half generally owes a 10% additional tax as well. The pro-rata method applies to annuitized payments, not withdrawals, and annuity earnings never receive capital gains treatment.Internal Revenue Code Section 72

How are new shares of an exchange-traded fund created?

• a.The fund sells shares through an initial public offering only
• b.Authorized participants swap baskets of stock for creation units✓
• c.The exchange itself issues new shares as demand rises
• d.Retail investors buy new shares directly from the fund at NAV

Authorized participants, usually large firms, deliver a basket of securities to the fund in return for a creation unit of ETF shares and can redeem units the same way. Retail investors buy and sell on the exchange. An ETF is not limited to one offering, and the exchange does not issue shares.Exchange-traded products

A customer asks about holding a 3x leveraged ETF for several months. What should the representative explain?

• a.It targets its multiple for a single day, so longer results may differ✓
• b.It reduces losses because the fund resets and removes risk
• c.It holds the index stocks directly, so the holding period is irrelevant
• d.It delivers three times the index return over any period held

Leveraged and inverse ETFs reset daily, so compounding can make multi-day returns differ sharply from the stated multiple of the index return. They do not promise the multiple over longer periods, they use derivatives and borrowing rather than simple index holdings, and they increase risk rather than removing it.FINRA Regulatory Notice 09-31

An issuer skipped two quarterly dividends on its cumulative preferred stock and now wants to pay a common dividend. What must happen?

• a.The preferred holders rank ahead of the bondholders for the arrears
• b.The arrears are paid only after bondholders vote to approve
• c.The common dividend may be paid, since skipped dividends lapse
• d.Preferred dividends in arrears must be paid first✓

Cumulative preferred accumulates unpaid dividends, and the issuer must pay the arrears, plus the current dividend, before any common dividend. They do not lapse. No bondholder vote is needed, and preferred stockholders never rank ahead of bondholders in a claim on the issuer.Preferred stock features